Lockheed’s Net To Likely Rise On Growing F-35 Volume & Cost Cuts Despite Weak U.S. Military Spending

Lockheed Martin (NYSE:LMT) will announce its third quarter earnings Tuesday, October 21. The defense contractor is coming off a good second quarter in which its profit rose on higher F-35 volume and reversal of pension expenses. In the third quarter, we anticipate the company to continue to grow its profit as production under the F-35 program has continued to expand, albeit slowly. Gains from past cost cuts will also provide some tailwind to Lockheed’s third quarter bottom line.

However, the company’s top line will likely remain under pressure from weak U.S. defense spending. Lockheed currently generates over 80% of its revenue from U.S. government contracts, including about 60% from Department of Defense (DoD) contracts. With U.S. military spending remaining weak due to cuts ushered in by the Budget Controls Act of 2011, Lockheed has seen its total contract volume decline during the past few years. In the first half of 2014, the company’s top line contracted by a little over 2% annually due to these cuts. ^[1] For full year 2014, the company forecasts its top line to lie at around $44.8 billion (at the mid-point of its 2014 revenue guidance), down from $45.4 billion in 2013 and $47.2 billion in 2012. ^[1]

To temper this impact from flat-to-declining U.S. military spending, Lockheed has increased its focus on international sales and in recent months, the company has bagged a few major orders/commitments, particularly for the F-35 from Australia, Japan and South Korea. Lockheed is also benefiting from the growing production volume of the F-35. We figure these two trends will protect the company’s third quarter results from government austerity.

We currently have a stock price estimate of $165 for Lockheed, around 5% below its current market price.

See our complete analysis of Lockheed here

F-35 Program Margins Are Improving

The F-35 program constitutes about 17% of Lockheed’s revenue. So, rising volumes under this program are providing significant tailwind to Lockheed’s overall results.

Additionally, with considerable development work on the F-35 complete and the company ramping up this jet’s production, margins under the F-35 program are improving. One of the ways in which this transition from development to production is expanding Lockheed’s margin is through a reduced headcount. During the development years of the F-35, Lockheed raised its workforce of scientists, engineers and IT professionals. But now, as the company is transitioning to the production phase, it is slashing its development workforce. At the same time, the company expects this decline in its development workforce to be greater than the increase in its production workforce. So, Lockheed’s margins will benefit from a reduced overall headcount and lower salary costs. Also, with higher production volumes, manufacturing efficiencies will improve contributing to margin expansion thus in the third quarter, even though the company’s top line will likely decline, its profit will likely rise on higher F-35 volume.

Cost Cuts Will Likely Contribute To Q3 Profit Growth

Separately, Lockheed is also focusing on reducing its other costs. At the start of this year, the company announced that it aims to reduce its facility footprint by 2.5 million square feet through 2015. ^[2] We figure this cost reduction will support the company’s profit growth in the third quarter. For full year 2014, Lockheed anticipates its earnings to fall around $10.85-11.15 per share, up from $9.04 per share in 2013. ^[1]

A point to note here: not all of Lockheed’s 2014 earnings growth will come from cost cuts and higher F-35 margins. Lockheed is also actively buying back stock and in the first half, the company repurchased $1.2 billion of its stock. These share repurchases are contributing to per share earnings growth of the company by lowering its overall share count. Recently, while announcing the dividend for the fourth quarter, Lockheed’s board authorized another $2 billion for share repurchases. ^[3] So, the company’s earnings will likely continue to get a boost from stock repurchases in the remainder of 2014.

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1. Lockheed’s 2014 Q2 earnings form 8-K, July 22 2014, www.lockheedmartin.com [↩] [↩] [↩]
2. Lockheed’s 2013 Q4 earnings transcript, January 23 2014, www.lockheedmartin.com [↩]
3. Lockheed Martin Increases Share Repurchase Authority by $2.0 Billion, September 25 2014, www.lockheedmartin.com [↩]