How can we possibly be pitching a defense company as a long? We realize that steep federal budget deficits will mean pressure on defense spending as far as the eye can see, but we think that the current valuation of LMT - ~5.5x EBIT, 9x free cash flow - prices in a defense budget decline that we can confidently assume will not happen. Lockheed is a large, mostly defense, mostly government contractor with a positive revenue growth profile, in an oligopolistic industry with steep barriers to entry, and operating with impeccable capital discipline. You usually don't find those characteristics on a company this cheap. After running through a quick company description, we'd like to untangle the financials in order to actually come up with a realistic and economically accurate picture of operating earnings and cash flow, and then address the significant headwinds that, supposedly, hurt the investment case for LMT (i.e., the "bear case"). Finally, we'll wrap up with a valuation/return analysis.
Lockheed will generate ~$45.5B in revenues in 2010, with 60% of those revenues coming from its largest customer, the US Department of Defense, 25% of revenue coming from other US government agencies, and 15% of revenue coming from foreign sources, mostly foreign governments. The business is divided into four major segments, as follows:
- Aeronautics - ~30% of 2010 revenue - in the segment LMT is famous for, the company designs, develops, and manufactures (DDM) combat aircraft (F-16, F-35), air mobility aircraft (C-5, C-130J), and provides maintenance/sustainment services for presently operating aircraft in air forces throughout the world (but mostly in the US).
- Electronics - ~30% of 2010 revenue - in this segment, LMT focuses on DDM for both large scale military systems such as the Littoral Combat Ship and missile defense systems, and smaller scale missile programs. Additionally, the training and logistics business, in which LMT does everything from training pilots to fly advanced jets to providing the military with logistics support, is included in the Electronics segment.
- Information Systems & Global Services - ~20% of 2010 revenue - IS&GS is just a fancy name for Lockheed's IT/services segment, which includes a bunch of non-defense government programs such as air traffic control and census management, in addition to intelligence services and battlefield communications.
- Space Systems - ~20% of 2010 revenue - Space systems does DDM for both government and commercial satellites, fleet ballistic missiles, and space transportation systems (including the Orion space capsule). Space systems also houses a JV with Boeing that handles rocket launches.
For more information on the actual operations, the extensive Lockheed website does a great job in explaining every single one of the varied Lockheed businesses.
Due to peculiar contract accounting standards for pension expenses, Lockheed's earnings have been anywhere from slightly to significantly understated over the last few years (since the 2008 market wreacked havoc on the pension plan assets). Below, we back out share-based compensation expense (we'd rather take account of options issuance in the share count) as well as non-recurring gains or losses (mostly M&A gains since 2005). Here's LMT's income statement for the past 12 years (we include 12 years to incorporate the last margin and revenue downturn suffered by the defense industry in the late 90's):
(Geek's accounting note: we've adjusted the EBITDA/EBIT numbers to reflect the real-world economics of Lockheed's pension liabilities and expenses, which are, briefly, as follows: Since 85% of Lockheed revenue is generated by sales to the US government, approximately 85% of its pension expenses are also picked up by the US government. While that sounds fairly straightforward, the government's contract accounting standards (CAS) for pensions are different than corporate financial accounting standards (FAS). We'll spare you the details, but the important point is that while FAS may dictate that Lockheed book x as its pension expense in a particular year, the government will only reimburse pension expense as dictated by CAS, which is generally a totally different number. Over time, the two will converge, but in certain circumstances - such as when the plan assets get hammered by a severe equity market decline - FAS pension expense will be much higher than CAS pension expense for a while. These are mostly non-cash issues, and our analysis basically reflects only the CAS expense that Lockheed books and which is reimbursed by the government.)
Given the importance/attention that is ascribed to the Joint Strike Fighter program, which we will address in detail below, we think it makes sense to value Lockheed as a combination of the JSF plus the rest of the company. This exercise will also show that the JSF is presently being valued at 0 by the market. For 2010, non-JSF revenue will be about in the $40B range with associated EBIT at ~$4.8B. Over the next five years or so, we expect this revenue to be up low single digits (1-3%) compounded annually, driven by the overall Pentagon weapons acquisition budget (for the relevant discussion of the DoD weapons acquisition budget, see the bear case below). There's a good chance we are underestimating non-JSF revenue growth given Lockheed's large exposure to missile defense and the central role that will be playing in our country's military strategy over the near to intermediate term.
In terms of margins over the next few years, government procurement pressure will be the biggest issue, as the DoD will pressure all defense contractors to take on more contract risk than they have been taking over the last few years. On the other hand, the Pentagon expects a larger proportion of its weapons acquisition budget to go towards procurement rather than research, which should be a significant net positive for the defense industry margins as a whole. From a Lockheed-specific perspective, margins will be impacted positively by a) the growing proportion of future revenue coming from production as opposed to design & development contracts (production contracts can have margins more than double those of design & development contracts, which are generally in the 5% operating margin range) and b) a larger proportion of revenue coming from foreign governments, where the margins are 50% higher than domestic government sales.
Non-JSF revenue of $40B and ~$4.8B in EBIT implies a 12% EBIT margin. Assuming that normalized EBIT margins are 250bp lower (we're trying to be conservative because it's unclear what the effects of tougher government acquisition practices will be), subtracting interest expense of $325M, and using a tax rate of ~33%, we get FCF of about $2.35B. At a present market cap of $26B, that's an FCF yield of 9%, which will yield a total return of over 10% once growth is factored in. By itself, ex-JSF Lockheed is therefore an attractive investment with a reasonable return profile and solid downside protection.
The Bear Case
The bear case, in our mind, centers on two major points:
We'll take on each of the bear arguments separately.
- The federal government is clearly constrained from a budgetary perspective and is going to look at all available options to cut the presently enormous budget deficit. As it stands now, defense spending has a pretty big target on its back. We will try hard to deal with this issue as we think it will play out instead of how we think it should play out; in other words, logic will not play a very big role in deciding what and how much will get cut.
- The JSF program is a disaster (so say the bears). It is already over 50% more expensive than projected when the program was originally awarded, Pentagon officials from Robert Gates on down have complained about performance, and the target date for flying the plane in a military setting has already been postponed by over a year and rumors are that it will soon be postponed for two years on top of that.
Defense Spending Cuts
Let's start with a few facts on defense spending that do not include idiotic non-relevant information such as "The US spends more on its military than the next x countries put together" (of course it does - it subsidizes the defense budget for the entire Western world). Anyway, here goes:
- 2010 defense spending as a percentage of GDP was ~4.9%, well below the historical average, although above the 3% trough of 2000. Excluding the supplemental defense budget (i.e. Iraq and Afghanistan), that number for 2010 is ~3.9%. For the purposes of this discussion, we're talking about the base budget, which excludes the supplemental spending, as Lockheed has almost zero exposure to the latter. Meanwhile, by the way, total government spending as a percentage of GDP is at an all time high. Do the math and you will find that base-budget defense spending as a percentage of total government outlays is pretty much at a post-WW2 low.
- The state of military equipment today is pretty bad. The age of US military equipment today is the oldest it has been in 50 years and is in serious need of upgrade/recapitalization. The average age of an air force airplane, for example, is over 25 years old versus 7 years old after the Vietnam war. The fleets for every single class of aircraft in the air force are all past their projected half lives, which is something that has never happened in the modern era.
Regarding the actual spending trajectory, Secretary of Defense Gates has set a $100B over the next few years in defense budget efficiency gains plus an additional $78B in cuts. What does he plan to do with the $100B in efficiency savings? Invest in weapons procurement, sustainment, and research.
Let's back up a bit and explain what is going on here. The base defense budget is made up of two major portions - Operations & Maintenance (O&M) and what's called the "investment account," which is basically weapons acquisition. The investment account itself is divided into two parts - procurement of weapons and research, development, and testing of weapons (RDT&E). The 2010 base defense budget was ~$530B. Of that, approximately $210B went to the investment account (weapons procurement of $130B and RDT&E of $80B). The vast majority of LMT revenue is exposed to the investment account. The other $300B in defense spending went to O&M, of which half was spent on military personnel and the other half on training, military-base support, equipment maintenance, IT outsourcing, etc. (the military portion of Lockheed's IS&GS segment is exposed to this non-personnel O&M budget). Getting back to the SecDef's goals - the plan is to a) find $100B in savings from the O&M budget and reinvest the entire savings into the investment account and b) cut $78B in "waste," which also includes certain weapons systems.
If you're thinking that the above information seems to argue for at least modestly positive revenue growth for the defense contractors over the next decade, then you're right. Further, there's almost no way Congress will agree to cut the entire $80B that the administration is requesting. As a Reuters article from this morning put it, "Lawmakers often block administration efforts to cancel pricey weapons programs since they provide high-paying jobs in their home districts." It's pretty easy to set up a spreadsheet and play around with a few variables to see what the effect will be on the investment account outlays. Assuming Congress and the administration split the $80B and $40B is actually cut from spending, with $20B of that cut from the investment account over the next five years, we are talking about compound annual declines of about 2%. And, by the way, that's an inflation-adjusted 2% decline. Once that is converted to nominal dollars, the spending trajectory is likely to be about flat. Or, as the WSJ put it today, in summarizing the Congressional hearings starring SecDef Gates, "Under a revamped five-year budget plan, the Defense Department will continue to see real, albeit steadily diminishing, growth for the next three fiscal years before flattening out in 2015 and 2016." Essentially, today's hearings confirmed that the huge cuts imply a flat to slightly up spending trajectory for the Pentagon over the next five years, with the investment account doing better than the overall pie.
Applying the above facts to Lockheed, let's remember that only 60% of Lockheed's revenue comes from defense spending and that the rest - non-defense government revenue plus international military sales - are likely to grow over that five year time frame (not to mention that foreign sales carry significantly higher margins than domestic sales). We also think that in the extremely unlikely scenario that Congress decides to go all out and agree with the administration's $80B in proposed DoD cuts, it will also go ahead and implement some sort of defense contractor export reform so that at least some of the domestic revenue shortfall will be made up with international (higher-margin) growth. Even in that draconian case, and even if the DoD investment account gets a proportional share of the cuts, we're talking about a 4% compounded annual decline in real spending which will turn into ~2% once inflation is factored in, which will only affect 60% of Lockheed's business, which will be somewhat offset with growth in the other 40% of revenues. Again - this is the absolute worst case scenario, and it results in a -1% CAGR in non-JSF revenues over the next five years. More likely is a scenario in which the Pentagon, White House, and Congress split the difference with $40B in defense cuts centered mainly on O&M spending. Doing the aforementioned math, it's easy to see LMT revenue growing low single digits even over a period of spending restraint.
The JSF Program is a Disaster
The F-35 Joint Strike Fighter is THE LARGEST PENTAGON CONTRACT IN HISTORY - just in case the media didn't get that across with their usual subtlety when discussing Lockheed Martin. The JSF accounted for ~11% of Lockheed revenue in 2010 and it was low margin revenue for the most part given that the program is still in the SDD stage (system design & development) as opposed to production (we estimate, based on conversation with IR, that it accounted for ~$275M in EBIT). The conventional wisdom on the JSF program is that it has been handled horrifically by both Lockheed and the Pentagon. The proof is that the program is about 3 years behind schedule and the total cost of each plane is expected to be over 50% greater than originally expected when Lockheed won the contract in the early part of the last decade.
The truth is that the JSF program, while certainly not the greatest showcase of weapons procurement efficiency, is not the massive disaster that is portrayed in the press. First of all, you'd expect the largest contract in pentagon history to have, proportionally, the most snafus of any contract in pentagon history. Thus far, pretty much all the delays and cost overruns have come as a result of the SDD portion of the program not going according to plan. That said, there's a reason why the SDD portion of a weapons procurement contract is always set up as a cost-plus contract - it's because everyone knows that it's impossible to determine, ex-ante, how the research and development stage of a product will go and what will be learned about the nature of the product through initial research and testing. It makes sense that a jet that is being designed to serve all three military services (Air Force, Navy, Marines) while making the largest technological leap in aircraft history will also have a pretty volatile design & development progression.
Secondly, the estimates of what the all-in cost per plane will be are Pentagon estimates that are determined via a cost modelling process that is guaranteed to be inaccurate. In fact, on the small production contracts that have already been executed, Lockheed has come in below the Pentagon estimates. Lockheed management thinks the manufacturing learning curve will continue to generate cost improvements that the Pentagon is not factoring into their estimates. So, while the cost per plane will probably come out higher than initial estimates, it will not be the "50% more than we thought" number that the Pentagon is currently projecting.
Let's put some numbers on the JSF program. As originally envisioned, the JSF program would mean over $20B in annual revenue in the middle part of this decade at >10% operating margins. If that actually came to pass, we estimate that the present value of the program is ~$11B (our simplified model uses the $5.5B in 2010 revenue, steps it up to $20B by 2015, steps up operating margin on the program from 5% to 10% over that time, assumes a decade of flat revenues and margins, and then a 2% annual decline beyond that; we discount the cash flows with a 10% discount rate). Our model is a bit conservative given that margins continually increase on this type of program (F-16 margins have continually increased since the program got into gear 25 years ago).
While we think that the Pentagon is aware of the above points that argue that the JSF is not the disaster the press wants you to think it is, we also think that some restructuring of the program is inevitable. Whether that will come through the abandonment of the Marines-version of the JSF or through lower allowable margins or through a cut in the number of planes the Pentagon will buy in the long run, we're not sure. Using a similar back-of-the-envelope model for the program as above but with diminished expectations - cutting the peak revenue by 25% to $15B and cutting allowable peak margins to 8% - the present value of the program falls to $7B. That's probably overly pessimistic, but it gives you an idea of what we think the worst-case scenario is (or at least a pretty bad-case).
What we are pretty certain will not happen is a cancellation of the program. Canceling the JSF would mean that the US will not be able to field a fifth generation fighter jet until at least 2025 if a new program were started today. You can be sure that the Chinese and Russians are already in the process of developing their own fifth generation fighter (press reports in recent days confirm that fact). There is no way the US can afford to equip its air force with planes developed in the 1970's in the year 2025 when its potential adversaries will be fielding 21st century jets. You can argue about the ROI of the program, about whether it made sense to develop it in the first place, etc., but now that we're ten years into the process, with knowledge that other non-ally countries are also in the process of developing stealthy fighter jets, there's simply no way this program gets cancelled.
We would add here that the vast majority of headline risk on the JSF program is in the past given that most mistakes happen in the early SDD stages of the program as opposed to production, which is starting in small scale now and actually has a chance of proving Lockheed right in its own learning curve expectations.
With a >9% FCF yield on Ex-JSF Lockheed and an additional $7-10B in JSF value, we believe LMT is an extremely attractive investment, especially in the current environment with true bargains few and far between and anything trading at 10x normalized FCF is almost impossible to find (we don't consider 10x FCF at peak margins to be cheap; using 2010 margins and backing out the JSF, LMT trades at a 15% FCF yield if you want to compare). In addition to an extremely attractive valuation, we think there are several factors that may significantly embellish the eventual ROI:
If pressed for an actual valuation (we prefer estimating potential long term return ranges), using relatively simplistic modelling, we think ex-JSF Lockheed is worth $30-35B with the JSF adding $7-10B on top of that (ex-JSF assumptions are normalized margins of 250bp below 2010, flat revenue growth for 5 years, and 3% in perpetuity after that; discount rate of 10%) . That's a share price of $105-125 per share. By the time we get there, we'd bet share count is lower, valuation is higher, and you've gotten paid 4% in the meantime. For now, with a current FCF yield of 12% and an estimated normalized (and growing) FCF yield of >9%, we think your downside risk is negligible.
- Defense industry valuations have fluctuated widely over the last 10 years depending on the markets' optimism or pessimism regarding future defense spending. EV/EBIT has ranged from 5x during the early 2009 depths to 20x after 9/11 (that multiple is ~6x right now). EV/Sales has fluctuated between 0.5x to 1.5x over the past decade, and LMT presently trades at 0.6x. Our investment thesis does not rely on multiple expansion, but if we get it, LMT is a home run.
- Somewhat related to the multiple expansion potential, we think that the present geopolitical security situation is not exactly "Peace in our Time." If something goes wrong - and really, have we had a decade in the past where something has not gone wrong? - valuations will jump (as they did post-9/11) and the defense spending expectations will change almost overnight.
- LMT management is, in our opinion, stellar when it comes to capital allocation. It's easy to see that they've used the vast majority of FCF over the past few years to pay dividends, buy back shares, and pre-fund their pension (that pre-funding, by the way, is close to fully reimbursable, so we will see cash inflows of ~$2.5B over the next few years that will not be booked to the income statement but will still come into the coffers; we haven't taken these into account here). What they have not done is pursue stupid acquisitions. Thus, we feel extremely comfortable when we say that we're not relying on multiple expansion for investment returns - dividends and share buybacks will take care of that.
The official unveiling of the Pentagon budget and projections in February should show quite clearly how non-onerous the DoD budget will be on defense contractors.