Was General Dynamics' Move Back Into IT a Huge Mistake?
Five years ago, General Dynamics (NYSE: GD) was struck by disaster.
Years of acquisitions in the IT space, designed to turn the defense giant best known for its battle tanks and nuclear submarines into a cybersecurity specialist, had failed to produce significant profit growth. Instead, realizing that it had overpaid for its new subsidiaries, General D acknowledged its mistake, took a $2.9 billion charge to earnings, fired its IT division head (or allowed him to retire "to pursue new professional opportunities"), and reported only its second full-year net loss in the last 30 years.
Now the question is: Is General Dynamics preparing to make the same mistake a second time?
General Dynamics hopes IT will become its secret weapon to keep sales -- and profits -- growing. Image source: Getty Images.
Second verse, same as the first?
Since 2012, General Dynamics' IT business has generally declined in revenue but gained in profits, reflected in data provided by S&P Global Market Intelligence. Perhaps encouraged by this trend, General Dynamics bid $9.6 billion to acquire government IT specialist CSRA Inc in February. That purchase closed in April, meaning that Q2 represented nearly three full months of General Dynamics' results with CSRA as part of the mix. So how are things going with GD's latest expansion into IT?
We got a hint last week when General Dynamics reported its fiscal Q2 2018 earnings results.
What General Dynamics said
By and large, Q2 was a successful quarter for General Dynamics. Both sales and earnings exceeded Wall Street's expectations, and on earnings day General Dynamics' stock jumped 3% in response. But then a strange thing happened. General Dynamics stock took a U-turn, and dropped steadily over the next three days. Athe time of this writing, the stock is trading below where it traded before earnings were announced. So what's up with that?
For Q2 2108, General Dynamics reported:
Sales grew 20% to $9.2 billion.
Operating profit margins for the company as a whole slipped 210 basis points to 11.8%, largely due to a charge taken related to the CSRA deal.
And earnings per share grew only 7% to $2.62 per share, also because of the CSRA charge. (Without it, General Dynamics said its earnings would have grown 15%.)
A clue!
So right off the bat, you can see that absorbing CRSA has not been beneficial for General Dynamics so far. Seeing this, investors may have had second thoughts about whether they want to continue owning the stock, especially considering the company's checkered history with IT expansions. That being said, GD CEO Phebe Novakovic reassured investors that "integration of [CSRA] is well underway," and General Dynamics is now "a leading government IT services provider."
And there's merit to that statement. After all, in absorbing CSRA, General Dynamics instantly more than doubled the size of its IT business, driving quarterly revenues in the division up 132% and transforming IT into the company's biggest unit by revenue. At better than $2.4 billion booked in Q2, it's easy to see IT becoming a $10 billion-a-year business for General Dynamics.
Still, operating profit margins in IT did decline 190 basis points, the biggest drop seen in any of General Dynamics' four main divisions. While IT revenues more than doubled, IT profits increased only 79% due to the absorption of CSRA.
What comes next
But Novakovic doesn't seem to think this will be an ongoing problem. To the contrary, giving guidance to investors in the company's after-earnings conference call with analysts, GD's CEO raised the company's earnings-per-share outlook for the year to a range of $11 to $11.05 per diluted share -- and the reason for her optimism soon became apparent.
Earlier this week, General Dynamics was awarded a five-year, $3.9 billion contract to supply U.S. Army Contracting Command with "Common Hardware Systems 5th Generation." These revenues should fall within the IT division's bailiwick, boosting revenues there by an average of nearly $800 million each year over the next five years.
How profitable those revenues will be is the big question -- and the answer may determine whether this time General Dynamics' drive to invest in its IT business works out better than it did last time around.
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Rich Smith has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
