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Lockheed Martin Corporation (NYSE:LMT)

Q1 2009 Earnings Call

April 21, 2009 11:00 am ET

Executives

Jerry Kircher - IR

Bruce Tanner - EVP and CFO

Analysts

Robert Springarn - Credit Suisse

Joseph Campbell - Barclays Capital

Robert Stallard - Macquarie Capital

Howard Rubel - Jefferies & Company

Ronald Epstein- Merrill Lynch

Joseph Nadol - JP Morgan

Cai von Rumohr - Cowen & Company

Sam Pearlstein - Wachovia Securities

Heidi Wood -Morgan Stanley

Noah Poponak - Goldman Sachs

Myles Walton - Oppenheimer and Company

Douglas Harned - Sanford Bernstein

Jim McIlree - Collins Stewart

Operator

Good day and welcome everyone to the Lockheed Martin First Quarter 2009 Earnings Results Conference Call. Today's call is being recorded. At this time for opening remarks and introductions, I would like to turn the call over to Mr. Jerry Kircher, Vice President of Investor Relations. Please go ahead, sir.

Jerry Kircher

Thank you Michael and good morning everyone. I would like to welcome you to our first quarter 2009 earnings conference call. Joining me on the call today is Bruce Tanner our Chief Financial Officer and Executive Vice President.

Statements made in today's call that are not historical facts are considered forward-looking statements and are made pursuant to the Safe Harbor provisions of Federal Securities Law. Actual results may differ. Please see today's press release and our SEC filings for a description of some of the factors that may cause actual results to vary materially from anticipated results.

Please also note that we have posted charts on our website which supplement our comments today. With that, I will turn the call over to, Bruce.

Bruce Tanner

Thanks Jerry. Good morning everyone and welcome to the call. I would like to begin by stating that we had a solid first quarter with strong operational and financial performance across the corporation. Financial highlights include expansion of segment operating profit margin above last year's level, generation of cash from operations in excess of $1.2 billion and maintaining our backlog in excess of $80 billion.

Our operational earnings were particularly strong this quarter. We have included a reconciliation sheet on our web charts that outlines the 11% growth in adjusted earnings per share achieved by our operations after removal of the negative FAS/CAS pension adjustment and non-recurring gain in 2008.

Our GAAP earnings per share declined only slightly despite the anticipated shift from pension income to pension expense that we disclosed in January and in our 10-K and the lack of any comparable non-recurring items in the quarter.

These results were consistent with our expectations and are enabling us to continue providing value to customers and shareholders. Before moving to specific details of our first quarter performance I want to provide an update on the defense budget environment and a brief status on the progress of our continuing efforts to broaden our business portfolio.

The FY 2010 core defense budget proposed by the administration in February outlined a budget ceiling of $534 billion. While this budget target reflects growth of approximately 4% above FY 2009 levels, we continue to believe that our revenue growth will exceed the overall DoD rate driven by strong future sales expansion of the F-35 Joint Strike Fighter program and in our information systems and global services business area.

In an April 6th press conference, Defense Secretary Gates proposed new program priorities for the upcoming FY 2010 DoD budget. His proposed budget actions range from increases to selective programs, to reductions and cancellations of other programs. Key Lockheed Martin programs identified for potential increases included the F-35 Joint Strike Fighter, Aegis, THAAD, Littoral Combat Ship and AEHS Satellites.

Other key programs recommended for potential decreases including stopping the VH-71 presidential helicopter and ending F-22 Raptor production of 187 aircraft. These recommended program revisions will be reviewed by the President and Congress in the coming month as the FY 2010 budget deliberations are concluded later this year. If these proposed revisions are implemented in the final budget, they represent both opportunities and risk for Lockheed Martin programs going forward. Even if all their proposed program revisions were enacted in the final FY '10 budget, we see no change to our current 2009 guidance.

Looking at the overseas contingency fund portion of the FY 2010 defense budget, an initial place holder of $130 billion was inserted in order to continue to fund activities in Iraq and Afghanistan. Determination of the final budget will be made after evaluation of any further requirements. Contingency operational budgets are projected to decline from the peak level and FY 2008 as trip levels are reduced. With very little revenue exposure to the non-core defense budget, we do not see a material impact to our business portfolio from any future reductions in contingency operations budgets.

Turning to our non-DoD work, we continue to shape our portfolio to respond to changing requirements. As I look back over the last 10 years we have actively worked to expand our civil government portfolio from approximately 15% of revenues to over 25% last year. This growing civil and government work coupled with our international and commercial business now comprises 42% of our total annual revenues. Growth in civil and government activities is expected to support the administration's new national focus areas such as Smart Power application, cyber security, healthcare, IT and energy.

We believe our strategic actions and early recognition of emerging initiatives have us well positioned to provide key solutions to several government customers. New focus areas such as the application of smart power to support nation building actions have enabled us to expand our work in this area which is expected to see additional budget growth in future years.

The increased national attention on the critical need for cyber security solutions is another opportunity for our corporation. The growing demand for increased cyber security is expected to provide a multi-billion dollar future opportunity. The need to provide IT solutions, to digitize and manage government Healthcare records is more acute than ever.

With the recent completion of our 14th straight year as the largest IT provider to the US Government and our established IT support on large scale data management systems for agencies such as the Department of Justice and Social Security Administration, we are well positioned to provide solutions in this area.

Finally we have a growing list of energy related programs and activities within our business units. These activities range from smart grid management to energy efficiency, security and alternative power generation. While still in formative stages; we believe our energy solutions offer future growth opportunities in support of key national leads. These emerging activities coupled with our focus on several government agencies and international customers are expected to provide continued growth in our non-DoD revenues.

Turning to our first quarter results, the corporation achieved solid financial performance, operational milestones and won key new business awards. Financial achievements in the quarter included sales growth consistent with our expectations, segment margin expansion and strong cash generation with first quarter activities generating over $1.2 billion in cash from operations, we were able to continue to make opportunistic share repurchases. During the quarter we repurchased 8.1 million shares of our stock for $555 million.

Based on first quarter accomplishments we have increased our 2009 full-year guidance for earnings per share, cash from operations and return on invested capital. Details of the new increased guidance are outlined in the webcast chart and in today’s press release. Let me now highlight some of the recent new business awards and operational achievements in each of the business areas.

Starting with electronic systems, new business lines included a contract from the US. Navy authorizing construction of our Second Littoral Combat Ship. LCS will become a critical element as the Navy continues to modernize and expand its fleet and we are proud to continue our partnership with the Navy on this revolutionary program.

Recent comments by DoD leadership reaffirmed the need to purchase up to 55 LCS vessels to satisfy major requirements. This high level domestic need coupled with international interest in our LCS design offers solid growth opportunities on this program.

Internationally, electronic systems received a $665 million contract from Taiwan to upgrade their P-3 maritime patrol reconnaissance aircraft. Upgrades will include new mission system avionics and service life extension kits. These upgrades will provide its Navy with state-of-the-art maritime patrol or reconnaissance aircraft and enable electronic systems to grow its international revenue international revenues.

In addition to new business plans, Electronic Systems also had significant operational accomplishments. In the area of theater missile defense our team conducted their six consecutive successful test of the THAAD system. This flight test demonstrated the ability of the system to detect, track and intercept a separating target inside the earth's atmosphere.

The THAAD system is critical to providing ballistic missile defense to domestic and international customers and was recently highlighted by DoD as one of the priority programs in the FY 2010 defense budget. Further validating the importance of the system, THAAD was on operational status and ready to provide missile defense protection during the recent launch of the failed satellite deployment by North Korea. A final key accomplishment in Electronic System was a successful operational use of the view it system.

This system provides a real time streaming video to a patchy air crews, improving situational awareness, intelligence and effectiveness against critical targets. I should note that the Electronics team was able to complete the design to production effort in less than seven months and satisfy a rapid fielding request in US army to provide this new system to our war fighters.

I would now like to turn for our fastest growing business, Informational Systems and Global Services. The IS&GS team continues to lead the corporation on top line sales growth again this quarter. The new business win rate success of IS&GS differentiates them from competitors and enabled expansion of their revenues by 10% above last year's level.

Key awards this quarter included a contract from the US special operations command to provide full scope logistic support to special operation troops around the globe. This 10-year ID/IQ contract has a potential value of up to $5 billion. Although, this award has been placed under protest by a competitor, we look forward to successful protest resolutions so work can proceed and enable us to provide critical logistic support to this key customer.

Other IS&GS wins included $400 million award by the General Services Administration to provide system support to the federal and acquisition service. These wins at IS&GS have solid backlog and we expect that to continue generating the highest revenue growth of all of our business areas this year.

Before leaving IS&GS, I wanted to reiterate our press release disclosure earlier today announcing the realignment of IS&GS's three lines of business effective January 1st. This realignment to several defense and intelligence better aligns the segment based on its core customers and business activities. Current quarter and historical financial results have been realigned to provide comparative financial data.

Looking at the Aeronautics business, our team continues to perform at an exceptional level and successfully won key international and domestic new business awards this quarter.

Despite Aeronautics continuing focus on expansion of their services and logistics work, they grew their international portfolio with the receipt of a $300 million multiyear contract to provide seamless services for the Royal Australian Air Force for C-130J aircrafts. This contract will provide innovative solutions and may have some engineering and will utilize our supply chain management expertise to reduce the cost of ownership of the C-130J aircraft in the Australian fleet.

This effort builds upon similar sustainment activities that we will provide to the UK, Italy and Canada for their C-130J fleets. Aeronautics sustainment activities continue to improve aircraft availability rates and reduce the cost of fleet ownership.

Domestic new business awards this quarter included a contract in US Air Force for additional modernization work on a C-5 and Super Galaxy airlifter program. This contract provides funds for work on nine additional aircrafts under the reliability enhancement and re-engineering program.

Three modernized C-5M aircrafts have already been delivered to the Air Force and are demonstrating increased operational capability. Current plans call for delivery of 52 fully modernized C-5M air lifters over the next seven years as we ramp up our work on this program. Modernization of these strategic airlift assets should extend the service life of the fleet through 2040.

Turning to operational performance, our aeronautics team continues to retire development risk and expand their low rate initial production work on F-35 Joint Strike fighter program. Successful flight test milestones continue to be achieved on the conventional take-off and aircraft landing AA-1 including the 81st flight. It was the first flight conducted by an active duty marine pilot.

Also this quarter, our BF-1 STOVL aircraft completed the 14th flight in conventional mode and the initial flight of our second STOVL aircraft known as the BF-2. The current test fleet has expanded to sixth aircraft, consisting of three flight aircraft and three static test aircraft. As anticipated this quarter, we received the updated engine from the government, which enabled the BF-1 STOVL aircraft to begin hover-pit testing in March.

To-date, the testing has progressed exceptionally well with the engine generating more vertical thrust than DoD performance requirements. We expect successful completion of hover test this March with the aircraft then proceeding to conventional mode flight test later this quarter followed by the first STOVL flight to be conducted this summer. These operational successes on the Joint Strike Fighter have increased confidence from domestic and international customers on the program's progress.

Support of the progress maturity was shown by the Department of Defense first award of $305 million in contract for long lead materials for 32 aircrafts under LRIP Lot 4. Additionally, last week, we completed successful negotiation on LRIP Lot 3 contract for a total of 17 aircrafts consisting of 14 for the US and 3 for international customers. International support for the firm remains strong with the recent announced intention of the United Kingdom to purchase three test aircrafts and reaffirmation of it's commitment to purchase 138 STOVL aircraft.

Also the Italian Parliament recently approved funds for the construction of the Final Assembly and Checkout facility. This facility is expected to become operational in 2013 to support in-country fabrication activities and will add to the collective capacity of the F-35 worldwide supplier base and production capabilities.

Italy also reaffirmed its commitment to continue with its acquisition plan to purchase 131 aircraft for international requirements. Overall the F-35 program remains solidly on track as it ramps up production to meet the needs of our domestic and international customers for the fifth generation fighter aircrafts.

Finally in Aeronautics, we are pleased with the recent ratification of a new-three year labor agreement with the International Association of Machinists and Aerospace Workers. These employees perform critical task for our customer and the nation through their workup supporting our programs. This agreement is an essential element to workforce continuity and in our ability to move forward as we ramp up production on our F-35 aircraft line.

Turning to our Space Systems segment, operational performance was demonstrated this quarter as they continued to build upon its legacy as the leading provider of GPS satellites. The Space Systems team completed fabrication of a modernized GPS satellite that was successfully launched for the US Air Force.

This satellite is the seventh of eighth GPS IIRM satellites and will provide additional capacity and user access. These modernized satellites provide enhanced operations and navigation of signal performance for military and civilian users around the globe. The GPS constellation has become a main stay in our life by supporting a wide range of civil, scientific, commercial and military functions.

With the award of the next-generation GPS 3 satellite constellation space systems last year, we are well positioned to continue our legacy of providing these critical access to US Air Force for decades to come.

In summary, our operational accomplishments, new business wins and financial performance across all of our business segments this quarter have us well positioned for increased financial growth in 2009 and beyond. With a solid financial foundation and diversified portfolio, we look forward to continuing to create value for shareholders and customers.

I would now like to open the line for your questions. Michael, please open the line please.

Question-and-Answer Session

Operator

(Operational Instructions). And we will take our first questions from Robert Springarn of Credit Suisse.

Robert Springarn - Credit Suisse

Good morning, everyone.

Bruce Tanner

Hi, Rob.

Robert Springarn - Credit Suisse

I have a lot of different things I would like to ask about, but the one thing I think a lot of us are focused on is the F-35 program and what happened on April 6? And Bruce, you alluded to that. Understanding that it doesn't affect fiscal '09, when I look at the puts and takes and what we saw on April 6, I see Lockheed in a net positive position largely because of F-35.

Could you give us some specificity on what kind of increase we are actually looking at, what you know so far? A lot of this has been characterized as $5 billion plus, but it's really fiscal '09 to fiscal '10 that we see the $5 billion increment.

What kind of increment do we see from what might have been the old 10 plan to the new ten plan, and how will that manifest itself in terms of spending, the number of test air craft they are adding versus other R&D.

Bruce Tanner

Yes thanks Rob, long question, but a good question. Now quite honestly as we look at the F-35 program and what was announced by the Secretary, in terms of the actual aircraft quantities that with affect our next few years of planning, we honestly don't see increases to those numbers, I mean the numbers we were talking about in the FY-10 advance funding that we talked about, that I talked about in my script, was for 32 aircraft. I think that is right in line with what Secretary Gates mentioned in his comments on April 6th. The multi-billion dollar funding increase that you talked about, it is obviously something we noticed as well. It's not entirely clear to us at this point without the details of the budget, so exactly what that is for, at this point to be perfectly honest with you so, we are little bit waiting or maybe a lot waiting at this juncture to see what the details come out from, when they do come out later this month or early in next month to get more insight into the FY-10 budget to actually be able to answer that question.

Robert Springarn - Credit Suisse

Bruce is it fair to say though that if we look at what the accelerated plans that various people had proposed and they were numerous studies of an accelerated F-35 plan, that fiscal 10 was always going to be meaningfully above the 6 billion in fiscal '09.

Bruce Tanner

That’s correct.

Robert Springarn - Credit Suisse

Yes, okay so the delta is something other than that. Thank you very much.

Bruce Tanner

You bet, Rob.

Operator

And we will take your next question from Joseph Campbell with Barclays Capital.

Joseph Campbell - Barclays Capital

Hi, good morning. We wanted to ask the same kind of questions about either side. I guess somebody asked about the plus, less about the minuses. If they actually and the President’ helicopter and the F-22 program, what will actually happen say if we take the F-22 as an example, what will happen down in Marietta and how will that affect the other programs that are down there if the F-22 line actually ends.

And I guess the other question I have about the F-22 is, I read that the Secretary wants to do this, but traditionally that’s meant that Lockheed and the Air Force have gone over to the hill and rounded up letters from 50 senators or 100 senators or as many as you can get to try and reverse what the Secretary wants to do by wining on the helm if you are are loosing the Pentagon.

Are you still going to do that kind of battle to keep your plane sold or is this something that you have decided since the President and the Secretary don’t want it that you are going to leave them alone?

Bruce Tanner

Well let me say whatever you came with Joe. We talked about the VH-71 and F-22 just the couple of maybe overarching comments before I get to the specific answer to that. Those are kind of two different discussions that were talked about in the Secretary’s words, I mean the F-22 it is not a termination, it's simply a lack of continuing production at the current level and actually the current program with the four additional aircraft to a total of 187 aircraft would take us out to about the first quarter of 2012 in terms of production of that program, the VH-71 is entirely different situation. And the words from the Secretary were basically that we are going to end that program, that would actually be a full blown termination. You asked about the impacts of that?

Joseph Campbell - Barclays Capital

Does that mean you don't expect to get termination fees for the F-22 and so on? It's just no action taken that's your interpretation of what’s happening here?

Bruce Tanner

We think Joe that there are tail-up costs which is kind of a little bit of term of aircrafts in the industry but there are tail-up costs associated with the end of any production line and we would expect that to be prevalent in the last four aircraft, as well as potential mode or change resulting in the overall recruitment of that tail-up cost for the end of the program. That’s different than a normal termination, say again the VH-71 where we have a pretty standardized process for terminations for convenience that reflect what costs are recoverable, which costs are not.

At this point, I think it's important to say though that there is nothing actionable on either one of those programs at this point. There is no notification, no letters from customers that would say you should perceive with the termination proposal if they are separate and telling us and what to do for instance with those assets. So, we are a little ahead of the game there as well.

You had asked about impact to Marietta and I will prove in the impact of Owego as well. Again the Marietta impact is further out in the 2012 timeframe. We are fortunate in Marietta and at the same time we are seeing the downturn in the F-22 production, we are seeing a significant up-tick in production for the C-130J program, as well as, as I mentioned in my prepared remarks, a fairly significant up-tick in production of C-5 program.

So, it remains to be seen if those things align perfectly to be able avoid any kind of issues there and we will have to take a look at things what elements of the F-35 program can be moved around between the aeronautics locations, but that’s something we will always strive to do to have as little disruptions as possible at Marietta workforce.

The Owego situation where the Presidential helicopter is built, a little different situation, there is no C-130J coming along behind it if you will, in Owego and that's something if that were to come to fruition along with the delay or the demise of the combat search and rescue helicopter, the CSAR-X program for the Air Force, that would likely have some near-term reductions on our Owego workforce that we are looking at as we speak here today.

The last question you asked was about that we team up with Congress and try to the fight the F-22. Look, from my perspective the Secretary of Defense, the Secretary of the Air Force and the Chief of Staff of the Air Force, looking for that by I can go with the defense, Deputy Secretary of Defense and others within the Pentagon as well are all completely aligned on this matter from top to bottom, we had our chance to lobby this matter, we think we had a full hearing of that discussion, we are disappointed by the decisions but we will accept those and go on.

Operator

And we will take your next question from Robert Stallard of Macquarie.

Robert Stallard - Macquarie Capital

Good morning.

Bruce Tanner

Hello.

Robert Stallard - Macquarie Capital

Bruce, if we can just follow on the same band if you could give us an update on the advance of the C-130J. It wasn't specifically commented I think on by Secretary Gates, but if you could update us on your volume increase there and the time table for that?

Bruce Tanner

We still see, we are very much on-track and we seed up the fact that we are going to double production by the end of the decade. I am very comfortable with that statement as I sit here today. And we could see some potential growth beyond that and the years after the decade that would be our expectation. I think the Secretary actually made some nice comments. When he was speaking to some of the war college venues that he did after the announcement on April 6, where he talked about robust C-130J sales, which I think is affirmation of what we see in that regard as well Rob.

Robert Stallard - Macquarie Capital

Have you seen any interest on the export side of C-130J as well?

Bruce Tanner

Absolutely. Internationally, I will say increased interest particularly with the couple of Middle Eastern countries and I think there has been additional inquiries. I think we are really in that regard but a couple of inquiries relative to what could happen relative to A400M's lack of success on the delivering aircraft with the time and dollars that they were putting to.

Robert Stallard - Macquarie Capital

Great, thank you.

Bruce Tanner

Thank you, Rob.

Operator

And we will next go to Howard Rubel of Jefferies.

Howard Rubel - Jefferies & Company

Thank you very much.

Bruce Tanner

Hi, Howard.

Howard Rubel - Jefferies & Company

I am good. It’s still morning. Good morning, gentlemen. The opportunities that exist before you extend not only in aeronautics but also I think in space and DNI Blair had some announcements the other day and talked about existing designs for some additional satellites. Does that position you pretty well for some volume growth in that market?

Bruce Tanner

I think the short answer is yes, Howard, but the longer answer is probably not necessarily the near-term, but we saw the comments by Mr. Blair and were encouraged by them. This notion of the need for kind of these exquisite level satellites as there is something that we see as well and something that we are particularly well suited to produce. So, those align very nicely with our interest and past capabilities, but I don’t think it’s a near-term impact but it does set us up for a longer term growth, absolutely.

Howard Rubel - Jefferies & Company

And then just, if you look at all your programs you look like you are performing really well. Are there any areas where you feel like you have got maybe a couple of red programs and you like to highlight where there are some opportunities so far for some improvement?

Bruce Tanner

You know I probably never want to highlight red programs, but I will try to answer the question nonetheless. I think it was a very clean quarter and we really did not have any hiccups or pop-ups from a performance perspective.

The programs that probably I'm watching, you know they are always characterized as having their reddish trance through them include several of the satellite programs while we are still in the developmental cycles. The MULOs program as well as potentially the current build on the AEHS satellites. I think we are making very good progress on both those. We have gone through a couple of interim tests particularly the AEHS satellites that have come out very favorably recently. So I'm encouraged by that. We have, I think I had mentioned a few quarters back a ground-based EW program within electronic systems that we had an issue with few quarters back. That’s still a locked item for us going forward and one we’re open to result here shortly.

Howard Rubel - Jefferies & Company

Thank you very much Bruce.

Bruce Tanner

Thanks Arnnet.

Operator

And the next question goes to Ronald Epstein with Merrill Lynch.

Ronald Epstein- Merrill Lynch

Good morning again guys.

Bruce Tanner

Good morning, Ron.

Ronald Epstein- Merrill Lynch

Bruce can you give us some color on the opportunities for the Lockheed Martin in cyber space, I mean in cyber security, I guess on the Wall Street journal there was a big picture of F-35 and talk about a cyber breach, how big an opportunity is it and what you guys bring into the space?

Bruce Tanner

Yeah great question, we saw the picture as well. Unfortunately can't talk a lot about nor does the US Government talk a lot about security matters, but nonetheless we actually believe the Wall Street journal was incorrect in its representation of a successful cyber attack on the F-35. I mean I’ve not heard of that to my knowledge and to our knowledge there has never been any classified information breach.

And like the governments, these attacks on our systems are continuous and we do have stringent measures in place both to detect and stop these attacks. So, caught us a little bit by surprise there to be honest with you. As far the opportunity for Lockheed Martin, I think the opportunity is as rich as for anyone else kind of in this business. I think we have got great bonafides in terms of our past practices particularly as I look back on what we’ve done with a lot of the business and with our intelligence customers.

So we probably had data encryption classified access all the programs for probably a quarter of a century with that customer. And I think that is the kind of protection that we are looking. This is not sort of anti-virus Internet protection sort of things you would buy going down to your computer retail store.

This is very sophisticated, very redundant capabilities and I think that we provide and have provided for a number of years to a number of US government customers and I think that is nicely going forward.

Size of the market I think, everyone describes it as in the billions of dollars, we describe it that way as well. Although, it is awfully hard to predict exactly how that market grows year-over-year, I do see it growing as faster than the DoD growth rate. And the hard part of that is from our perspective is we really do not get orders, change orders or contracts themselves to say put this cyber security application on the program, instead we get changes and programs that have requirements for like I said earlier redundancies and those sort of things that are just part of the normal costing of the program or that change order. So we currently don’t see, and we likely won't see the specific dollars associated with cyber security opportunities, but we do see that volume growing as we go forward.

Ronald Epstein- Merrill Lynch

Okay thanks Bruce.

Bruce Tanner

Thank you.

Operator

And our next question comes from Joe Nadol with JP Morgan.

Joseph Nadol - JP Morgan

Thanks good morning.

Bruce Tanner

Hi, Joe how are you?

Joseph Nadol - JP Morgan

Good thanks. Bruce, if you could talk about the IS and GS business a little bit, the margins were a little lower than they have been over the past couple of years, edging below that 9% market. I think for the first time since '06 you did the re-organ and it wasn't quite clear from the MD&A here on the margin as to why they were lower. The decrease in civil was due to the absence of benefit. It doesn’t explain why you are down kind of overall?

Bruce Tanner

Yes, I got the question Joe, thanks. Yeah with margins within IS and GS for 8.8 last year was about 9.2. Last year had the benefit that we did mention on the call as well as the press release of the contract restructuring. That was a fairly significant item that if we remove that from 2008, 2009’s performance actually exceeds that, now taking a look at the absolute value if you will and your comment I think is right relative to comparing it back to 2006 time frame. Margins at the 8.8% level are lower than what we have done in the last two years.

Couple of reasons for that, one of which is as I have talked about on numerous occasions, IS and GS has the largest percentage of what we call service contract accounting programs where we have great variability in the quarterly flow of those costs basically on service contract accounting your revenues is fairly levelized but your expenses or cost of sales associated with those contracts are expressed in the period which incurred.

So depending on what you have won in the early stages of those service contract accounting, contracts you can have great fluctuation in the cost of sales recognized on a quarter-by-quarter basis. I think that’s what happened in the first quarter time frame. There were no performance issues, there was not a performance write-off in any of our programs, it was strictly the timing of that cost of sales recognition.

Looking forward I still see we talked about in the past that IS and GS has the largest share of award fees of any of our four business areas and those award fees tend to get locked in the second and fourth quarter. We actually had a fairly low portion, we have to work these off in all four quarters, but we also had a little bit lower award fee portion in the first quarter compared to say years passed. And yet we still expect to see in the second and fourth, significant increases in the margin as we reflect the award fees that will be received in those two quarters. I still figure today looking out at the year confident in our guidance that we provided to you and I will share with you one another comment maybe before I let you go.

You mentioned the '06 time frame, we are just going back and restating some of the history for IS and GS because of the reinstatement of the lines of business. You take a look at the 2006 earnings out of IS and GS compared to 2009 earnings and EBIT out of IS & GS it's up 50%.

We have about $800 million of earnings in the 2006 time frame and $1.2 billion is what our outlook in the 2009 time frame. So I don’t think there’s anything to be ashamed about.

Joseph Nadol - JP Morgan

Yeah. Thank you very much. That’s very good color. And just on the reorg though what drove the timing I guess specifically?

Bruce Tanner

I think the timing was just driven by the fact that we have some significant growth in what was formally the global services line of business within IS and GS and we were starting to get some contract applications that were cutting across not just within the global services but in all three business areas and we are cutting across our customer base and we just felt that having this alignment more geared towards our customer set presented a more consistent phase to those customers, and it was actually easier for us to align our resources that way as well. Nothing more than that.

Joseph Nadol - JP Morgan

Got it, thank you.

Bruce Tanner

Thank you, Joe.

Operator

And our next question will go to Cai von Rumohr of Cowen & Company.

Cai von Rumohr - Cowen & Company

Thank you very much. Secretary Gates talked about in-sourcing contract acquisition work, and bolstering government's workforce there. And we saw I guess a Bloomberg article about how the VA has in-sourced the VAT work from you and representative [inaudible] and is crowing about how they would save all this money. Could you comment on the VA, is that an isolated incident and related to kind of what Gates said, where do you see -- is in-sourcing really a threat and if so where and how much business do you have that might be subject to in-sourcing.

Bruce Tanner

Okay. First maybe a little correction, it’s called DFAS which is actually the payment office if you will for the Government in Columbus, Ohio there and the contract, you are talking about, and then bringing in what that announcement actually discussed with the fact that they would not be exercising the next option on that contract.

That contract expires in the 2010 timeframe and the comment from the customer that they do not want to exercise the option past that timeframe. And we will support them in that endeavor and we will make sure the transition is seamless from our perspective. That particular one was a fairly small contract of say less than $50 million or so of annual sales actually quite a bit less than $50 million of annual sales.

The things, probably the broader question Cai, that you are asking about is, what does this portend for other programs that are similar ilk. And I think in general this, at the top level I would say A-76 programs that have recently been awarded are probably areas that will be scrutinized going forward.

And we have a couple of contracts that probably fall in that category. The AFSS contract, the alternative flight station support contract out of IS&GS is one of them. And we also have just kind of call it two different things again, both the IHOP or the HR access program for the Department of Homeland Security.

Those are ones that I will be watching going forward, because they were fairly recent awards. Most of the rest of our kind of support of customer, government customers for things like sustainment activities and so forth, I don't particularly see those at risk. I think we have got well established kind of ground rules, our boundaries stay between ourselves and the depots where we have a very, very comfortable working relationships, they are in fact a partnering relationship on many of our programs, and I don't see that changing going forward.

Cai von Rumohr - Cowen & Company

Okay, could you comment, Kucinich sort of has this combat of, or they wish growing up we are going to save so much money. Is this really kind of an isolated specific incident with politics, or if you see this as part of a broader, or is this kind of related to what Gates talked about?

Bruce Tanner

I think by any measure that the customer used to evaluate us, we performed very well in that contract and I will leave with that.

Cai von Rumohr - Cowen & Company

Okay, great. Thanks a lot.

Operator

And our next question goes to Sam Pearlstein with Wachovia.

Sam Pearlstein - Wachovia Securities

Good morning.

Bruce Tanner

Hi, Sam.

Sam Pearlstein - Wachovia Securities

Hi. This is kind of a multi-part question, but I am just wondering if you can talk a little bit about capital allocation. If I just look at what the stock hit in this first quarter and your buyback activity while you certainly bought back an awful lot of the stock really had been down below 60. I am just trying to think about the combination of your strength in your balance sheet what the stock prices have done, and then looking at your appetite for acquisition given current multiples. Can you just talk a little bit about how you are thinking about capital as we go forward?

Bruce Tanner

Yes, good question, Sam maybe just to give a start of that, I will just talk about cash in general and I’ll start by playing the first quarter and we are really proud of the results in the first quarter $1.2 billion.

Just like I'm probably as proud of if not more is the fact that our free cash flow exceeded $1 billion as well. And just to kind of give you a preview of what we are looking at in the next few years, our next few quarters, I think cash going forward will probably be somewhat levelized to get to the $4.1 billion probably each quarter about the $1 billion range, so I don't see huge fluctuations there.

Relative to its deployment and its effect on the capital structure, we did 67% return on free cash flow in the first quarter that was lower than what we did in 2008. But in 2008, there were significantly greater numbers of options that were exercised. And as we tried to avoid or tried at that timeframe to avoid some of the share creep associated with those exercising options, we ended up buying a whole lot more shares in that quarter than this quarter.

I will also remind everyone that first quarter of 2009, the dividend payouts or the dividend rates that we are paying out is 36% higher than was the dividend in the first quarter of 2008, and we look at cash back to shareholders in the forms of, both share purchases and dividends, so we went up on the dividend side significantly, but we came down a little bit in the share repurchase side.

But even with that, I think we still reduced share count by 1.6% in the quarter, which is one of our highest quarters that we have ever done since we have had the share repurchase program. Going forward, I still think we are trying to keep powder a little dry from an acquisition perspective. From an opportunistic use of the cash, we continue to like the string of pearls approach we have used and we are still looking at those situations as we speak today.

Sam Pearlstein - Wachovia Securities

But if it's the type of thing with the buyback we hear in the market everyday, or is it when the price presents an opportunity you are more aggressive?

Bruce Tanner

Well, the answer to that is yes. We are typically in the market everyday, but we try to accelerate when we think the price has not an opportunistic reason to buyback more shares.

Sam Pearlstein - Wachovia Securities

Okay. And then can I just ask a follow-on, the FAS/CAS adjustments, were there changes in assumptions that would have led to a $10 million shift in the last couple of months?

Bruce Tanner

Yeah, good guess. The FAS/CAS did change 10 from when we talked to you in the January timeframe, and we've got 18 or so different pension plans and finally put together call we were still crunching on all the actuarial assumptions behind that, Sam.

That happens every year about that time. Most years, I shouldn't say most years. Last year it didn't reflect the change in the first quarter when we presented results there. In prior years if you look back, we have actually had kind of similar levels of adjustments, but all of it was kind of trueing up for that actuarial data, nothing more significant than that.

Operator

And we will take our next question from Heidi Wood with Morgan Stanley.

Heidi Wood -Morgan Stanley

Good morning.

Bruce Tanner

Hi, Heidi.

Heidi Wood -Morgan Stanley

First, a big picture question for you and then another couple of specifics from the quarter. You guys were the first to focuse in the shift from defense to talking about global security, but I am wondering what you think that mean from a numerical perspective. I mean what does this portend for margins or do you see revenues growing faster.

And I better want to understand if we take a look at this status smart power, cyber security, healthcare, IT and energy as future growth opportunities, how big are they collectively and how fast do you see them growing?

I am sure you can't give us number for cyber security, but if it is part of a overall group that does thrust of growth, perhaps you can give us color that way.

Bruce Tanner

Yes, Firstly, big picture. I think those prospects for the four items that we talked about in the prepared remarks is for some potential for some significant growth, although again probably not in the immediate near-term.

I think the one that probably has the quickest near-term growth potential is in the cyber security, I wish I could give more detail as to why that is, but really just can't at this point in time.

The other ones that we are watching along that ilk, again I think the health care IT is one that is implemented the way things are being talked about. We have some great opportunities there. And that could be a near-term revenue growth item than say the energy business.

The energy is still kind of in its nascent point right now still starting from not much, but we do see great potential in that area. And the US about margins going forward, it's a little bit too early to tell at this time, I would think that the cyber security margins would be comparable to the rest of our DoD business. I would think that the healthcare IT would be comparable to what we experienced on other federal IT programs, so I don't see it necessarily increase or decrease in those margins going forward.

Heidi Wood -Morgan Stanley

But the collection of the four, including Smart Power, how would you band with their size now, so we can watch this expand?

Bruce Tanner

Yeah, I'm sorry. I didn't mention Smart Power. That's the one we think will grow. I didn't mention that earlier. That probably will grow as fast or faster than the other two as well, and that will probably in all honesty has margins that are a little bit lower than the overall margins of the rest of the business areas. And pretty in particular within IS&GS.

Again Heidi, I think it's just difficult to quantify that near-term, I think other than saying cyber, healthcare IT and Smart Power for the near-term chances to have some revenue growth and at least on the cyber and the Smart Power those have potential for significant near-term.

Heidi Wood -Morgan Stanley

All right, and then as it pertains M&A, it seems that most of the M&A we have seen you do has been expanding on this global security paradigm, does that continue or do you think that there is some opportunities to add more of the core over in 2009?

Bruce Tanner

I think you will see some core acquisitions as I just looked out over the horizon of what we are looking at. I think there is some very, very promising core items that we are pursuing, but quite honestly in terms of what we have done in the past, and while we still see opportunities within the IS&GS sorts of business because that is our hurdle ground, we believe and we continue to think that's a hurdle going forward. Also an area going forward is the sustainment part, and we still see some benefit in potentially doing some acquisitions in that area as well.

Operator

(Operator Instructions). We will go next to Myles Walton of Oppenheimer and Company.

Myles Walton - Oppenheimer and Company

Thanks, good morning guys.

Bruce Tanner

Hi Myles.

Myles Walton - Oppenheimer and Company

We touched on the Secretary Gates comments on the topping of the 22 or 187, but what I was curious on is your perspective on the upgrade potential of the existing aircraft or the first hundred to bring them upto 2.2 increment. And do you think, or do you have a read yet on his desire to put that full effort behind which I guess on Young’s comments late last year were put around $8 billion or so?

Bruce Tanner

Maybe just a couple of comments on the F-22 just to set the stage. I think we continue to have in my words just exceptional cost and schedule performance along with record quality levels on that program and that’s in the midst of all the churn and turmoil and discretion has been flying around the programs head at that point in time. So, I am very happy with the performance that we are seeing even in the face of a lot of the discussions were going on.

You talked about the potential for and I would characterize it as sustainment, mods upgrades for the program. We see those things literally that aircrafts will be flying for decades to come and the need for sustainment, the need for modification, the need for upgrades with this aircraft is just as with any other aircraft will also continue for decades.

That won't change simply because the aircraft is out of production. We see that the numbers that you mentioned Secretary Young’s comments, we see those as being very viable, very feasible and I think we are literally talking multiple billions of dollars in mods and upgrades that need to be done for the aircrafts over the next five to ten years.

Myles Walton - Oppenheimer and Company

Okay. And so would you expect those to kind of feather into 2010-2011 such that the wind down of the I guess percentage of completion basis, that would probably effect you in the later part of 2010, you wouldn’t really see much of a decline on overall F-22 in 2010 and maybe you start to see it in '11.

Bruce Tanner

Yes, I don't think so, because as we look at it right now, we probably do about a $1 billion a year in kind of sustainment cost on the F-22 program as we speak today, that number is likely to grow. And I am not sure it grows in the timeframe you are looking at enough to offset kind of the planned reduction in the production aircraft, but beyond 2012, I think that’s where we will see a lot of the mod upgrade effort that you were talking about, but I was referring to as well take place, and that will help mitigate some of that reduction in my judgment.

Myles Walton - Oppenheimer and Company

Okay. That’s fair. And the last one from me, CAS I think your mark date is in May and so would you actually have almost at this point good visibility into what your 2010 CAS projection would be?

Bruce Tanner

I wish I could say yes, Myles, but the answer is no. There is still a lot of thing, the things are going on and I heard you chuckle there, but the things that are going on literally is, I can see what the assets return is right now, no great secret here I don't think we are fairly flat as far as the asset returns is concerned not tracking with the 8.5% for the year if you will. But on the other hand, the discount rate if we were to strike a line in the sand today, that discount rate is significantly higher than what we had at the end of the year last year, that’s more on the FAS side I guess, as opposed to CAS. But we still got another what 3.5 or so months of performance on the asset side. Still too early to call for what the CAS is going to be without the passage of those two months or so.

Operator

And our next question goes to Noah Poponak of Goldman Sachs.

Noah Poponak - Goldman Sachs

Hi, good morning.

Jerry Kircher

Good morning.

Bruce Tanner

Good morning. How are you, Noah?

Noah Poponak - Goldman Sachs

Good. In the tactical vehicle world, you guys are part of the JLTV down select, but there is always a conjecture of that being sort of pushed to the right. Is there any opportunity for you to get involved in what might happen between now and then we've got, MATV out there, there's now discussion of ECV-2 where the sole source was taken away. So, what's your latest thinking on timing of JLTV and is there an opportunity for you to be involved in what might happen between now and then?

Bruce Tanner

Yes thanks. I think the short answer to the question is, we are engaged in the JLTV competition, that’s the 27 month tech demo phase and it is likely that there won’t be opportunities for us to get into the tactical vehicle market other than that entry if you will.

Noah Poponak - Goldman Sachs

Okay. One quick follow-up, the revenue growth in the quarter is lower than what the full year guidance implies for the full-year. So, you are expecting some acceleration. Can you just give us the two or three things that drive that and kind of help us with the quarterly profile for the last nine months of the year?

Bruce Tanner

Yes that’s a good question, given what we did in the first. Maybe what I will do, spend a little more time than maybe, you are expecting, let me answer that question but I will kind of go through each of the four business areas maybe just the center stage. IS&GS growth of 10%, looking forward I will expect to see revenue growth within IS&GS sequentially increasing quarter-over-quarter and still within the numbers that we are looking at for the full-year guidance. I don’t see anything it would cause us to back off of that assumption.

Within Electronic Systems, this is the one that might be a little bit of surprise to you listening there as we look into the second quarter, the second quarter last year for Electronic Systems was the highest quarter of the year, and that was driven by significantly higher deliveries in that particular quarter for air defense products as well as tactical missile products. We don’t see that same level of sales recognition in the second quarter of 2009 timeframe. In fact, I would expect to see a reduction quarter-over-quarter in electronic systems in the second quarter simply because of the lack of those delivery items this year versus last year.

After second quarter in electronic systems, we expect to see accelerating growth with each of the last two quarters growing at fairly good eclipse for the rest of the year still getting to the level we talked about in the guidance obviously. Within the Aeronautics business area, we were down slightly in the first quarter here. We had one F-16 delivery less than we had in the previous year. We are also holding it lighter on the F-22 volume and even though we had increased volume as a little lighter than we were expecting on the F-35. I think those are pure kind of timing issues that will resolve themselves in the next three quarters. Same quarter situation is IS&GS strong sequential revenue growth quarter-over-quarter getting to the level we saw in the guidance.

And then just talking with some color on Space. Space I would expect to be down from a comparable basis relative to last year’s second quarter. Last year’s second quarter had two delivery events, one launch vehicle and one satellite, a commercial satellite and a commercial launch vehicle that we don’t expect to have happen this year. So, that in it of itself will break out the second quarter to be lower. And then from that point forward space is probably going to have fairly flattish growth, probably the fourth quarter being the highest quarter of the year as we look there.

Also within Aeronautics I should make the point that the quantity of aircrafts were up 3 aircrafts on the F-16 production line and up 4 aircrafts on the C-130J production line. Interestingly, for both of those programs all the increase in aircrafts occurred in the second-half of the year. So, overall we are going to see probably a lower second quarter than a lot of people are expecting and then probably more rapid growth in second-half of the year that people are expecting as well.

Noah Poponak - Goldman Sachs

As I plug those in while you are saying and it looks like the second quarter growth rate will actually be lower than the first quarter growth rate and then 3Q and 4Q will be in the double-digits.

Jerry Kircher

Yes, I think the second quarter growth rate will be

Bruce Tanner

I think you said it right. I think you have got it right.

Noah Poponak - Goldman Sachs

Thanks a lot.

Bruce Tanner

You bet.

Operator

And our next question goes to Douglas Harned of Sanford Bernstein

Douglas Harned - Sanford Bernstein

Good morning

Bruce Tanner

Hi Dough

Douglas Harned - Sanford Bernstein

Hi, I wanted to ask a question on electronics and just to understand really from a margin standpoint you highlighted two things in the release, one was a one-time item on the resolution of stimulation and training contract. And then also some declines in the quarter in MS-2, could you sort of scale those and in the MS-2 side, is this something that’s really just a one-time a timing issue for the quarter and how do you see that going forward over the rest of the year?

Bruce Tanner

Yes, couple of responses to that, one we highlighted in the press release we did, as you said kind of a one-time contract resolution/settlement in our stimulation training business in Orlando. We think of that in the tens of millions of dollars but that drove Electronic System's margins in the first quarter higher than probably what we are going to experience for the rest of the year without some sort of unplanned performance improvements in the remainder of the year if you will.

So, as you said, that was kind of the one-time event, you also talked about the MS-2 that was I will say kind of seasonally lower in the first quarter than probably we are going to see for the rest of the year. There are couple of, just talk about the revenue there was a number of deepwater aircraft deliveries, the so called MPA aircraft that happened in the first quarter of last year. That brought the revenue down a little bit, but the margins were also slightly less than what we expect for the rest of the year. I think that's more of a seasonal thing than anything else, Dough.

Douglas Harned – Sanford Bernstein

Because you should be seeing good growth overtime in that unit I would expect?

Bruce Tanner

And we would as well. I should point out that within the Electronic Systems, we expect all three of the lines of business there, the MS-2, missiles and fire controller and platform training to have double-digit return on sales and that's consistent with what we are out looking to you.

Douglas Harned – Sanford Bernstein

Okay. Great. Thank you.

Bruce Tanner

Thank you, Doug.

Jerry Kircher

Michael, this is Jerry, I think we got time for one more call.

Operator

Okay. And our last question will come from Jim McIlree of Collins Stewart.

Jim McIlree - Collins Stewart

Thank you very much. This will be easy all my questions have been asked and answered.

Bruce Tanner

Okay, great Jim. Thank you. Okay. With that I would like to offer some closing comments. Looking forward it is essential that we continue our efforts to execute on program and deliver the best value solution to our customers. The future budget environment and change in customer priorities will require continuous focus on cost efficiencies and program performance. Our 146,000 employees have us uniquely positioned to deliver on these requirements and differentiate Lockheed Martin in the eyes of shareholders and customers.

I would like to close by thanking you for your questions and for joining the call today; and we look forward to talking to you again in July. Michael, that concludes our call.

Operator

And this does conclude today's Lockheed Martin conference call. Thank you for joining us and have a wonderful day.

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Source: Lockheed Martin Corporation, Q1 2009 Earnings Call Transcript
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