Lockheed Martin: Continued Improvement Due to Accounting Changes

The outlook for Lockheed Martin (LMT) is stable. The US Defense budget is expected to rise a meager 14.3% over the next 4 years, from $439B in 2007 to $502B in 2011, roughly 3% a year. This however does not include special supplementary budgets for the war in Iraq, the war in Afghanistan and the war on terrorism (which is less specific).

Analysts are expecting a continued improvement in margins. What is little known is that part of this improvement is due to an accounting change.

LMT has five divisions:

Aeronautics (31%) - F16, F-22, F-35

Electronic Systems (29%) - Missiles

Space (18%) - Satellites

Integrated Systems (11%) - Communications

IT Systems & Services (11%) - Information Technology

We estimate for 2007 a 3% decline in revenue for the Aeronautics division and a 6% decline for the Space division. The decline is Space should be offset with an 11% increase in the IT division.

Change in Accounting

Instead of awarding a contract to LMT, then sub-contracting components to others, LMT formed the United Launch Alliance with Boeing (BA). According to this new procedure, contract revenue does not appear on LMT's statements, only the relative portion of income. This will automatically improve margins. Margins could hit 10.5% in 2007, compared with 8.9% for 2005.

When comparing margins in the future, this change has to be taken into account for the Space division. The higher margin does not necessarily imply an improved execution environment.

There are no changes in our estimated 2007 EPS; $6.20. We realize that Q1 contains $0.21 in extraordinary gains; however we anticipate an offset in Q3. LMT recently guided upwards from $5.80 - $6.00 to $6.20 - $6.35.

US Navy Cancellation

We (CrossProfit) view the Navy's cancellation for a new prototype shallow water warship as a blessing in disguise. LMT should concentrate on aeronautics. When getting into something that you are second best at, production overruns are inevitable. General Dynamics (GD) should fair better in this naval commission though rumors have it that G-D could use a little help from Poseidon.

LMT 1-yr chart

Disclosure: No conflicts.