Lockheed Martin (LMT)

Lockheed Martin is the world's largest defense contractor with enough capacity for the most lucrative government contracts. Lockheed Martin is the leading aerospace company in the US and has had good earnings growth, but its PE ratio is lower than average for its industry.

Furthermore, the F-22 is claimed by many to be the world’s most effective fighter aircraft. Lockheed recently reported a big success at the recent Joint Expeditionary Force Experiment 2008 (JEFX 08).

"Lockheed Martin was excited about the Air Force's decision to demonstrate the value of sharing F-22 ISR data with other fighters and back to the Combined Air Operations Center," said Larry Lawson, Lockheed Martin Aeronautics Company executive vice president and F-22 general program manager. "This is the first time in history that F-22 sensor data was down-linked to the Combined Air Operations Center [CAOC] using a tactical network." This should lead to increased F-22 business going forward.

LMT is in a sector that has been hard-hit twice in a short time span. As the markets were weighing the impact on defense stocks of a change in administration, the credit bubble burst bringing future government spend on the sector into question. LMT stock today is down 35% from its high of $120 (Q3 of 2008) while the S&P is down just 20% in the same period. This leaves LMT trading at around $75 with a P/E of 9.92, well below its long run average of 15. Throughout the current recession, LMT has remained profitable and has had no issues pertaining to credit.

The outlook for the industry is unpredictable at the moment as the recessionary environment is the priority of governments around the world. The United States government, the company’s largest customer is also currently occupied with ongoing concerns such as health care reform and energy initiatives in addition to programs to stimulate the economy. Longer term, large annual deficits and federal debt may have an impact on government defense spending. While the ultimate size of future defense budgets is uncertain, it is currently indicated that overall defense spending will continue to increase over the next few years but at a lower rate of growth than has been seen.

LMT’s customers are split as follows: 84% of net sales to the US government, 13% to foreign governments, 3% to commercial and other customers. The US government is a very stable customer, as they have a military reputation to uphold and they can print money. Despite all the talk about decreased government spending on defense, this will not be sustained long term as our world slowly returns to a multi-polar system. These developments will only bring an increase in defense spending as governments attempt to maintain their countries’ defence capability in the global arena. This is already demonstrated by the high level of negotiated backlog LMT has; approximately $80.9 billion, of which 58% will still be remaining after one year. Regarding the uncertainty of government spending going forward, LMT feels it is well positioned to take advantage of areas where the government has already indicated increased funding; namely intelligence, surveillance, and reconnaissance (ISR) support for the warfighter, cybersecurity, helicopter maintenance and training, and lift, mobility, and refueling aircraft. LMT provides a diverse product offering to the industry and is well positioned to take advantage of these areas of increased spending while other segments may suffer. This company may have been knocked for being in an industry with such an uncertain near-term future, but it is well positioned to thrive within it. Additionally, the company is pursuing a strategy that will see it “expand and complement our existing products and services by moving into adjacent businesses in which we believe that our core competencies will enable us to successfully compete.” Areas of opportunity the company foresees are “the need for more affordable logistics and sustainment, expansive use of information technology and knowledge-based solutions, and vastly improved levels of network and cybersecurity,” all national priorities. The company expects revenue growth to exceed the growth in the Department of Defence’s budget, as LMT’s revenues historically have not been dependent on supplemental funding requests (the requests beyond those for critical recapitalization and modernization programs) where cuts are most likely to happen.

The current debt to capital ratio of approximately 57% is high due to a reliance on one major customer – this affects the estimated equity risk premium. Using 60% as the long run target debt/capital ratio, 5.2% as the cost of debt (current yield to maturity) and 11.1% as the cost of equity (equity risk premium added to cost of debt), yields a weighted average cost of capital (WACC) for the firm of 6.41%. As a quick return on invested capital (ROIC) is 24.3% for the last 12 months, earnings power on an equity value per share basis (EPV) is expected to be significantly greater than net asset value per share (NAV).

A thorough valuation of LMT shows an EPV of $85.4 and a NAV of $48.5. This is in line with ROIC (replacement value of balance sheet) of 9.27%, which is greater than WACC. The competitive advantage which gives rise to the EPV-NAV discrepancy seems highly sustainable as it is based both on relationships (government connections) and capabilities (proprietary technology). Additionally, there are high barriers to entry in this industry as the government is generally a captive customer of LMT for upgrades, parts and service. It would be very difficult if not impossible for a competitor to take away market share from any of LMT’s existing products.

The value of growth plays a part in the valuation of LMT as the company has a stated goal of growth, both organically and through acquisitions, which will add value with ROIC being greater than WACC. The 5-year average growth in net-income of 20%, while likely not sustainable in the long run, lends credibility to assuming a long-run growth rate of 3%. Applying a value of growth multiplier to EPV at this rate of growth yields an intrinsic value for LMT of $108.5 per share.

As always, I recommend incorporating a margin of safety in order to account for sensitivity in my calculations. A reasonable margin of safety implies an entry price of approximately $76. As such, I believe LMT is a great purchase at its current price of around $75.

Lockheed has situated itself perfectly to play a lucrative role in the newest facet of the defense industry as a systems integrator, countering the escalating threat of cyber crime, cyber terror and cyber warfare.

While those threats might not seem like much, they pose very real danger to everyone. IT security specialist McAfee, estimates that black hat hackers create 8,000 variants of malicious software every day, some of which were used back in July of this year, in attacks on the Pentagon, New York Stock Exchange, and government websites in South Korea.

In fact, these kinds of threats have become such a danger to national security, that President Obama has made cyber security a major policy priority of his administration.

Market estimates of how much the Unites States plans to spend in this area vary widely, but some experts predict it will exceed $50 billion in the next six years.

Over the past 15 years, Lockheed Martin stood out as the leading IT provider for the US federal government. And even while technology affects more and more of the global experience, it has marched right along by providing sophisticated security systems for government-related networks ^[1].

1. ↑ "A New Era in the Defense Industry: Lock And Load On Profits" Article from InvestmentU

One should never underestimate the wherewithal required to successfully do business with the government. Unfortunately, working with the government is getting harder, not easier. When you couple that unquestioned fact with the knowledge the government will continue to buy everthing from bullets to cyber tools, LM is well positioned for growth.

LMT has recently signed a $40 million foreign military sales contract to deliver Sniper Advanced Targeting Pods to the Royal Saudi Air Force. Although this will not significant reduce US exposure, it certainly helps LMT. As LMT continues to be awarded such contracts, this definitely helps LMT as it is traditionally tied to US markets.

LMT has recently signed a $40 million foreign military sales contract to deliver Sniper Advanced Targeting Pods to the Royal Saudi Air Force. Although this will not significant reduce US exposure, it certainly helps LMT. As LMT continues to be awarded such contracts, this definitely helps LMT as it is traditionally tied to US markets.

LMT has recently signed a $40 million foreign military sales contract to deliver Sniper Advanced Targeting Pods to the Royal Saudi Air Force. Although this will not significant reduce US exposure, it certainly helps LMT. As LMT continues to be awarded such contracts, this definitely helps LMT as it is traditionally tied to US markets.

LMT has recently signed a $40 million foreign military sales contract to deliver Sniper Advanced Targeting Pods to the Royal Saudi Air Force. Although this will not significant reduce US exposure, it certainly helps LMT. As LMT continues to be awarded such contracts, this definitely helps LMT as it is traditionally tied to US markets.

LMT has recently signed a $40 million foreign military sales contract to deliver Sniper Advanced Targeting Pods to the Royal Saudi Air Force. Although this will not significant reduce US exposure, it certainly helps LMT. As LMT continues to be awarded such contracts, this definitely helps LMT as it is traditionally tied to US markets.

Lockheed Martin for FY2009 have begun to expand into smart grid and alternative energy, teaming up with several large utilities companies such as Northern Virginia Electric Cooperative and PPL Electric Utilities. The underlying reason for LMT's involvement is to provide smarter system for electric grids, many of which are still operated manually. This entry serves as a good hedge for LMT against decreased U.S. defense spending.

Recent increases in global instability will continue to fuel defense spending and thus, Lockheed Martin's growth.

Current export opportunities for products such as the F-16 fighter jet and anticipated export opportunities for the Joint Strike Fighter will provide significant revenue.