Author: Alan Gutman, Andrew Qiao, and Jerry Yuan
Summary:
- The future of U.S. defense spending is shifting to cut out legacy programs, for which Lockheed Martin (LMT) is becoming prepared.
- LMT’s Space business sector has seen the largest increase in revenue growth of 10.3% out of all sectors in Q2 2021.
- The future-proof Space segment is poised for continued growth with LMT’s acquisition of Aerojet Rocketdyne as well as NASA contracts for the production of the Orion capsule.
- A possible hike to between 25% to 28% in the corporate tax rate along with a potential delay of the Aerojet Rocketdyne merger, pose a sizable risk to future earnings.
- Tenjin AI issues a BUY rating and predicts LMT’s intrinsic value to be between $424.26 to $433.75, reflecting a possible upside of 14.9% on the low-end.
Investment Thesis
Strong margins are relative to the aerospace and defense industry and Lockheed Martin’s (LMT) competition, coupled with growing business sectors that have the potential to expand as world tensions heighten, allow LMT to continue to outperform analyst expectations year-over-year. Specifically, the Space sector has the greatest potential for growth as the United States government continues to renew its interest in space. LMT has also made significant strides to solidify the sector’s supply chain and prospects with the acquisition of Aerojet Rocketdyne and a contract from NASA to construct 6 Orion capsules.
Catalysts
- Increased tensions between the U.S., Russia, and China will facilitate increased government spending in the aerospace and defense industry.
- Growing prospects for LMT’s Space business segment, as evidenced by Orion capsule production and Aerojet Rocketdyne acquisition.
Risks
- Potential delay in LMT’s acquisition of Aerojet Rocketdyne.
- A possible corporate tax rate hike from 21% to between 25% and 28%.
- Future defense budget cuts in legacy spending.
Composition of Revenues
LMT operates in more than 50 countries across the world, with a total of 350 facilities. Around 72% of LMTs revenues are confined to the United States, with the second-largest regions in Q2 2021 being Europe and Asia Pacific, each accounting for 10% of revenues. Similarly, in Q2 2020, the United States region contributed 80% of all revenues. Looking back even further, the United States has historically accounted for around the same percentage of revenue composition.
In terms of revenue segments, Aeronautics contributes to the greatest percentage of LMT’s total revenue, with 40.16% in fiscal year 2020. This is followed by the Missiles and Fire Control segment, which contributed 24.46% of the total revenue in the same period. The two remaining contributing segments have comparable revenue makeups to that of Missiles and Fire Control. The pie chart below shows this breakdown by segment. The breakup of total revenue has also remained relatively consistent over the past four years.
Total revenues in the fiscal year 2020 totaled $65,398 million, with an average operating margin of 11.07%. Missiles and Fire Control has the largest margin of 13.7%, with the three other segments obtaining around 10%.
Breakdown of Total Revenue by Segment (2020)
Source: Company Data
Segment Outlooks
Aeronautics:
This sector consists of three main categories: combat aircraft, air mobility, and aeronautical research & development. LMT designs and manufactures quality combat aircraft such as the F35-A Lightning II, which placed first in a Swiss evaluation of potential fighter jet purchases. Following this, at the end of June 2021, the Swiss government confirmed a purchase deal with LTM for $5.5 billion. This is the most recent deal with LMT and shows a continuing trend of growing interest in their aeronautics sector, specifically with its F-35 and F-16 programs.
Missiles and Fire Control:
LMTs Terminal High Altitude Area Defense and Patriot Advanced Capability-3 programs contributed higher net sales than other systems in fiscal year 2020. However, these two high revenue drivers are set to be scaled back as the United States is set on scaling down these systems in the Middle East region as troops along with military equipment withdraw from Afghanistan. However, this pullback is not bad news for LMT, as these withdrawals allow room for the U.S. to focus more on military threats from Russia and China. Additionally, there are no plans for withdrawals from Iraq and Syria. On top of that, the segment is still anticipated to grow as more deals are being announced, such as the United States awarding $160 million for indefinite manufacturing contracts of LMT’s artillery rocket systems.
Rotary and Mission Systems:
This segment is focused mostly on providing training and military applications for land, air, and sea vehicles and devices. Increases in revenues for this segment have primarily been driven by the rise of various helicopter contracts along with undersea combat systems. Looking forward, this segment was awarded $231.4 million by the United States on July 20th to produce 70 vertical launching system modules for two classes of Navy ships. Additionally, the Rotary and Mission Systems segment obtained a $80.2 million contract to install undersea warfare combat systems.
Space:
The focus on space and cyber warfare/security is perhaps one of the greatest potential areas of growth, not only for LMT but military programs in general. LMT holds many valuable contracts for the research and manufacturing of military satellite communications, tracking, and defense systems. Satellite development is the leading driver of revenues in this segment. In June of this year, LMT opened its Spacecraft Test, Assembly, and Resource facility outside Kennedy Space Center in Florida. After winning a $4.6 billion contract with NASA at the end of 2019, LMT is set to develop and produce six Orion capsules to be used for future manned U.S. missions back to the moon. If successful, there is further room for growth in this segment, as NASA has claimed the potential for an additional six missions using the produced capsules. Furthermore, this new facility opens up the possibility of winning more space contracts in the future as more focus is placed on space by the United States government, which is in the process to award $24.8 billion to NASA along with other increases to space incentives under Biden’s $6 trillion federal spending bill.
Also important to consider is the acquisition of Aerojet Rocketdyne by LMT, which will help LMT support its national security and space objectives. This acquisition further solidifies the LMTs supply chain, while at the same time poses great possibilities for future revenue growth as tensions increase between the U.S., Russia, and China.
Assessing Possible Risks
Possible Anti-Trust Action on Aerojet Acquisition:
Calls from Raytheon (RTX) and Senator Warren have pushed attention onto LMT’s $4.4 billion purchase of Aerojet along with future deals across the defense industry. In July, the FTC received a letter from the senator, asking the commission to further extend its review of the deal after it had already extended it back in February of this year. LMT currently anticipates the purchase to go through Q4 2021. Possible setbacks could adversely affect anticipated revenues in fiscal year 2022 and beyond. Additionally, LMT has been rated an “A-“ by Fitch, signifying no issues in repaying the financing of the $4.4 billion acquisition.
Potential Corporate Tax Rate Hikes:
In Biden’s proposed infrastructure plan lies a planned increase in the corporate tax rate from 21% to 28%, aimed at funding the plan itself. In May, Biden claimed that he was open to decreasing the proposed tax rate to 25%, and is still receiving backlash from congress members and various business coalitions, including LMT, to keep the rate at 21%. The updated $1 trillion plan passed the Senate on August 10th, and is set to be voted on in the House of Representatives, and a $3.5 trillion infrastructure bill is now being drafted. There is no corporate tax rate hike in the bill that passed the Senate, but there will be in the newer plan. If the corporate tax rate increases, LMT will see smaller margins along with disruption to its anticipated earnings in the years to come.
Future-proofing Lockheed Martin in the Defense Industry:
Over the years, increases in the U.S. Defense Budget have been shrinking and stagnating. The most recent official estimates were put out in April 2020, with an anticipated average increase of 2.16% year by year from 2021 to 2025. However, these estimates were put out under the Trump Administration, and with Biden in office, changes to the defense budget are almost certain. This April, Biden released a statement requesting $753 billion for FY 2022, reflecting a 1.7% rise from 2021 spending (an increase of 4.3% from Trump’s call for $721.9 billion for the same year). However, this increase mostly pertains to maintaining the current nuclear weapons arsenal and not to research & development programs nor manufacturing contracts. In the long term, cuts to legacy programs are expected. This means that LMT will need to place greater focus on business segments, such as their Space segment, to both offset the decrease of legacy program funding and low budgetary increases of around 2% on the high-end in the U.S. defense budget. This shift can already be seen with LMT’s Q2 2021 earnings showing that the Space segment saw the greatest revenue increase over the past TTM of 10.3%.
Margin Analysis
Source: Finbox
Comparing important margins to its competitors, LMT is in a stronger position than Boeing (BA), Raytheon (RTX), and General Dynamics (GD). LMTs margins most closely compete with GD’s while beating out the others in more recent years. This can be mainly attributed to BAs heavy reliance on commercial aircraft sales and leases, which had seen declines leading up to the Coronavirus pandemic that was further exacerbated by its decreasing liquidity. Similarly, RTX also faced heavy pullback from the onset of the Coronavirus due to its new presence with low diversification in the Defense and Aerospace industry. Taking these factors into account, we will be focusing on comparing margins between LMT and GE.
GD and RTX beat out LMT in only one margin that is being compared: gross margin. This shows that LMT has a relatively smaller proportion of costs of goods sold to its sales as compared to GD and RTX. However, the average difference since 2020 is small enough not to have a significant effect on the relatively more important profitability margins. The gross margin is also the only margin where these companies underperform the industry average of 17.61%.
LMTs higher EBITDA margin, which signifies a more efficient operation, coupled with its higher operating and net income margins, show that LMT is in a better position than GD and its other competitors at the end of fiscal year 2020 and in the past trailing twelve months. LMT also significantly outperforms the industry averages of 12.59%, 8.11%, and 2.49%, respectively.
Valuation
Forecast Driver Assumptions:
Forecast Drivers for Discounted Cash Flow Analysis
Source: Company Data, Estimates
In determining the proper forecast driver assumptions, two approaches were taken. With regards to the last four drivers in the table above (Capex, D&A, Taxes / EBIT, and Changes in Working Capital), the average of the previous three years was taken. It is our expectation that LMT will mirror its historic means for these categories, as these percentages remain fairly stable. For the sake of simplicity and fewer assumptions, all of the drivers are constant for the foreseeable future.
In forecasting revenue growth, an average of the past three years of 9.4% was not used due to this not reflecting the historic-mean nor analyst expectations. Analyst expectations of this driver range between 4% to 6%: Seeking Alpha’s proprietary forward-looking 5-yr revenue growth is 5.47%, while other analyst expectations are on the lower end. Sticking to a conservative forward-looking growth rate of 5% integrates the possibilities of LMT’s space segment in the long-term while also considering possible risks, such as increased corporate tax rates.
While LMT has a healthy operating margin above its competitors, with a 4.40% growth rate averaged over the last five years, the selected EBITDA margin of 13% falls just short of the 3-yr average of 15.49%. Keeping with conservative valuation, the forward-looking EBITDA margin more closely reflects the 10-yr historical mean of 13.7%, which is rounded down to 13% to allow for current and unforeseen risks in the long term.
Discounted Cash Flow Analysis:
By utilizing data from LMT, the forecast driver assumptions, a terminal growth rate of 1%, and a weighted average cost of capital (WACC) of 6.37% (based on a risk-free rate of 2.89%, a beta of 0.98, an equity market risk premium of 4.31%, pre-tax cost of debt of 5.26%, a tax rate of 21%, and a target debt percentage of 25%), an implied share price of $424.26 was derived. The figures used in calculating the WACC were obtained from LMT’s financials as well as analyst reports.
An implied share price of $424.26 suggests that LMT is trading at a 14.9% discount at market close on Monday, August 9, 2021. However, small changes in the terminal growth rate of the weighted average cost of capital could easily shift the implied share price below or further above $424.26.
Sensitivity analysis between revenue growth and EBITDA margin is also shown below, as these were the only two forecast drivers that did not rely on the averages of the previous three fiscal years.
Weighted Average Cost of Capital Sensitivity Analysis
EBITDA Margin / Revenue Sensitivity Analysis
Source: Company Data, Estimates
Dividend Discount Model Analysis:
To further support the discounted cash flow analysis, two forms of dividend discount models were undertaken. The first, a simple Gordon Growth Model, considers the most recent dividend, the required rate of return on equity, and the constant growth rate. The expected dividend of $10.62 for fiscal year 2021 was used in place of the most recent dividend. The predicted dividend is based on Seeking Alpha’s consensus rate. The required rate of return on equity is simply the already calculated WACC of 6.37%. Lastly, the constant growth rate is calculated from the required rate of return on equity along with a payout ratio. The payout ratio for LMT is 40.41%. The Gordon Growth Model returns an implied share price of $427.96, with a 18.53% discount as of market close Monday, August 9, 2021.
The other dividend discount model constructed is the Multi-Stage Dividend Model. This differs slightly from the Gordon Growth Model, as expected dividends for the next three fiscal years (2021, 2022, and 2023) are factored in. The Gordon Growth Model takes effect in fiscal year 2024, and then the values are then brought back to present value and summed up. The Multi-Stage Dividend Model returns an intrinsic value of $433.75, which suggests that LMT is trading at a 20.14% discount as of Monday, August 9, 2021.
Multi-Stage Dividend Model
Source: Seeking Alpha, Estimates
Takeaways and Recommendation
LMT is in a great position in the aerospace and defense industry. It holds excellent margins relative to its competition in the important EBITDA, operating, and net income margins. All four of LMT’s business sectors have sizable room for growth, especially the Space sector. The acquisition of Aerojet Rocketdyne coupled with the opening of a spacecraft test, resource, and assembly facility near Kennedy Space Center opens up further solidification of LMT’s strength and opens up new growth opportunities. However, one of the risks to consider for long-term profitability is the possibility of an increased corporate tax rate to between 25% and 28%. Considering all of these factors, a discounted cash flow and two discounted dividend models were built. The dividend models closely reflect the discounted cash flow valuation. Taking all three into account, we have an anticipated intrinsic value of between $424.62 to $433.75. At the current market price of $361.04 on market close August 9, 2021, the possible upside resides between 14.9% and 20.14%. The low-end of the estimate reaches our benchmark of 15%, so we issue a buy rating for LMT.
