Why General Dynamics' Gulfstream Business Could Crash

By Rich Smith Markets Fool.com

Here at The Motley Fool, we've been hearing for months that General Dynamics' (NYSE: GD) all-important Gulfstream business jet business is in trouble. Now, one of the General's biggest rivals seems to be confirming it.

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Gulfstream sales are in their descent. But will they take off again? Image source: Getty Images.

Background

Last quarter, General Dynamics informed investors that it delivered only 27 Gulfstream business jets to its customers worldwide. That was a 37% unit reduction compared to the third quarter of 2015. Even with a strong profit margin on the product, the fall in business jets pushed General Dynamics' aerospace revenue down 14% year over year.

Around the same time, rival business-jet maker Textron (NYSE: TXT) warned investors that sales of its Cessna-brand business jets are "stubbornly soft." And it's not just Textron and General Dynamics that are in trouble. Textron says that demand for this sort of plane remains "weak" across the entire industry, and Bombardier(NASDAQOTH: BDRBF) CEO Alain Bellemare agrees the market is "oversupplied."

Rounding out the bad news, this weekAviation Week ran an interview with the CEO of yet another rival -- Brazilian plane maker Embraer (NYSE: ERJ) -- and what he had to say dashes cold water on any hope of an immediate recovery in the industry.

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Sales are down by half

Asked by Aviation Week to give a forecast for the business aviation market in 2017, Embraer CEO Paulo Cesar de Souza e Silva adopted a somber tone. Noting that in 2008 global plane makers delivered 1,350 business jets to their customers, Silva observed that 2016 deliveries will probably add up to fewer than 680. The competition to grab at least some share of this shrinking market, warned Silva, is creating "huge pressure on price and margins."

In response, Embraer has "taken the decision to be more disciplined in terms of the number of aircraft we are going to manufacture and deliver to make sure we will not operate under losses." Embraer will cut production to dry up supply, in hopes that if its competitors follow suit, those sales that do still get made may earn a profit.

But here's the bad news: Simply cutting production may not be enough. It may be necessary for one or more producers to go bankrupt.

Too many cooks are watering down the soup

Currently, says Silva, there are five big manufacturers of business jets worldwide. (In addition to Embraer, General Dynamics, and Textron's Cessna, he's probably including Canada's Bombardier and France's Dassault). Problem is, according to Silva, with five plane makers fighting over a shrinking pile of plane sales, no one company is able to maintain the necessary scale of operations, the "critical mass that allows everybody to make [a] profit." (As we'll see in a moment, that's a bit of an exaggeration -- but broadly correct.)

Now, there's word that Bombardier may exit the market for light business jets, perhaps by selling Learjet to Textron. That wouldn't necessarily cut production overall -- just shift one airplane brand from one owner to another. (Still, from Textron's perspective, with Beechcraft, Cessna, and Learjet all in its pocket, it would help give Textron more scale of production.)

"Used planes -- 4 sale cheep"

Complicating matters is the fact that "the inventory of used aircraft is still very high," with about twice as many used aircraft for sale today as there were in 2008. Not only does the supply of used aircraft available for purchase depress sales of more expensive new aircraft, but it also delays the effect of cutting production of new aircraft, because "we still have to clear the market of used aircraft" before buyers will notice any supply crunch.

What it means for investors

So what does all this mean for investors? With a profit margin of 19.3% on its Gulfstream aircraft, General Dynamics is probably best-positioned to weather this storm. According to data from S&P Global Market Intelligence, General Dynamics makes more than twice the profit on its Gulfstreams than Textron (8.3% operating margin) does on its Cessnas and Beechcraft. Bombardier, earning 4.4%, is already thinking of selling. And Embraer, eking out a mere 3.2% profit margin on its planes, is worst off of all.

For the long term, this is probably good news for General Dynamics, as it suggests that the company's weaker rivals may soon begin dropping like flies. In the shorter term, though, General Dynamics could face serious pricing pressure as its dying rivals fight for their life and offer to sell planes for (almost) any price.

The upshot for investors: Expect to see profits go down before they resume their ascent.

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Fool contributorRich Smithdoes not own shares of, nor is he short, any company named above. You can find him onMotley Fool CAPS, publicly pontificating under the handleTMFDitty, where he's currently ranked No. 358 out of more than 75,000 rated members.

The Motley Fool recommends Embraer-Empresa Brasileira. The Motley Fool has a disclosure policy.