Lockheed Weathers DoD Cuts with $7.4bn F-22 Upgrade

Lockheed Martin (NYSE:LMT) continues to offset cuts to Department of Defense (DoD) spending, most recently by increasing the size of an F-22 Raptor upgrade contract. Reuters reports that the deal’s potential value has been raised to $7.4 billion, up from an undisclosed amount, with the Pentagon keen to address recent concerns about oxygen system malfunctions. ^[1] New funding for the F-22 will contribute to Lockheed’s growing share of DoD spending while also potentially stemming the decline in its aeronautics EBITDA margin. After taking projected cutbacks into account, the Trefis price estimate for the company remains at $98 – some 30% above the market price. The projected modest declines relative to government cutbacks reflects our belief that the DoD will continue to favor Lockheed above competitors such as Boeing (NYSE:BA) and BAE Systems

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DoD Spending Less, but Relying on Lockheed More

Lockheed Martin is currently the Pentagon’s number one defense supplier, with the total value of contracts for DoD, NASA and Homeland Security spending expected to reach $383 billion this year. Against a backdrop of deep government cuts we anticipate that this figure will fall gradually between now and 2014, before leveling off at about $360 billion per year.

While this projected decline looks modest relative to expected government cuts, as mentioned before we believe that the cuts will be offset as the government will favor Lockheed over competitors. The company’s share of total Pentagon aeronautics contracts has risen since 2008 – up from 2.6% to an expected 2.86% this year – and we believe this trend will continue until at least 2014. Much of this growth will be driven by the flagship F-35 program. The military expects to purchase 2,447 of the aircraft under a contract worth $382 billion, which is 64% higher than initially budgeted for. ^[2]

Higher F-22 Spend Gives Fillip to EBITDA Margins

While total F-22 expenditure is dramatically lower than spending on the F-35, the Raptor contract remains a top priority for the DoD. The aircraft is the most advanced fighter jet in the US Air Force, and its new higher spending cap underscores the Pentagon’s commitment to seeing through sorely-needed upgrades on the 187 units produced. In particular, the $7.4 billion contract will allow Lockheed to address recurrent oxygen system glitches and cockpit drainage problems.

While Lockheed’s ten-year F-22 deal winds down in 2012, we believe the Pentagon’s commitment to further upgrades could have a favorable impact on the company’s aeronautics EBITDA margin. We currently forecast margins to fall from 13.4% this year to 11.8% in 2013, due mainly to cost over-runs associated with new programs like the F-35. Ongoing cash injections to more mature programs such as the F-22 or F-16 could stem this decline, potentially pushing our stock valuation from $98 to $100.

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1. Lockheed clarifies latest F-22 fighter upgrade deal, Reuters, Nov 22 2011 [↩]
2. F-35 makes headway amid criticism US budget crunch, Reuters, Nov 25 2011 [↩]