RESEARCHOctoberREPORT 7, 2019 OctoberDefending 7, 2019 Alpha Stock Rating BUY Insert Picture in Master View Price Target CAD $224.00 Current Price CAD $176.64 Bear Price Bull Case Target Case $199.98 $224.00 $233.31 Ticker GD General Dynamics Market Cap (MM) $50,900 Defending Alpha P/E NTM 14.0x EV/EBITDA NTM 11.5x General Dynamics is an aerospace and defense company with a broad product and services portfolio spanning business jet-aircraft, 52 Week Performance combat vehicles, information technology, mission-critical systems, combat ships and submarines. 120 The Industrials team took a deep dive into three of GD’s most prominent business segments to gain a more comprehensive understanding of the company’s positioning in each. 100 (1) Specialized Services to Capitalize on Naval Expansion (2) Market Over-Punishment of Combat Systems Segment 80 (3) A Compelling Risk-Reward Aerospace Profile 60 The Industrials team believes that General Dynamics has very strong Oct-18 Feb-19 Jun-19 lines of business, with a customer base that is less dependent on the US government than its peers. At GD’s current valuation, we price in Index GD 28% upside, and intend to enter the name in the immediate future. Industrials Mathew Andreou [email protected] Deven Chander [email protected] Tina Fang [email protected] The information in this document is for EDUCATIONAL and NON-COMMERCIAL use only and is not intended to Tawfek Abdelwahed constitute specific legal, accounting, financial or tax advice for any individual. In no event will QUIC, its members or directors, or Queen’s University be liable to you or anyone else for any loss or damages whatsoever (including [email protected] direct, indirect, special, incidental, consequential, exemplary or punitive damages) resulting from the use of this document, or reliance on the information or content found within this document. The information may not be reproduced or republished in any part without the prior written consent of QUIC and Queen’s University. Matt Kampe QUIC is not in the business of advising or holding themselves out as being in the business of advising. Many [email protected] factors may affect the applicability of any statement or comment that appear in our documents to an individual's particular circumstances. © Queen’s University 2019 October 7, 2019 Defending Alpha Table of Contents Company Overview 3 The Aerospace and Defense Landscape in 2019 5 Thesis I: Specialized Services Position GD Well to Capitalize on Naval Expansion 7 Thesis II: Market Over-Punishment of Combat Systems Segment 9 Thesis III: A Compelling Risk-Reward Aerospace Profile 11 Catalysts and Risks 13 Valuation 14 References 15 2 October 7, 2019 Defending Alpha Company Overview General Dynamics (“GD”, “the company”) is an continuing to expand their services network with three aerospace & defense company. Incorporated in 1952, additions set to open this year. GD is the world’s 5th largest aerospace & defense company by revenue. GD is primarily a defense Combat Systems company, deriving 74% of their revenue from defense segments, while the remaining 26% is sourced from The Combat Systems group offers combat vehicles, their Aerospace division. Since its founding, GD has weapon systems and munitions for the United States acquired and integrated more than 65 businesses to (U.S.) government and its non-U.S. partners. The complement their portfolio. GD is headquartered in segment consists of three business units: European Falls Church Virginia, employing more than 105,600 Land Systems, Land Systems, and Ordnance and across their five operating segments. Tactile Systems. Revenue increased 8.1% Y/Y to $1.7B in Q2 ($6.8B est. FY2019), with a book to bill ratio of General Dynamics offers a diverse portfolio of 0.5x. The Combat Systems group had $17B on backlog products and services including business aviation, at the end of 2018. combat vehicles, weapons systems, munition, shipbuilding, information technology system and solutions. The company is organized into five operating segments: Aerospace, Combat Systems, Information Technology, Mission Systems and Marine Systems. Each business segment operates with a high degree of autonomy, with responsibility for its strategy EXHIBIT I and operational performance, resulting in greater Revenue Breakdown by Segment operational flexibility and agility. Their organizational structure allows them to be segment leaders and to be responsible to changing customer needs and opportunities. Business Segments Overview 24% 23% Aerospace General Dynamics’ aerospace segment consists of Gulfstream and Jet Aviation business units. The Gulfstream unit provides aircraft and a full range of services for business aircrafts produced by Gulfstream. 13% Gulfstream is a leader in the production and servicing 17% of mid-size and large cabin business jets. The aerospace segment saw 12.7% higher revenue in Q2 Y/Y, with backlogs up 18% Y/Y and expecting to deliver 145 aircraft in 2019. Their book to bill ratio was Aerospace 23% Combat Systems 1.0x. The aerospace segment had $11.375B on backlog IT Mission Systmes at the end of 2018. The FAA in the last quarter certified Marine Systems their new business aircraft, G600, with deliveries expecting to begin in the later half of 2019. GD is Source(s): Company Filings 3 October 7, 2019 Defending Alpha Company Overview Marine Systems 12.4%. Their book-to-bill was 1.2x. with backlog increasing to $8.9B, up 6% Y/Y. The Marine Systems segment is a market-leading designer and builder of nuclear-powered submarines, Mission Systems surface combatants, and auxiliary and combat-logistics ships for the U.S. Navy, the Jones Act ships for The Mission Systems provides data collection and commercial customers. GD also provide repair services for processing products, command and control applications, nearly all classes of Navy ships. More than 90% of the and computing and communications equipment. The segment’s revenue is for Navy engineering, construction Mission Systems segment had revenue increase 11.3% in and lifecycle support awarded under large, multi-year Q2 to $1.3B ($5B est. FY2019). The book-to-bill ratio was contracts. Revenue for Q2 was up 7.2% Y/Y to $2.3B ($9B 0.9x with a backlog of $5B at yearend 2018. est FY2019), with two major contracts awarded totaling $765M in the quarter. The Marine Systems segment had Customers $27B in backlog at yearend 2018. In 2018, 65% of GD’s consolidated revenue was derived Information Technology from the U.S. government, 14% was from U.S. commercial customers, 10% was from non-U.S. commercial The Information Technology segment was formed in 2018 customers, and the remaining 11% was from non-U.S. concurrent with their acquisition of CSRA and the government customers. GD’s single largest customer was reorganization of their legacy Information Systems and the Department of Defense (DoD), accounting for $18B in Technology segment into two separate segments: sales for FY2018, representing 48.8% of their revenue. Information Technology and Mission Systems. Revenue was flat for Q2, with industry leading EBITDA margin at Exhibit II U.S. Government Contracts as a % of Revenue NOC 82% BA 29% RTN 68% BAE 42% LMT 70% GD 65% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% Source(s): Company Filings 4 October 7, 2019 Defending Alpha The Aerospace and Defense Landscape in 2019 General Defense Industry Weaker U.S. Budget Environment Defense is unique in its dependence on government High growth from international defense budgets was defense budgets. This sets it apart from most expected from 2014-18. This did not materialize, as traditional industrials companies, who are subject to budgets fell off in the Middle East with slowing GDP the ebb and flow of more cyclical end markets. Thus, growth caused by falling oil prices. At the same time, defense companies have been viewed as hedges the U.S. saw a budget increase in 2018 under the against recessions, which is one reason why the Trump administration, and U.S. arms exports grew due Industrials team has dedicated more time to exploring several factors: (1) Threats from Russia in Eastern the space. In this sector, companies deal with a Europe (2) Increased Chinese military presence in Asia- concentrated customer base where the U.S. Pacific (3) North Korea threats (4) Syria and Yemen government is frequently the primary contractor. Some conflicts. companies generate >90% of their revenue from the government; GD, with their business aviation segment, What now? NATO countries appear to be focusing on is more diversified than most at 65%. Many defense defense budgets to counter threats from Russia and products have very long product cycles; some the Middle East. There is more spending on products may take 5-10 years, or more, to produce. cybersecurity programs, as military strategies worldwide shift towards integrating digital technologies. The U.S. remains the largest defense budget. After budget increases in 2018-19, U.S. spending is moderating under the 2020-21 budget agreement. EXHIBIT III EXHIBIT IV Market Share of Large-Cap Defense Names U.S. Military Spending 2008-2018 1,000 BA 3% 2% 1% LMT 8% 750 UTX 34% GD 8% NOC 500 RTN 8% LLL 250 TXT SPR 0 TGI 20% 16% 2000 2006 2012 2018 Source(s): Mergent Source(s): U.S. Department of Defense 5 October 7, 2019 Defending Alpha The Aerospace and Defense Landscape in 2019 The $738 and $740B budgets for 2020 and 2021 Business Aviation represent a mere 3% nominal increase over 2019, and only a 1% increase in real terms. International defense Demand for business jets is in part a function of budgets are becoming more important than ever, and corporate profits; the correlation between corporate are expected to grow faster than domestic budgets, at profits and jet deliveries is 0.8.