Lockheed Martin: Now Is The Time
Summary
- Lockheed Martin missed Q2 2021 earnings due to a charge in the Aeronautics segment and the sales outlook was also lowered.
- The company raised the total earnings guidance for 2021.
- Lockheed Martin is acquiring Aerojet Rocketdyne to establish leadership in missiles and hypersonics propulsion.
- The dividend is well-covered by earnings and the yield is greater than the trailing 5-year average.
- The stock is undervalued.
In a bull market that demands perfection, Lockheed Martin (NYSE:LMT) missed GAAP earnings estimates and the stock price responded negatively. The company was hit with a charge in the Aeronautics segment and the sales outlook was cut, more on that below. There is also the uncertainty of the acquisition of Aerojet Rocketdyne (AJRD) and the lengthy regulatory review process. Lastly, there is fear by investors that the U.S. defense budget may be cut in the future. In fact, the stock price has been trending down since April 2021. However, dig a little deeper and one can see that Lockheed Martin is performing well and some of the negatives may be unfounded. The most recent quarter saw revenue increase in all four business segments. The company also upped its earnings outlook for 2021. Furthermore, Lockheed Martin is a Dividend Contender with 19 years of dividend growth. The stock is undervalued today, and I view Lockheed Martin as a long-term buy.
Overview of Lockheed Martin
Lockheed Martin Corporation, which was founded in 1912, is today the world’s largest defense company. The company consists of four business segments: Aeronautics (~40% sales) - which produces military aircraft; Rotary and Mission Systems (~26% sales) - which houses combat ships, naval electronics, and helicopters; Missiles and Fire Control (~16% sales) - which creates missile defense systems; and Space Systems (~17% sales) - which produces satellites. The company has significant strength and exposure in military aircraft and produces the F-16, F-35, F-22, C-130, C-5, P-3, Black Hawk, Chinook, and others. About 60% of the company’s revenues comes from the U.S. Department of Defense, with other U.S. government agencies (10%) and international clients (30%) making up the remainder. The company had total revenue of over $65.4 billion in 2020 and $66.8 billion in the LTM.
Aeronautics Earnings Hit by a Charge
Lockheed Martin had a decent Q2 2021 that was affected by a one-time event. The headline was that that company grew revenue to $17 billion from $16.2 billion and diluted adjusted earnings to $6.52 per share from $5.79 per share. However, the defense giant was hit by an unexpected charge of $225 million or (-$0.61) per share. This was due to performance issues on a classified program. This is seen in segment operating profit from the earnings release where the Aeronautics segment saw a large drop.
Source: Lockheed Martin Q2 2021 Earnings
Specifically, the CFO stated:
Our segment operating profit was impacted this quarter by a one-time charge associated with a classified program in our Aeronautics business area. While the classified nature of this program precludes us from discussing this matter in depth, we can say that our customer is highly attracted to the capabilities that we’re developing on their behalf that we're committed to delivering these capabilities and that the long-term potential of this solution is significant for the company.
It looks like the charge is for a platform in development that if successful may have a positive impact on the top and bottom lines in the future. However, the outlook for both sales and operating profit in the Aeronautics segment was cut. But both categories were increased in other segments leading to no net change.
Source: Lockheed Martin Q2 2021 Presentation
Source: Lockheed Martin Q2 2021 Presentation
Despite the negative news of the Aeronautics segment, Lockheed Martin increased its outlook for earnings to $26.70-$27.00 per share from $26.40-$26.70 per share. The company intends to accelerate share repurchases, book investment gains, reduce costs, and improve other program performance to make up the difference.
Aerojet Rocketdyne Acquisition Status
Lockheed Martin announced at the end of 2020 that it would acquire Aerojet Rocketdyne for $56 per share cash or $4.6 billion equal to $4.4 billion including assumption of net cash. Aerojet Rocketdyne announced a special dividend (paid in March 2021) that makes the per share cost of the acquisition $51.
The acquisition makes sense for Lockheed Martin as it would strengthen its position in space and hypersonics, especially propulsion, relative to competitors. Since Aerojet Rocketdyne has $2 billion in revenue, it would also add to revenue for the Space and Missiles and Fire Control segments.
Lockheed Martin is planning on closing the acquisition in Q4 2021. However, there is some risk that the acquisition will not be completed. The FTC made a second request of Aerojet Rocketdyne about the deal in February 2021. The main concern is likely the concentration of the propulsion technology in the No. 1 defense contractor. For perspective, Aerojet Rocketdyne makes about 70% of solid fuel rocket motors used in missiles. In addition, a new chairwoman was appointed to the FTC, which likely delayed review. Lastly, the deal has gained negative attention from some Senators.
If the deal is successful though, it would essentially give Lockheed leadership in propulsion for missiles and hypersonics. This is a growing market.
U.S. Defense Budget Cuts in Procurement
Perhaps the most likely factor weighing on Lockheed Martin’s stock price is the potential of future U.S. Defense budget cuts in procurement. The period from 2016 to 20201 saw rapid growth of the defense budget. The budget for fiscal 2022 will grow by $11 billion to $715 billion, which is below the rate of inflation. However, the budget would change some priorities in the Pentagon. The proposed budget would increase development and testing, essentially R&D, by $5.5 billion. On the other hand, procurement would fall by $8 billion.
The lower procurement budget would impact some legacy aircraft, and result in decommissioning for four littoral combat ships and two cruisers. According to federal news network:
The divestments will hit all of the military services and U.S. Special Operations Command (SOCOM). The Navy will plan to decommission some littoral combat ships, cruisers, and dock landing ships. It will also cast off some F-18s and RQ-21 drones for a total savings of $1.3 billion. The Air Force is once again trying to lose at least some of its popular A-10 planes, along with some F-15s, F-16s, KC-135s, KC-10s, C-130Hs, E-8s and RQ-4s. The total savings would end up being $1.4 billion. The A-10 Warthog is a service member and lawmaker favorite, known for its loud and intimidating frontal guns.
Lockheed Martin makes the F-16, C-130s, and has content in other platforms, which means that a cut to procurement will impact the company.
However, the new Space Force is part of the Air Force now and will result in a rise to spending for missiles and hypersonics. This is the most likely reason why Lockheed Martin is acquiring Aerojet Rocketdyne. In addition, the company is showing organic rising sales and operating profit in 2021 indicating defense spending in the Space segment is already increasing.
Lockheed Martin Valuation
To determine a fair value for Lockheed Martin, we use a price-to-earnings ratio of 16X, which is slightly higher than the trailing P/E ratio in the past decade. We use a slightly higher P/E ratio to account for Lockheed Martin’s market leadership in aeronautics and the strength of its product platforms, especially the F-35 and F-16. The mid-point of updated 2021 earnings guidance is $26.85 per share. This gives a fair value estimate of $429.60 per share.
We apply a sensitivity analysis using P/E ratios between 15x and 17x, and obtain a fair value range from $402.75 to $456.45. The current stock price is ~81% to ~92% of my estimated fair value. The current stock price is ~$368.96 as of this writing, suggesting that the stock is very undervalued based on P/E ratio.
Estimated Valuation Based on P/E Ratio
P/E Ratio | |||
15 | 16 | 17 | |
Estimated Value | $402.75 | $429.60 | $456.45 |
% of Estimated Value at Current Stock Price | 92% | 86% | 81% |
Source: dividendpower.org Calculations
How does this compare to other valuation models? Morningstar is known to use a fairly conservative discounted cash flow model and provides a fair value of $425. The Gordon Growth Model gives a fair value of $416, assuming a desired return of 8% and a dividend growth rate of 6.5%. This is below the growth rate for the past decade and trailing 5-years. Hence it is a conservative estimate. An average of these three models is ~$423.53, suggesting that Lockheed Martin is undervalued at the current price.
Final Thoughts on Lockheed Martin
Lockheed Martin is the market leader in defense contracting companies. The company has a strong product platform and is positioned in growth segments for its customer, especially the F-35 and F-16. If the Aerojet Rocketdyne acquisition is successful, Lockheed Martin will be the market leader in missiles and hypersonic propulsion. This will probably be a growth field in the next decade. There are some risks that the acquisition will not pass regulatory muster, and the defense budget will be cut more than expected for procurement. But I view that as unlikely at this point. The dividend is well covered by earnings with a conservative payout ratio of about 40%. This means that the dividend will grow for the foreseeable future. The current dividend yield of 2.82% is great than the trailing 5-year average of 2.6%. The stock is very undervalued to undervalued in an arguably overvalued market. I view Lockheed Martin as a long-term buy.
This article was written by
Analyst’s Disclosure: I/we have a beneficial long position in the shares of LMT either through stock ownership, options, or other derivatives. 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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