It’s a new year and that means there is a new list of inductees to the Dividend Aristocrats index – a group of companies with 25+ years of consecutive dividend increases.

One of the new inductees is General Dynamics, an aerospace and defense company with strong ties to the U.S. government.

Historically, General Dynamics has generated strong total returns, particularly in the past four years. The image below shows the performance of General Dynamics against the S&P 500 over the past decade.

Source: Yahoo! Finance

While General Dynamics may be one of the newest Dividend Aristocrats, it is still an attractive investment. General Dynamics is the only company in the following peer group to be a Dividend Aristocrat:

• Boeing (BA)
• United Technologies (UTX)
• Lockheed Martin (LMT)
• General Dynamics (GD)

Being a Dividend Aristocrat matters. The index has meaningfully outperformed the broader stock market over long periods of time, as the image below shows.

Source:  S&P

This post will analyze the investment prospects of General Dynamics in detail.

Business Overview

General Dynamics is an aerospace and defense company with headquarters in Fairfax County, Virginia.

The company can trace its roots back to the 1800s. The first iteration of General Dynamics was called the Holland Torpedo Boat Company and was responsible for producing some of the U.S. Navy’s first submarines.

Fast forward a few decades, and the company was reorganized under the current name in 1952. After decades of operational churn, the company now operates under four main business umbrellas:

• Aerospace (27% of 2016 revenue)
• Combat Systems (18% of 2016 revenue)
• Information Systems and Technology (29% of 2016 revenue)
• Marine Systems (26% of 2016 revenue)

General Dynamics’ revenue by operating segment for fiscal 2015 and 2016 is broken down in the following diagram.

Source: General Dynamics Quarterly Report

Growth Prospects & Competitive Advantage

General Dynamics has a huge backlog of future work that will ensure their growth for the foreseeable future. The total potential contract value of the company’s backlog is nearly $85 billion (which is 2.7 times 2016’s revenues) and the backlog is well-diversified across the company’s operating segments.

Source: General Dynamics 8-K

This backlog will be the source of General Dynamics’ revenue growth over time – which their CFO estimated to be 5.6% through 2020 on the company’s fourth quarter conference call.

General Dynamics’ competitive advantage comes from their patent portfolio and R&D capabilities. The company is responsible for the production of Gulfstream Jets, the Abrams and Stryker family of battle tanks, and a wide variety of lesser-known sophisticated weapons products.

Needless to say, the nature of General Dynamics’ business does not lend itself well to new competition. Most of the aerospace & defense industry’s business goes to well-established companies like General Dynamics, Lockheed Martin, Boeing, or United Technologies.

General Dynamics also has a strong competitive advantage stemming from their relationship with the U.S. government. In fiscal 2015, 57% of the company’s revenues were generated from this source.

Source: General Dynamics 2015 10-K

General Dynamics’ U.S. Government revenues are split into three categories:

• Department of Defense (DoD)
• Non-DoD
• Foreign Military Sales (FMS)

While the first two are rather straightforward, the Foreign Military Sales sub-segment is a bit more unorthodox. Under this agreement, General Dynamics sells products and services to non-U.S. governments while the U.S. government assumes the risk of collection from the customer.

This means that these sales can be grouped in with the rest of their U.S. Government business, since it is the domestic government that is ultimately responsible for payment.

The end result is more sales backed by a very reliable customer.

The General Dynamics-U.S. Government relationship is likely going to be even more of a tailwind given that the new Trump administration, which is expected to raise military spending by somewhere between $500 billion and $1 trillion.

While not all of this new business will be with General Dynamics, the company will surely benefit from this increase in spending.

Recession Performance

General Dynamics reported admirable financial performance during the 2008-2009 financial crisis.

This is largely because of the contractual nature of the company’s income streams – their counterparties were still legally obliged to pay for the company’s products and services, which provided downside protection to General Dynamics’ revenues.

In 2008 specifically, the company a significant increase in earnings-per-share of 20.2%. The rest of their performance during the financial crisis was also positive:

• 2007: $5.10
• 2008: $6.13 (20.2% increase)
• 2009: $6.20 (1.1% increase)
• 2010: $6.82 (10.0% increase)
• 2011: $6.94 (1.8% increase)

Given that General Dynamics did not report a single year of negative earnings growth during the 2008-2009 financial crisis (one of the worst in history), I am confident in the company’s ability to weather future economic downturns.

Valuation & Expected Total Returns

Based on January 31’s closing stock price of $181.08 and the company’s recently-reported earnings-per-share of $9.87 for fiscal 2016, General Dynamics is currently trading for 18.4 times 2016’s earnings.

On a looking-forward basis, the company’s valuation is slightly more attractive. Analysts expect $10.15 of earnings-per-share for General Dynamics for fiscal 2017.

Based on the same closing price of $181.08, this represents a forward price-to-earnings ratio of 17.8.

The following diagram compares how these figures compare to General Dynamic’s historical valuation levels.

Source: Value Line

The company’s current valuation exceeds its historical levels by a wide margin.

This is the opposite of what I would expect – typically, a company’s valuation will tend to compress as it becomes larger, all else being equal.

However, General Dynamics’ valuation compares favorably to the market as a whole. The S&P 500 currently trades with a price-to-earnings ratio of 25.6, which is a 39% premium over General Dynamics’ on a trailing basis.

So while the company is not pricey compared to the rest of the market, it’s still trading above its historical levels. I expect valuation contractions will reduce future shareholder returns for General Dynamics.

Other sources of returns for General Dynamic’s shareholders will be from earnings growth and the company’s current dividend yield.

I believe that investors can expect earnings growth that is in line with the company’s historical average. Further, it might be reasonable to expect a faster pace of earnings growth in the near-term as the company benefits from increased government defense spending.

The following diagram outlines General Dynamics’ EPS growth over time.

Source: Value Line

Over the past 16 years, General Dynamics grew their EPS from $2.24 in 2000 to $9.87 in 2016. This is good for a CAGR of 9.7%.

While this is certainly a high growth rate, I believe it is sustainable because of the company’s strong backlog and healthy relationship with the U.S. government (which will grow even more under the Trump administration).

I expect 8%-10% EPS growth for General Dynamics in the long run.

The last component of General Dynamics’ total return will be their dividend yield. The company’s last quarterly dividend was $0.76 per share, which equates to $3.04 annually. With the company’s current stock price of $181.08, their forward dividend yield is 1.7%.

Altogether, expected total returns for General Dynamics shareholders will be composed of:

• 1.7% dividend yield
• 8%-10% earnings growth

giving a base-case total return of 9.7%-11.7%. However, it is highly likely that valuation contraction will be a detriment to total returns given the company’s current valuation.

Final Thoughts

As one of two new additions to the Dividend Aristocrats index, General Dynamics has demonstrated an impressive ability to grow dividend payments in the long-term.

The company has a strong business model founded on contractual revenue streams. Further, they are well-poised to profit from boosts in defense spending under the new Trump administration.

General Dynamics is a high-quality business. Investors should look to create (or add to) a position when the valuation moderates to a more attractive level.