Lockheed Martin: What Hides In The Future?

Aug. 7.14 | About: Lockheed Martin (LMT)


Too much dependency on the U.S. government could be a potential downside.

The Middle East conflict could play a critical role in countering the lower earnings expectations.

An unexpected venture might rescue the company, but it'd be too soon to bet on it.

Lockheed Martin (NYSE:LMT) identifies itself as a global security and aerospace company that primarily specializes in the research, design, development, and integration of advanced technology systems, products, and services. The company operates at a global level, and serves both domestic and international customers.

The company is correctly labeled as too dependent on the U.S government for its sales. For instance, in 2013, 82% of its total net sales of $45.4 billion were from the U.S government, including 61% sold to the US Department of Defense alone. The remaining 17% were from international customers, mostly in the form of foreign military sales contracted through the U.S. government, and 1% were from U.S. commercial and other customers (SEC filings, quarterly report).

Systematic Reduction in Defense Budget by U.S. Government is Expected in the Future

As the U.S. tried to shy away the aftermath of the financial crisis of around 2008-2010, there has been ever-increasing pressure on the government to take steps towards monetarism and away from Keynesianism. This strategy has been put into action through the continued quantitative easing program by the Federal Reserve. This was a strategic move to revive the U.S. economy sooner than later. To further aid the policy, the U.S. government was put under pressure to reduce its defense spending levels. Pursuant to this narrative, the Budget Control Act of 2011 was passed by Congress. The Act established limits on discretionary spending on armaments to reduce spending levels by $487 billion over a 10-year period that began with government fiscal year 2012. The Budget Control Act also provided additional spending restrictions known as sequestration. These were put into effect on March 1st, 2013. According to these restrictions, spending would be reduced by an additional $500 billion over the next nine years. This amounts to $987 billion taken from the defense spending budget over the next 8 years of the 10-year program.

However, in December 2013, Congress approved the Bipartisan Budget Act, which revised the budgetary limitations on defense spending to provide for an additional spending fund of about $22 billion for fiscal year 2014 and $9 billion for fiscal year 2015. However, it must be noted that the revised budget maintained the statutory limitations for the period of 2016-2021 in accordance with the Budget Control Act. Thus, these limitations could prove to be a considerable restraint on the company's revenues for the coming years.

Armaments Supply to Middle Eastern Countries:

However tragic the current situation in the Middle East might be, this could somewhat stabilize earnings for Lockheed Martin. This is because the turmoil has made these countries more cautious and wary of the upcoming precarious circumstances. To start with, Iraq has just signed an agreement with the U.S. to purchase 5,000 hellfire missiles valued at approximately $0.7 billion. These missiles are only developed by Lockheed Martin, and thus, it presents an opportunity for potential earnings. Similarly, there is an ongoing deal worth $6.8 billion with Saudi Arabia. Also, the U.S. has recently signed an agreement worth $11 billion with Qatar for Patriot missiles and Apache helicopters. Both of these are products only developed by Lockheed Martin. Thus, as a primary contractor of the U.S. Department of Defense, Lockheed Martin has reasonable short-term potential to increase its revenues and earnings.

Efforts to Commercialize its Desalination Water System:

Keeping an eye on the reduced earnings potential from the U.S. armaments sales, in the long run, the company is investing in the R&D of a product that varies from the company's portfolio. The project is to desalinate sea water and make it fit for drinking. In the wake of restrictions, the company has already made a breakthrough by registering patents of its water desalination system.

The system utilizes a membrane developed by placing holes that are one nanometer or less in thickness in a graphene membrane. These holes are small enough so as to stop impurities, while improving the flow of water molecules through the holes, thereby leading to less clogging and pressure on the membrane. As the graphene membrane is only one atom thick, quite strong, and durable, it makes the system more effective and less costly.

Given the fact that access to clean drinking water is going to become more critical in the future, techniques like this will become very important in providing potable fresh water. However, there is one important obstacle in translating this potential growth opportunity into tangible earnings: the commercialization of the system to produce clean water at a large scale. Right now, the company is looking for partners to commercialize this project, but it might take longer than anticipated to transform this opportunity into a practical reality.

Final Thoughts:

In my opinion, Lockheed's business segments with shorter-duration contracts such as Information Systems & Global Solutions (IS&GS) are prone to taking the biggest hit from the budgetary constraints. On the other hand, it is evident that the hit to operating results will lag in certain businesses with longer cycles, such as Aeronautics and Space Systems, Missiles and Fire Control "MFC", and Mission Systems and Training (MST) segments due to production contract backlogs. But if the situation remains unaltered, these segments will see major declines in earnings.

Therefore, for those who are currently long on the stock, I'd recommend holding the stock to gain from the short-term potential. However, for those who haven't entered yet, I wouldn't opt for buying the stock for the long term. A quick in-and-out strategy might be more beneficial, as holding the stock for longer maturities would mean betting on U.S. politics instead of the dynamics of the stock.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: The article has been written by APEX Financial Consultants. This article was written by one of our research analysts. APEX Financial Consultants is not receiving compensation for this article (other than from Seeking Alpha). APEX Financial Consultants has no business relationship with any company whose stock is mentioned in this article.