By Matt Doiron
Lockheed Martin (LMT) is a risky stock. Not because it is exposed to macro conditions in the U.S. or the world (its market beta is 0.7), not because it is heavily exposed to oil prices, and not because it depends on trends in consumer fashion. No, the risks to Lockheed Martin's business stem from the fact that its largest customer, who is responsible for over 80% of its revenue- the U.S. federal government- is considering cuts to its spending, including to its spending on military and defense programs, as it attempts to control its budget without having to resort to broad-based tax increases.
Lockheed Martin's second quarter 10-Q reported rises in first-half sales and net income. Of the company's four business units, only Information Systems & Global Solutions- its management services and IT contracting business- saw declines in revenue and operating income. Lockheed Martin did warn that under current federal law, automatic budget cuts set to begin at the end of the year if alternative cuts are not passed would lead to significant reductions in federal spending. Since, as mentioned, the company generates the vast majority of its business from the government (about 60% from the Department of Defense and about 20% from other U.S. government programs, according to the quarterly report), this would have a material effect on the company. Lockheed does note that it is prepared to engage in cost-cutting actions with regards to its suppliers and employees, including issuing conditional termination notices.
Valuation multiples are not quite as useful when evaluating a business which largely depends on discretionary spending decisions from one customer, but it should be noted that analysts' expectations of the government's defense plans are not anticipated to have a major impact on earnings going forward: Lockheed Martin's $29 billion market cap is 10 times trailing earnings but still only 11 times forward earnings. A long term investor would likely have to assume that more defense cuts await in the future in order to be bearish on the stock, particularly as Lockheed Martin currently pays a 4.6% dividend yield to investors and currently has nearly $4 billion in cash on its balance sheet.
The two largest 13F holders of Lockheed Martin at the end of this past March were First Eagle Investment Management and Chieftain Capital. First Eagle owned 3.9 million shares and has been steadily increasing its ownership over the past several quarters (see other stock picks from First Eagle). Chieftain Capital, managed by John Shapiro, has been reducing its position but still owned 1.8 million shares of the company at the end of the first quarter (find other stocks in Chieftain's portfolio). Cliff Asness's AQR Capital Management also had a moderate position in the stock. There has been little insider selling at Lockheed Martin and it has been composed of insiders cashing in their stock options, which they may be doing out of a desire to diversify or to make consumption purchases (the point of stock options is, after all, as compensation).
Lockheed Martin's peers include other aerospace and defense companies. General Dynamics (GD), Raytheon (RTN), and Northrop Grumman (NOC) are all comparable businesses which pay smaller dividend yields, in the 3-4% range. Also similarly to Lockheed Martin, they trade at earnings multiples in the narrow window between 8 and 10 and EV/EBITDA multiples between 5 and 6. They are also all large caps, with the smallest (Northrop Grumman) having a $16 billion market cap. Lockheed Martin only stands out compared to its peers when its slightly higher dividend yield is considered, and that is a fairly small advantage. Lockheed Martin can also be compared to Boeing (BA), although Boeing has a much larger civilian customer base which makes it more highly exposed to movements in the macro economy but makes it less dependent on government spending. Boeing pays a lower dividend than the defense contractor peers at 2.4% and has a P/E ratio of 13, indicating that the market is more confident in the U.S. and global economies than in Lockheed Martin's ability to adapt to scheduled revenue reductions. We don't see a clear difference in attractiveness between any of these companies from a value perspective, but think that Lockheed Martin in particular might be a good choice for a dividend-seeking investor who wants an option other than utilities.