Part-way through earnings season, the outlook remains bright. Many of the most high-quality dividend stocks have beat expectations, and corporate earnings seem to be growing at a rate higher than previous expectations (although time will tell if this trend holds).

On July 26, General Dynamics (GD) reported earnings for the three-month period ending July 2, 2017.

General Dynamics is a well-known dividend stock, partially due to its long dividend history.

The company’s annual dividend payments have increased for 26 years, making it one of the ‘youngest’ members of the Dividend Aristocrats – a group of dividend stocks with 25+ years of consecutive dividend increases. You can see the full list of all 51 Dividend Aristocrats here.

General Dynamics’ second quarter earnings results contained satisfactory growth from this high-quality business.

This article will analyze the company’s second quarter earnings release and investigate whether General Dynamics’ stock is a buy at current prices.

Business Overview & Second Quarter Financial Performance

General Dynamics is a military and defense contractor with a market capitalization of $58.5 billion.

The company is divided into four main segments for reporting purposes:

• Aerospace
• Combat Systems
• Information Systems and Technology
• Marine Systems

Each segment’s contribution to second quarter revenues can be seen below.

Source: General Dynamics Second Quarter Earnings Release

General Dynamics’ main competitors include:

• Boeing (BA)
• United Technologies (UTX)
• Lockheed Martin (LMT)
• Raytheon (RTN)

General Dynamics’ second quarter earnings release was strong from a number of perspectives.

The company reported diluted earnings-per-share of $2.45, a 6.5% increase from the $2.30 reported in the same period a year ago.

In addition, General Dynamics’ company-wide net income of $749 million on revenues of $7.7 billion implied a profit margin of 9.7%. Excluding non-operating expenses, the company’s operating margin of 13.8% expanded by 60 basis points (or 0.60%) from the same period a year ago.

The most important part of General Dynamics’ earnings release was the company’s revision of full-year earnings-per-share guidance.

More specifically, General Dynamics increased per-share profit guidance from $9.50 – $9.55 to $9.70 – $9.75. At the midpoint, this represents an increase of 2.1% over the previous guidance band.

General Dynamics also provided an update on its current share repurchase program.

The company repurchased 2.7 million of its outstanding common shares during the quarter, bringing its year-to-date share repurchase total to 4.6 million.

For context, General Dynamics reported basic weighted average shares outstanding of 299.8 million. The company’s year-to-date share repurchase total of 4.6 million represents ~1.5% of the company’s current total, putting General Dynamics on pace for a ~3% reduction in shares outstanding over the full-year of 2016.

Source: General Dynamics Second Quarter Earnings Release

At current prices, General Dynamics’ year-to-date share repurchases of 4.6 million carry a market value of $898 million.

The company has paid $483 million in dividends during the same time period, which combines for a total shareholder return of ~$1.4 billion.

Clearly, General Dynamics is shareholder-friendly, with a preference for share repurchases over dividend payments.

Dividend Safety & Valuation Analysis

General Dynamics has a very high degree of dividend safety. We can show this from a number of perspectives.

First, the company reported cash and equivalents of $1.9 billion at the end of the most recent quarter.

How does this compare to their periodic dividend payments?

Over the six month period ending July 2, 2017, General Dynamics paid $483 million in dividend payments. The company’s current cash account is sufficient to pay its dividend for nearly four six-month periods (or two years) if the business environment turns completely sour and General Dynamics’ business stops generating cash completely.

However, that is an impossibility. General Dynamics has a proven ability to continue operating profitably through even the toughest economic environments.

Remarkably, the company increased its adjusted earnings-per-share each and every year of the 2007-2009 financial crisis:

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

The company is currently well-positioned to continue generating rising profits, largely thanks to its impressive backlog of contracts with creditworthy counterparties like the U.S. government.

At the end of General Dynamics’ second quarter, the company’s backlog totaled $58.6 billion, with a total potential contract value of ~$83 billion.

Source: General Dynamics Second Quarter Earnings Release

Amazingly, General Dynamics’ backlog is roughly equal to its market capitalization. The company’s contracted business model is unique and gives investors comfort knowing that the company can continue operating even if defense spending experiences a temporary downturn.

The last way we can consider General Dynamics dividend safety is through the traditional payout ratio: dividends-per-share divided by earnings-per-share.

Since 2001, the highest payout ratio reported by General Dynamics in a full fiscal year was 32% (which is near where the metric sits today).

Source: Value Line

General Dynamics’ conservative payout ratio gives the company plenty of room to continue its impressive streak of dividend increases even if earnings stagnant for a period of time.

It also gives the dividend a significant level of downside protection. General Dynamics’ earnings would need to be cut by two-thirds before its dividend came under pressure.

The only detractor from General Dynamics’ dividend is its relatively low yieldof 1.7% – though, an investor’s yield on cost for this security will certainly grow over time thanks to consistent annual dividend increases.

General Dynamics’ strong fundamental growth and its dividend safety make it appealing for the conservative, long-term investor.

Unfortunately, while the business looks great, the stock looks overvalued.

Ever since the outcome of the last presidential election was announced in November of 2016, any stock with a relationship to the defense sector has risen dramatically due to the possibility of increased defense spending under President Trump.

General Dynamics is no different. The company’s stock price since the beginning of last November can be seen below.

Source: YCharts

General Dynamics’ stock has surged since November, which raises concerns for value investors. We can examine the company’s fundamentals to determine whether General Dynamics is overvalued relative to historic norms.

As mentioned, General Dynamics recently updated its 2017 earnings guidance to a range of $9.70-$9.75 per share. We’ll use the midpoint of this guidance range: $9.725.

The company’s current stock price of $194.86 is trading at a price-to-earnings ratio of 20.0 using 2017’s expected earnings. The following diagram compares General Dynamics’ current valuation to its long-term historical average:

Source: Value Line

General Dynamics’ average price-to-earnings ratio since 2001 is 13.8, while its current price-to-earnings ratio is 20.

Right now is not the time to buy General Dynamics’ stock. Relative to earnings, shares are trading at a notable premium to normal levels because of the market hype surrounding increases in defense spending.

Final Thoughts

There was plenty to like about General Dynamics’ second quarter earnings release:

• Diluted earnings-per-share up 6.5%
• Operating margin expansion of 60 basis points
• A 2.1% increase to 2017’s full-year earnings-per-share guidance

Looking ahead, General Dynamics is well-positioned to continue delivering satisfactory earnings growth thanks to its impressive contract backlog and the possibility of boosts to defense spending under the new presidential administration.

However, these growth catalysts are outweighed by the stock’s expensive valuation. General Dynamics’ current price-to-earnings ratio of 20 is a 40%+ premium to its long-term average of 13.8.

The potential for increased defense spending has generated irrational interest in this stock from the investment community. Simply put, General Dynamics is a popular security right now.

As we know, popularity is not the defining characteristic of a good investment.

“Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can’t buy what is popular and do well.”

– Warren Buffett

Patient investors should wait for a better opportunity to buy General Dynamics stock. This high-quality business remains a hold for existing investors, particularly those with low cost bases; long-term, business fundamentals should continue to grow at a solid basis.