Lockheed Martin: A Screaming BUY

Summary

• Lockheed Martin's shares have underperformed the S&P 500 by about 27% in the last one year due to potential headwinds such as a changing political landscape and the F-35 uncertainty.
• However, the company has solid fundamentals, continues to win massive contracts, has recently announced a smart purchase, and offers a mouth-watering dividend yield.
• I have a BUY recommendation on Lockheed Martin with a target price range of $411.69-$454.00, which suggests an upside of approximately 22.5%-35% to the closing price on 8 January.

Lockheed Martin’s (NYSE: LMT) stock has taken a bit of a battering recently and has had a year to forget, underperforming the S&P 500 by about 27% in the last one year. Some of this underperformance can be attributed to the continued challenges faced by its F-35 program and to the potential threats of tax increases as well as the possibility of a reduced focus on defense spending under the incoming Biden administration. The company started 2021 with a bang, agreeing to acquire one of its key suppliers, Aerojet Rocketdyne (NYSE: AJRD) for a whopping $4.4 billion.

Despite these headwinds, the stock looks significantly oversold, especially since the said headwinds are short-term in nature and the growth prospects of the company look bright and intact. The fundamentals also look strong, and the dividend yield continues to be a monster. In this article, I highlight some of the key catalysts for Lockheed, which makes its stock not a solid, but rather a screaming BUY. I also estimate LMT’s 12-month target price using DCF analysis.

Company Overview

Source: www.military.com

Lockheed Martin is an aerospace and defense company, which designs, develops and manufactures military aircraft & helicopters and defense systems. The company also has a Space division, which designs, develops, and produces satellites and space transportation systems. With annual sales of $59.81 billion in FY2019 and a market-cap of approximately $95 billion, Lockheed Martin employs close to 110,000 worldwide and is one of the largest players in aerospace and defense sectors.

A Defense Behemoth that Continues to Win Big

Seeking Alpha contributor Dhierin Bechai’s recently published article highlights that, for 2020 alone, the value of the contracts that Lockheed won stood at a whopping $123 billion. 2021 looks to be no different, with a whopping $4.9 billion contract already awarded by the US Space Force to develop three missile-warning satellites by 2028 and a $1.28 billion contract signed with the U.S. Department of Defense for the sustaining the F-35 fighter jet fleet globally. The former is of particular interest since it shows the strength and growth potential of Lockheed’s space division, which accounted for only 19% of the total revenue in FY2019 compared to its aeronautics division, which accounted for 40% of the total revenue. Lockheed’s space division is primed for significant growth especially since the budget of the Space Force (the one established under the Department of Air Force, not the Netflix comedy series starring Steve Carrell and John Malkovich), is projected to increase by an additional $2.6 billion over the next five years, of which, $2.3 billion will be allocated for procurement spending. These figures are according to a report that the Air Force Secretary Barbara Barrett submitted to congressional committees in March 2020 (Source: www.spacenews.com). The continued emphasis placed by the Pentagon on space defense will only bring in fatter contracts for Lockheed’s space division, which, in the future, looks like a potential Star and is most likely to offset any revenue lost due the uncertainties surrounding the F-35 Program.

A $4.4 Billion Gift to the Missile Segment

On January 4, 2021, Lockheed paid a staggering $4.4 billion for Aerojet Rocketdyne Holdings, a key supplier to both Lockheed and one of its main competitors, Raytheon Technologies. 26% of Aerojet’s FY2019 Revenue came from Lockheed Martin and 21% came from Raytheon. Therefore, not only is Lockheed purchasing one of its key suppliers but is also acquiring a company that has developed key business connections with its competitors as well. The acquisition will also help to align Lockheed more closely with the U.S. Government given Aerojet’s ties to NASA (accounted for 14% of Aerojet’s FY2019 sales according to data obtained from Thomson Reuters).

The acquisition also comes with a bonus of gaining a foothold in the hypersonic missiles market, where Aerojet is a key player. This market is poised to grow from $505.8 million in 2019 to $607.1 million by 2024 at a CAGR of almost 4% (source: Business Wire) and this acquisition will enable Lockheed to boost its missiles segment, which contributes the least to its sales. These positives seem to be the rationale behind the acquisition as evidenced from this statement from James Taiclet, President and CEO of Lockheed Martin:

"Acquiring Aerojet Rocketdyne will preserve and strengthen an essential component of the domestic defense industrial base and reduce costs for our customers and the American taxpayer. This transaction enhances Lockheed Martin's support of critical U.S. and allied security missions and retains national leadership in space and hypersonic technology. We look forward to welcoming their talented team and expanding Lockheed Martin's position as the leading provider of 21st century warfare solutions."

(Source: Aero-News)

Valuation

I estimated the 12-month target price for the stock using DCF Analysis. The following were the key assumptions made in the analysis:

Revenue Growth Rate	8.41%
Pre-Tax Margin	12.1% in the first two years before falling to 7.6% for the next 3 years.
Perpetual Growth Rate used to Calculate Terminal Value	1.5%
Capex/Total Revenue	2.37%
Effective Tax Rate	20%

I took a conservative approach when determining the estimates for the key variables used in the model. The Revenue growth rate was consistently maintained at 8.41%, which is the 5-year growth rate of Revenue, as per Thomson Reuters. There is a very high probability that the revenue growth rate will be much higher than 8.41%, especially given the growth prospects of its Space Division. However, I deliberately chose to remain as conservative as possible while estimating the target price.

Pre-tax margin was estimated to remain the same as the current margin for the first two years, before falling to the industry median of 7.6% for the next three years. This remains unlikely, since the Aerojet acquisition is expected to drive down Lockheed’s costs. However, given that the cost reduction will mostly have a positive impact on its missiles business, which is the smallest contributor to Lockheed’s revenues, and given that Lockheed continues to suffer from the uncertainties surrounding its F-35 Program, the margin growth assumptions were made cautiously.

The perpetual growth rate of 1.5%, used to calculate the Terminal Value, is again chosen conservatively (I also mention the target stock price if growth rate is increased to 2%).

Lockheed has consistently maintained a Capex/Revenue ratio of around 2.4%, so I have used this figure (2.37% to be precise) for my model.

I used effective tax rates of approximately 20%. While incoming President Joe Biden has consistently maintained his stance on reversing the tax cuts initiated by his predecessor and while one could argue that Democrats gaining control of the Senate makes this a likely prospect, I belong to the group of individuals who think that dramatic tax increases are unlikely given the 1-seat majority held by the Democrats in the Senate. Despite this, I have gone for a slightly higher Effective Tax Rate in the model.

Based on these assumptions and using a Weighted Average Cost of Capital (OTC:WACC) of 6.35%, the 12-month target price of LMT is estimated to be $411.69, which implies an approximate 16% upside to the December 31 closing price of $354.98. The stock price has further dropped since, and closed at $336.10 on Friday, January 8, 2021, which implies a 22.50% upside.

If I assumed the perpetual growth rate to be 2%, the 12-month target price estimate becomes $454.00, which implies an approximate 28% upside to the December 31 closing price and a 35% upside to the January 8 closing price.

Risks

The obvious risk to consider is the shift in the political landscape. The incoming Biden administration is more likely to spend 2021 repairing an economy battered and bruised by the COVID-19 pandemic. The administration is also likely to push forward with higher tax increases, especially since more heavy borrowing is anticipated as part of the stimulus measures, and this will need to be offset once the pandemic subsides. Although I have taken into account the possibility of higher taxes in my model, this is one risk that is too costly to ignore.

There is also the possibility of a shift in spending pattern under the incoming Biden administration to areas such as healthcare and infrastructure. This could lead to a reduced defense budget, which could adversely affect Lockheed’s sales, especially since almost three-quarters of Lockheed’s sales is generated from the U.S. Government (approximately 71% in FY2019). This could also lead to a reduced budget for the Space Force, which would adversely impact the growth potential of Lockheed’s space division.

There is also the risk of regulatory approvals not being granted for the Aerojet acquisition. While not a major risk, this is still an important factor to consider especially since Lockheed would be denied from not only acquiring a key supplier but also a major player in the hypersonic missiles segment, should the acquisition fail to close.

Finally, the constant delays to the F-35 Program is also a major risk. The company is in the process of negotiating a long-term contract with the U.S. government, but the continued delays and problems faced by the fighter jet program could lead to less favorable deal terms for the company, which could offset the positive impact of contracts won by the company’s other divisions.

Concluding Thoughts

The recent battering taken by Lockheed Martin’s stock seems to be an extreme over-reaction. More than the headwinds causing the damage, which are themselves short term in nature and are driven by a number of assumptions, it looks like the company's stock has become a victim of a shift in investors' preference from value to growth.

The company has been making all the right moves to sustain its growth and the establishment of Space Force has also been a blessing for the company’s Space division, which has a tremendous growth potential and great margins. The acquisition of Aerojet Rocketdyne also looks like a smart move, given that it is a vital supplier not only for Lockheed but also for its competitors.

My 12-month target price for the stock, estimated using DCF analysis, ranges between $411.69 and $454.00 depending on the perpetual growth rate used, which suggests an approximate 22.5% - 35% upside from the January 8, 2021 closing price of $336.10. Finally, the stock trades at a P/E multiple that is significantly below the industry median and offers a mouth-watering dividend yield. All these factors make Lockheed Martin nothing but a screaming BUY.