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Why General Dynamics Shares Were Down in May

Lou Whiteman, The Motley Fool

What happened

Shares of General Dynamics (NYSE: GD) fell 10% in May, according to data provided by S&P Global Market Intelligence, continuing the company's troubling trend of underperforming its key rivals. There are compelling reasons to buy in, but the market remains skeptical for now.

So what

General Dynamics lost ground during what was a tough month for equities, but not for most defense stocks. The company's shares failed to keep pace with defense peers Northrop Grumman, Lockheed Martin, and Raytheon, and even lagged Boeing despite that company's ongoing issues with its 737 commercial jet.

GD Chart

Defense data data by YCharts.

General Dynamics has long been the straggler of the group, with its shares climbing only half as much as its nearest competitor over the past five years. In the past, that variance was understandable: General Dynamics has been weighed down by its Gulfstream business jet unit, which has failed to regain altitude since the 2008 recession.

Gulfstream's worst days were supposed to be behind it, with a range of factors including fleet age and new depreciation rules included in last year's tax legislation expected to spark a resurgence in business jet sales. General Dynamics has a number of fresh designs to sell into that rally, and in its first-quarter earnings discussion in APril indicated that demand and sales data are strong.

Gulfstream's G500 business jet.

Gulfstream's G500 business jet. Image source: General Dynamics.

Improvements at Gulfstream will take time to hit the bottom line; margins on airplane programs tend to increase over time, as volume grows and early development costs are paid for. Investors should expect Gulfstream margins to increase significantly in 2020, and again in 2021. Based on the stock's movement, Wall Street is not yet ready to give Gulfstream or General Dynamics the benefit of the doubt.

On the defense side, it's hard to find a reason for the valuation gap. General Dynamics isn't as exposed as some peers to red-hot areas for Pentagon spending, including warplanes and missile defense, but it does have an important shipbuilding franchise that's responsible for the Navy's forthcoming Columbia-class ballistic submarine.

Now what

Wall Street analysts are slowly beginning to come around on General Dynamics. In late April, J.P. Morgan upgraded the stock, with analyst Seth Seifman in a note saying that GD's challenges are well understood by investors and there appear to be "fewer obstacles ahead." Goldman Sachs followed in mid-May, upgrading GD to a buy from neutral, believing the valuation gap has grown too large.

Critics can argue that General Dynamics and the rest of the defense patch are overvalued relative to historical averages, but the Pentagon is in the process of ramping up new equipment spending after a period of relative quiet coming out of the Cold War, and General Dynamics trades at a sector-low multiple on nearly every metric available. There is a lot of visibility about U.S. military spending plans well into the next decade, and no sign of the spigot being turned off.

It may take some time for Gulfstream margins to mature, but over time General Dynamics is a good bet to outperform its defense brethren.

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Lou Whiteman owns shares of General Dynamics. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.