EV/EBIT = 12.42x
ROE = 150%
FCF Yield = 6.8%
Dividend Yield = 3.2%
Debt/Equity = 221%
Lockheed Martin (LMT) is a defense contractor that was a result of a 1995 merger between Martin Marietta and Lockheed Aerospace. Weapons-as-a-service doesn’t seem to be popular in this market, but I thought it was worth a closer look due to the formidable moat and high returns on capital.
Lockheed’s customers are primarily governments. Their main client is the US government. 74% of revenue is derived from the US government and 25% is from international sales. The business is divided into four key segments: Aeronautics, Missiles & Fire Control, Rotary & Mission Systems, and Space.
Aeronautics is the crown jewel of Lockheed’s operations and represents 40% of revenue. This segment produces Lockheed’s legendary fighter jets. The most significant is the F-35, which has been a strong source of growth for Lockheed since 2015. The F-35 is a fighter jet introduced in 2006 and contracts are in place to sell this to the US government & allies. It is a technological marvel - a stealth aircraft that is highly maneuverable with a long-range equipped with one of the most advanced sensor networks ever implemented in a fighter jet. It is sold to the US government and US allies such as Israel, Australia, Norway, Japan, and the United Kingdom. Other jets produced by the aeronautics unit include the C-130 Hercules (an air lifter), the F-16, and the stealth F-22 raptor.
Rotary and mission systems represent 25% of sales. Mission systems are systems used to target and guide weapons (like missiles) to focus on enemy targets. An example of this is the Aegis Combat System, which is used by the Navy to defend ships. Rotary represents mainly the Sikorsky helicopter.
The space segment represents 18% of sales. Some of the hardware developed by the space segment includes the space-based infrared system, which is being deployed to give the US warnings about missiles fired anywhere in the world. They are also working on the Orion Multi-Purpose Crew Vehicle, which is going to be used by NASA to take astronauts into low Earth orbit.
LMT also has a hypersonic unit within the space segment. Hypersonic speeds are over Mach 5 (60 miles per minute), and Lockheed is developing hypersonic weapons, such as long-range missiles that can travel faster than Mach 5. They are also working on the next generation of GPS satellites, updating the current GPS infrastructure. The space segment is likely to grow in the future, particularly with the growing demand for hypersonics and the growth of the US Space Force.
Missiles represent 17% of sales. This includes surface-to-surface missiles, missile interceptors, surface-to-surface rockets, aircraft missile systems, shoulder-fired missiles. They also manufacture the Sniper Advanced Targeting Pod that is used in Apache helicopters.
An area of Lockheed’s R&D that is particularly exciting to me is their compact fusion division. Compact fusion would allow for the building of reactors the size of a truck that could power a city. Nuclear fusion fuses together hydrogen to form harmless helium. Nuclear fission, in contrast, splits uranium or plutonium and creates radioactive nuclear waste, which nobody wants in their backyard.
A compact fusion reactor would run on hydrogen and produce no nuclear waste. Right now, everyone is fantasizing about the end of fossil fuels. But that’s all it is, a fantasy. The market acts as if an incredible energy innovation has already taken place when nothing has actually happened. Investors act like a Tesla plugged into a coal plant is going to change the energy fundamentals of our civilization.
Lockheed isn’t just fantasizing about a post-fossil-fuel world. They are actually researching the most promising area of energy innovation that can actually change the world. Compact nuclear fusion is like a call option with massive potential upside embedded within this business with the potential to change the world.
Lockheed’s revenue and profits have grown consistently over time while stagnating from 2007-2015 during the GFC & the winding down of the wars in Iraq & Afghanistan, and the budget showdowns in the early Obama years. The business began growing significantly in 2015 as the business picked up in many segments, but a significant source of growth was sales of the F-35.
Over the last decade, revenues have grown at a 3.1% CAGR, with much of the advancement occurring during the second half of the 2010s. Through all of it, Lockheed has been able to maintain high returns on capital and generate significant amounts of free cash flow that have been used to deliver shareholder yield. This has driven per-share EPS and FCF to grow at an 11% CAGR.
Moat & Growth Prospects
Lockheed has solid contracts in place with various governments and has a formidable moat. They are at the forefront of defense innovation and are essential to the national security of the United States, practically guaranteeing their survival as a business.
The defense industry is not going to be disrupted by an upstart competitor. Put simply, no one is going to come along and say: “I think I’ll start selling fighter jets and missiles to the US government.” Even if VC gamblers were willing to dump $100 billion to compete, they would have a tough time disrupting Lockheed. Building out the infrastructure to do this would be a painful process with no guarantee of success. They would also need the connections within the government to win new contracts and would need to match Lockheed’s lobbying might, which also seems unlikely. Lockheed is not going to be disrupted anytime soon.
The space segment can potentially face private competition from the likes of SpaceX, but I think it is unlikely that the US government will hand over military-grade defense satellites to a private company with no track record of maintaining confidentiality and no demonstrated expertise with military-level equipment.
A good example of Lockheed’s moat is the F-35 fighter. Lockheed has in place a contract to sell 2,456 F-35’s through 2044 and they expect the fighter jet to operate through 2070. The backlog of business for the F-35 is currently $147.1 billion, and that is increasing as Lockheed secures more orders (in 2019, the backlog was $144 billion). How many businesses have that kind of visibility into future revenues?
I like the defense industry. I also own General Dynamics. There are only a handful of defense contractors and they all have pricing power because they lack competitors. There is only a handful of them and the government is forced to do business with them. Even if Lockheed were unable to win new contracts (unlikely, based on its history and expertise), the government would need Lockheed’s expertise for the hardware that is already purchased from the company that is used in the US arsenal.
Defense spending is also quite sticky. Defense spending has been steadily declining as a percentage of US GDP for several decades as the economy grows, but defense spending still grows in nominal terms & defense contractors continue to grow and their stocks perform well. Defense spending doesn’t need to change course for the defense industry to do well, but if it were to ever ramp up, these companies will do even better. There are sometimes worries that Democrat administrations will cut defense spending, but it never actually happens.
It’s quite possible that defense spending actually ramps up in the next decade. I think that the US is in a new Cold War with China, which means that defense spending will need to grow across the board.
China is ramping up its military development to challenge the US as a superpower. The US will need to respond to that growing threat. China’s air force consists of approximately 3,000 aircraft and the US air force is over 5,000. China is still behind the US and doesn’t have anything as advanced as the F-35, but it is clearly moving in that direction and willing to spend money to grow its military reach. The US will need to keep up and companies like Lockheed will benefit.
The greatest risk to a company like Lockheed is solvency issues on the part of the US government. Even if that were to happen, I doubt very much that the US will cut the defense budget significantly. There is plenty of other fat to trim in the budget without gutting the nation’s defenses.
When considering the threat of US government solvency issues, it’s also worth considering: if things were so bad that the US government faced serious solvency issues, what do you think is going to happen to the average stock? The entire global economy is likely headed to hell in that scenario and I’d rather own a company like Lockheed over most other investment candidates.
Lockheed has more debt than I am typically comfortable with. It has a debt/equity ratio of 221%. With that said, the stability of its business model generates enough free cash flow to comfortably sustain that debt. Interest coverage is strong at 14.73. The Altman Z-Score is healthy at 3.79, so there is no bankruptcy risk. M-Score is -2.57, so there are no signs of earnings manipulation. The average ROIC over the last 10 years is 43% and the WACC is estimated at 6.53%, so LMT is not a net destroyer of capital.
The forward dividend yield is 3.2% and the share count is down .82% in the last year. That is a decent shareholder yield, particularly for a company that regularly increases dividends and consistently buys back shares. The total share count is down 19% in the last decade. Annual dividends increased from $4/share in 2011 to $9.80 today. It seems likely that an investor’s shareholder yield on cost will likely continue to increase into the future.
LMT has a free cash flow yield of 6.8%. This is a good yield and much of it should be returned to shareholders.
With an EV/EBIT multiple of 12.42, Lockheed is in the cheapest decile of the S&P 500. The average EV/EBIT multiple over the last 5 years is 16, so it is significantly below that. It peaked at an EV/EBIT multiple of 20 back in 2018. The stock price is currently in a 24% drawdown from that peak valuation.
However, while this is a bargain to where the stock has traded over the last five years, multiples were much lower throughout the early 2010s after the GFC and during the budget showdowns of the early Obama years. At the GFC lows, LMT traded at 6x EV/EBIT. It stayed there through 2015.
Even during the height of the Iraq war, LMT only traded around current levels, between 10-13x EV/EBIT.
There is a similar pattern in price/sales. After the GFC, this traded at 55% of sales. Currently, the stock is at 1.4x sales. The average over the last 5 years is 1.7x and peaked around 2x. Prior to 2015, the stock usually traded below sales for most of its history.
The stock is likely cheaper than the rest of the market right now for two reasons: (1) ESG Flows, (2) The incoming Biden administration.
I’m not concerned about flows and I would be perfectly content to hold this business and not have the multiple re-rate. They’ll continue to grow and I’ll continue to earn a decent yield.
As for politics, the Biden administration doesn’t exactly strike me as left-wing anarchists that want to tear down the defense department. They strike me as a completely standard run-of-the-mill Democrat administration that will continue the status quo regarding defense spending that all previous Democrat administrations have maintained.
- Can the stock deliver a 10% CAGR for the next decade?
Through the lens of shareholder yield, LMT currently delivers a 3% dividend yield and has reduced share count by 19% over the last decade. Over the last decade, dividends and EPS have been able to grow at a 10% pace. This seems likely to continue. Revenue growth has mostly been in line with nominal GDP at 3.7%, but per-share figures have grown faster thanks to the profitability of the business and buybacks. I think that the stability of the business means that all of this is likely to persist in the future.
An investor is currently earning a 6.8% free cash flow yield and that is likely to grow, making a 10% CAGR easily obtainable.
With that said, looking at the history of the stock’s multiples, multiple appreciation cannot be counted on.
- Has the company consistently generated returns for shareholders?
LMT has consistently generated returns for shareholders. Since 1985, it has delivered a 12% CAGR. Since 2000, the stock has generated a 16.44% rate of return. Since 2010, it has been 17.74%. This period of time included both the end of the Cold War and the de-escalation of the war on terror during the last 10 years. Through all of it, LMT has been able to generate returns for investors.
- Has the company survived previous recessions?
LMT has survived numerous downturns in the economy throughout its history. It remained profitable throughout the GFC. Net income declined after 2008 as the US de-escalated the war on terror and there were budget showdowns between Obama and the Republicans in Congress. Net income peaked at $3.2 billion in 2008 and declined to $2.6 billion in 2011, but then began steadily increasing again after that. While LMT can certainly be affected by recessions and the impact on government finances, it is capable of surviving and staying profitable throughout them. A GFC-style event will not be fatal to this business.
- Does return on equity consistently exceed 10% without the use of heavy leverage?
LMT has strong returns on capital. Throughout the last decade, ROE is typically in excess of 100%. The average return on invested capital for the last decade is 43%.
- Is the company financially healthy?
LMT is financially healthy. Interest coverage is strong at 14.73. The Altman Z-Score is healthy at 3.79, so there is no bankruptcy risk.
- Is the industry in secular decline?
The defense industry is not in secular decline. World peace seems unlikely to occur in the near future and threats facing the United States are currently growing. China is expanding the size of its Navy and Air Force, meaning that the US will need to respond accordingly if it wants to maintain its position of global dominance. Lockheed’s space segment is also likely to grow in the future. The compact fusion segment has massive potential if it succeeds.
- Does the company have a moat?
LMT has as big of a moat that an investor can ask for. Its main client is the US government and it has established contracts that guarantee revenue for decades to come. At a bare minimum, LMT is needed for product expertise and maintenance on the equipment that is already sold to the US government. It operates in an industry lacking in competition.
- Is management sketchy?
LMT’s management has no signs of being dishonest. In fact, they are quite skilled. James Taiclet became CEO last year. Management of Lockheed has always been transparent with no signs of manipulation or shady behavior. James had a strong track record at American Tower, during a period of time when that stock delivered a 20% CAGR. He was previously a military aviator.
- Is the stock cheap on an absolute and relative basis?
At 12.42x EV/EBIT, this is a cheap stock compared to the rest of the market. It is in the cheapest decile of the US stock market. It is cheap on a relative basis.
It is not cheap relative to its history. Over the last 20 years, LMT has frequently traded below 10x and below sales. The valuation from 2015-2020 has been above normal levels. I think an opportunity to buy at those low levels will occur again.
- If I was forced to hold the stock for 10 years, would I be terrified?
I would not be terrified to hold this stock for 10 years. It is doubtful that Lockheed is disrupted any time soon by a competitor. This is not a melting ice cube in secular decline. The valuation is also not unreasonable. If an investor bought this stock at current levels, they would likely earn a satisfactory return.
Conclusion: I think that Lockheed is a wonderful company at a fair price. However, it’s not a wonderful price yet. I suspect I will have an opportunity to buy sub-10x EV/EBIT and below sales the next time that the market sneezes.
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