Source: LockheedMartin.com
Investment Thesis
My secular bullishness on aerospace and defense stocks is predicated on five key pillars.
- The international arms race that will continue to accelerate, at least for the next 50-100 years. If it's not China next decade, it will be India or the Middle East. If it's not those countries, it's space defense as we travel into the cosmos.
- As the economy continues to globalize, a global police force will be required.
- Space is a growing frontier. Just as a city, county, state, or globalized economy needs a defense/police force, so too will space.
- Defense spending is vital to national security, which means the U.S. government cannot source military equipment from international defense contractors. This is a crucial factor, which will never change, especially in light of events such as the coronavirus, which have sparked national concern regarding our reliance on Chinese supply chains.
- Defense companies' dispersed presence throughout the United States creates an environment wherein congress is incentivized to maintain the defense budget, else they lose jobs in their districts.
These five pillars serve as the basis on which I will construct the following investment narrative, and in light of these five pillars, I have built stakes in Lockheed Martin (NYSE:LMT), L3Harris Technologies (LHX), and Northrop Grumman (NOC).
The International Arms Race (Aka the China Threat)
The Trump administration and the recent coronavirus outbreak have clearly highlighted the stark divide between the political realities of China and the U.S. That is, one operates as an authoritarian, self-avowed communist superpower; whereas, the other operates as a democratic (though not perfect) nation focused on empowering individuals through creating an environment where life, liberty, and the pursuit of happiness are seen as rights.
With that being said, both entities are vying for global hegemony, and as we've seen over the last 70 years of U.S. dominance, he or she who carries the biggest stick and controls the world's reserve currency influences the policies of the rest of the 190 or so countries. In the 21st and 22nd centuries, China wants to be that power, hence, we've witnessed a dramatic rise in military spending by the CCP, as can be seen below.
Source: MotherJones.com
Here's another chart to illustrate the accelerating rate at which China spends on its military.
Source: www.brookings.edu
As can be seen above, China has dramatically increased its defense spending in a bid to compete with the United States as the world's most influential superpower. In response, the U.S. has accelerated its defense spending as well.
Source: Washington Post
As can be seen above, U.S. defense spending has re-accelerated, and in light of the growing Chinese threat, this spend should only continue to grow.
The Need For A Global Police Force
My line of reasoning, in this case, can be summed up by the following points:
- A household pays for some form of security. A city pays for security. A county pays for security. A state pays for security. A country pays for security. So, a globalized world is going to pay a great deal for security also. Therefore, whether defense contractors are selling to the U.S. or India or Japan, there will always be a steady need for large scale weapon systems for security and defense.
This leads to the conclusion that defense spending will continue to accelerate, which is reality. Even if the world were to achieve complete peace (which is far from happening in the next 100 years), the next frontier of defense would be space, where there are far more threats to us than those on earth.
Defense As A Matter Of National Concern
Companies such as Lockheed Martin, Northrup Grumman, and L3Harris Technologies are indispensable to the United States. That is, their work cannot be outsourced to a cheaper international alternative. This has been extraordinarily highlighted by the supply chain disruptions that have occurred in the U.S. as a result of our reliance on China as the world's cheap manufacturing hub.
NAFTA (Now USMCA) was signed so that western industrial democracies could coalesce and form a union that would champion certain political ideologies through combined economic might. We have forsaken those ideals in pursuit of short-term profits and have damaged our self-reliance and national security as a result. While masks and certain technologies might not be as vital to national defense as, for example, fighter jets and space defense technology, the combination of the coronavirus disruptions and China's aggressive military spend should only further solidify and fuel defense spending in the U.S.
Political Engineering
Defense contractors, such as Lockheed Martin, Boeing (BA), and Northrup Grumman, employ a tactic known as political engineering, whereby, these defense contractors establish operations in as many locations across the U.S. as possible. This leads to the creation of jobs in numerous political districts across the United States.
In the "Who We Are" page of Lockheed Martin's website, they claim to have suppliers to the company in every single U.S. state.
Operations: 375+ facilities and 16,000 active suppliers, including suppliers in every U.S. state and more than 1,000 suppliers in over 50 countries outside the U.S.
So, the U.S. Congress is certainly not incentivized to reduce the flow of money that creates jobs in their communities and enhances national security. Instead, there is incentive to actually expand the defense budget so as to create more jobs in their respective political districts.
This is further evidenced by a chart that Lockheed Martin published with respect to the economic impact from the F-35 fighter jet. It's a very interesting, interactive map that can be found here. Now, to be clear, I am not ascribing intent with respect to Lockheed Martin or any defense contractor for that matter. I am only stating that they have operations in many locations, and the U.S. Congress is, therefore, incentivized to support these companies so as to ensure these jobs stay in their political districts, which, in turn, appeases the constituencies of the elected officials.
The New Space Age
Space is a growing frontier, and Lockheed Martin is focused like a laser on the segment. Below, we see how Lockheed Martin breaks out its revenues:
Source: Lockheed Martin FY19 10-K
As can be seen above, Lockheed Martin's Space segment accounts for approximately 16% of sales and grew 14% yoy from 2018 to 2019. Its space segment consists of products found below.
Source: Lockheed Martin's Twitter
Just as a city, county, state, or globalized economy needs a defense/police force, so too will space. Such a reality is depicted below.
Source: Lockheed Martin's Twitter
And, in my last article on Lockheed Martin, I discussed the implications of Space Force. While some readers thought it wasn't wise to base an investment thesis on the coming demands of the Space Force, it's still worth noting that this segment of the military will demand hundreds of billions of dollars' worth of Lockheed Martin equipment over the coming two decades.
Financial Analysis: Should We Buy LMT Today?
If you're a new reader, here's an introduction to how I value stocks. If you've been here before, feel free to skip to what you know matters. I call my valuation model the "L.A. Stevens Valuation Model", whereby I arrive at the true intrinsic value of a company from a few angles; at the end of which, I provide a precise estimate as to what you could expect in the way of total returns. Here's an outline of the model:
- Traditional Discounted Cash Flow Model using free cash flow to equity discounted by our (as shareholders) cost of capital
- Discounted Cash Flow Model including the effects of buybacks
- Normalizing valuation for future growth prospects at the end of the 10-year period. (3a.) Then, using today's share price and the projected share price at the end of 10 years, we arrive at a CAGR. If this beats the market by enough of a margin, we invest. If not, we wait for a better entry point.
So, let's get started!
Step 1
In order to complete step 1, we must make a few notable assumptions, a few of which are based on consensus analyst estimates that are based on company guidance.
- Over the last ten years, Lockheed Martin has grown its free cash flow per share at an average annualized rate of 14.78%. Much of this growth is the result of share repurchases, so we must parse exactly what the core operations growth will be. In order to do this, I will take consensus analyst estimates, as can be seen below. Based on this graph, we will grow core free cash flow in lockstep with revenue growth, which is projected to be 6.2% in 2020, 5.54% in 2021, and 4.34% in 2022.
Source: YCharts
Traditional Discounted Cash Flow Model
| Assumptions | Values |
| FCF To Equity Growth Rate (10yr) | 4% |
| Terminal Growth Rate | 2% |
| Discount Rate (90yr Annualized Return S&P 500) | 9.8% |
| Initial Free Cash Flow To Equity Per Share | $23.69 |
| Fair Value | $357.72 |
Source: Data compiled from YCharts
Therefore, Lockheed Martin is, currently, overvalued by about 3.4% (at a price of $369), but this is far from the end of the story.
Let's check out how Lockheed Martin's capital return programs will influence the rate at which the company grows free cash flow per share throughout the 2020s.
Step 2
In step 2 of the L.A. Stevens Valuation Model, I assess the effect of share count fluctuations on the rate at which free cash flow per share grows.
Source: YCharts
As can be seen above, Lockheed Martin has prolifically repurchased shares over the last decade, decreasing shares outstanding by a little over 27% over the last decade, which is incredible to say the least.
With this in mind, we must adjust the rate at which free cash flow per share will grow in our discounted cash flow model.
Discounted Cash Flow Model With Share Repurchases Incorporated
| Assumptions | Values |
| FCF To Equity Growth Rate (10yr) | 4% |
| Terminal Growth Rate | 2% |
| Discount Rate (90yr Annualized Return S&P 500) | 9.8% |
| Initial Free Cash Flow To Equity Per Share | $23.69 |
| Fair Value | $357.72 |
| Fair Value (Including Effects of Share Count Reduction Via Buybacks) | $446.35 |
Source: Data compiled from YCharts
Once I factored in a 25% reduction in shares outstanding, which is 2% less than what was achieved over the last decade, I arrived at an effective free cash flow per share growth rate of 7.04%, which resulted in a fair value of $446.35.
So, in light of the fuel that will be applied to free cash flow per share growth through buybacks, Lockheed Martin is undervalued by about 17.13% as of a share price of $369.87.
But we're still not done! So far, we've determined the extent to which Lockheed Martin is undervalued, but we haven't determined total return one should expect.
Step 3: Normalizing Share Price For Growth Post-10yr
In step 3, I normalize the share price for post 10-year growth. The discounted cash flow model doesn't truly determine what future expected returns will be; so, therefore, we must make one last assumption, i.e., what its price to free cash multiple will be at the end of 10 years.
| Assumptions | Values |
| Fair Value (Present Value of All Future Free Cash Flow to Equity) | $446.41 |
| Current Price to Free Cash Flow to Equity | 18.02x |
| Implied Price to Free Cash Flow to Equity at 10yr End | 9.68x |
| Conservative Price to Free Cash Flow to Equity at 10yr End | 17.5x |
| Fair Value At 10yr End | $818.30 |
Source: Data compiled from YCharts
Therefore, if one were to buy Lockheed Martin at $369, they should expect an annualized return of 8.26% based on share price appreciation alone.
Now, let's factor in the dividend. Below, I provide a depiction of what investors can expect to receive if they were to buy Lockheed Martin in a Roth IRA and if they were to DRIP it.
Notable assumptions:
- Over the last 10 years, Lockheed Martin has grown its dividend at 15% annually. Over the next 10 years, I conservatively forecast that it will grow its dividend at 10% annually.
- I assumed that the dividends would be invested annually at the end of the year after the share price had increased by 8.26%. This leads to a slightly lower annualized return than one would receive had they re-invested quarterly.
Source: HughCalc.org
In light of the above DRIP scenario, one could expect to receive 10.87% total annualized return if they were to buy Lockheed Martin at ~$370.
Risks
The greatest risk to Lockheed Martin would be a dramatic reduction in spending on defense. Certain political factions could dramatically reduce defense spending so as to fund social welfare programs or reduce the U.S.'s growing budget deficit.
Concluding Remarks
The returns that I illustrated in this article are highly, highly conservative. Over the last decade, Lockheed Martin has grown its free cash flow at between 12-15% annualized; it has raised its dividend by about 15% each year, and it has a backlog of orders worth $144B.
Therefore, even if everything goes as poorly as possible, you will still generate market beating returns. If everything goes very well, i.e. free cash flow grows 10%+ each year and the dividend is raised at a rate higher than 10% each year, your returns will be in the mid to high teens, and you will decimate the market.
I'm betting on the latter in my L.A. Stevens Investment Fund, although it's incumbent upon you to decide for yourself.
As always, I'm very grateful for your readership! Please remember to follow, and happy investing!
