Defense firms have underperformed during the last six months, mainly due to concerns over budget cuts. President Obama has called for $400B in defense spending reductions over the next decade, and the wars in Iraq and Afghanistan have started to wind down. With the need to reduce our national debt, it is highly probable that future defense spending will be significantly lower than in the last decade. This will impact the six major defense contractors, but how much and how will this impact their valuation? I examined Lockheed Martin and found that even with low growth assumptions, the downside risk appears limited based on an intrinsic DCF valuation. Obviously the market is subject to swings due to macro and emotional factors. In Lockheed Martin’s case, this could create a buying opportunity, provided that defense cuts don’t go too much beyond what has been requested.
Lockheed’s (LMT) Headwinds
While Lockheed Martin is the largest defense contractor in the world, internal and external forces will pressure its growth and margins over the next decade. Lockheed Martin relies on the U.S. government for 84% of its sales (64% from Department of Defense, 20% from non-defense agencies), but this source of funds will decline as supplemental funding for the Iraq and Afghanistan wars winds down and deficit concerns lead to budget cuts. With major defense firms strongly competing for fewer dollars, and the U.S. government in control of pricing and contract terms, Lockheed Martin’s top-line growth will not match that of the last decade. Furthermore, Lockheed Martin has experienced cost overruns with its F-35 fighters due to production issues and higher input costs. With fixed-cost contracts making the manufacturer more accountable for going over budget, Lockheed Martin’s operating margins will be strained until it can consistently and efficiently meet its production and cost targets. In addition, Lockheed Martin’s growing pension liability and high debt-to-equity ratio will also impact its margins more in the expected low to declining-growth environment. Combined, these factors have limited the recent performance of Lockheed Martin and other defense firms, but the downside risk may not be as bad as the news suggests and the 3.7% dividend appears to be safe.
Lockheed Martin focuses on being a platform provider specializing in aerospace and electronic technology systems. It has core competencies in aircraft design (Aeronautics), enabling persistent global surveillance (IS&GS), missile systems (Space Systems), and systems integration (Electronic Systems). Over the last decade, Lockheed Martin has sold off divisions that did not fit with these competencies to focus corporate efforts  and maximize synergies. It also partners with other defense contractors to provide complete solutions to its customers. More recently, in an effort to cut costs and streamline operations, Lockheed Martin reduced its top-level management by 600 employees through a voluntary separation program and realigned its businesses to match its strengths with customer needs. The firm also plans to cut more jobs depending on the scale of the government budget cuts.
Lockheed Martin competes with many companies to receive contracts from the U.S. government, but the majority go to six major firms: Lockheed Martin, BAE Systems (BAESF.PK), Boeing (BA), Northrop Grumman (NOC), General Dynamics (GD) and Raytheon (RTN). Of these firms, Lockheed Martin maintains the leadership position as the largest defense contractor. The U.S. government is careful to distribute contracts among these firms to ensure competition and multiple suppliers; there is incentive to avoid additional consolidation among the larger firms. As long as Lockheed Martin continues to innovate and to avoid legal and quality issues, it should continue to receive a significant portion of the government contracts. However, while the U.S. government provides a fairly stable revenue stream that reduces some risks to the firm, government work is also highly regulated and offers limited margins, especially given the current political concerns over the budget deficit. In general, commercial aerospace firms have higher ROIC than defense firms and offer greater growth opportunities, though with higher risks. The SWOT analysis discusses specific issues and characteristics in more detail. The Valuation section will incorporate this information into a DCF valuation.
As the largest weapons manufacturer in the world, Lockheed Martin has brand recognition and size in its favor. While heavily dependent on U.S. government funding (84%) and possessing little pricing power, Lockheed Martin has diverse capabilities and products, allowing it to pursue both defense and non-defense contracts within the aerospace and defense industry. Currently, Lockheed Martin’s product revenues come mainly from military aerospace applications, whereas half of Boeing’s revenue comes from commercial aircraft and 28% of General Dynamics’ revenues are from non-U.S. military sources. Any application of technologies to commercial applications would help to grow and balance Lockheed Martin’s sources of revenue. For example, there is increasing demand for security systems including: satellite tracking systems, complex data security, and fingerprint ID technology. In addition, Lockheed Martin is pursuing more foreign contracts to expand international sales. The firm also continues to make strategic acquisitions to add new capabilities to core product divisions and to extend relationships with key customers.
U.S. military spending is projected to slow or decline, but the F-35 Joint Strike fighter, unmanned aircraft and missiles, and information technologies remain priority areas, and Lockheed Martin has expertise in all of them. Lockheed Martin’s technological expertise and strong R&D give it the advantage with respect to new aircraft, missile, and satellite technologies. These capabilities should allow it to keep pace with technological changes. While Lockheed Martin’s product lines address several of the military’s on-going priorities, the government controls the terms of the contracts and the amount of funding, which is on the decline due to deficit and cost concerns. Last year, only 30 of 43 planned F-35 fighter purchases were approved by the House Armed Services Committee, a reduction of 25%. The government is also shifting toward more fixed-cost contracts, which places the burden of any cost overruns on the producer. 35% of Lockheed Martin’s contracts are fixed cost, and it has experienced delays and cost overruns with the F-35 program. The U.S. government is currently reviewing the long-term operating costs of the fighter, which are projected at $1T. Lockheed Martin is working with the U.S. government to reduce these figures. The firm is also struggling with containing production costs. It received just one of five bonuses in 2010 due to missed production targets, and paid 30% of cost overruns on a recent order of F-35s. Until Lockheed Martin improves its production operations, margins will be reduced due to these issues.
Lockheed Martin will need to be mindful of its operating costs; EBIT has declined to its lowest level since 2006, falling from a pre-recession high of 11.6% to 8.7% in 2010. With little pricing power and an increase in fixed-cost contracts, managing costs effectively will be critical to improve operating margins. Margins may also be impacted by legal and cleanup costs related to pending environmental actions. Lockheed Martin has been designated a potentially responsible party by the EPA at some of its facilities and former facilities. These issues place significant pressure on Lockheed Martin’s operating margins, and thus far, the firm has not demonstrated the ability to slow the decline.
Estimated Impact of Defense Cuts
Growth in total defense spending is projected to slow or decline in the coming years. For fiscal 2012, the U.S. government requested $553B for the base Defense budget. This represents a $27B increase over the prior fiscal year. However, supplemental funding requests for the global war on terror decreased by $41B. In addition to the winding down of the Iraq and Afghanistan wars, political concerns over the deficit may limit defense appropriation growth going forward. With the U.S. federal deficit reaching new heights, the government will be pressed to cut defense spending, as it makes up 20% of the overall budget based on Congressional Budget Office data. President Obama’s deficit reduction panel recommended $100B in defense cuts by 2015 to reduce the deficit. President Obama recently went further by calling for $400B in defense cuts over the next 10 years. A quick estimate suggests that this could impact Lockheed Martin’s annual revenue by approximately $2B (4.3% of Lockheed’s 2010 Annual Revenue), assuming even distribution of the cuts.
Valuation and Cash Flows
A DCF valuation was created using the previous five years of annual financials as a baseline, and then adjusting some levers to account for changes based on my analysis of Lockheed Martin’s future business environment and challenges. These adjustments included:
- A 4.3% reduction in the 2012 revenue growth rate to reflect $40B in annual budget cuts; this resulted negative revenue growth. Future growth, starting from this new baseline, was restored to 3.5% (slightly above inflation rate) over 5 years with 3% terminal growth.
- 10% Lower after-tax EBITDA margins, phased in over 5 years, ending at 7.2% (started at 7.9% in 2011).
- Treating the growing pension liability as debt.
- An equity discount rate of 8.8%. (This is highly dependent on what you assume for the equity risk premium.)
The model yielded an estimated value of around $91 per share, which is close to the analysts’ mean estimate of $87 (Yahoo Finance). This intrinsic value is contingent on the accuracy of the lever values, with the discount rate and EBITDA as a percent of revenue levers having the greatest sensitivity. For comparison, with a 10% discount rate, the value is $77, slightly above the current price of $75. With the trend toward fixed-price contracts, increasing input costs, and more complex advanced technology, there is a greater chance of Lockheed Martin experiencing delays and cost overruns, which it will now be more responsible for, so the lower EBITDA margin seemed to be a reasonable assumption. Obviously if Lockheed Martin can improve on this, its valuation will be higher.
Since the $400B in cuts probably excludes supplemental war funding, I reduced the growth rate even further to test a lower-growth scenario. I admit that it is unclear to me how much of the supplemental funding actually flows to Lockheed Martin or other firms, but regardless, I would expect overall revenues to increase at least a little each year due to inflation once the initial cuts have occurred. After giving Lockheed Martin three years of negative growth (-4%,-2%,-1%), and changing the long-term revenue growth to 2%, the model yielded a valuation of around $64. So even with larger initial cuts and then lower growth, the downside risk appears limited based on the recent price of $75. Again, this is all dependent on what the government actually does and on other model assumptions.
In terms of the dividend, Lockheed Martin pays out a little over $1B in dividends annually. This is readily covered by its $2B+ in annual free cash flow and its cash balance. In the models, including the low-growth scenario, free cash flow to equity (excluding the new debt for the pension liability) easily covered the dividend in each year. Therefore, the dividend appears safe and could increase, though the company has also been repurchasing shares at a steady clip (~$2B each year, 2006-2010).
Despite the concerns over U.S. defense budget cuts, the deficit, the end of the wars in Iraq and Afghanistan, and production cost issues, Lockheed Martin continues to be a profitable company. While the firm may see slower or even negative growth in the near-term, the U.S. government is sure to continue spending on defense, and there will be international opportunities for older technologies. As one of just six major defense contractors, Lockheed Martin will receive its share of these contracts. If it can improve its operational efficiencies, the firm can maintain or even grow its margins, despite increased use of fixed-cost contracts.
Based on the presented DCF models, even with low-growth revenue forecasts and reduced EBITDA margins, Lockheed Martin appears to be slightly undervalued at current levels ($75). If more significant defense cuts come to pass, the stock could fall 15%, but the dividend appears well covered by the cash flows and balance sheet cash. The firm has also been consistently buying back shares, which will support EPS and the stock price. I don’t expect this stock to increase as rapidly as industrials less dependent on defense sales, such as Gardner Denver (GDI) or perhaps Boeing. However, if you are looking for an industry-leading, stable firm with a solid dividend and slow growth, Lockheed Martin is a candidate for your portfolio.
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 Lockheed Martin. (2011). Annual Report. Lockheed Martin Corporation. p. 2.
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 Trimble, S. (May 20, 2010). Congress Threatens to Slash F-35 Procurement. FlightGlobal.com.
 Capaccio, T. (April 21, 2011). Lockheed Martin F-35 Operating Costs May Reach $1 Trillion. Bloomberg.
 Capital IQ. (April 26, 2011). Lockheed Martin Financials.
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 American Society of Military Comptrollers. (April 27, 2011). Secretary Gates says decisions on $400 billion defense cut must be “driven by analysis”.
Disclosure: I am long GDI, VIS.