Hedge Funds Dig into Lockheed Martin

By SumZero Research - January 23, 2012 | Tickers: GD, LMT, NOC, BA | 0 Comments

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Lockheed Martin (NYSE: LMT)

(The following write-up is an edited and abbreviated pitch pulled from the SumZero community.)

Recommended Action: Long
Current Price: $83.50 Target Price: $100.00
Source: Hedge Fund. New York, NY.

The Opportunity

Lockheed Martin offers the opportunity to invest in an oligopoly business that:

• Derives 50%+ of operating income from long-term, recurring programs;

• Generates a 9% FCF yield, which is all spent on dividends and buybacks;

• Will be receiving $2+ billion in cash payments (8% of market cap) from the government in coming years to reimburse it for pension pre-funding.

Conventional Wisdom Vs. "The Facts"

This is a contrarian recommendation. Conventional market wisdom is saying that the defense budget is already facing 10% cuts, or 20% if sequestration kicks in. The market is very focused on the fact the US military has left Iraq and is winding down in Afghanistan and that the US spends too much on defense and needs to make cuts to help close the budget gap.

Here are the facts, however: 

1. Due to Washington math, 10% “cuts” actually amount to flat spending.

2. Dating back to the Kennedy administration, the defense budget has never declined >15% from peak to trough in nominal terms. 

3. Only 1% of the company's revenues are exposed to the war budget from Iraq and Afghanistan.

4. As a % of GDP, US defense spending is low by historical standards (4.1% in 2012 compared to an average of 5.2% from 1962-2012). The defense base budget = 15% of the total federal budget.

5. Compared to the last defense downturn (“peace dividend” years following Soviet collapse), the current threat environment remains elevated (Iran, North Korea, Al Qaeda, China).

6. Current military equipment is old and needs to be replaced.

Despite what the headlines say, the defense budget is projected to grow by low single digits with an emphasis on modernizing the armed forces by continuing to purchase new systems or upgrade or refurbish existing platforms. A majority of the areas that most big-name defense contractors serve will still be a (slowly) growing sector.

State of Affairs

Pessimism is already priced into LMT’s valuation (6.2x EV/EBITDA compared to a historic range of 4.1x-16.4x). The company currently sports a 9% FCF yield and it will receive an additional $2+ billion in cash (8% of market cap) from the
government in coming years in delayed pension reimbursements.

How Lockheed Makes Money

Lockheed focuses on long-term programs with long lead times -- 50%+ of operating income comes from aircraft and space programs. 25% of operating income comes from replacement and modernization demand. The company's major customers include the US Department of Defense (60% of sales), other US goverment departments (25%), as well as foreign governments (15%).

Lockheed’s Aeronautics division is its largest division and accounted for $13.2B (or 29%) of revenue in 2010. Aeronautics derives 81% of its revenue from domestic customers and 19% from international customers.

Prime competitors in the military contractor space include Northrop Grumman (NYSE: NOC), Boeing (NYSE: BA), Raytheon (NYSE: RTN), and General Dynamics (NYSE: GD). Unlike some of its brethren, however, Lockheed specializes in fighter jets (duopoly with Boeing), missiles, satellites, and other space programs. For operators in this space, the advantage is there are very high barriers to entry. And, in many cases, the government pays for R&D, factories, and proprietary tools, and reimburses pension expenses.

The F-35: Lockheed’s Largest Program

The F-35 accounts for 12% of total company revenues today and is projected to account for 25% of the total by 2018. The US government wants to buy 2,443 F-35s to replace a fleet of ~8,000 aging fighter jets (mostly F-16s and
F/A-18s).

The consensus view is that future problems or cuts to the F-35 Joint Strike Fighter program will pummel Lockheed. However, this is a high priority program -- the US military has 8,000 aging jets that that it intends to replace with 2,500 F-35s and the Joint Strike Fighter (JSF) is still early in its production ramp. It accounts for 6% of consolidated EBIT today and will help offset shrinkage from other programs as JSF income increases every year until reaching 33% of current EBIT by 2018 once full production volume is achieved.

We believe that the JSF program is the most attractive asset in Lockheed Martin’s portfolio. With the scheduled closure of the F-22A production line, the JSF is the Air Force’s only option for procuring a frontline fifth generation stealth fighter. With the emerging threat of the new Chinese J-20 stealth fighter, we believe it is highly unlikely that significant cuts will be made to the JSF program. The Air Force essentially has no choice but to go forward. It would take decades and untold billions to start a new frontline fighter development program and bring production up to a reasonable level. It also can’t just “make do” with older inventory, as those items will need extensive rebuilding and modernization to extend their service lives and make them capable on the next generation battlefield. In short, the Air Force is stuck with the JSF.

Conclusion

In an industry that will continue to grow regardless of existing pessimism, Lockheed Martin has perhaps the best portfolio of core programs, including the JSF crown jewel, of its competitors. Despite the headlines, the defense spending environment is still attractive as the DoD is intent on modernizing its forces and the budget projects top line growth.

SumZero (www.sumzero.com) is content created by hedge fund professionals for hedge fund professionals. Click here to join SumZero's free Weekly Dispatch.

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