Magic Formula Stock Review: Lockheed Martin (LMT)
Lockheed Martin (LMT) is the largest defense contractor in the world by sales. 85% of sales originate from the U.S. federal government, particularly the Department of Defense (DoD). Another 13% comes from foreign partner governments, and only 2% come from the private sector. The current company was formed by the 1995 merger of Lockheed, historically a defense aerospace company, and Martin Marietta, who was known for their space systems.
The remnants of the mega-merger can be seen in Lockheed Martin's four operating segments. Aeronautics (27% of sales, 30% of profits) makes and maintains some of the well-known military jets and transport planes, such as the F-16, F-22, and C-130J. Lockheed has a long history making fighter and stealth jets, dating back to famous planes like the SR-71 Blackbird and F-117 Nighthawk.
Space Systems (19% for both) is the "Martin" part, making satellites, space-based missile systems, and space transports. Electronic systems (27% of sales, 31% profits) makes missile systems, naval sensor systems, electronic spy equipment, etc. Finally, Information Systems & Global Services (IS&GS) is engaged in general information technology activities for various departments within the government.
A Magic Formula investment in Lockheed Martin is a defensive play in more ways than one. The company is one of the few major government contractors, with a long history, significant trust, massive scale (in a limited market), and accrued experience that simply cannot be duplicated by potential competitors, giving the company a truly wide economic moat. Additionally, defense spending is largely protected from wild economic swings, as witnessed by net growth in the defense budget over the past few years, despite a major draw-down in Iraq. Fast moves in technology have required continued investment in upgrading military equipment. In short, Lockheed is a not a stock that is going to give you a 100% one-year gain, nor is it likely to lose your shirt for you.
Over the next year, probably the major underlying fundamental catalyst in either direction are developments in the F-35 aircraft program. The F-35 is one of the largest new aircraft endeavors in over 30 years. The plane is designed to replace several existing units across several branches of the military, including the F-16 (Air Force), F/A-18 (Navy), and AV-8B (Marines). It will also replace the expensive F-22 program (also a Lockheed product), which winds down in 2012. The expected order volume for the F-35 could reach over 3,000 units. To put this in perspective, the 30-year old F-16, probably the world's most ubiquitous fighter jet, has had just over 4,500 units build in its entire lifetime! The F-35 program could be worth a combined 1 trillion dollars to Lockheed in equipment and maintenance contracts. It is a major component of the company's future.
Of course, a program this high profile has seen issues. The software is still incomplete and not as reliable as needed. The test side has run about 6 months behind in building and qualifying prototypes. In February, Defense Secretary Robert Gates withheld over $600 million in payments due to delays and cost overruns. More bad news would be detrimental to Lockheed's stock price, particularly over a short 1-year holding period.
It should be said that the F-35 program does not appear to be in danger of being outright cancelled. It is clearly a high priority for the DoD. Operational and tactical metrics have been stellar.
The other major consideration is the overall level of defense spending. Fortunately, both budgets under President Obama have exceeded expectations for defense spending. Lockheed's programs have been well-supported. Despite some rumblings about major project cuts or reformed procurement, I think it is likely that defense appropriations will not be a major factor here, given the variety of other political concerns of the moment.
So, we have to look closely at Lockheed's valuation. Currently, the stock sells at a Magic Formula-adjusted earnings yield of 12.65% - a decent number. A few things to consider, though. First, defense contractors are not historically a high-multiple sector. Lockheed's 5-year average earnings yield is 10.7%, so there may not be as much valuation growth potential as we want. Also, the past decade has been very kind to defense contractors. Lockheed's 10-year trailing growth numbers (15% compound annual profit growth) are not likely to be duplicated.
I have a neutral rating on Lockheed - the stock looks just about fairly valued. The F-35 is a nice catalyst, but it probably will not start contributing to the bottom line for a few years. On the other hand, both the company and the stock are relatively predictable, selling below historical valuations, and delivers a nice 3% dividend yield. Lockheed makes a better multi-year or dividend play than a one-year Magic Formula pick.