Lockheed Martin: The Unknown Knowns

| About: Lockheed Martin (LMT)

Summary

There are known knowns, there are known unknowns.

And holding LMT probably isn't worth the risk of a misstep.

A large short sale crossed the tape in November following additional debt issuance.

Isn't this just too much leverage?

... there are known knowns; there are things we know we know.

We also know there are known unknowns; that is to say we know there are some things we do not know.

But there are also unknown unknowns - the ones we don't know we don't know.

To any good investor, this famous quote by Donald Rumsfeld should be so internalized as to seem obvious.

Indeed, the omnipresent spectre of Seeking Alpha's Chris DeMuth Jr. (a reasonably good investor) frequently makes reference to a paper with a strikingly similar concept, the "unknown and unknowable" in investing.

These concepts are critical to the assessment of risk, reward, mispricing, and comparative advantage in investing. If you don't agree, you're wrong.

Making an unknown unknown a known unknown.

While part of investing is acknowledging that we can't know everything, that's not an excuse to be lazy. So here's something you didn't know about Lockheed Martin's (NYSE:LMT) stock, but probably should know.

Click to enlarge

On November 25th, at $224.16, the majority of shares traded in LMT were short sales (red bars on the chart above). In a stock like LMT, that's extraordinarily rare.

Even more extraordinary, perhaps, is that these short sellers appear to have very effectively picked a local maximum in LMT's price, and either hedged effectively or profited handsomely as a result of their excellent timing.

What do they know - if anything?

We don't know what they know, but whenever $267M in short sales occur in one day, we start to wonder what we may be missing.

So what's at risk in LMT? If you were to peruse any article on Seeking Alpha, you would get the impression that Lockheed is the very definition of "stability." Much of this, however, seems to be the clouded reasoning of yield-chasers.

Unfortunately for the ubiquitous optimist, there are plenty of downside catalysts hiding in plain sight.

Click to enlarge

1. The ongoing F-35 debacle. They're twice as expensive as they were supposed to be, and getting pricier every day. And that's just the beginning, really. Vanity Fair summed it up nicely (here):

The Joint Strike Fighter is the most expensive weapons system ever developed. It is plagued by design flaws and cost overruns. It flies only in good weather. The computers that run it lack the software they need for combat. No one can say for certain when the plane will work as advertised. Until recently, the prime contractor, Lockheed Martin, was operating with a free hand-paid handsomely for its own mistakes. Looking back, even the general now in charge of the program can't believe how we got to this point. In sum: all systems go!

Will LMT be able to shove this flying bloatware down its customers' throats anyway? Canadian procurers, for one, are wishy-washy.

And if you were about to say that the F-35 is just one of many opportunities, consider that LMT just lost a big contract from the USMC to competitors SAIC and BAE - and that the F-35 accounts for a substantial portion (20%) of current sales and anticipated revenues.

2. Democrats. Election season is approaching, and budget cuts are a real possibility. Over 80% of LMT's revenue comes from the U.S. government in its many forms.

Generally, the government is a good basket to put your eggs in, but it should still be sobering to think that legislators have so much power over LMT's revenue.

3. Leverage. Lockheed's balance sheet just called, and it would like to consider suspending the share buyback program. How often do you see a debt-to-equity ratio like this?

Click to enlarge

[Source: SEC Filings]

While leverage is not bad per se, leverage in an arguably overvalued company with more down- than up-side catalysts can be a scary thing. In 2015, more than $9B (Isn't that how much they payed for Sikorsky?) was spent on share buybacks (1/3) and paying down debt (2/3). Is it a coincidence that this 8-K, reporting the issuance of more debt, came just a few days before that short sale?

Combined...

These factors make for a deceptively fragile situation. Our sense that the risks seem to be largely brushed aside and the "stability" of LMT universally acknowledged makes the leverage that much more dangerous to the stock.

And then there's the fact that the leverage funds a frothy dividend and that taken-for-granted buyback program. And the fact that holdings are nearly 90% institutional. The upshot is that hardly anyone will want to short a stock like this, and so the risks compound indeterminately alongside sunny expectations. No voices of reason are permitted in LMT, and everything will be just fine.

That is, until the buyback program is suspended. Or F-35 orders don't meet the grade. Or the Democrats arrive on the scene. Then we're back to $185 in a few days' time.

"Unknown Knowns?"

Slavoj Žižek says there's another type of information, "unknown knowns" - the things we know, but really don't want to admit to ourselves. That seems to describe investor sentiment in LMT pretty well.

Is this why we see uncharacteristic short selling at $224? Is someone finally taking the other side of the trade, even if it costs them >5% in interest and dividend payments to do so?

Maybe.

But what's more important is that this is a good a time as any to reconsider your position in LMT, and your expectations for the future. Don't underestimate the risks.


Hopefully, we've been able to turn a few unknown unknowns into known unknowns. Something else you should know is that the referenced short sale data comes from FINRA's TRFs.

If you want to know more, read this, or shoot us an email at info@sqzme.co.

Matt

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.