Lockheed Martin: A Great Business At A Fair Price

Summary

• At current price level of ~$385, investment in Lockheed Martin represents an opportunity with large upside up to ~70% in 3 years but little downside.
• The stock price decline over the past few months has been largely unwarranted and created an entry opportunity for a great business at a fair price.
• The current uncertainties in the US government military budgeting and COVID interruptions are only temporary and do not impact the moat or the secular trend of the business.
• The F-35 program is a main cause, though not the only one, for the optimism and it alone could fuel LMT’s growth for many years to come.

Photo by ArjanL/iStock Editorial via Getty Images

The investment thesis

At current price level of ~$385, investment in Lockheed Martin (NYSE:LMT) represents an opportunity with large upside up to ~70% in 3 years but little downside. The stock price has declined over the past few months from a peak of $440 (Feb 2020) to the current level of ~$385 due to the uncertainties in the U.S. government military budgeting and the COVID interruptions. However, these issues are only temporary, and do not impact the moat or secular trend of the business. Instead, such price fluctuation created an entry opportunity for a great business at a fair price. The F-35 program is a main cause, though not the only one, for the optimism and it alone could fuel LMT’s growth for many years to come.

The business, the moat, and the float

Lockheed Martin is a global leader in defense systems, with concentration in space and missile systems, electronics, and aeronautics.

The business is protected by a wide and durable moat, created by sheer technological superiority, scale, and customer relationship. Due to my day job, I happen to know quite a bit of the technical aspects of their F-35 business, especially the aerodynamics aspects. Innovations like supersonic flight both with and without afterburning, the long-range ability, and the short take-off and vertical-landing (STOVL), are so ahead and only these features alone would take competitors decades to catch up. And the aerodynamic aspects are only the tip of the iceberg of its technological lead. The business boasts other dramatic leads in electronics, sensor fusion technology, radar, stealth technology, et al. These technological leads are sufficient to make the business essentially a monopoly with no alternative in sight. The scale and customer trust further add another irreplaceable intangible asset. Customers are sticky and switching cost is prohibitive. In Warren Buffett’s words, this is a business with a wide moat that is filled with crocodiles.

The business also enjoys a secular tailwind for any foreseeable future. Despite the temporary budgeting uncertainty in the US, it is unlikely that the defense budget, not only in the US, but also globally, would stagnate given the increasing level of geopolitical tension and polarization in many parts of the world. Global defense budget has been increasing faster than GDP and faster than inflation for many years and is projected to further accelerate in the next 10 years.

Specific to LMT, the US still plans to have 2,456 of these planes in its arsenal (and to put things into perspective, LMT has “only” delivered 600 of them thus far in total). Globally, a number of partner nations have either placed order or are keenly interested in procuring this fifth-generation fighter. The total worldwide demand for the F-35 is projected to be somewhere between 3,000 to 5,000 by 2035. All of this is probably best encapsulated in the massive backlog and its steady increase as shown below. As seen, 2020’s backlog is $147B (and to put it in perspective, 2020 sales is $65B). So it is not only a business with a wide moat, but also a massive float. With such a float, hiccups like the current US budgetary uncertainty would not impact its cash flows at all, and there would be little uncertainty in the expected returns.

Source: Author and Lockheed Martin earnings release.

The growth

First let’s take a look of the management’s outlook for 2021, as recently announced in their earnings release. As can be seen, management expects 4% top line growth and ~8.5% bottom line growth over 2020. Compared to the growth rate over the past five years, we can see such expected growth rates (i.e. 4% top line and ~8.5% bottom line growth) are very reasonable and sustainable. And we will later further show that at current valuation, we do not even need such a growth rate to generate a handsome return.

Source: Author and Lockheed Martin earnings release

A back-of-the-envelope calculation will show that the F-35 program itself should be able to fuel about 6% of earnings growth in the next many years to come based on the following pieces and bits of information: A) as mentioned above, take 3,000 (the low end of the projection) as the total worldwide demand for F-35 by 2035 (i.e., in the next 15 years); B) LMT has delivered 120 of them last year and 600 of them thus far in total; C) delivering another batch next year (which will be more than 120 to meet the demand) will expand the existing fleet by at least 20%, and therefore increase the service revenue by more than 20%; and D) the F-35 accounts for about 30% of the firm’s current revenue. Based on these, a back-of-the-envelope calculation would show that the F-35 program alone would be able to drive about 5% growth in the top line. Assuming another 1% improvement in margin due to the scale of economics, this would lead to a 6% growth in the bottom line.

Again, the above analysis only considered the F-35 program and totally neglected all other business segments. As a notable example, its recent acquisition of Aerojet Rocketdyne (a space business) alone would add about $2B to the top line, more than 3% of its 2020 sales. As a second order effects, such acquisition could create further growth and synergy opportunities by capitalizing on the fledgling space business (such as the US' recent establishment of the Space Force).

The valuation

As can be seen from the following numbers in the table, at a price level of ~$385, LMT is fairly valued or slightly discounted depending on which valuation metric you use based on its historical valuations. As can also be seen in this table, it’s a pretty stable business with good predictability, and thus there is not too much variance in terms of the choice of valuation metrics.

The chart following provides a better visual of the valuation. The business has been pretty stably valued between 14x PE and 19.5x PE since 2014. Before that, the valuation had been compressed together with the overall market between 2008 and 2013.

In terms of absolute valuation, a current PE of 14.6x (or a 12x price to cash flow ratio) is very reasonable for a wide moat business leader like LMT, even without the excellent growth potential.

Source: Author and Seeking Alpha

Source: Author and Yahoo Finance.

The potential return

Based on the above analysis of the business fundamental, growth potential, and valuation metrics, it is relatively straightforward to project the return in the next a few years. Here let’s consider the following good case scenario first. This scenario considers the following return drivers:

1. 5% growth in the top line and 1% margin expansion (leading to a 6% growth in the bottom line). As analyzed above, this growth could be fueled by the F-35 program alone.

2. Share repurchase at 0.8% per year. LMT has been reducing its share account by ~0.8% per year in recent years (about $1.1B in dollar value). We expect such repurchase programs to continue given A) its free cash flow of more than $6.4B per year and a dividend of only $2.8B, and B) the relatively compressed valuation of the stock.

3. Dividend on the 2.7% level (assuming dividend increase would keep the dividend yield approximately at the current level).

4. A PE of 19.5x due to market mood swing. This is really where we need a bit of luck on our side in this good scenario.

Based on the above return drivers, the annual return could reach 18.6% a year as shown below, with a total return of more than 70% in 3 years.

Source: Author

Now consider a bad scenario where the market mood keeps negative and valuation remains compressed at its historical low near 14x. In this case, the annual return would be about 6.5% (purely due to the earnings growth) and about 25% in three years.

These analyses above show a potential upside of more than 70% with very little downside.

Source: Author

My holdings

First, a little bit more about my overall portfolio management strategy and my stock selection methodology. At the portfolio level, I follow a variation of Dalio’s All Weather Portfolio. I hold three asset classes: gold, treasury bonds, and stocks. The main variation is adding a dynamic leverage. The specifics are detailed in another one of my posts in case you are interested. Out of the stock asset class (currently at ~50% of my entire portfolio), 2/3 are invested in indexed stock ETFs (including leveraged ETFs), and the remaining 1/3 is invested in individual stocks.

For these individual stocks, I hold a rather concentrated portfolio of no more than a dozen stocks. For my stock selections, I follow a variation of Joel Greenblatt’s Magic Formula method. The variations primarily involve A) the inclusion of growth rate into the ranking, B) the use of a relative valuation metric (i.e., a stock’s current valuation compared to its historical valuation) to replace the absolute PE or EV/EBIT ratio in the original magic formula method, C) the fundamental aspects of the business, and D) some consideration of diversification across different market sectors (though I do not mind holding multiple stocks in the same sector).

With the above background, here are my current holdings and their weight in my current portfolio. As you can see, I currently hold 9 positions, and LMT is my largest position at 2.3% of my total portfolio. My other holdings are:

1. Walgreens Boots Alliance (WBA), for which I have posted a fully analysis here.
2. AbbVie Inc. (ABBV), a pharmaceutical juggernaut
3. Intel Corp. (INTC), a global leader in integrated circuits
4. Verizon Communications Inc. (VZ), a diversified telecommunications provider
5. Kroger (KR), the US' largest grocery store by sales
6. Merck & Co. (MRK), a global leader in health care and animal health products
7. General Dynamics Corporation (GD), a leading global defense contractor
8. Alibaba Group (BABA), the largest ecommerce company in the world in terms of gross merchandise volume

I have written an analysis for WBA in case you are interested. And I will gradually write my analysis for the rest of my holdings.

Source: Author

As you can see, my selection method tends to select stocks with reasonable valuation, reasonable growth, and high quality. In terms of valuation, all holdings are trading at very reasonable valuation (both in terms of absolute valuation and relative valuation). The average PE is ~13.x for this group, compared to ~44 for the overall market (represented by S&P 500).

In terms of the growth, the PEG column provides some insights. The PE Growth ratio (PEG) was defined as the PE divided by the sum of dividend growth rate and dividend yield. The dividend yield was included in the definition with the rationale that if a stock offers a high dividend yield currently, there is no need to require a high growth rate anymore to support a reasonable expected return. As seen, this group offers an average PEG of 1.4, with the maximum of 1.8. In contrast, the PEG for S&P 500 is ~4 (assuming ~8% growth rate and ~2% current dividend yield).

In terms of quality, they are all leaders in their sectors with a well-established business model, brand name, and moat. Their financial strength is among the strongest. For one thing - the interest coverage, calculated as EBIT divided by interest expense, is ~12x. And this calculation excluded INTC and BABA, which are essentially debt-free given their current working capital and EBIT. And the quality of the business, measured by return on equity (ROE), is on average 30%, more than double that of the overall market. Note the ROE of ABBV is ~160% with its particular capital structure and is not included in this average.

Certainly, each of them faces their uncertainties. But so does each component in the S&P 500. And as a diversified group with such a wide margin of safety compared to S&P 500 both in terms of valuation, financial strength, and quality, I am optimistic of their odds of beating the overall market and at the same time can sleep well during any market turmoil.

Conclusion and final thought

Lockheed Martin is a global leader in the defense industry, and at its current valuation, it can provide a strong defense for your portfolio. The company enjoys a wide and durable moat, both due to its dramatic technological lead, its scale, and its customer trust. It operates in an acyclical business with a massive backlog, and has superior ability to weather any short-term hiccups and uncertainties. At the current price level, there is a potential upside of more than 70% in ~3 years with very little downside.

As a final thought, I wish Seeking Alpha not only asks (or at least encourages) authors to not only disclose their ownership of a given security, but also to disclose the size of their position. For now, I would encourage authors to volunteer this information. I am a firm believer that actions speak louder than words. Instead of (or in addition to) showing the arguments and analysis, show what and more importantly how much you actually hold. How much we actually hold tells more about our true opinion than our analysis.

Disclosure: I am/we are long LMT, WBA, ABBV, INTC, VZ, KR, MRK, GD, BABA. 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.