Higher F-35 Margins Will Help Offset Impact From Budget Cuts In Lockheed’s 2014 Results

Lockheed Martin (NYSE:LMT) faced a very challenging demand environment in 2013 with U.S. government spending declining due to sequestration. The defense contractor was initially assessed to be highly vulnerable to this decline as it gets over 80% of its revenues from the government, but it fared exceptionally well growing its profits by nearly 15% annually to $2.5 billion in the first nine months of this year on gains from cost cuts. ^[1] In the fourth quarter, the company is likely to maintain its strong performance. In our opinion, Lockheed’s profits rose despite reduced government spending due to its strategic position on important longer cycle government contracts like the F-35 which remain funded from prior year budgets and are therefore not impacted significantly from sequester, which came in force from March 2013.

Looking ahead, in 2014, we anticipate higher margins under the F-35 program, which constituted around 16% of Lockheed’s total revenues in the previous quarter, to offset in part the negative impact from government austerity.

See our complete analysis of Lockheed here

Uncertainty Over Future Levels Of Government Spending

The deadlock continues in the Congress over a deal that could potentially remove the current across-the-board spending cuts. If sequester remains in place then Lockheed will face a challenging 2014, even though in recent years it has increased its international sales.

The company in its preliminary 2014 outlook announced in October that revenues will likely fall slightly from 2013 levels, but margins will likely not be impacted much due to gains from cost cutting measures and transition in the F-35 program from development to production.

Higher Margins In F-35 Program Will Help Offset Impact From Potential Budget Cuts

Over the past few years, Lockheed was deeply involved in research and development of the F-35 during which period the company raised its workforce of scientists, engineers and IT professionals. However, with significant development work complete under the program and the company looking to ramp up F-35 production rate, its margins under the contract are set to improve. One of the ways in which this transition from development to production will expand the company’s margins is through reduced overall headcount. The company plans to reduce the number of development workforce it employs. At the same time, it expects the increase in its production workforce to not fully offset the decline from development workforce. In this way, in 2014, it will benefit from reduced headcount and employee wages.

Additionally, the company says that cost savings achieved from this shift from development to production will more than offset the negative impact from lower F-35 prices negotiated from the government. In the most recent lot 7 F-35 production contract, the price that Lockheed is getting for producing a F-35 is lower than what is was getting in the lot 6 production contract, which in turn was lower than what it was getting in the lot 5 production contract. The company says that this steady decline in F-35 prices is not hurting its margins as the F-35 development work during which margins were actually very low is substantially complete. Going forward, gains from ramp up in production will more than offset the price decline negotiated by the Pentagon. The company anticipates that this scenario will persist when it negotiates for lot 8 and next production contracts. In all, in 2014, higher margins at the F-35 program will help Lockheed offset the impact from potential cuts in government spending.

In case, a deal avoids large spending cuts in government spending then there could be further upside to Lockheed’s profits in 2014.

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1. Lockheed’s 2013 Q3 10-Q, Ocotber 25 2013, www.lockheedmartin.com [↩]