- Lockheed Martin's payout ratios through Q2 2020 remain very sustainable at 40.4% of diluted EPS and 35.3% of FCF and provide plenty of room for future dividend growth.
- Lockheed Martin delivered 12.4% YoY revenue growth from Q2 2019 to Q2 2020 and 15.8% YoY diluted EPS growth from Q2 2019 to Q2 2020.
- Along with its strong liquidity, LMT is capable of being a great, long-term investment if shares are acquired at or below fair value.
- Fortunately, shares are trading near fair value despite the 7% run-up in the share price since I covered the stock last month.
- Between its 2.5% yield, 7-8% annual earnings growth, and 0.4% annual valuation multiple expansion, Lockheed Martin is positioned to meet my 10% annual total return requirement over the next decade.
A true measure of whether a stock is worthy of consideration for a dividend growth investor's portfolio lies not only in how a company performs in a stable operating environment, but also how a company performs in an uncertain operating environment.
One company that has delivered strong operating results in a stable operating environment, and more recently in the uncertain operating environment, is Lockheed Martin (NYSE:LMT).
As I'll discuss below for the first time since last month, Lockheed Martin's safe dividend with high-single-digit growth potential, solid Q2 2020 operating results and strong balance sheet, in combination with its attractive stock price relative to my estimated fair value prompted me to reiterate my buy rating for shares of the stock.
The Dividend Remains Safe And High-Single-Digit Growth Potential Is Intact
While Lockheed Martin's yield of 2.53% is relatively close to the S&P 500's yield of 1.82%, I will nonetheless be evaluating the EPS and FCF payout ratios through the first half of 2020 to determine the extent of its dividend safety and further determine the growth potential of the dividend going forward.
Starting with Lockheed Martin's diluted EPS, the company delivered $11.87 through the first half of FY 2020 against dividends/share of $4.80 paid out during that time for a diluted EPS payout ratio of 40.4%.
Compared to the $11.00 of diluted EPS through the first half of FY 2019 and dividends/share of $4.40 paid out to this time last year, Lockheed Martin's payout ratio is essentially in line with where it was a year ago.
Moving to FCF, the company generated $4.496 billion in operating cash flow through Q2 2020 against $636 million in capital expenditures for total FCF of $3.860 billion.
Against the $1.364 billion in dividends paid out during this time, that equates to an FCF payout ratio of 35.3%.
When measured against the $3.331 billion in operating cash flow generated through Q2 2019 and $533 million in capital expenditures, total FCF was $2.798 billion.
Against the $1.260 billion in dividends paid out through Q2 2019, this works out to an FCF payout ratio of 45.0%.
Given Lockheed Martin's stable diluted EPS payout ratio and improved FCF payout ratio over the past year, I maintain that it is reasonable to conclude that dividend growth will slightly exceed diluted EPS growth over the long term.
When considering that Yahoo Finance analysts are forecasting 9.1% annual earnings growth over the next five years, Lockheed Martin's desirable payout ratios, and what the company has managed to achieve through the first half of 2020 despite COVID-19, I reiterate my 7.75% annual dividend growth rate over the long term.
Lockheed Martin Produces Strong Q2 Earnings And Maintains Ample Liquidity
Lockheed Martin's operating results for Q2 2020 were spectacular, especially given all of the operating challenges that businesses across many sectors of the economy faced as a result of COVID-19.
One of the many things that stuck out to me in Lockheed Martin's Q2 2020 earnings results was the fact that its backlog managed to grow once again to an all-time high of more than $150 billion as indicated in the above slide.
As mentioned by new CEO James Taiclet during Lockheed Martin's Q2 2020 earnings call, the company received nearly $22 billion in orders during the quarter, which more than offset the $16 billion in sales during the quarter.
Most notably, the Aeronautics segment led the way with orders, logging over $9 billion in orders, with $7 billion of total orders booked for the F-35. Missiles and Fire Control followed closely behind, with several Defense Department PAC-3 awards, including one worth over $6 billion to supply PAC-3 MSE interceptors, launcher modification kits, and associated equipment to support the United States and foreign military sales customers across multiple contract years, as noted by CEO James Taiclet's opening remarks in Lockheed Martin's Q2 2020 earnings call.
The Rotary and Mission Systems and Space segments also received over $1 billion each in orders during the quarter to round out Lockheed Martin's backlog story.
Lockheed Martin also delivered 12.4% YoY growth in its revenue from $14.427 billion in Q2 2019 to $16.220 billion in Q2 2020 led by volume in the Aeronautics and Missiles and Fire Control segments, according to CFO Kenneth Possenriede's opening remarks during Lockheed Martin's Q2 2020 earnings call.
As was the case in my previous article on Lockheed Martin, the Aeronautics segment was the primary driving factor of its impressive overall top-line growth, with its revenue surging 17.2% YoY from $5.550 billion in Q2 2019 to $6.503 billion in Q2 2020.
The Missiles and Fire Control segment once again closely trailed the Aeronautics segment, upping its revenue 16.2% YoY from $2.411 billion in Q2 2019 to $2.801 billion in Q2 2020.
The Rotary and Mission Systems segment produced 7.2% YoY growth in revenue, increasing from $3.768 billion in Q2 2019 to $4.039 billion in Q2 2020.
Rounding out the segments, the Space segment managed to increase its revenue 6.6% YoY from $2.698 billion in Q2 2019 to $2.877 billion in Q2 2020.
When Lockheed Martin's 20 basis point expansion in operating margin (10.8% in Q2 2019 to 11.0% in Q2 2020 based on the data in Lockheed Martin's Q2 2020 earnings press release) is combined with the above top-line growth, we can begin to understand how the company was able to grow its operating profits by 15.2% YoY from $1.554 billion in Q2 2019 to $1.790 billion in Q2 2020.
Delving into Lockheed Martin's capital allocation during Q2 2020, the final piece of the puzzle is illustrated above by the fact that the company repurchased $259 million of shares during Q2 2020, which is how it generated 15.8% growth in its diluted EPS from $5.00 in Q2 2019 to $5.79 in Q2 2020 as indicated by CFO Kenneth Possenriede's opening remarks in the Q2 2020 earnings call.
Lockheed Martin's $930 million of capital allocated to dividends and share repurchases allowed the company to retain $909 million or 49.4% of its FCF, which leaves it with ample FCF to handle a potential downturn in its operations.
In addition, Lockheed Martin built upon its cash and cash equivalents position, with that surging from a bit less than $2.0 billion to end Q1 2020 to just under $2.9 billion as of June 28, 2020.
Finally, Lockheed Martin's interest coverage ratio surged from ~10.3 in Q2 2019 to ~13.2 in Q2 2020 based on the data in the Q2 2020 earnings press release.
When I take the developments in the above section and this section into consideration, I reiterate my conclusion that Lockheed Martin is operationally and financially sound at this time.
Lockheed Martin also provided updated guidance in its Q2 2020 earnings release, with the company adjusting its Aeronautics, Space and RMS segment sales forecasts upwards and the Missiles and Fire Control segment's previous forecast reiterated, as noted by CFO Kenneth Possenriede's opening remarks during the Q2 2020 earnings call.
As a result, Lockheed Martin revised its midpoint total sales figure for FY 2020 upward by $1.125 billion from $63.125 billion to $64.250 billion.
Segment operating profit was also adjusted to account for the above, which explains the $100 million increase in that estimate from Lockheed Martin's April 2020 forecast to July 2020 forecast.
Lockheed Martin also revised its diluted EPS figure upward from a midpoint of $23.80 in its April 2020 forecast to $23.90 in its July 2020 forecast.
Rounding out the recent update in guidance, Lockheed Martin estimates that it will generate cash from operations of greater than or equal to $8 billion in FY 2020, which is a $400 million upward revision from the prior forecast as per CFO Kenneth Possenriede's opening remarks in the Q2 2020 earnings call.
When I factor in Lockheed Martin's strong operating results through the first half of 2020 and upward revisions in guidance for the fiscal year, strong interest coverage ratio, and ~$2.9 billion cash and cash equivalents position, I believe the stock is capable of being a great, long-term investment if shares are acquired at or below fair value.
Risks To Consider
Even though Lockheed Martin is the largest defense contractor in the world, the company faces its fair share of risks that both prospective and current shareholders must occasionally monitor to determine whether the investment thesis remains intact.
Because the COVID-19 risks that I discussed in my previous article on Lockheed Martin haven't materially changed in the past month, I'll be solely focusing on a non-COVID-19 set of risks that developed in the month between when I last covered the company and now that are outlined in pages 50-51 of the most recent 10-Q.
The risk that I'm alluding to is that political issues and considerations in the U.S. and abroad could have a material impact on Lockheed Martin's business (pages 50-51 of the most recent 10-Q).
On July 14, 2020, China announced that it may impose sanctions against Lockheed Martin as part of its response to the recent Congressional Notification of the potential Foreign Military Sale of Repair and Recertification Patriot Advanced Capability-3 (PAC-3) Missiles to Taiwan (page 50 of Lockheed Martin's most recent 10-Q).
While the vast majority of Lockheed Martin's Q2 2020 sales were generated in the United States (80.4% per data sourced from page 13 of the most recent 10-Q), it's worth noting that a material minority of its sales were generated in international markets and the company will continue to follow official U.S. government guidance on sales to Taiwan.
Although China has yet to announce the specifics of potential sanctions against the likes of Lockheed Martin and the company expects any potential sanctions to have minimal impact on its sales at this time, it expects that these sanctions could seek to restrict its commercial sales or supply chain, including its supply of rare earth or other raw materials, and could also impose sanctions on its suppliers, teammates or partners.
Despite the minimal overall impact of this development in the grand scheme of Lockheed Martin's operations, it's still worth monitoring whether or not China imposes sanctions against any of Lockheed Martin's suppliers or partners because those could result in some level of difficulty on the part of LMT's suppliers to deliver the necessary raw materials to Lockheed Martin, which could have a disruptive impact on the company if its contingency plans prove to be inadequate.
While on the topic of geopolitical developments, it's also worth mentioning that at any time, the U.S. government could impose restrictions or delays on the sale or delivery of Lockheed Martin's products to countries such as Saudi Arabia or suspend sales of key products such as the F-35 to Turkey as was the case last summer (though the U.S. Air Force recently announced it would be purchasing the F-35 jets that were denied to Turkey by awarding Lockheed Martin an $862 million firm-fixed-price contract).
It goes without saying that geopolitical developments could have a material impact on Lockheed Martin's financial results at any point in time.
Although I have discussed several key risks associated with an investment in Lockheed Martin, the above discussion isn't to be interpreted as a complete discussion of the risks facing the company. For a more comprehensive discussion of the risk profile, I would refer interested readers to pages 9-20 of the most recent 10-K, pages 48-51 of the most recent 10-Q, and my previous articles on Lockheed Martin.
A Fairly Priced And Wonderful Company
Despite the fact that Lockheed Martin has proven itself to be a high-quality defense contractor, investors must still determine the fair value of shares before contemplating an investment in the stock in order to reduce the risk of overpaying for shares because significantly overpaying regardless of a stock's quality results in a triple threat combination (lower starting yield, increased risk of valuation multiple contraction, and lower total return potential).
The above is precisely why I will be using a couple valuation metrics and a valuation model to arrive at a fair value for shares of Lockheed Martin.
The first valuation metric that I'll be utilizing to determine the fair value of Lockheed Martin's shares is the TTM PE ratio to 13-year median TTM PE ratio.
As per GuruFocus, Lockheed Martin's TTM PE ratio of 16.61 is a bit higher than its 13-year median TTM PE ratio of 16.08.
Factoring in a reversion to its 13-year median TTM PE ratio of 16.08 and a fair value of $366.90 a share, shares are trading at a 3.3% premium to fair value and pose 3.2% downside from the current price of $379.00 a share (as of August 2, 2020).
The second valuation metric that I will use to approximate the fair value of shares is the TTM price to FCF ratio to the 13-year median TTM price to FCF ratio.
As indicated by GuruFocus, Lockheed Martin's TTM price to FCF ratio of 15.55 is a tad below its 13-year median TTM price to FCF ratio of 15.93.
Assuming that Lockheed Martin's TTM price to FCF ratio reverts to 15.93 and a fair value of $388.26 a share, shares are priced at a 2.4% discount to fair value and offer 2.4% capital appreciation from the current share price.
Image Source: Investopedia
The valuation model that I will be using to assign a fair value to shares of Lockheed Martin is the dividend discount model, or DDM.
The first input into the DDM is the expected dividend per share, which is another term for the annualized dividend per share. While the current annualized dividend/share is $9.60, I estimate that the company will be announcing an 8.3% increase to its annualized dividend next month, bringing it to $10.40.
For the sake of this article, however, I will be using the current annualized dividend/share of $9.60.
The next input into the DDM is the cost of capital equity, which is the annual total return that an investor requires from their investments. While this often materially varies from one investor to another, I require 10% annual total returns on my investments because I hold the opinion that such returns provide adequate reward for the time and effort that I spend researching investment opportunities and occasionally monitoring my investments.
The third and final input into the DDM is the long-term dividend growth rate, or DGR.
Unlike the first two inputs into the DDM that require merely data retrieval and subjectivity, accurately projecting the long-term DGR requires an investor to consider a multitude of factors, including a stock's payout ratios (and whether those payout ratios are positioned to remain the same, contract, or expand in the long term), annual earnings growth potential, industry fundamentals, and the condition of a stock's balance sheet.
Given that Lockheed Martin's payout ratios are on the low end of ideal and that annual earnings growth is positioned to be 7-8%, conservatively, over the next decade, I am maintaining my annual 7.75% long-term DGR.
When I plug the above inputs into the DDM, I arrive at a fair value of $426.67 a share, which indicates that shares of Lockheed Martin are trading at an 11.1% discount to fair value and offer 12.6% upside from the current share price.
Upon averaging the three fair values, I compute a fair value of $393.94 a share, which implies that shares of Lockheed Martin are priced at a 3.8% discount to fair value and offer 3.9% capital appreciation from the current share price.
Summary: Lockheed Martin Still Offers An Attractive Yield And High-Single-Digit Dividend Growth Potential
Lockheed Martin's dividend coverage has held steady over the past year in terms of its diluted EPS payout ratio and markedly improved in terms of FCF payout ratio, which is due to the fact that the company is firing on all cylinders from an operational standpoint.
As a result of Lockheed Martin's continued manageable payout ratios and its strong top- and bottom-line growth delivered in Q2 2020 and through the first half of FY 2020, I believe the company will deliver about as strong of a dividend increase in 2020 (even with the current challenges of COVID-19) than it did with its 9.1% dividend increase last year.
Lockheed Martin's ~13 interest coverage ratio through Q2 2020 is a marked improvement over its ~10 interest coverage ratio through Q2 2019, not to mention the fact that the cash and cash equivalents position has nearly doubled from $1.5 billion at the end of Q2 2019 to $2.9 billion at the end of Q2 2020.
Adding to the case for an investment in Lockheed Martin is the fact that the current share price indicates that it is trading at a 4% discount to fair value based on my interpretation of data sourced from GuruFocus as well as the dividend discount model.
As a result of Lockheed Martin's high probability of meeting my 10% annual total return requirement over the next decade with its 2.5% yield, 7-8% annual earnings growth, and 0.4% annual valuation multiple expansion, I am maintaining my buy rating on the shares at this time.
This article was written by
Analyst’s Disclosure: I am/we are long LMT. 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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