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The Argument

If you are an active stock trader or someone who monitors the market closely you certainly have heard all the recent talk of a pullback in the market. The age old battle between the bulls and bears is heating up with the bears starting to gain momentum. The S&P has seen gains so far this year of over 8 percent. It seems just yesterday when I was playing the 138/139 call spread on the SPY. The bears are making the argument that the market is overbought therefore it is in need of a pullback. To add fuel to the bearish argument is the pending spending cuts that are slated to take effect March 1st.

If you have read my previous posts you will see that I have been warning of this sequester since January. I started establishing puts on the QQQ and I purchased some VXX calls in anticipation of higher volatility. I plan on buying some vertical put spreads starting this week on the SPY but I will save that for a different post early next week.

Last week the president held a press conference stating to the public that he will be asking congress to delay the spending sequester, to provide additional time. The delay would address the spending cuts during the budget debate that the administration is required to draft. That of course is due to the congress stipulation of its approval of raising the debt ceiling, otherwise we would have another year of a stale and outdated budget.

I am not writing to predict if congress will allow the sequester to happen or a grand bargain will be reached to avoid the whole thing, but I will give my opinion. I think there are stubborn people on Capitol Hill, and I think that many congressman and senators, democrats and republicans alike, see the sequester as an inevitable event. I think it will be interesting to see what happens now after the president's state of the union on Tuesday.

If the sequester happens, the already beaten down defense sector can, and in my opinion, will, drop further. If you look at the breakdown of the spending cuts it calls for a 50/50 between defense and discretionary spending. I don't know about you but I think 50 percent of the cuts affecting the defense industry doesn't sound good for the sector.

Based off this information, I wanted to know what defense companies have the most exposure to government spending. This led me to a Seeking Alpha article showing that the top three by exposure are Northrum Gruman (NOC) at an astounding 92 percent, Raytheon (RTN) at a lower 88 percent, and Lockheed Martin (LMT) at 84 percent.

During my research I found an interesting study by Bloomberg where the spending sequester impact was evaluated. The conclusion of the presentation states that the top three companies that may be hurt the worst due to the cuts on the defense and discretionary side are Lockheed Martin, SAIC (SAI), and Booz Allen (BAH).
The common denominator of the two lists is Lockheed Martin. I also noticed something very bearish on SAIC but I will post that separately.

With this information, the question is will Lockheed Martin have the ability to sustain the current prices after having cuts to both its defensive and discretionary spending exposure? Chris Mathews of Meet the Press Friday morning reported that the Department of Transportation, in particular the FAA, will be hit with a 10 percent budget decrease. A simple Google search of "Lockheed Martin FAA contracts" shows that they have large exposure on new software enhancements for that government area.

Lockheed Martin does not only have a large exposure to the spending sequester but the company also has a large exposure to current war efforts that are coming to an imminent end. Lockheed Martin is a fantastic company, they have been a pinnacle of the US defense industry for many years and have always attracted the best talent. With that talent came high pay resulting in high pensions from previous decades. If Lockheed Martin's sales and revenues are impacted due to the ending wars and future spending cuts then the profit margins will be extremely impacted.

Even Lockheed Martin themselves expressed an indirect concern on their latest Q4 earnings conference call when they stated the following prior to giving 2013 outlooks:

The Corporation's outlook for 2013 is premised on the assumption that sequestration does not occur, that the U.S. Government continues to support and fund the Corporation's programs, which is consistent with the continuing resolution funding measure through March 2013, and that Congress approves defense budget legislation for government fiscal year 2013 at a level consistent with the President's proposed defense budget for the second half of the U.S. Government's fiscal year 2013.

The concern is highlighted again in the conclusion of the report when LMT stated while once again referring to potential impacts on the 2013 earnings outlook:

the future effect of legislation, rulemaking, and changes in accounting, tax, defense procurement, changes in policy, interpretations, or challenges to the allowability and recovery of costs incurred under government cost accounting standards (including potential costs associated with sequestration or other budgetary cuts to avoid sequestration, such as severance payments made to employees and facility closure expenses), export policy, changes in contracting policy and contract mix;

And once more when referring to potential unexpected costs:

the ability to attract and retain key personnel and suppliers (including the potential for disruption associated with sequestration and related employee severance or supplier termination costs) and to provide for the orderly transition of management as the Corporation reduces the size of its workforce.

The good news for LMT is the president is expected to extend and make permanent the R&D Tax credit when he proposes his 2013 budget. This tax credit was explicitly called out in the earnings report as being a factor in LMT's EPS estimates. But even with the credit added into the estimate, LMT only guided $8.80 - $9.10 EPS for 2013. That is above the 2012 number of $8.36 but is not rapid growth by any stretch. A concerning fact for all LMT investors is if LMT is not accounting for any spending cuts in 2013 and they only guided .44 cents on the low end above last year's EPS, then what will happen if there is spending cuts?

The Fundamentals

There is no question that LMT is a fantastic company and has been so for many years. 88 percent of the shares are owned by institutions, which is proof enough that large professional investors believe in LMT; but if you look at the fundamentals, especially compared to previous years' fundamentals, the foreseeable future does not look so promising.

Looking at the two charts above, you can see that cash and short term investments are considerably below the 2011 levels, in fact these levels are at a five year low. When you compare this against LMT's current debt the results are alarming.

LMT has debt levels that are just fractionally lower than the 2011 levels. The table below shows the total liability breakdown for the 5 year period of 2008 to 2012.

Total Debt3,8055,0525,0196,4606,308
Pension Benefits - Underfunded13,39012,13111,82014,77616,498
Other LT Liabilities3,0793,0963,3763,5413,807
Other Liabilities, Total16,46915,22715,19618,31720,305

Looking at the Operating Cash Flow from the same time period, it is can be realized that LMT is generating less income from operations than in previous years. It's interesting to point out that while total cash from operations has decreased, Operating Income has increased from 2011 levels, pointing to a much higher rate of CAPEX spending.

This brings into question LMT's margins. When you compare the profit margins of LMT to the Aerospace & Defense industry median you will see that Lockheed is considerably lower than its peers.

The following table shows LMT compared to the industry average.

  • Gross profit margin - 8.89% vs 23.01%
  • Operating profit margin - 9.40% vs 11.08%
  • Net profit margin - 5.82% vs 6.42%

LMT is a highly leveraged company. The Total Capital ratio is 99.39% which is extremely higher than the industry average of 48.17%. Although I do not envision LMT having any problems repaying their debt, the high debt to capital ratio leaves Lockheed very vulnerable to future government cuts and possible loss of revenue.

It is important to note that LMT does pay a very nice dividend to its shareholders. The table below shows the dividend payout from 2008 to 2012. The $4.15 paid out to shareholders in 2012 was well above the 2.14 industry average.

Common Stock Dividends
Gross Divid - Common Stock7379089691,0981,360

The Technicals

If you look at the three year chart of LMT and analyze the major pullbacks that the stock had you will see the 3 year low occurred between the week of November 29th 2010 and December 6th 2010. Consequently on 11/29/2010 President Obama signed a bill to freeze government employee compensation due to deficit problems - which were much less severe compared to our current deficit issues.
The next pullback was on 8/8/2011. This pullback could potentially be discarded because that was when the USA was downgraded from our AAA rating. One could also read into the pullback and make the argument that the drastic sell off of over 10 percent was due to the fear of spending cuts.

(click to enlarge)

When looking at a company's technicals, the first chart I like to look at is the Point and Figure (P&F) charts provided by I will write about the basics of P&F charting in a future post, for now take solace in the fact that the charts represent past performance and future demand. These charts are very useful in predicting reversals and trends.

Looking at the P&F chart for LMT we see that it has hit a double bottom breakdown.

(click to enlarge)

After seeing that the short term technicals point to a bearish pattern, I decided to look at the all time chart for LMT. I realized that starting in 2003 the stock started a climb from 50 dollars a share to the current price of over 85 dollars a share. The argument can be made that the slow and steady climb was supplemented by the over-spending of the government that will soon be reversed.

To support my bearish argument, last week LMT closed below its 50 day moving average. The last time this happened was August 2011 and the stock went on to chart a 8 dollar decline for close to a 20 percent pullback.

(click to enlarge)

The Trade

If you own Lockheed Martin and have made profits from the stock over the past several years then I would consider lowering my exposure to the stock. Take some profits but don't close the position totally; after all, they are Lockheed Martin.

I personally think that there are going to be some kind of spending cuts to defense. I think it's inevitable and will for all intents and purposes be good for the economy in the long run.

I don't know if the sequester will happen or not on March 1st, but I do think that even if the sequester is avoided or delayed until the budget talks in May, the end result will be at a minimum moderate defense cuts.

All this does not bode well for LMT. The trade that I like is to play the 85/82.50 Mar 13 Vertical Put Spread. This gives me 33 days till expiration for LMT to pull back. Below is a breakdown of the trade. The most I can lose is the 80.75 that I am putting up. I have a Max profit of 180 bucks if LMT falls below 82.50 by expiration. Anything below 85.70 puts the trade into the profit.

Capital Required80.75
Max Profit180.0
Return %222.91%
Break Even85.7
Max Risk80.75
Source: Will Lockheed Fly High Or Crash And Burn?