General Dynamics Lands a $15.4 Billion Navy Contract

No one has ever accused the U.S. Navy of moving too fast.

It’s been nearly 10 years since the Navy announced it would build a new fleet of 12 nuclear-powered, nuclear ballistic missile-armed Columbia-class submarines to replace its aging Ohio-class boats. It was three more years before the first steel was cut, and six years since the first keel was laid. It will be 2027 before the first boat is actually delivered, and it could be as late as 2031 before it’s operationally ready – 15 years, start to finish.

That doesn’t mean the money isn’t already flowing, however.

Image source: U.S. Navy.

$15.4 billion for 12 boats

In 2017, the Navy awarded prime contractor General Dynamics (GD 2.40%) a $5.1 billion contract to begin designing the first Columbia-class vessel, USS _District of Columbia. Three years later, GD received another $9.5 billion award to begin building the boat. _Even with District of Columbia perhaps five years from full operational capability, however, the Navy agreed last week to award General Dynamics another $15.4 billion, “for additional Columbia-class ballistic missile submarines design, class lead yard support and sustainment, integrated enterprise plan initiatives for the class, and submarine industrial base supplier development enhancement efforts to support Columbia-class ballistic missile submarine program execution.”

It seems the Navy is confident enough that the program is on track that it’s already making preparations to begin serial production.

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According to an announcement on the Department of Defense contracts page, the $15.4 billion will cover development costs through June 2035. Upgrades to shipyards will also support the construction of additional Virginia-class fast-attack submarines, or SSNs.

$154 billion… and a little bit more

That’s just the cost for getting _ready _to build the boats, however.

According to the Government Accountability Office, the total program cost for building all 12 planned Columbia-class SSBNs will run to $126.5 billion, resulting in a cost per hull of $10.5 billion. Not all of that will go to General Dynamics – but most of it will. As General Dynamics points out, its competitor-collaborator Huntington Ingalls (HII 0.78%) will be building the bow and stern portions of the Columbia-class submarines, but General Dynamics will be responsible for building 78% of each Columbia-class boat.

There’s also the possibility that the Navy would build one or more additional non-nuclear missile-armed guided-missile submarines (SSGNs) based on the Columbia design, to replace the four Ohio-class SSBNs that were converted into SSGNs.

Government weapons contracts are notoriously subject to change, of course – both to the downside when they are abruptly cut short and canceled, and also to the upside as costs run over budget. Assuming the Columbia-class program runs as expected, however, it sounds like General Dynamics can expect to collect at least $99 billion over the life of the construction project, with the remaining $27 billion or so going to Huntington Ingalls.

But does this make General Dynamics the better defense stock to invest in? Not necessarily.

General Dynamics stock or Huntington Ingalls: Which is the better buy?

Consider that at a share price of more than 22 times trailing earnings, but a long-term forecast earnings growth rate of only 10.5%, General Dynamics stock sells for a PEG ratio of more than 2.0 – roughly twice the ideal valuation for a value investor.

Valued on earnings, rival and Columbia-class-partner Huntington appears more expensive than General Dynamics at first glance, selling for 25.7 times trailing earnings. However, as a near pure-play on shipbuilding, Huntington Ingalls is better positioned to profit from the Trump Administration’s efforts to bulk up the U.S. Navy by building the Columbia-class and other new warships, such as guided-missile battleships. Analysts polled by S&P Global Market Intelligence forecast that over the next five years, Huntington Ingalls will average a 14% earnings growth rate – giving it a PEG ratio of only 1.8.

Final point: Whereas General Dynamics generates weaker free cash flow than it reports as net income, Huntington Ingalls’ trailing free cash flow of $794 million is 31% ahead of its reported net income of $605 million. (Which is to say, Huntington generates more cash profit than it claims as reported earnings.) This pushes Huntington’s price-to-free cash flow ratio below 20.

By this metric, Huntington Ingalls isn’t just growing faster than General Dynamics stock. It’s cheaper, too.