Lockheed Martin's Business Model Under Threat Within Context Of Shifting Global Realities

About: Lockheed Martin (LMT), Includes: DASTY, EADSY, RTN
by: Zoltan Ban

German decision to scrap purchase of F-35's as a replacement for aging fleet, highlights greater EU emphasis on domestic arms development support.

Countries like Turkey, India and others may potentially be excluding themselves from being able to buy F-35's as they opt for attractive Russian S-400 air defense system.

Last resort buyer, the US military may be looking at cutting back as well, since it does not have unlimited resources either, therefore things may get tough going forward.

While Lockheed Martin (LMT) is known for many weapons systems, including aircraft of various designs and capabilities, as well as missiles, anti aircraft systems, by far its most important project at the moment is the on-going F-35 stealth fighter portfolio. It is expected that thousands of units will be delivered to the US military, as well as to a number of eligible customers around the world. At an average price per unit of about $85 million, it is going to be worth hundreds of billions of dollars in revenues for Lockheed Martin, even in a worst-case scenario, while in a best-case scenario it may be worth almost $2 trillion in revenues for the duration of the project. Recent developments are putting a question mark on whether the project is still worth trillions of dollars. The latest news should have been expected, given rhetoric we had coming out from a number of EU elites. I am referring to Germany's decision to drop the F-35 as an option to replace its aging fleet of fighter jets. It may be a sign of things to come for the F-35 in the EU and perhaps beyond.

EU looks to become militarily independent of US hardware.

The reason why Germany opted not to buy the F-35 is because it would make it harder for the French-German joint effort to produce a new Euro-Fighter project to come to life. Only a few days after Germany passed on the F-35, an announcement was made for the beginning of a new fighter jet program which will be a joint Airbus (OTCPK:EADSY), Dassault (OTCPK:DASTY) project. It is expected that other EU countries will most likely join in this project. It remains to be seen how many will, but Spain is seemingly already on board, while Britain may join in as well, merging their own separate project with the EU project, despite the Brexit issue. The smaller EU states will most likely want to participate in order to get some development and manufacturing contracts.

Not long ago, France's president Emmanuel Macron declared that while Europe looks to meet its NATO spending obligations, thus ushering in an era of European re-arming, the US should not assume that it will mean new contracts for its weapons producers. He wants to bolster France's own weapons sales in the EU, given that it is one of the leading producers of weapons on the continent. It goes without saying that most other countries also wish to increase their domestic weapons industries, thus they will try to buy European-made in order to increase their own chances of selling to other EU countries. Hungary for instance recently bought German tanks and French helicopters. It probably hopes to at the very least sell these countries some small arms in return, while also expanding cooperation on parts manufacturing for such products.

While there are still some countries like Poland and Romania, which view their US partnership as being indispensable therefore are likely to continue to rely heavily on US weapons, there is definitely a sense that the EU is likely to shrink its overall US weapons demand, replacing it with its own domestic industry. In effect, the EU commitment to increase its own military capabilities, with the dual objective of meeting its NATO obligations, as well as work towards a joint EU military force is doing much the same that America's own robust military expenditures program is doing for the US weapons industry. It is spurring on a revival of Europe's own domestic weapons industry, having the opposite effect of what investors thought it will have on the likes of Lockheed Martin, as well as other American weapons producers. After all, we don't see much in the way of America importing European weapons systems either. The US military prefers to be dependent on its own domestic industry.

Lockheed Martin has an S-400 problem.

It is thought that the Russian-made S-400 air defense system might be one of the most advanced, if not the most advanced system in the world today. To make matters worse, it sells at a fraction of the price that Lockheed's own arguably comparable system, the THAAD sells for. Even the aging Patriot system made by Raytheon (RTN) sells for double, while its overall capabilities seem to be greatly outmatched comparatively speaking. While this by itself may be troubling in regards to Lockheed's air defense systems sale, the bigger problem arises from a growing number of countries buying the S-400 system, which will then potentially disqualify them from also purchasing the F-35 fighter jet.

Some of the countries which already bought the S-400 system include China, India and Turkey. While there was never a chance that China will buy F-35 fighter jets, Turkey was part of the development program, while India could have been a potential customer. As things stand right now, Turkey may be excluded from the F-35 project, because it is thought that the S-400 could be used to study the vulnerabilities of the F-35 if its military were to have both systems. A number of other countries are considering the S-400 system, including Iraq, Qatar and Egypt, all of which could also be potential future customers for the F-35. Even Saudi Arabia, which has been a major customer for the US arms industry is apparently keen on buying the S-400 system.

One major takeaway from recent developments is that the period of US arms sales exclusivity may have come to an end. There are three major competitors on the scene, namely Russia, China and perhaps a resurgent EU arms industry. Traditional buyers of almost exclusively US weapons, such as Saudi Arabia, will from now on demand the right to shop around, meaning that aside from when they buy from the EU, similar issues to the S-400 problem will likely come up.

It may seem hard to imagine right now, within the context of the Ukraine crisis, but it may be that EU-Russian arms industry ties and collaboration will see some strengthening next decade, with trade and technological collaboration in the field being seen as a natural win-win for both sides. For Lockheed Martin, which is in the middle of executing arguably the most important arms project within the US and NATO alliance, it effectively means that the world that existed when the project was conceived, is starting to show signs of coming apart. With that, so will the opportunity for the project to reach its maximum commercial potential. If by any chance the US Air Force decides to cut back on its own purchase of the plane, as it has been rumored to be currently considered, Lockheed's longer term prospects in regards to this project as well as future ones may be greatly diminished.

Current investor sentiment on Lockheed makes my argument contrarian.

While I personally think that Lockheed is facing major headwinds due to the changing global economic and geopolitical dynamics, general investor consensus on this stock is mostly positive. Reason for it has to do with the fact that current results are in fact making the case for the bulls. In the fourth quarter of 2018 revenues were up 5% compared with the same quarter of 2017, while net earnings came in at $1.25 billion, versus a $744 million loss in the fourth quarter of 2017.

Lockheed Martin sales & profits Source: Lockheed Martin.

The full year results paint a more accurate picture in regards to both sales and profits. Comparing the full year results, with quarterly results however also suggests that there may be some early signs of there being some reason to worry. For instance sales increased 8% in 2018 compared with 2017, while in the fourth quarter we only saw a gain of 5%. It would take a few more quarters to confirm a structural slowdown, rather than perhaps just a quarterly fluke. I personally think that we will not see that confirmation just yet.

There is the matter of the 400 F-35 order backlog, which suggests that Lockheed Martin will only see a decline in revenues in coming quarters if it fails to execute, not so much due to any immediate demand issues. The first signs of demand issues arising from what seems to be a narrowing field of potential customers may only come into play in a year or later. The first sign that it is happening is likely to be a decline in the orders backlog, without an associated increase in deliveries. When that will start to happen, it will be a good early indication for investors that it is time to stop looking for an entry point and for those who own this stock, it will be a good time to start planning an exit strategy.

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.

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