Sales Slip in General Dynamics' Most Profitable Business -- but Here's Why It Could Boom Soon

General Dynamics (NYSE: GD) stock shed about 1% of its market cap since reporting earnings a week ago, closing out Tuesday just under $302 a share. That's a curious reaction on investors' part, however, in light of the company's third-quarter results.

For fiscal Q3, ended Sept. 29, General Dynamics reported 10% sales growth, 12% operating profit growth, and 10% growth in net income, to $3.35 per share. Sales grew in three of the company's four main operating divisions, and were down only slightly in the fourth (combat systems).

These were good numbers in and of themselves -- but not the only reason investors should be happy.

Sales and order trends at General Dynamics

Three months ago, if you recall, General Dynamics stock reported a week book-to-bill ratio, with new orders failing to come in fast enough to replace old orders going out the door (i.e., revenue). The good news last Wednesday was that the company was able to rectify that situation, bringing in $1.10 in new orders for every $1 in revenue reported (i.e., its book-to-bill ratio flipped to 1.1). As a result, order backlog grew to $92.6 billion, enough to keep GD running at full speed for the next two years straight.

Keeping those orders coming in is of course essential for General Dynamics to continue growing at its current rate -- which is pretty impressive. In Q3, the company's aerospace division (Gulfstream jets) posted an astounding 22% increase in sales, and 14% growth in earnings. Marine systems, currently the company's biggest business, grew sales 20% and earnings 22%.

But the division I want to focus on today isn't either of those. It's combat systems -- the division that saw a small slowdown in sales (0.5%), yet still managed to grow its earnings by 8%.

General Dynamics combat systems

Best known for its Abrams tanks and Stryker armored personnel carriers, combat systems is by at least one measure General Dynamics' single most profitable division. Although its $325 million in Q3 operating income was slightly behind the $326 million earned at the company's technologies division, combat systems is GD's smallest division by revenue -- just $2.2 billion collected last quarter. The reason it came close to earning the most profit of any GD division, therefore, is because the profit margin it earns on that revenue is so very big.

In Q3, combat systems reported a staggering 14.7% operating profit margin, nearly 2.5 percentage points better than the company's next most profitable division, aerospace. And combat systems expanded its profit margin by 120 basis points in comparison with the year-ago quarter, meaning it's not just uber-profitable; it's actually getting more profitable over time.

So what does this mean for General Dynamics?

A bright future for General Dynamics' most profitable division

Simply put, it means General Dynamics' profits are going up -- and perhaps by more than you think. While undiscussed in the earnings report per se, you see, General Dynamics revealed in its post-earnings conference call with analysts that combat systems took in $3.3 billion in new orders in Q3 -- 50% more than its $2.2 billion in revenue, resulting in a book-to-bill ratio of 1.5 for the ultra-profitable division.

General Dynamics credited orders for "near defense vehicles" and munitions -- particularly 155 mm artillery rounds -- for the order increase, which accounted for almost the entirety of the increase in General Dynamics' backlog in the quarter. And with these orders in hand, CEO Phebe Novakovic promised investors, "we'll see increased revenue from our from our combat vehicle business" as the company shifts from growing munition production capacity to actually producing munitions for sale.

Is General Dynamics stock a buy?

More sales at General Dynamics' most profitable business should be good news for profits at the giant defense contractor. In the near term, it eases concerns about both the company's iffy book-to-bill ratio and its overall profit margin, which dipped sharply in 2023 but now seems to be improving.

This doesn't necessarily make the stock a buy, however.

Priced at 23 times earnings today, and paying only a 1.9% dividend, General Dynamics is pegged for only 13% annual earnings growth over the next five years, according to most analysts polled by S&P Global Market Intelligence. Even viewed in the most charitable light, that works out to a total return ratio of 1.6 -- whereas most value investors like to see total return ratios of 1 or below before calling a stock "cheap."

Pleased as I am to hear about growth in combat systems, and the extra profits that will bring, General Dynamics stock remains no more than a hold for me.

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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.