In Space, Lockheed Needs Another "Martin Moment"

Summary

  • We initiate on Lockheed Martin at Neutral. Taking the business as a whole, the stock seems priced in-line, assuming success in the F-35 program.
  • But LMT's space business has some problems - lack of revenue growth is the key indicator.
  • LMT ceded potential leadership in mid-market space hardware and services to Northrop Grumman, when NOC bought Orbital in 2018.
  • We believe the correct move for LMT now is to acquire a number of low-cost Space 2.0 vendors, so that it can occupy the fastest-growth section of the space market.
  • This idea was discussed in more depth with members of my private investing community, Invest in the New Space Race. Get started today »

DISCLAIMER: This article is not directed at, nor intended to be relied upon by any UK recipients. Any information or analysis in this article is not an offer to sell or buy any securities. Nothing in it is intended to be investment advice and it should not be relied upon to make investment decisions. Cestrian Capital Research Inc or its employees or the author of this article or related persons may have a position in any investments mentioned in this article. Any opinions or probabilities expressed in this report are those of the author as of the article date of publication and are subject to change without notice.

Introduction

Here we initiate on Lockheed Martin (NYSE:LMT) at Neutral.

The company appears to be well managed, is growing earnings and revenues, the F-35 fighter program appears to be about to deliver on its promises, and despite being pretty much at its 52-week high, the stock’s fundamental valuation looks acceptable at sub 2x TTM revenue, 13.5x TTM EBITDA and 15.8x TTM EBIT. If you think F-35 will hit its cost targets and therefore volume targets, there are likely gains ahead for the stock. All good so far.

Our focus here though is not the headlines around LMT, which are for good reason mainly F-35 related right now. No, as befits our space-sector focus, our analysis here centers on LMT’s space business, a $10bn revenue, $1bn segment operating profit behemoth.

We think it has some challenges ahead.

LMT’s Space Division

We operate a pure-play space-sector equity research service. This means that although space isn't its largest division, LMT is a key company to us. In our coverage universe, it has the second-largest space division by reported revenue at c.$10bn in FY12/18.

Source: Company SEC filings

LMT’s space division in large part reflects the merger with Martin-Marietta Corporation. LMT completed the merger with Martin Marietta in 1995, valuing the combined group at approximately $10bn (source; Lockheed and Martin Marietta Set to Merge in $10 Billion Deal) . The combined Lockheed Martin business then rationalized its portfolio, spinning off the relevant defense products into what was to become L-3 Technologies (LLL) and the materials division into what is now Martin Marietta Materials (MLM).

The LMT-acquired Martin-Marietta Corporation was at the forefront of the original space industry. It built Titan ICBMs and then repurposed them as spacecraft launch vehicles – lifting all ten of the Gemini missions successfully in the space of just two years and paving the way for the Apollo mission series. It acquired General Dynamics’ (GD) space business, bringing into the family the Atlas line of rockets, descendants of which are still used today. And it built a number of key spacecraft which cemented the US as the lead spacefaring nation – including the Magellan Venus probe, and the Viking Mars probes. Today LMT’s space-sector products include the upcoming new Orion spacecraft, and LMT holds a 50% stake in United Launch Alliance, its JV with Boeing which builds and operates rockets for (inter alia) US government resupply missions to the International Space Station.

But we think LMT has a problem. It is one of only two major companies in the space business where its space division revenues are flat – the other being Aerojet Rocketdyne. Everywhere we look we see evidence of growth in space exploration and space exploitation. Northrop Grumman (NOC)’s space division grew revenues at +17% p.a. in 2018; the space division of Moog Inc (MOG.A) at +10% in 2018; Boeing (BA) at +13% in 2018.

Why is this? We think that LMT has lost impetus in the space business. It has – so far – missed the generation shift in the space-sector cost base. It’s not alone – we think the same has happened at Boeing >> Seattle, We Have A Problem - Initiating Coverage On The Boeing Company.

In a way, this is as unsurprising at LMT as it is at BA. BA’s business is critically-dependent upon success in civilian aircraft. And LMT’s short- and medium-term future is dependent on success in military aircraft – specifically its F-35 Lightning II fighter aircraft project. This project kicked off in 2001 and the first airplanes were delivered recently. Production models (which carry full margin) are expected to be delivered in 2019/2020. Getting this right – meaning airplanes accepted and used by customer organizations, produced in a way that generates sufficient margins for LMT, followed up by long-term service contracts to support and upgrade those airplanes – is company-defining and LMT cannot get it wrong. LMT is working hard to deliver the airplane for less than $80m/unit in order to access a larger market.

This last 3-4 years have been a critical phase in the F35-II project and we would expect that the CEO’s in-tray usually has F-35 matters at the top of the pile, since the F-35 program alone accounted for some 27% of revenue in 2018 (source- LMT 10-K for 2018) . It’s a key single point of failure risk within LMT and that means it will be top priority.

But in these last few years, the space industry has quietly changed a great deal. You can read up on our thesis here >> Introduction To Investing In The New Space Race - in essence, that the falling costs in the space business are leading to a profusion of customers and vendors and with those, a new and growing market segment. This has arisen for many reasons but a key factor was the 2011 cancellation of the Shuttle program and the prior 2008/9 cancellation of its replacement (the Constellation program). This created a period during which NASA was somewhat in limbo and other customers – satellite operators principally – became more important and looked to commercial vendors such as SpaceX to fulfil their needs.

We think the market for traditional, government-driven, huge budget ‘Space 1.0’ matters such as reconnaissance satellites or planetary exploration hardware and services is going to continue – grow, even, as global risks rise and richer nations turn once again to space as a theater of power, pushing the US to spend more to keep pace. LMT and BA in their individual space divisions, and together in ULA, will benefit from this trend. LMT’s space focus lies in segments where the US government is the only truly viable customer, costs are high, production rate low, and organizational complexity vast amongst buyers and suppliers alike. Its new products are all oriented toward these monolithic heavyweight missions. The Orion spacecraft, the relevant sections of the SLS rocket, the Mars Insight lander – these are all exciting products but they are all in the image of Space 1.0 – procured by government and flown by government, with huge procurement budgets and usually long-delayed timelines.

When industries go through tectonic shifts like this, usually the vendor landscape changes dramatically. Few incumbents make the move successfully.

We believe the poster child for an incumbent’s navigation of these changes in the space industry is Northrop Grumman (NOC). As time goes by, NOC’s $10bn acquisition of Orbital ATK in 2017 (it closed in 2018) is looking like a better and better strategic decision (see our note here >> Deep Space Acquisition - Initiating Coverage On Northrop Grumman). As we have already reported, Orbital was acquired at a good price for NOC – it was and is growing faster than NOC’s existing business, and NOC paid a lower multiple of earnings for it than NOC’s shares themselves traded at. When we spoke to NOC recently they commented that in addition to the financial logic, they felt well positioned for the New Space Race because the Orbital deal took them further down the cost curve – ie. in addition to NOC’s existing high end military-grade space products, Orbital gave them lower-cost vehicles and other products with which to serve the growing space market. We don’t think Orbital is a whole answer to the New Space Race for NOC – the group still lacks true low-end products such as smallsats and small launch vehicles, and we see this as a weakness for the company that they ought to address.

We think LMT has to date not positioned itself well to prosper from the increasingly low-cost, non-government space segment. We believe that LMT missed out by not acquiring Orbital. Orbital would have given them renewed growth and vigor in the space market in the same way that merging with Martin Marietta did in the 1990s. Perhaps LMT considered the opportunity and decided it would be blocked on antitrust grounds – certainly the combination would have heavy market share in the government launch business – we don’t know. But we think LMT should now look for another ‘Martin Moment’ – a defining transaction that could deliver the next generation of growth in the space industry. We don’t think this will be through organic growth – new products take too long to design, certify, procure and so forth. We think LMT’s space business would be best served through an acquisition once again.

What Would We Say To LMT Management If We Could?

We applaud the ‘Lockheed Ventures’ approach.

We think that assigning some capital to the New Space segment is a great idea – it gives you visibility into the new market segments and should enable you to judge when theses segments are ready for prime time.

Indeed we’ve urged Aerojet Rocketdyne (AJRD) to do the same thing – they have the same problem of over-concentration in Space 1.0 and consequent flat revenue.

But we hope you do in fact treat your ventures fund as an M&A pipeline – the rhetoric we’ve seen (e.g. Lockheed Martin sees an appetite for startup investments ) is all about how you don’t plan to buy the companies in the Ventures portfolio but instead to hope they become independent businesses which fit into the LMT ecosystem as a supplier. We hope this is corporate-speak for “we do intend to acquire some, but we think it will alienate some potential investees if we out-and-out say that”. As former venture investors ourselves we can tell you – every one of your actual and potential portfolio companies sees you as a possible acquiror and treats you as such. So as long as you don’t believe or act according to the rhetoric, it won’t disadvantage you!

Martin-Marietta was a transformative deal - don’t be afraid to think big again when it comes to M&A in the space sector.

We think it was a miss not buying Orbital, and if we had just joined your board of directors, we would want you to see this too. We’d show you the growth that Orbital was delivering to NOC and say – this was a cheap deal despite the big absolute price tag. (We haven’t done the math but we suspect that was true of your own deal with Martin Marietta too). Maybe antitrust made it impossible. In any event, there isn’t really another Orbital around right now but we would be keeping a very close eye on the low-cost launch providers such as Rocket Lab and on the small-satellite fleet operators such as Spire Global. These types of companies would probably demand high multiples of revenue as a purchase price, but the overall sum would be modest vs. LMT’s balance sheet – and owning these kinds of companies would leapfrog LMT directly into the fastest-growing, lowest-cost segment of the space business, putting LMT out front and ahead of BA and NOC in the segment. We think that leapfrogging NOC into low-cost space is the way to deal with NOC’s Orbital acquisition.

Get ready for some project delay risk in your existing space business portfolio.

This risk won’t be of your making – it will be to do with the funding of NASA’s current programs – but it is likely to hurt you. SLS looks to be running very late and the implementation of Space Policy Directive 1 is about to hit some appropriations issues – NASA Administrator Bridenstine is indicating an additional $20-30bn will be required to deliver on the ‘Artemis’ moon missions that will use SLS and Orion, and that is going to take some time to get through Congress. (See NASA administrator says it will cost an extra $20 to $30 billion to send astronauts back to the Moon).

Be ready for prior government allegiances to change on you – at short notice.

The old-line aerospace & defense companies on which the US government has relied since the beginning of the original Space Race in the 1950s – those which, like LMT, helped to deliver the Mercury, Gemini and Apollo projects – are just beginning to feel the burn as NASA and other US government agencies turn to the new generation of space vendors. SpaceX and Blue Origin have found great favor in Washington of late. Indeed to our eyes it seems that Elon Musk’s true calling is, rather surprisingly, as a federal-sector salesman. Huge quantities of federal appropriations have landed in SpaceX’s coffers over the years, and the courtship between Musk and Bridenstine appears to be intensifying. We anticipate that the cost issues above will lead to NASA and other agencies moving to favor lower-cost vendors – see for instance the award to Maxar Technologies (MAXR) for the propulsion element of v1.0 of NASA’s lunar gateway, seemingly on very-low-cost grounds. If this trend continues, SpaceX will likely gain share with Blue Origin not too far behind, and LMT’s market share will experience some compression.

We will continue to report on LMT, with a focus on its space business unit.

Cestrian Capital Research, Inc – 15 June 2019

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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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