June 07, 2010 - 9:41pm EST by
2010 2011
Price: 77.00 EPS $7.80 $7.50
Shares Out. (in M): 368 P/E 9.9x 10.3x
Market Cap (in $M): 28,300 P/FCF 11.3x 9.5x
Net Debt (in $M): 1,500 EBIT 4,800 4,800
TEV ($): 0 TEV/EBIT 6.2x 5.6x

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At $77, LMT is available at less than 10x 2010 earnings and at a 3.3% yield.  The company's position as the Prime contractor on the JSF should allow the company to maintain or grow revenue and earnings over the next 3-5 years, despite expected DoD budget cuts.  LMT is also likely to be negatively correlated to the general market in the event of a major world conflict/incident.



            LMT, headquartered in Bethesda, MD, was created in 1995 through the merger of Lockheed and Martin Marietta.  Prior to the merger both Lockheed and Marin Marietta were leading defense contractors.  In 1996, LMT acquired Loral's defense and systems integration business.  In 1998, LMT proposed to merge with Northrop Grumman, but was turned down by the DoD and DoJ on concerns over market concentration.  In 2001/2, LMT divested its commercial telecom and satellite businesses.  Today, LMT is the nation's leading defense contractor, employing over 140,000 people and acting as the prime/integrator on over 70 major weapons/programs.  LMT is involved in the research, design, development, manufacture and integration of leading edge technology systems and weapons.  LMT earns revenue from over 4,000 government contracts ranging from the experimental/alien technology of the F-35 fighter jet, missile defense and complex IT solutions to the mundane of providing private interrogation contractors, and social security processing.  LMT gets over 80% of its revenue from the US government, revenue is: 58% DoD, 25% other Federal Government (NASA, CIA, Homeland Security), 13% foreign governments, and 3% commercial.  In 2008, the company's top 10 programs accounted for 35% of revenues.

            LMT makes money by winning government contracts (generally based on performance capabilities or design wins) and completing those contracts such that the government will continue the program and hire LMT for addition/future work.  LMT gets roughly 65% of its revenue from cost plus contracts and roughly 35% from fixed price contracts.  For the past 20 years, DoD contracts have been designed to be low-risk to the contractor. (see discussion of DoD contracting below)

LMT earns very high returns on tangible assets (over 20% on gross tangible assets and over 40% on net tangible assets since 2005) and needs very little net capital to run the business. 

            LMT operates in four business segments: Electronic Systems, Information Systems and Global Services, Aeronautics and Space Systems.

            Electronic Systems designs and develops hardware, electronics and software for air, land and sea weapons platforms, radar, surveillance, command control and communications capabilities.  Electronic Systems is part of a consortium that manages the Sandia National Laboratories (US nukes) and the UK Atomic Weapons Establishment.  The Electronic Systems division produces the Aegis missile defense system and the THAAD missile defense system.  The Electronic Systems division gets 71% of its revenue from the US government.           

            Information Systems and Global Services (IS&GS) provides federal services IT solutions and technology expertise.  IS&GS provides full life-cycle support for IT services (like IBM's service offerings), and personnel for operational support, peacekeeping, and nation-building.  The government accounts for 93% of IS&GS's revenue.

            Aeronautics is engaged in the research, design, development, building, integration and servicing of advanced military aircraft.  Aeronautics is home to the famed Skunk Works R&D operations.  The US government accounts for 81% of the segment's revenue.  Key programs include the F-35 (Joint Strike Fighter or JSF), F-22, F-16 and C-5/C-130.  The JSF is a transformational 5th generation fighter/attack platform and is expected to drive the division's results over the next 20 years.

            Space Systems is engaged in the research, design, development, engineering and production of satellites, offensive and defensive missile systems and space transportation systems.  The space business builds commercial and government satellites, space based missile defense, intercontinental ballistic missiles and Orion, the next generation human space flight system.  The US government accounts for 96% of the segment's sales.



            The Defense Industry exists to build and maintain America's weapons and military systems.  The strength of the industry's research, development and production capabilities determine the US military's capabilities and power.  The Defense Industry is a key American strategic asset.  Due to industry concentration (107 firms have become 5 in response to defense spending cuts in the early 1990's and increased technological requirements), the large defense contractors' act as a toll on the nation's continued military dominance.  As long as the US wishes to be a global military power, the prime defense contractors will collect a fee for inventing, developing and producing the nation's weapons, programs, and systems.   

            The US defense industry is made up of 5 prime integrators (LMT, Boeing, Northrop Grumman, General Dynamics and Raytheon), L3 (which is a hybrid prime/sub-supplier) and sub-suppliers.  The Prime Integrators are hired by the government to build complex weapons, platforms and IT systems.  The Primes coordinate the research, development and building of weapons and systems.  The Primes do most of the R&D in house, build some of the equipment and hire sub-suppliers to build parts of the system.  Generally, a Prime retains 50-60% of the revenues associated with a contract and the rest is earned by sub-suppliers.  The industry is highly concentrated, with generally only 2 players (sometimes 3) capable of acting as a Prime for a give type of weapon, platform or system.

            The defense industry is driven by government contracts.  It is important to realize that the government has historically wanted defense contractors to do well and earn a profit.  The preamble to the government's profit policy regulation reads as follows:

"Effective national defense in a free enterprise economy requires that the best industrial capabilities be attracted to defense contracts.  These capabilities will be driven away from the defense market if defense contracts are characterized by low profit opportunities.  Consequently, negotiations aimed merely at reducing prices by reducing profits with no realization of the function of profit, cannot be condoned." 

DoD contracting is fairly rational.  R&D and early development for unproven space age technology/weapons is done on a cost-plus basis because no company could prudently afford to take on the risk of a fixed-price contract for such an uncertain endeavor.  Despite the low-risk, low-incentive, low-profit of cost-plus contracts, contractors are incentivized to do their best.  The firm that creates the winning solution/equipment during the early development phase will be the only company capable of producing the weapon/program and be in a position to earn attractive returns on the production and support portion of the weapon/programs life cycle.

The product development cycle can be broken into 4 distinct phases: Concept Decision, System Development & Demonstrations, Production and Development, and Operations and Support.  (See page 24 for a visual depiction of the process) Concept Design includes determining what the DoD wants.  At point A the DoD typically gives a contract to 2 defense companies to complete R&D and demonstrate the feasibility of the pertinent technologies.  Development work is done on a cost-plus basis.  At point B, after reviewing each company's proposal and feasibility, the DoD selects one contractor to build a prototype for demonstration and testing purposes.  Development of a prototype is also done on cost-plus basis.  If the DoD decides to buy the weapon/program, the company will receive an order for a set quantity of the weapon/system and negotiate a fixed-price contract with the DoD.  Ongoing operations and maintenance are also provided on a fixed-price basis.      

Contractors operate under 4 types of contracts: Firm Fixed-Price, Fixed-Price Incentive, Cost-Plus Award Fee, Cost-Plus Incentive Fee. (the contracts are relatively self-explanatory, but see pg. 25 for greater description)  Typically cost-plus contracts contain lower margin and fixed-price contracts are designed to have higher margin. 

Contracts are designed to produce 10-15% operating margins (production and maintenance at the high end and R&D below 10%) before considering corporate and overhead.

Once selected as the winning contractor the company becomes dependant on the government to fund the program/weapon/system.  The DoD must submit a budget annually and congress must approve.  A program can have support from the DoD, the services, or legislators in districts/states poised to benefit from jobs supported by the program.  At any point the government can stop funding for a program.  (for example, the DoD originally wanted 22 F-22s but will only end up buying 187)



            The level of defense spending, particularly the level of R&D and Procurement, are the major drivers of the industry.  Historically, US defense spending rose and fell in response to threats and conflicts.  Since WWII, peak spending occurred during Korea, Vietnam, Cold War build-up in the 1980's and the current War on Terror.  Since WWII, defense spending has ranged from 14.2% (Korea) to 3% (2000) of  GDP (currently 4.7%) and from 73% (Vietnam) to 47% of the discretionary budget.  The key to accessing the industry's outlook is to determine a view for future R&D and Procurement expenditure.

In the near-term, the 2010 DoD budget calls for 4% nominal and 2% real growth over

2009.  Longer-term, Obama has suggested $60/70bn (10%) savings from the DoD budget.  The most obvious place for savings is supplemental expenditures used to fund the wars in Iraq and Afghanistan.  The Primes tend to get a small share of revenue from the supplemental budget.  Despite attempts to separate the "supplemental" from the "base" budget, the DoD budget should be considered on a consolidated basis because the supplement is being spent on things (F-22, O&M and Training) that are long-term core operating expense.  So, even if cuts are made only to the supplemental budget, it is likely that shifting expenses will crowd out some R&D/Procurement from the "base" budget.  Counter balancing budget pressure is Secretary Gates, who says spending must rise 2-3% real in order to modernize the force and meet the mission.  The military is undergoing a modernization because equipment is old and the info/tech advances are producing a Revolution in Military Affairs ("RMA" -  New technology allowing for game changing mission coordination and situational awareness).  The need (real and perceived) to modernize and the opportunity presented by RMA pose a dilemma in an ear of relatively high DoD spending and record budget deficits.

Determining military spending in an intrinsically political process.  The industry lobbies heavily to encourage spending on state-of-the-art weapons and capabilities.  In addition, each contract handed out by the DoD means jobs for some representative's district and state.  Even following the Cold War, it was difficult to make nominal cuts in the military budget: From the peak in 1989 the DoD budget declined -12.5% (1996 trough) on a nominal basis and -32% (1999 trough) on a real basis.  R&D/Procurement spending was more easily cut, declining -28.6% (1996 trough) on a nominal basis and -45.5% (1999 trough) on a real basis.

            Defense spending is driven by threats (perceived & real).  Near-term budgets will be driven by current threats (Terror, Iraq, Afghanistan, Iran), potential threats (de-stabilized Pakistan, Aggressive Russia or China and North Korea) and the DoD's mission (to fight two theater full wars at the same time).  Currently the threat level is perceived to be high and the mission ambitious, so large Defense cuts are unlikely in the near-term.  In addition, Obama has retained Gates as Sec. Def. - essentially continuing Bush's DoD.

            In the near-term (3-5 years) Defense spending does not tend to be heavily influenced by the broader economy.  But over long periods defense spending can only be sustained as a % of GDP.  The current economic crisis has caused a significant budget deficit.  A continued weak economy and continued deficit will ultimate cause pressure on the defense budget.  Excessive deficits will eventually lead to DoD budget cuts because the DoD is one of only 4 budget areas that matter enough to make a meaningful impact: DoD at 21%, Welfare at 10%, Social Security/Medicare/caid at 44% and Interest on debt at 8%.

Absent new threats/hostilities, the DoD budget is not likely to grow as it has in the past five years.  Given the level of deficits, the DoD budget is more likely to shrink (particularly on a real basis).  The worst case has been articulated by Barney Frank who has suggest 25% cuts to the DoD budget.  25% nominal cuts would represent an extreme and require force reduction (fewer carrier groups or air wings).  Force reduction means job cuts, so Frank's 25% cuts are fairly unlikely.  Most likely the base budget will grow on a nominal basis and shrink on a real basis and the supplemental budget will decline as Iraq and Afghanistan wind down.



LMT will be impacted by changes in the DoD budged (same as other Primes).  Officially,

LMT gets less than 5% of its revenue from the supplemental budget.  Which should be a benefit, but the supplement is being spent on tradition areas (training, procurement), so the entire budget will reset in the event of cuts to the supplement.  LMT is relatively well positioned due to its role as the prime contractor for the JSF - the largest defense contract in history ($250bn+). 

The JSF is a 5th generation Fighter/Attack jet intended to replace the air power of the USAF, USN and USMC as well as 8 allied countries.  The JSF will be the first plane to come in 3 forms: traditions, carrier and STOVL.  The JSF is important because US air assets are old and in need of update to ensure air superiority.  The JSF is unique because it will replace at least 4 existing aircraft.  Over time, the military expects to realize savings on the cost of maintaining the aircraft due to cross service volumes.  Currently there are 5 JSF in existence and the planes are completing testing and potential modifications.  If successful (and really the military has no choice but to make the JSF successful because there is no alternative 5th generation F/A available, modern planes take 10-20 year to develop and the existing equipment is very old) the JSF could sell over 4,000 Jets and result in $15bn ($10bn incremental) of annual revenue to LMT by 2015/16.   The JSF positions LMT relatively well to manage shrinking Defense budgets, but the program is not without troubles, the production schedule will likely be 2/3 years delayed and the program will like face Nunn-McCurdy examination/violation.

              LMT and the industry have been operating at peak margins over the past 3 years If operated well, defense contracting should be an 8-12% operating margin business.  LMT's management is credited with cleaning up the company after operational and integration issues in the early 2000s.  Assuming continuity (CEO is 57 and COO is 48), one could assume continued operating margin discipline.  The industry is operating at peak levels and declines/stagnation in budgets should present excess capacity and pressure margins.  The current administration is hostile to the industry and, like all administrations, plans to save money on defense procurement.  In addition, corporate margins will be hurt by increased pension costs.  Offsetting some headwinds will be the JSF, which should see margins go from 5% to near 15% as the plane moves into the production phase. 

Over the past 5 years management has used excess capital to pay down debt, make small

acquisitions and buyback stock.  Management has indicated that they intend to return at least 50% of FCF to shareholders.  Over the past 3 years, LMT has returned 82% of FCF and proceeds from option issuance to shareholders through buyback and dividend. 


eventual success of JSF
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