Lockheed Martin (NYSE:LMT) will announce its fourth quarter earnings Thursday, January 23. The defense contractor will likely post higher profits despite a negative impact on its top line from across-the-board spending cuts, called sequestration, which came in effect from March 2013. We figure gains from Lockheed’s large scale cost cutbacks which include headcount reductions will lift its profits in the fourth quarter.
In the first nine months of 2013, a similar trend was observed when the U.S government’s defense budget cuts lowered Lockheed’s revenues by nearly 4% annually to $33.8 billion. However, gains from the company’s cost reduction measures more than offset this fall in its revenues to lift its earnings by 14% annually to $7.54 per share. 
We currently have a stock price estimate of $120 for Lockheed, around 20% below its current market price.
Sequestration Will Weigh On Lockheed’s Fourth Quarter Top Line
For the fiscal year 2013, which ended on September 30, 2013, sequestration reduced the government’s defense spending by $37 billion.  This fall in spending added to the cuts that are already in effect under the Budget Control Act and require a reduction of around $500 billion in the government’s defense spending over a ten-year period starting from fiscal year 2012. These budget cuts in all have been largely responsible for the $1.3 billion year-over-year fall in Lockheed’s revenues in the first nine months of 2013. 
For the fourth quarter, sequestration will continue to weigh on the company’s revenues as deadlock continued in the Congress through the quarter over a potential deal that could rollback these cuts. Furthermore, in our opinion, the impact from these cuts could actually increase in the fourth quarter, as in the last fiscal year, the Department of Defense (DoD) lessened the impact from sequestration by allocating a portion of the mandated reduction to previous year un-obligated balances and multi-year investment appropriations. In the fourth quarter and remaining months of fiscal 2014, DoD will likely have much less flexibility for such maneuvers that allocate cuts to future years. This will increase impact from sequestration on defense contractors like Lockheed.
F-35 Deliveries Will Partially Offset Sequestration Impact
On its part, even though Lockheed is trying to grow its international sales to lower dependence on the U.S. government, it still gets more than 80% of its total revenues from the government and is therefore highly vulnerable to budget cuts. These government spending cuts have had maximum impact on the company’s shorter cycle programs like those in its information technology segment. On the bright side, Lockheed’s presence on longer cycle programs like the F-35 fighter jet has worked in its favor, as these programs remain funded from fiscal year 2012 and prior year budgets and have therefore seen minimal impact from sequestration, which came in effect from last year.
In the fourth quarter, we figure deliveries against F-35’s existing order backlog will likely offset in part the impact from sequestration. At the end of the third quarter, Lockheed had a backlog of 106 F-35s from the U.S. government and the program’s international partners.  This program constitutes a large part of Lockheed’s business. In the previous quarter, it generated 16% of the company’s total revenues and going forward we anticipate it to occupy an even larger share of the company’s revenues. 
Cost Reduction Initiatives Will Lift Fourth Quarter Profits
Furthermore, in the fourth quarter, like in the first nine months of 2013, we anticipate gains from Lockheed’s cost reduction initiatives like headcount reductions and temporary factory shutdowns to lift its profits. Through these measures, Lockheed expanded its segment profit margins to 12.8% in the first nine months of 2013, from around 12% in the prior year period.  As cost reduction measures continued through the fourth quarter, we anticipate the defense contractor to post further gains in its margins.
Dividend Hikes & Share Buybacks Ease Shareholder Concerns
Looking ahead, uncertainty continues over the exact defense spending levels of the U.S. government, and Lockheed accordingly anticipates its top line to fall slightly in 2014, from 2013. To ease shareholder concerns arising from this negative impact from government austerity, Lockheed is returning significant capital to its shareholders. The company recently raised its fourth quarter dividend by 16% to $1.33 per share and also hiked its share repurchase plan by $3 billion.   Lockheed’s dividend yield, currently at around 3.5%, is among the highest in the industry and at the end of the third quarter, the company had around $3.8 billion left in its share repurchase authorization. Overall, through dividends and share buybacks, Lockheed returned around $3.1 billion to its shareholders in the first nine months on 2013. Notes: