Getting Defensive with Defense

12/17/2008 11:15 am EST

Focus: STOCKS

Paul Larson

Editor, Morningstar StockInvestor

Paul Larson, editor of Morningstar StockInvestor, says a major defense contractor is an attractive stock in the current rocky market.

While many defense contractors pursue new programs at any cost, General Dynamics (NYSE: GD) takes a more focused approach.

Like the other top five defense contractors, GD boasts prime contracts for large, strategically important platforms. But unlike its peers, the firm’s revenue base is well balanced among submarines, ships, tanks, armaments, ammunition, land vehicles, and even a growing information-technology practice.

About two-thirds of the firm’s sales are to the US government, with the balance made up by sales to foreign governments and business jet customers. The firm is based in Falls Church, Va., and employs about 81,000 people.

GD is one of [the] few defense players that has consistently generated returns above its cost of capital and, consequently, has earned a “wide moat” rating. Shunning risky projects, GD directs resources to building capabilities on established platforms [such as] submarines and warships are unlikely to ever be phased out of the military, but few competitors have the resources to match GD, especially when it comes to engineering new variants that meet the changing requirements of the Defense Department.

Although the firm will likely maintain its incumbent position on high-return projects, management isn’t sitting on its hands. The leadership of GD assiduously doles out dividends and repurchases shares while shrewdly waiting to pounce on new opportunities.

The latest project involves MRAPs (mine-resistant ambush-protected vehicles)—land vehicles that can withstand roadside bombs, which have become a leading cause of casualties in Iraq. The firm quickly teamed up with Force Protection (Nasdaq: FRPT), the innovator of these vehicles, to build up large-scale manufacturing to meet increasing delivery schedules, and this project [may be a stepping stone] for the even-larger program of next-generation joint light tactical vehicles.

GD’s management is among the best in the industry, led by Nicholas Chabraja. Having taken the helm in 1997, Chabraja has overseen a period when GD solidified its lead in marine and land systems while expanding into business jets. He is flanked by chief financial officer Hugh Redd, a 20-year company veteran who recently replaced retiring CFO Michael Mancuso.

Chabraja has been particularly adept at maximizing shareholder value from existing products while extending and expanding the firm’s capabilities. Chabraja is planning his own retirement in 2009, but this does not necessarily mean that the firm’s performance will falter, as the firm possesses a culture focused on returns on capital. (Board member Jay Johnson, chief executive officer of Dominion Virginia Power, will take over as CEO next July—Editor.)

We recently reduced our fair value estimate to $81 to factor in a slightly greater equity risk assumption. (The shares closed above $56 Tuesday—Editor.) We expect revenue to increase at a 5% annual rate during the next nine years. We also expect companywide operating margins to scale higher before declining mildly. GD’s defense-related businesses generally exhibit more steady margins, but we expect the aerospace segment to fluctuate in response to cyclicality. As a result, companywide operating margins will be affected proportionately.

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