Chit Chat Stocks - General Dynamics (Ticker: GD) Not So Deep Dive

Episode Date: May 9, 2023

General Dynamics Corporation (GD) is a global aerospace and defense company that produces a range of products from business aviation to combat vehicles and has contracts with the US government and other countries. At the end of the month, we will publish an Arch Capital episode that will cover the company: Dropbox. Listen closely as Brett and Ryan go through the history, financials, and future prospects of General Dynamics. Enjoy the show! ****************************** Subscribe to our Substack to receive free show notes and charts that go along with every episode: https://chitchatmoney.substack.com/ Want updates on future shows and projects? Follow us on Twitter: https://twitter.com/chitchatmoney Contact us: [e-mail] Timestamps Company Background | (2:00) Industry | (17:22) Management & Ownership | (21:46) Earnings | (24:40) Balance Sheet | (27:35) Valuation | (28:35) Our Analysis | (29:45) Disclosure: Chit Chat Money hosts and guests are not financial advisors, and nothing they say on this show is formal advice or a recommendation. Brett Schafer and Ryan Henderson are general partners and portfolio managers at Arch Capital. Arch Capital and its partners may hold securities discussed on this show. Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to Chit Chat Money. On this show, hosts Ryan Henderson and Brett Schaefer interview industry experts and riff on the world of investing. As a quick reminder, Chit Chat Money is a CCM Media Group podcast. Ryan and Brett are also general partners at Arch Capital, and Arch Capital may have positions in the securities discussed in this podcast. Anything discussed on Chit Chat Money by Ryan or Brett or any other podcast guests is not formal advice or a recommendation. Now, please enjoy this episode. Welcome into Chitchat Money. My name is Brett Schaefer, and I'm joined by my co-host, Ryan Henderson. Today is our Tuesday not-so-deep-dive episode where we analyze

one stock by covering its business model, ownership, financials, future growth opportunities, and much more. After listening to this episode, we hope you get a better perspective on the company that we are covering. And today we are moving on to our next theme, which is defense and aerospace companies. We got a good mix of three stocks coming up over the next few weeks, and that will be General Dynamics, Rocket Lab, and Boeing. Today, though, we are going to be covering General Dynamics, one of the defense primes, one of the largest defense contractors for the United States government and its allies, as well as the owner of the Gulfstream Jets. Before we get to today's episode, I wanted to remind any listener, because throughout this

episode, we are going to refer to any charts we make, any graphics that we refer to. We might share the screen for Spotify and YouTube listeners. And if you want to see our note sheet, you can do so for free by subscribing to our newsletter. The link is in the show notes. It is a great complimentary document to go along with each podcast, especially if you are more interested in the stock that we are covering this week. So as I mentioned, today we are covering general dynamics. So Ryan, it looks like you got a lot of notes on all their different business segments. Why don't you get into what they do? Yeah. And as Brett mentioned, we've had people, listeners basically say, how do I get a look at the Word document before? In this case,

again, there's going to be some visuals just because they're manufacturing a lot of different products. There's going to be some visuals that I laid out as well. We'll try to show them here and I'll try to describe them because I know listeners probably hate that. So I'll try to describe them as well, but just that newsletter can't be helpful. Yeah. General Dynamics is basically a multi-purpose engineering and manufacturing company working primarily for the US government. 70% of the revenue comes from the US government, but they've diversified a little bit over the last 20 years or so through an acquisition. But they also service some commercial customers and then US government allies as well. But they break their business into four different

parts. So they've got aerospace, marine systems, combat systems, and technologies. I'll go through each one. Aerospace, this refers to two different businesses, Gulfstream and Jet Aviation. People might be familiar with Gulfstream because you hear, I think rich people mention it sometimes where they go, oh yeah, you got a Gulfstream CR500 or something. Basically, this is one of the world's largest private business jet manufacturers and General Dynamics acquired them in 1999 for $5.3 billion. Today, Gulfstream sells about 120 jets a year, or at least that's what they did last year. And there's a variety of different models. Basically, they're selling to either rich individuals or big companies that want private jets for their executives.

And so that's kind of a straightforward business. The jet aviation segment provides basically, I think it's, they call it aftermarket services where after you've bought a jet, you typically need either maintenance, repairs, charter services. So someone to kind of fly the jet for you. And jet aviation does that all around the globe. They have 50 plus locations where they help out existing jet owners. That segment accounts for 22% of revenue. The reason I think that segment is important is just because it's diverse. So there have been periods, and we'll get into this more throughout the show, there have been periods where defense budgets have contracted or whatever, and that reliance

on the US as your sole customer. And I know it's different subsegments within the US government, but having them as your sole customer can lead to contracting periods. And so having that commercial revenue at least helps offset it a little bit. The second one here, and feel free to butt in whenever you want, Brett. The second one here, and this is marine systems. This is kind of where they got their start. And I'll talk about the history here in a little bit, but it refers to General Dynamics' nuclear-powered submarine production business.

So they also produce some surface ships like destroyers or oilers, kind of ships to help other ships. But really, the bulk of the revenue comes from their long standing now production of Virginia class submarines. And then Brett, you're going to talk about this kind of in the future growth opportunity. They're since kind of shifting up. I think it's been since what, 2016, 2017? uh i think so yeah it's it's hard they got the full contract i believe a little later than that but it was talked about the new age submarine as as we all know as listeners probably know the government moves slowly and yeah they've been talking about this new age project for the submarine class for a while yeah so this new age is going to be called the columbia class submarines and basically the way this segment works is i believe um general dynamics is contracted to deliver two submarines a year to the US government or Department of Defense, Navy,

Navy in this case. And they're basically paid, on the production side, they're paid a fixed price contract, which I'll go into a little bit more. But this segment as a whole accounts for 28% of revenue, and it typically generates 8% to 9% operating margins. I'm curious, did you think it would be higher prior to looking at it well at first reading i thought it would be higher margin just because i understand that the typically these defense contracts can have 10 to 20 margins um although it can change for different types of projects however i think it makes sense that their margins have contracted a bit because they are really ramping up the project production for the columbia class and once that gets to a steady state i would expect the margins to

inflect higher. I did talk to someone before the show, one of our fellow workers at The Motley Fool, Lou Whiteman, and he said, yeah, he follows these companies closely, the defense contractors. So I wanted to say, hey, someone who's followed these a long time, what do you think about their operating margin for marine systems? Is it going to go higher once this Columbia class gets in full production? And he said, definitely, because there's the upfront cost and then the way works from the revenue recognition and how they you know generate their earnings on the fixed you know as the contract kind of fully rolls in and they do all the services under the contract then the margin should go higher but i guess it's a big to be determined on what those

steady state margins will get to again then the third segment here is combat systems this basically refers to general dynamics sale tanks or they like to call it land combat solutions and i guess that's a fair kind of catch-all because um it's not just tanks that they're delivering some of these are tanks like tracked vehicles but also um but when i say tracked i just mean like it's it's not running on wheels it's running on sort of like that that track that you think of when you see a tank um but then they also have wheeled combat vehicles and there's really two products here that the u.s army um that they're the sole producer of for the u.s army and that's the Abrams battle tank and the striker wheeled combat vehicle. I've included a little visual here that

they have in their 10K that shows all the different vehicles. And I mean, it's a pretty diverse offering. And then they also have, they sell some sophisticated weapon systems. So not necessarily vehicles like heavy machine guns, grenade launchers, that kind of thing. This accounts for only 18 percent of revenue so it's smaller than the marine systems but it has higher operating margins at least currently as as brett mentioned maybe marine systems will change um but yeah it's 14 to 15 percent operating margins in this segment last one i'll talk about here is technologies i'll be honest i don't know the nitty-gritty of this segment at all and i think they are probably discrete or kind of um it's really different yeah and it's really diversified

it's a lot of different it's basically technology you have a lot of notes here but it's basically technology and uh you know new technology consulting for government agencies as they try to modernize yeah and there's it's i mean there's 40 000 employees in the segment there's uh a number of the businesses under this umbrella have probably been acquired they've been big acquirers over the last 30, 40 years. And so it really is a number of different businesses. I'm going to steal a quote from the 10K just to kind of highlight why this is an important segment. It says, over the past decade, the US government basically has increasingly prioritized technology solutions as a critical element of their missions. COVID-19, the cyber threat landscape and demand

for advanced warfighter connectivity have accelerated these trends, adding urgency to required technology investments. Basically, a lot of these investments going into both IT, the hardware, the software are getting contracted out to some of the subsidiaries of General Dynamics. And this is the largest segment for them. It's 32% of revenue, typically generates around 10% operating margins. So it's an important one. Yeah, biggest earning contributor.

I was surprised to see that last year. I mean, it's pretty close. all of them generate around a billion in earnings. And again, for the newsletter subscribers, you should check out the charts we'll have for that. It shows the historical trends for all these segments. But yeah, 1.2 billion in earnings from this segment. I was kind of surprised. Yeah. And the last thing that's really important to mention here is around basically the billings process. So like I mentioned, sales to the US government account for 70% of General Dynamics' is billings. However, those sales are typically paid for in one of three ways, either fixed price

contracts, which accounts for the majority, cost reimbursement contracts, which is the second largest, and then time and materials, which is usually pretty small. But most of their production contracts are fixed price. This means that General Dynamics will agree to perform some specific piece of work and they're paid a fixed amount for it. That means General Dynamics is taking a little risk in that if they're going to get margin, they have to be efficient on their side, as opposed to a cost reimbursement contract, which are more like the services and maintenance stuff where they will pay, the government will just pay whatever the cost is plus a little added margin. So I don't know, I guess it's a riskier, the margins and the profits are a little

more at risk than I initially thought coming in. I figured it would have just been like they, General Dynamics builds the government for whatever their costs were, and then they add whatever, some revenue to get some margin. Yeah. You hear the complaints about the defense contractors having the cost plus model, which can lead to inflated costs over time. And generally people in the public dislike that. But from a business perspective, that can be quite advantageous. General Dynamics for 56% of their business. And I do have a chart over time. It's been pretty close to in between 50% to 60% of their revenue has been fixed price. So it's actually not what you may have assumed before looking at this company.

All right. As for the history, General Dynamics, I thought this was kind of interesting to go back to. General Dynamics roots date back all the way to the late 1800s. So there was a gentleman named john holland who had developed designs for a submersible ship aka a submarine and he developed a company around it called the holland torpedo boat company and in 1899 i loved i i loved old company names like it's very descriptive not these there was yeah there was yeah our friend on financial twitter lawrence hamtel who funny enough covers these type of companies that has a good blog post will link in the show notes said that if companies like quantum scape called themselves american battery uh this is a bit of a joke he said the bubble

wouldn't have happened because if you just called them like the old-time companies uh they're not as sexy sounding yeah that's true um anyway so he in 1899 uh he sold his company to isaac rice and isaac rice changed the company to the electric boat company which is still around today, it's basically a subsidiary of General Dynamics. But starting in 1900, the electric boat company began selling their submarines to the US Navy. And as people can probably imagine, the next basically 45 years were quite lucrative for the electric boat company since there was quite a lot of wars or quite a lot of fighting going on. And so, in fact, in World War II, electric boat company produced a total of 80 submarines for the Navy, which is a pretty

staggering figure considering that it's two a year in today's world. And I imagine our manufacturing and production capabilities are a little more advanced. So there was really a lot of volume and a lot of demand for the electric boat company's products back then. However, After the war, General Dynamics had a whole bunch of cash and basically no orders. I think they downsized their workforce by like 75%. So they began looking for acquisition targets to kind of try to do something with the cash on hand. And in 1947, they acquired Canada Air, and that was kind of a big shift in strategy,

and they started to really move towards aircraft production. And at the time, I mean, if you're selling aircraft and your company's name is the Electric Boat Company, it doesn't really make a whole lot of sense. So in 1952, as aircraft production kind of grew, they changed the name to General Dynamics. A year after, they bought Convair, which I believe does aircraft manufacturing, once again, for the US government. um and from that point on it's been basically just this long history of new acquisitions divestitures um and kind of this constant shift of what they're manufacturing but the theme has always been that the bulk of the sales go to the u.s government they're doing contracting on behalf of the government um and then there's been like some commercial uh businesses all throughout

In the early 1990s in particular, there was a period when defense budgets started to contract, and that led to General Dynamics having to divest a big chunk of its business. And I think they kept divesting assets until around 1994 was the last time they did it. They had a space division at that point, which they divested. And then since 1994, it's been pretty much all acquisitions. Since 1999, they acquired Gulfstream. And then, like I said, there's been a lot of... If you go through the historical page on General Dynamics website, it's just acquisition, acquisition, acquisition, one after the other. So a lot of them have been kind of just integrated into the technologies segment.

But yeah, that's kind of the history. They have a really long standing relationship with the US government, I think is the important part to understand here. And once you've been working with the US government for more than 100 years, I'd say you've really established a trusted brand. Yeah, for sure. And for reference, this has been quite the lucrative business for shareholders. It is a thousand beggar. I guess we can put them and Monster Energy as the 2,000 beggars we've covered over the

years. Maybe Boeing has been as well, but we'll talk about that when we get to them. But yeah, it's been a thousand beggar since the 1970s. But let me hit the industry and competition. It's pretty simple, but also a bit complex because, as Ryan mentioned, there's a lot of geopolitical stuff that can affect demand. But they operate in two markets, defense contracting and private slash business aviation. The private aviation market is estimated to be about $30 billion a year and is projected to steadily grow this decade. The question I had, though, is how much is this tied to the stock market, the private aviation cycle?

And I think it's going to be fairly tied to it. While rich people are still going to buy private jets, I think if the stock market is at an all-time high, they're probably going to buy a few more. And that book-to-bill ratio is going to be a bit higher. And we'll talk about what book-to-bill ratio is when we get to earnings, because that is an important note for anyone looking at this company. It's fairly easy to understand, but they're going to reference it a lot, as the management team is. Yeah, the other thing that was probably a good tailwind for the business was COVID. Rich people didn't want to sit next to other people on planes after widespread illness, so there was probably a better conversion in terms of who was buying jets. The other thing I'm thinking is maybe the degradation or the decline in comfort of commercial flights over the years has been a boon to private jet purchases.

maybe maybe but i don't know if these people are were the ones flying economy i think they were probably flying in first class which seems to be still pretty darn nice however i'm guessing they probably don't do this but i'm thinking they don't like charlie munger very much because they're like you're worth a few billion dollars and you still fly you won't fly private come on get yourself a nice private jet and he'd fly he would fly net jets anyway so it doesn't matter yeah that's that's a fair point that's a fair point but uh back to the actual notes Gulfstream generated around eight and a half billion in revenue last year. So they're one of the leading brands and probably the leading brand in private aviation. Moving to defense contracting,

the industry, which I'd say maybe it's an industry, but it's a very unique one. Obviously, the most important customer is the US government, which is closing in on $1 trillion in annual defense spending. General Dynamics is going to sell products to US allies as well. For example, They're doing a nuclear submarine deal with Australia, but they're not going to be selling to adversaries or frenemies like China, Russia, Iran, and stuff like that. I will share quickly a chart showing how important the US government is for them as a customer. And we're loading it up here. It shows just comparatively, and people have probably, so many people have seen these charts

before, it shows US government defense spending versus all the other large companies out there. And the U.S. government is about the same size as China, Russia, India, Saudi Arabia, United Kingdom, Germany, France, South Korea, Japan, and Ukraine combined. So they are the most important customer by far and will be for at least the next few decades. Let's see. Anything else in industry and competition? Let's see. Yeah. I mean, in a broader sense, they have a lot of competitors because there are a lot of defense contractors out there. There's Lockheed Martin, Raytheon, Northrop Grumman, Boeing, et cetera, et cetera. There's lots of them. Now, General Dynamics is one of the big ones, one of the top five. They are ranked third in U.S. defense spending as percentage of all these contractors. They get approximately 5.2% of the defense budget allocated to them, and that is in 2020. But on a narrower sense, some of the product lines from General Dynamics in their defense section have minimal or zero competition. And from this case, I would say the nuclear submarines essentially have zero competition. And then the Abrams tanks and some of the more specialized stuff might have minimal competition where they're really, when they're looking for a contract for the nuclear subs, it's almost like, all right, you can't choose anyone else. No one else can build these. So you're going to choose us.

And then with Abrams tanks, there's probably very few people, but then in the munitions and technology segments, maybe some of the other stuff that they sell, I would guess there are a wide range of competitors out there. And especially with consulting, that's probably more of a competitive market. But as we've seen last year, at least it generated the most earnings for them. All right, let's move to management ownership. Let's make this one quick because it's not too important, but I want to talk about how the proxy statement was pretty solid. So they have the CEO and chairperson of the board is Phoebe Novakovich. She has been the CEO since 2013 and has been with General Dynamics since 2002. Long-running management team, that's nice. I want to mention that the board of directors does have 13 members and they pay each other all $300,000 a year. For a company this size, it's not going to matter much. And I bet these people provide some value to this business, but I don't like when board of directors get paid such a healthy salary for not doing very much. Moving to executive compensation and incentives, I generally liked them. It was really, usually it's pretty poor when we look at these stuff. You have adjusted EBITDA, you have revenue targets, it's never per share stuff. And for them, their annual bonuses, at least for the executive team, are based on earnings per share growth, free cash flow, and operating margin targets, which I thought was pretty

good. But the one thing I would note, though, is if you really care about these executive incentives and that sort of stuff, that's very important to your investment thesis, I would check the changes and hurdles that they give themselves each year, because sometimes they might lower it, sometimes they might raise it. And that can indicate how optimistic they are about their business over the next few years, because they do typically want to meet these hurdles. But overall, I think these are good incentives.

And then if we look at their long-term stock awards, also pretty solid. Some of them were just kind of given away as stock options, but they had these performance stock units. And you can look at the details, but generally they're based on total shareholder return and return on invested capital hurdles over a three-year time period. And the current ROIC hurdle is 12.6%, which again, I think is solid. If we look at overall nominally, the executive compensation is pretty healthy, but not crazy for a company of this size. Novakovich got $21 million last year. The CFO got $7 million and the division leads all got a few million dollars, which again, I don't think they're complaining, but it's not as egregious as some of the other large cap

companies. And since moving on to ownership here, since this is an old company, the insiders only own 1.5% of the stock, a large chunk that comes from Novakovich. But interestingly, Interestingly, when we look at outside investors, unlike some of the other large caps we've covered, they actually have a decent chunk of stock owned by what look like our active managers like Longview Capital Management, Newport Trust Company, and Wellington Management. I don't know whether that means anything, but it could be helpful to not just have a pure index shareholder base. And if you want the actual details on that, that will be in the shareholder letter.

We have a table of all the big shareholders, but that's going to cover management and ownership Ryan, why don't we move on to their numbers, talk about the earnings, what you saw from them financially over the last year? Yeah. So for context on full year numbers, they do about 39... In 2022, they did $39 billion in revenue for the full year, about $4.2 billion in operating income. And this has fluctuated a little bit as they go through big investment cycles, but the last year it was an 11% operating margin. It could sometimes be a little bit higher, but I think generally think low teens operating margins for this business. Operating cashflow is $4.6 billion. Keep in mind though, they do have, this is very

CapEx intensive business. So they have about just over a billion in CapEx. So $3.5 billion in free cash flow, fairly similar to their gap net income. And then in terms of capital allocation, they buy back stock pretty regularly and they issue dividends. That's probably why most shareholders own them, at least if you've been a holder for a long time, because they've done, and I think Brett, you were the one that brought this up, they've increased their dividend by 12% annually since 1990. Is that right? That is correct. And shares outstanding are down since then. So on a per share basis, it's even better. I will have that chart in the newsletter as well. Yeah. And then most recent quarter,

revenue is growing about 5%. Earnings basically growing in line a little, maybe slightly less. They cited some supply chain issues as an issue. And then operating cashflow really outpaced earnings. Sometimes you get, and a big thing to track here is the customer backlog. And so the backlog can either be orders that are unfunded or customer advanced orders where they pay up front. And the funded orders, so the percentage of the backlog that's been funded already has grown by a lot over the last couple of years. And so you get sort of this positive working capital advantage where operating cash flow looks a lot better than the gap earnings because those significant customer advances. The other thing that's worth tracking is the

book-to-bill ratio. So this is the ratio of orders received to the actual units shipped or billed for. And so that was at 0.9. That's actually down a little bit relative to the last year or so, it's generally above one. You want to see that number creep back up above one because it indicates future demand and future revenue for this business. You defined what that was? Yeah. Yeah. Okay. All right. Balance sheet? Yeah. Pretty straightforward balance sheet, $2 billion in cash, $10.5 billion in total debt. Most of it's long-term. Most of it's dated out past 2027. So long maturities. The weighted average interest rate is just over 3% and it's pretty much all just fixed rate debt. So really clean, low cost. And like I said earlier, they

generate over $4 billion in operating income annually. So net debt of eight and a half versus $4 billion in operating income, it's basically net debt to annual earnings ratio of two times. So not that steeply levered here. Not very, yeah, they're not that aggressive, yeah. Yeah, they also, I mean, they were aggressive when they should be because they were able to raise really low cost debt kind of throughout the last three years. So kind of kudos to them during that time period. 100%. All right, let's move to the valuation.

I'll keep this one quick because, again, valuation is complex. It's not just earnings multiple, but just for the context, we'll take this up quickly just for anyone that's interested. Current market cap's about $58 billion. Add back on the neck debt, we're about at $67 billion for an enterprise value. And then the earnings ratio I was looking at, which is taking the enterprise value, and then I combined all the operating segments, their earnings, and just added that for kind of a combined operating earnings number. So their EV to combined segment operating earnings or really kind of their operating earnings is about 15 and a half. So a little bit below the market average on that front. However, I would note that you might want to discount this earnings multiple a bit because it does not include taxes or interest expenses, which are going to be meaningful for them. And it does not include some corporate overhead. So if they're trading at 15 and a half times their operating earnings, they're maybe trading at near the market multiple if it's around 20. So it doesn't mean it's technically cheap in that regard.

But let's move on to anecdotal evidence. Ryan, what do you think? How many nuclear submarines and Abrams tanks have you driven in your life, right? Yeah, I'm not their ideal customer, I don't think. Not a consumer. Yeah, not a consumer product. unless i guess the gulf streams yeah and i haven't bought one of those either maybe if uh maybe if the show does really well yeah we get a few more listeners right we just need to maybe maybe a

couple more people to listen yeah that would that should put us over the edge um no i obviously no experience with their product but just in kind of trying to assess gut feel of the business Because it feels like the incumbents in the defense industry are so advantaged, not only because there's the know-how of engineering these products and being the sole producer, but also working at a place like this. I mean, we live near one of the big marine systems production bases for General Dynamics. It's in Bremerton, Washington. And you have to have like, there's so much clearance stuff, so many different regulatory processes in being a contractor for the US government, especially one where it's weapons systems. that it it's got to be so hard to be like an emerging company in that industry because you have to invest so much and try to replace a customer that the government knows and trusts

and has worked with for a long time and it's such like um the government has to be so cautious who they who they deal with in these um in this respective industry yep agreed i'm gonna hit anecdotal evidence for Gulfstream. Again, like Ryan, you'll be surprised to hear I have not written in one, but it seems like Gulfstream is the top brand in private jets. That's the one that people talk about. That's the one that anyone references offhand. It's sort of like the, quote unquote, Kleenex of the private jet industry. And I think that will hopefully give them durability and customer demand. It'll give them customer loyalty over the next few decades and beyond, especially as they bring out some of these new jets, which I don't know if

we're going to specifically talk about them on the show, but they do have quite a few coming down the pipe over the next few years. All right. Future growth opportunities, Ryan, what do you got for us? Yeah, I feel like, I mean, there was one of two really big growth opportunities you could take here, which, well, I guess you could talk about some of the new Gulfstream jets or like new potential products, but I don't have a whole lot of value to provide there. I think the new federal budget is ultimately going to be a big tailwind for this business. So around July of last year, the House voted to pass a bill that boosted the national security budget to $850 billion a year. That's up $72 billion relative to last year. So a 9% increase in the national

security budget. Apparently, this was well above Biden's initial proposal. Lawmakers cited inflation, the Ukraine invasion, and concerns about China as the primary reasons to up the spending. I think that makes sense if you've been keeping up with the geopolitical news. I know it's a depressing growth opportunity, but if the government feels compelled to invest more in the defense budget for whatever reason, it's going to be a tailwind for General Dynamics. Yeah. And just think about the flip side, when the Cold War ended in the early 90s, that's when their demand fell off a cliff and a lot of the companies saw a really, really decrease in revenue. If the opposite is occurring and there's perceived or real threats out there,

there's going to be increase in defense spending. And maybe just talk about a little more. In the last 40 years, there haven't really been a lot of periods where defense spending declined. It's really only, as Brett mentioned, kind of that late 80s to early 90s time period. It is inflation-proof, yeah. The defense budget as a percentage of GDP is at an all-time low, basically. So it's really come down steeply. So they do kind of have the capacity to expand that, I would think, versus like 30 years ago. So I think there's two numbers that are worth tracking there, not just like pure defense

budgets, but as a percentage of GDP. Yeah, for sure. For sure. All right. My future growth opportunity is going to be the big one for this business that we've already talked about, and that is the new Columbia class submarine. So let me just give a little bit more context for the listeners on why this is going to be important. So this is going to replace the aging nuclear submarines in the U.S. Navy arsenal that are, I believe, about 40 years old now. Our electric boat is going to run around 78% of the construction for these projects and has essentially locked down production through at least 2042. However, I think we can assume that it's going to be much longer than that. As one of the only shipyards in the world that can build

these, there really isn't much of a choice for who the U.S. Navy is going to choose here. And I ran a, well, in the newsletter, I said a very simple analysis. It was basically just taking the current earnings for marine systems and then having it grow by 5% a year as their operating margin hopefully increases, and then as the Columbia class comes online. So if that happens, and 5% a year through 2042, through the end of these contracts, right? If that happens, that would lead them to generate $32 billion in cumulative operating income from now until then. How much is that worth today? Some of that earnings is going to be coming 15 to 20 years from now. But again, that's a pretty sizable earnings base from a market cap of, what is it

today? $57 billion. Enterprise value of, no, it was 59. Enterprise value is $67 billion at today's prices. And I wouldn't call that, I mean, nothing's 100% guarantee, but is this some of the most predictable earnings you could ever have, Ryan? I think it's hard to see how this doesn't materialize. Obviously 5% isn't the number that it's going to be, but it's going to grow and it's going to be there. I wouldn't necessarily call the earnings the most predictable because of the fixed price contract nature. And it's dependent on their ability to be efficient with costs, but the revenue, I mean, it's, yeah, it's locked in.

It's not, you know, it's not these kind of, it's much more predictable than, you know, your typical software business or anything like that. Yeah. And even within the defense contract, this is the most predictable because here's a quote from just a document that we saw outlining the Columbia class program. They said, quote, as the Navy's top priority,

the Columbia class program will remain funded even at the expense of funding other Navy programs. So this is really maybe the first, maybe the first couple things on the defense budget that are going to get funded. So even if there's a decrease in overall spending, these are the things that are going to the Columbia class is going to get their money. All right. Highlights and lowlights, Ryan, what do you like? What do you dislike about this business? Seems like this is a pretty simple one. I'm sure we have the same, the same highlights and lowlights here.

Yeah. I mean, it's very predictable revenue streams. That's always nice. It leads to a little less volatility, I think, in terms of the stock price. And then obviously, their largest customer has a clear interest in General Dynamics being well-compensated, being a well-run business. They want to make sure General Dynamics succeeds. And so that's always nice. Capital returns to shareholders have been great over the last decade. I mean, they've primarily driven the returns. Share count has come in by 22% and dividends have more than doubled. I really like that they're just fairly straightforward with their capital returns. They don't make it too complicated. Other highlights, I guess, I already mentioned

just the trust for General Dynamics. They're probably going to get a lot of the new contracts because the government knows what they'll get with General Dynamics. They're not taking a risk on like a new contractor. And then I like that Gulfstream diversifies the revenue somewhat. If there is any sort of a budget contraction, at least there's kind of a buffer there in that commercial revenue might be a buoy. Do you think Gulfstream is good business? yeah i don't know i mean i might not own it into like if it were just on its own

it would have to be a heavy big discount yeah yeah it seems like a good business not a great one it's a good i mean it's a great brand um but yeah i just don't necessarily like the economics of those big manufacturing companies um so i don't know i kind of treat it like boeing maybe yeah even maybe a little worse to be honest yeah low lies for me though on the business just earnings growth over the last decade and i know uh brett mentioned that maybe it's been a bit of an investment period um i'm sorry not over the last decade but over the last five years earnings growth has been pretty meager kind of lab cluster it's it's up seven percent roughly earnings before interest in taxes over the last five years in total. So I think you got to believe that there's

going to be a little bit of margin expansion over the next five years in order for you to want to own shares at this price. And then the other low light is just obviously the ties to the defense budget. We saw what happens in the 1990s, what can happen if those budgets come in. And I don't think it's likely given that it's at such a low percentage of GDP versus the defense budget overall versus like the 1990 time period and sorry sorry

geopolitical stuff so like right now it doesn't seem like it but if three years you know some of the stuff were resolved maybe budgets come in a bit yeah sorry I was gonna say I was kept thinking you were done talking but the yeah I was gonna mention the same thing 10 years from now

is China more aggressive or less aggressive as a geopolitical adversary for the United States government That's a very tough question to ask and not one that as our financial analysts, we can be certain of. I don't think anyone could be certain of that. But if I had to bet, I would go in the camp of saying there would be more aggressive and that will lead to higher defense spending from the U.S. Navy and the U.S. other Department

of Defense companies. All right. My highlights, anything different from you? I do think the marine system segment is really top notch. I mean, it's highly predictable. maybe the most predictable defense segment out of any of the contractors, although we're no experts on all these companies. And it is a monopoly. I don't think you can ask for much more. Yeah, it's not going to be a super fast score, but this is almost guaranteed earnings

and revenue. But as Ryan mentioned, the flip side is they do have a lot of fixed price contracts there. And yeah, you already talked about the capital return strategy and the brand relationships with the Department of Defense. I like those as well. They have grown their dividend payout by 12% a year since 1991. And their shares outstanding are down. So the dividend per share is up even more.

Lowlights though, yeah, I will mention the fixed contracts. Again, over half of the business is on these fixed cost contracts. We talked about how these are different than what maybe people generally dislike are these cost plus contracts that can lead to a lot of overruns and costs.

but these are riskier for the defense contractor because you're going to get the fixed payment from the government, but you don't know how much it's going to cost. Yeah, you're going to probably have a good understanding, given their decades of expertise in manufacturing these things, but you never know. It just adds a little bit more risk. And then I think my other highlight, and this is more of a long-term one, is I believe it'd be tough for us as investors to identify any deterioration in technological capabilities or the potential of losing a government contract maybe outside of the nuclear submarines. Because right now there's a big narrative around these new defense contractors, these startups like, I can never say the name,

but the most famous one is Anduril, A-N-D-U-R-I-L. They keep getting a lot of funding from venture capitalists. They keep getting some new contracts. Yeah, there's a lot of money to go around but you know over the long term how much can they step on general dynamics toes how much can they step on these older defense contractors toes it's not going to happen overnight but i think it'd be pretty hard to know when general dynamics is going to lose one of these contracts i'd have no idea and again it just happens overnight oh our backlog is just destroyed oh we lost this contract sorry like i guess yeah it's probably if you continue to see that book to bill ratio drop. That's an indicator, but it can happen quick if it's like big contracts.

Right. Because then they have the contract and then when it gets renewed, oh, we went for someone else. All right. Let's move to the bull case to wrap things up. Ryan, what do you think has to happen for the stock to do well over the next, say, decade? Well, if geopolitical concerns or tensions persist or even worsen over the next five years, i i mean it's that would be an unfortunate world to live in but i think general dynamics would benefit in terms of new bookings the eastern european customers have been buying a bunch of these tanks yeah yeah that would be obviously a nice tailwind for the bookings and then if we i think if you believe that this is a big investment period and the operating operating

margins can maybe expand to like 12 or 13 percent as opposed or maybe even higher um over the next five years, that's going to lead to much better operating earnings growth over the next five than the last five. And you think about it, even over the last five, the stock hasn't done that poorly and earnings before interest and taxes are up almost flat, basically. So I think that is kind of a testament to the capital return strategy. I think basically, if you get 5% bookings growth and a little bit of margin expansion here, plus the dividend, you're going to have a good next five years. The ceiling's not that high. Well, the ceiling's not. I mean, as a company of this large cap, that's not in an industry where

they can, one of the big tech companies or something like that, where they can just have a huge amount of revenue and earnings there. Yeah, it's not going to be that high, but it's one of those where it can, I think if you buy at the right price over the longterm, it can sneakily turn into $1,000 back here, right? Especially if the capital return strategy is sound. But yeah, I think my bull case is similar. Again, we're at over 15 times operating earnings here, which again, I'll talk about this during the bear case and look at their earnings deal. We are at a pretty high compared to their historical averages for where they trade. I think if you want to own the stock today, you need to be confident in three things.

Ryan outlined these as well. Steady revenue growth at about 5% plus a year, steady margin expansion as all the stuff we outlined in the show and then consistent repurchases and dividends which i think is probably a lock if this happens i think the stock likely does well over the next two decades but the key here is the margin expansion how much how how much it's going to be all right let's move to the bear case what could go wrong here it looks like you have the defense budget stuff yeah i mean that's always one of the obvious risks The other one, like you mentioned, would be that there is maybe other well-funded competitors that end up getting some of the contracts. I don't know.

I think if I had to bet whether the backlog is higher or lower in five years for General Dynamics, I would say, I think pretty confidently, you could say it's probably going to be larger. But basically, if billings come in, it's going to be tough for general dynamics to generate any really solid returns for shareholders. I think you'll still get the dividend. You could probably get maybe a little bit of growth, just kind of like inflation level growth, which maybe if inflation is really high, you get better growth. But I think it's like a low downside, low upside scenario. You're probably going to get mid-single-digit percentage returns over the next five years would be my bet. Yeah. I think it depends on, again, the margin is the key one.

If that goes much higher than maybe we're assuming, then the returns could be better. But yeah, I think, look, I will caveat my bear case for anyone that owns this stock. I think it's one where if you're looking to just never lose money, I struggle to think that one really loses money over time. And maybe that's the best way to invest. However, given the low earnings yield versus its historical average result, hit on next. I think there is kind of the cliched risk of multiple compression. If you have low growth and they lose a little customer contracts outside of the monopoly

businesses, I could see them not growing revenue much, margins not growing that much, and then the multiple comes in and you don't really make much money. outside of the dividends. And I want to share, let me just get the full screen up here. And then I will share the thing. I'll describe it for the listeners. Pretty easy to understand. So if you look at their earnings yield, which for anyone that doesn't know is the inverse of the priced earnings. So it's basically how much in earnings they're yielding. It's just taking earnings divided by price instead of price divided by earnings. Look at today, their earnings yield compared to the, we're not including Q1 here, is 4.9%.

And if we look at kind of back in 2020, 2021, they were closer to 6% to 7%. And then right during the GFC, they were closer to 10%. And then kind of in the 2000s, we're in the 5% to 6% to 7% range. And then in the early 90s, they were a little higher because of everyone's concerns over the declining defense budgets after the Cold War. But we're really close outside of a period where they had negative one, which I would probably disregard. We're at a pretty close to an all-time high on their earnings ratio.

Maybe people are pricing in that margin expansion, but I think there is that risk here for a company that's not as dynamic as other you know where it's a very predictable business so when the earnings yield is like this i think you can indicate maybe we're there's a bit of a flight to safety right now for stocks like this consent you know similar to the consumer staples we studied last month yeah i agree all right more or less interested what do you think i'm more interested i think at the right price these are very again it's got to be a little lower than this but at the right price these are just guaranteed returns. And I think at an earnings ratio on the operating earnings, which again,

was different than the earnings yield we were just looking at, it's going to be a little lower, I think at an operating earnings of maybe if we're at 10 times, I'm pretty darn interested in this one just because I like some of the businesses here. However, this is not one I'm willing to pay up for. What do you think? Yeah, I agree. I think mostly because of the price right now. I'm just not that interested, honestly. It would take a huge contraction or at least multiple contraction for me to get excited. And then just in general, if you're looking for fun with your investments, if you like volatility, you're probably going to want to fish elsewhere. But I mean, obviously it's a very high quality business and the earnings are

super predictable so if there is for some reason a mispricing um yeah it would be i think worth digging in again 100 all right that's gonna do it for this episode we do one of these every tuesday if you don't know so follow the show on either spotify apple or youtube and you can get updated on it give us a uh if you want you know the newsletter like we mentioned the link for that will be in the show notes or you can search chit chat money on substack give us a review on spotify our Apple podcast. If you like the show, that is the best way to support us. Remember, we are not financial advisors. Anything that we say on the show is not formal advice or recommendation. We are general partners at Arch Capital and clients may hold securities discussed in this podcast.

Next week, we're covering Rocket Lab. The week after, we're covering Boeing to get some more defense and aerospace companies. Thank you, everyone, for listening. We'll see you next time. Bye.