General Dynamics' Massive Miss


General Dynamics shares plummeted 5% after yesterday morning's earnings miss, before screeching to a halt, reversing course, and bouncing back to end the day higher. What, an investor may wonder, was the reasoning for Mr. Market's dramatic rethink?

Let's begin with the highlights. In fiscal Q4 2012, General D reported:

  • A $6.07 per share GAAP loss on its earnings from continuing operations, down from $1.68 profit in Q4 2011

  • A less frightening decline from $1.68 to $1.39 per share, once GAAP earnings were "adjusted" to ignore the effect of a $2 billion writedown for "goodwill impairment" on companies General D had purchased and absorbed into its information systems and technology (IS&T) group over the years

  • And a 12% decline in quarterly revenues to $8.1 billion

Wait just one cotton pickin' minute. What was that about a $6.07 loss?
Right. That does bear some explaining. Turns out, when General D was shopping for businesses in years past, it based the prices it paid on expectations of how fast these businesses would grow once they were made part of GD. Problem is, that was then, this is now, and "now" the Pentagon looks less interested in spending money on IS&T than it did "then."

Result: GD appears to have bought some lemons. Hence the writedown... and the loss. After tossing other losses into the bath, General D says its total amount of impairments for the quarter reached $2.9 billion. This may bode poorly, incidentally, for other defense contractors with similarly large "information systems." For example, Lockheed Martin , gets about 22% of its revenues from its information system business, Northrop Grumman , 30%, and especially L-3 Communications , a true powerhouse in the business, which appears (depending on how you define the term) to generate upwards of 40% of its revenues from information systems-like departments.

But it's not all bad news.

Accounting charges aside, General Dynamics didn't do half badly this past year, and its peers mayn't have, either. For example, while Q4 pretty much tanked (get it? Tanked? General Dynamics builds tanks) the year's GAAP profits, the company still generated $2.2 billion in free cash flow in 2012. If it can keep that up, the company's price to free cash flow ratio -- now 11.4 -- doesn't look expensive.

Nonetheless, I still think investors called this one right the first time around, and were wrong to bid GD back up. Why? While not expensive per se, 11.4 times free cash probably still is too expensive to pay for a company that's only expected to grow profits at about 5% a year over the next five years. Even factoring GD's 2.9% dividend yield into the picture, the stock looks overvalued today.

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Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool owns shares of General Dynamics, L-3 Communications Holdings, Lockheed Martin, and Northrop Grumman. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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