Higher F-35 Volume Lifts Lockheed’s Net, Despite Weak U.S. Military Spending

Lockheed Martin‘s (NYSE:LMT) second quarter earnings rose by 5% annually to $2.76 per share as higher F-35 production volume and reversal of pension expenses outweighed weak U.S. military spending. ^[1] Since the last quarter, new rules have accelerated pension payments from the government to Lockheed and other defense contractors. Earlier, even though the government paid for a portion of the pension of a defense contractor employee who worked on military programs, these payments were made with a time lag of a few years. With the new rules that have come in effect from last year, these pension payments by the government have been accelerated, boosting cash and earnings of Lockheed and other defense contractors. This pension tailwind alongside higher F-35 volume helped grow Lockheed’s earnings in the second quarter. Buoyed by its strong profit performance in the first two quarters of 2014, Lockheed also raised its earnings guidance for full year 2014. The company now expects its 2014 earnings to lie in a range of $10.85-11.15 per share, up from $10.50-10.80 per share it forecast in April. ^[1]

However, the pressure on Lockheed’s top line continues to persist. In the second quarter, the company’s revenues fell by 1% annually to $11.3 billion reflecting lower overall contract volume due to weak U.S. military spending. ^[1] Lockheed currently generates over 80% of its revenues from U.S. government contracts, and as the government’s military spending is declining due to budget constraints, Lockheed’s top line is facing pressure. In the first six months of 2014, the company’s top line has fallen by a little over 2% on a year-over-year basis. And, for full year 2014, Lockheed anticipates its top line to fall to around $44.8 billion (at the mid-point of its revenue guidance), from $45.4 billion last year. ^[1]

Another cause for concern is Lockheed’s falling backlog. The company’s backlog has declined from a record $82.6 billion at the start of 2014, to $79.6 billion at the end of the first quarter, and then to $77.8 billion at the end of the second quarter. ^{[2] [1]} Even though this decline is not very steep, the trend is a cause for concern as backlog is a crucial indicator of future revenues. In our opinion, this decline in the company’s backlog again reflects the negative impact from flat-to-declining U.S. military spending.

We currently have a stock price estimate of $164 for Lockheed, marginally below its current market price. We are in the process of incorporating the second quarter earnings and shall update our analysis shortly.

See our complete analysis of Lockheed here

Rising F-35 Volumes Drove Earnings Growth

In the second quarter, despite a decline in Lockheed’s top line, its sales from its F-35 program increased due to higher production volume under this program. The F-35 program currently constitutes about 17% of Lockheed’s top line, and with the planned ramp up in F-35 production, we figure this program will occupy an even greater share of the company’s business in the coming years. Additionally, Lockheed is banking on higher F-35 production to temper the impact from declining U.S. military spending.

Separately, Lockheed also signed an affordability agreement with the Department of Defense (DoD) related to its F-35 program. This agreement seeks to reduce the price of F-35 to under $80 million a unit by 2019. ^[3] We figure this significant reduction in F-35’s price will help generate more orders from international partners who have expressed concern over the high price of this fighter jet. Till now, U.K., Norway, Netherlands, Italy, Israel, Turkey, Australia, Japan and South Korea, apart from the U.S., have placed orders/commitments for the F-35. In all, Lockheed anticipates to produce about 3,000 F-35s over the next 2-3 decades, out of which, about 2,400 are expected to be procured by the U.S. defense forces and the remaining by international partners. We figure if the F-35’s price is brought down to under $80 million a unit, then Lockheed will find it a easier to achieve its total production target.

New Contracts Received During the Second Quarter

Additionally, during the second quarter, Lockheed bagged three major military contracts from the U.S. government. Two of these were for the combat rescue helicopter and the Presidential helicopter for which Lockheed will supply crucial equipment. Sikorsky is the prime contractor for these two contracts. The third contract bagged by Lockheed was for additional production lots of the Space-Based Infrared System (SBIRS). SBIRS provides missile defense and warning capability against incoming ballistic missiles. We figure as these large contracts will run over the next several years, they will support long term growth at Lockheed.

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1. Lockheed’s 2014 Q2 earnings form 8-K, July 22 2014, www.lockheedmartin.com [↩] [↩] [↩] [↩] [↩]
2. Lockheed’s 2014 Q1 earnings form 8-K, April 26 2014, www.lockheedmartin.com [↩]
3. Lockheed’s 2014 Q2 earnings transcript, July 22 2014, www.seekingalpha.com [↩]