Lockheed Martin (LMT): A Solid Dividend Grower At The Right Price

Wide moat industrial stocks, such as defense contractor Lockheed Martin (LMT), often make excellent long-term dividend growth stocks.

 

In fact, Lockheed Martin is a dividend achiever with 15 straight years of consecutive dividend increases under its belt. Even better, the stock has managed to grow its payout at an impressive average annual rate of 10% over the past 30 years.

 

While Lockheed’s steady dividend increases have historically made it an attractive offering, past performance is not indicative of future results.

 

In addition to taking a look at the level of income growth investors can expect from Lockheed in the future, let’s also review the company’s competitive advantages and current valuation to see if Lockheed Martin could be a timely blue chip stock to consider for a diversified dividend growth portfolio.

 

Business Overview

Founded in 1909 in Bethesda, Maryland, Lockheed Martin is the world’s largest defense contractor and the biggest supplier of fighter aircraft. However, while the company best known for the F-35 joint strike fighter, Lockheed Martin actually has four major divisions:

 

Aeronautics (39% of sales and 41% of operating profits year-to-date): designs, manufactures, and maintains combat and air mobility aircraft,  including fighter jets (F-22, F-35, and F-16), military transport planes, and unmanned air vehicles.

 

Missiles and Fire Control (14% of sales and 21% of operating profits): provides air and missile defense systems, tactical missiles and air-to-ground precision strike weapon systems.

 

Rotary and Mission Systems (28% of sales and 17% of operating profits): builds and maintains military and commercial helicopters. Also designs ship and submarine mission and combat systems, including mission systems and sensors for rotary and fixed-wing aircraft, sea and land-based missile defense systems as well as radar systems, the Littoral combat ship, simulation and training services, and unmanned systems and technologies. This division also offers government cyber security services and specializes in military communication solutions.

 

Space Systems (20% of sales and 21% of operating profits): designs and builds satellites, strategic and defensive missile systems, and space transportation systems. This division is also where Lockheed designs its classified systems and services in support of national security.

 

Overall, Lockheed Martin generates 60% of its sales from the U.S. Department of Defense, 20% from U.S. government agencies, and 20% from international militaries.

 

Business Analysis

Many of the best dividend growth stocks generate growing and recurring sales, earnings, and cash flow, which are made possibly by durable competitive advantages that allow a company to protect its margins and returns on shareholder capital over time.

 

As an industrial company, and one that’s essentially 100% reliant on world governments for its business, Lockheed’s top line sales can be somewhat cyclical.

 

 

While the company operates in a highly capital intensive industry, the nature of its military and government contracts also locks in relatively high profitability, resulting in cyclical but relatively stable and generous profits and returns on shareholder capital.

 

 

Stepping back, the nature of defense contractors can create substantial moats for some businesses. The highly complex and very expensive development costs of these weapons systems, as well as the Department of Defense’s (DOD) conservative approach to whom it works with (company trust, expertise and reputation are everything in this business), mean that smaller, less well capitalized rivals are essentially locked out of the market.

 

In fact, many of Lockheed’s DOD contracts are non-competitive, meaning the U.S. military has no choice but to use Lockheed because there are no other qualified bidders. In 2012, for example, Lockheed obtained $17.4 billion worth of non-compete contracts from the U.S. DOD, representing about 37% of that year’s revenue.

 

And thanks to its $9 billion acquisition of Sikorsky Aircraft in 2015, Lockheed now has a massive business building and servicing UH-60 Blackhawk helicopters, of which the U.S. military maintains a fleet of 2,000. Replacing, maintaining, and servicing this large sunk cost for the DOD means Lockheed enjoys large switching costs in military rotary aircraft as well.

 

The deal essentially added the world’s largest military helicopter maker by sales to Lockheed’s combat jet and missile-defense businesses. When combined with Lockheed’s divestiture of lower-margin government IT and services businesses, these moves further concentrated the company on military businesses with greater competitive advantages and improving growth prospects.

 

Lockheed’s moat is especially wide in manned combat fixed wing aircraft, where it’s likely to be the U.S. military’s sole supplier by 2025, thus ensuring a steady stream of high margin sales and cash flow.

 

Another benefit Lockheed has is that it sells internationally to allied militaries, very few of which have the expertise or desire to take the time and money required to design their own homegrown weapons systems.

 

In other words, relatively small nations find it much easier to outsource their defense needs from U.S. contractors. As a result, once a major weapons contract, such as the F-35 joint strike fighter, is obtained from the DOD, Lockheed essentially gains a near monopoly of fighter aircraft not just in the U.S., but also in the majority of the free world.

 

In fact, Lockheed is currently close to signing a deal with the DOD and 10 allied nations for delivery of 440 F-35s that would be worth $35 to $40 billion.

 

However, it’s also important to note that the highly complex nature of these weapons systems is also a double-edged sword. That’s because it’s monstrously complex to build these jet fighters, including numerous subcontractors in a process that often takes decades of R&D and upgrades.

 

For example, the F-35 program, which Lockheed won the contract for in 2001, actually dates back to the late 1980’s. The $1.5 trillion program is designed to run through 2070, making it the most expensive military contract in history.

 

And while it offers Lockheed immense long-term profit potential, the program has also been plagued by various setbacks, including being more than a decade behind schedule and highly over budget, with cost overruns eating into Lockheed’s profits.

 

This is partially why the company’s margins are below industry average, with integration of its latest big acquisition, Sikorsky, also contributing to lower-than-normal profitability.

 

Lockheed Martin Trailing 12-Month Profitability

 

Fortunately, management is working with the DOD on its Blueprint for Affordability for Production (BFA) program, announced in 2014, to dramatically cut costs (by 35%) and maintenance expenses.

 

Lockheed also has a second cost saving program, the Sustainment Cost Reduction Initiative, in which it and its partners are investing $250 million in order to eventually cut annual expenses to build the F-35 by $200 million.

 

More importantly, Lockheed believes it can now profitably deliver F-35’s for just $75.4 million, which is $4 million lower than Boeing’s (BA) $79 million F/A 18 Super Hornet.

 

Still, the F-35’s cost per plane is 25% above what was originally planned for, which has caused numerous budgetary watchdog groups to lambast the program as the largest defense boondoggle in history.

 

In fact, a 2013 report from the RAND corporation concluded that it would have been much cheaper for the Air Force, Navy, and Marines to have designed their own custom planes, which would have also been far more capable than the F-35, which was burdened with the need to serve all branches simultaneously.

 

In other words, because the F-35 was designed to be a jack-of-all-trades, it has run into incredibly costly overruns and manufacturing delays.

 

That being said, Lockheed has spent the last few years ironing out the kinks in producing the jet, which accounted for 23% of all company sales in 2016, and expects ramped up and smoothed out production in the coming years to result in steady growth in its top and bottom lines.

 

That’s because the DOD plans to eventually purchase more than 2,400 of the jets. In fact, analysts expect Lockheed’s profits to grow by about 50% by 2020 due to the ramp up of F-35 production and delivery.

 

Since U.S. allies are similarly committed to the DOD’s “too big to fail” project, Lockheed’s strong backlog of orders ($103.6 billion at the end of 2016, with $46.9 billion in new orders last year), is likely to remain large and robust.

 

In fact, Lockheed’s backlog now represents about 2.5 years of total sales, meaning it has far more cash flow predictability than in its past.

 

 

Lockheed’s book-to-bill ratio (new orders/deliveries) has been steadily climbing over time as well, increasing from about 1.0 in 2016 to 1.2 YTD 2017 and almost 2 in the most recent quarter. This means that the order backlog, already at record highs, is likely to only grow over time.

 

In the meantime, the company is still generating strong returns on shareholder capital, as well as a solid free cash flow margin to support its steadily rising dividend.

 

Better yet, Lockheed’s management has proven to be one of the most shareholder-friendly teams in the industry, with the company returning 100% of free cash flow (cash left over after running the business and investing in its growth) via buybacks and dividends in 2016.

 

Lockheed has returned 72% of free cash flow thus far in 2017, showing its dedication to returning the vast majority of cash to its owners.

 

 

As a result, Lockheed, while sure to face substantial challenges in the future (as will all U.S. defense contractors), is likely to continue to be a solid long-term dividend growth investment.

 

Key Risks

While Lockheed’s very long-term contract for the F-35 means that it has essentially guranteed itself a lot of future growth, there are nonetheless numerous risk factors to keep in mind.

 

First, because of its large reliance on DOD contracts, Lockheed is very susceptible to any changes in military spending. For example, currently the DOD’s budget is operating under a continuing resolution (CR) from last year (meaning spending will be the same).

 

However, Congress is working on a 2018 budget (to pave the way for tax reform), and in December the CR will expire. Unless Congress can pass a budget, Lockheed might find itself facing military budget cuts under the previously passed sequestration legislation.

 

Speaking of tax reform, that could prove to be both a help and a hinderance to the company. That’s because the effective tax rate for Lockheed is 25%, meaning that the 20% corporate tax rate being proposed would only marginally boost earnings.

 

However, one of the proposals for tax reform is to eliminate debt interest deduction, and thanks to large scale acquisitions in the past few years, Lockheed’s debt levels have been gradually climbing (more on this later).

 

 

Depending on how the tax reform is structured (assuming it passes), Lockheed could find itself with a gradually phased in lower corporate tax rate (won’t drop to 20% until 2022) that is more than offset by a potentially immediate loss of interest deduction.

 

Next, all defense contractors face some amount of political risk, especially when defense platforms go wrong (as they usually do at some point).

 

For example, President Trump has publicly lambasted Lockheed for the cost overruns of the F-35, as well as the fact that the plane has badly failed to live up to expectations.

 

That’s because the plane was specifically designed to be stealthy (but only to certain radar signatures), but the trade-off has been reduced maneuverability and fighting ability.

 

In fact, in a 2015 mock battle with F-16’s (the plane the F-35 is meant to replace that was designed in the 70’s), the F-35 proved to be less maneuverable and capable of dog fighting, even though it was unencumbered by external weapons mounts or fuel tanks.

 

The much older F-16s, which did have large external fuel tanks, were still able to fly circles around the state-of-the-art fighter, calling into question whether or not the next generation aircraft is a worthy replacement at all, or merely an overpriced and over designed (the avionics alone require 24 million lines of code vs the F16’s 135,000) boondoggle that the DOD can’t undo.

 

Since almost all DOD contracts are now fixed cost, any cost overruns are mainly paid for by Lockheed, meaning that if it runs into unexpected problems delivering on weapons systems, its earnings can be badly affected. In fact, back in the 1970’s and 1980’s, several defense contractors nearly went bankrupt due to such issues.

 

The F-35 is hardly the only issue for Lockheed. For example, its Sikorsky acquisition has not gone as smoothly as expected, with cost synergies coming along slower than anticipated. In addition, Sikorsky sales are expected to be essentially flat for the year as it faces increasing competition from Airbus Helicopters, Augusta Westland, and Bell in the commercial helicopter space.

 

Meanwhile, missile systems are only expected to generate small growth, more than offset by the lagging space systems division (which is projecting double-digit declines).

 

Lockheed has enjoyed a duopoly position in missiles (with Raytheon) and space (United Launch Alliance joint venture with Boeing) for a long-time; however, increased competition from Elon Musk’s SpaceX and Jeff Bezos’s Blue Origin could threaten to undermine lucrative satellite delivery contracts with the DOD, which represent 15% to 20% of this division’s sales.

 

Lockheed has responded with a plan to cut the price of launching government satellites by 25% in the next few years, but SpaceX is now successfully using self-landing, reusable rockets that Lockheed might find difficult to match unless it can design its own reusable models. That’s a highly complex and expensive endeavor, and one that Lockheed has no guarantees of success since its moat is much shallower in this industry.

 

Fortunately, about 50% of the Space System’s business is in building DOD satellites, which are highly classified and in which Lockheed faces little competition. The same is true for the ballistic nuclear missile business, where Lockheed and Raytheon have the market locked up for supplying U.S. intercontinental ballistic missiles (ICMBs).

 

The bottom line is that Lockheed may have a near global monopoly on fighter aircraft and strong moats in its military helicopter, military satellite, and nuclear missile businesses.  This will likely ensure it modest growth in the coming years and decades.

 

However, its other divisions are struggling and enjoy much smaller competitive advantages.  This could drag on long-term sales growth, which is why investors may not be able to rely on the company being able to grow its dividend at the impressive double-digit pace enjoyed over the past 30 years.

 

Lockheed Martin’s Dividend Safety

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

 

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

 

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

 

 

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.

 

Lockheed has a Dividend Safety Score of 90, indicating a highly secure and dependable dividend, which is what one would expect from  a blue chip dividend achiever which has raised its payout every year since 2002.

 

 

While the company did cut the dividend in half in 2000 due to pressure on its free cash flow at the time, the Lockheed has come a long way in regaining the trust of dividend growth investors.

 

That’s thanks to management adopting a stricter discipline on dividend growth, and specifically maintaining safe EPS and FCF/share payout ratios. While the company’s payout ratios have been climbing in the past few years, a level near 50% or less in both earnings and free cash flow (where the ratios have stabilized) gives the company plenty of safety buffer should unexpected cost overruns result in a poor earnings year.

 

 

Another important safety factor is the balance sheet, since too much debt can restrict management’s flexibility in growing the business while maintaining a secure dividend.

 

While Lockheed has a large amount of net debt, that’s to be expected in a highly capital intensive industry such as this.

 

 

When we compare the relative debt metrics to those of its industry peers, we find that Lockheed’s debt burden is slightly above average, in terms of leverage (Debt/EBITDA) and debt to capital. However, its current ratio (short-term assets/short-term liabilities) is still safely above 1, and its interest coverage ratio is strong enough to give it a solid investment grade credit rating.

 

 

This ensures it has continued access to low cost capital that allows management to keep growing the business while rewarding shareholders with a highly secure and steadily growing dividend.

 

Lockheed Martin’s Dividend Growth

Lockheed Martin has a long history of strong dividend growth. In fact, over the past 30 years the company has been rewarding dividend lovers with double-digit payout growth, including 16% annualized growth over the past five years.

 

 

That being said, because Lockheed’s payout ratios are now at the limits of maintaining high security, investors should expect future dividend increases to closely track EPS and FCF growth.

 

Thanks to strong growth in F-35 deliveries, analysts expect Lockheed’s earnings and free cash flow to grow about 7% to 8% a year over the next decade, which means that this is a reasonable expectation for how quickly the payout will grow as well.

 

Valuation

Over the past year, enthusiasm over President Trump’s promise of increased military spending has sent all defense contractors into a strong rally and caused Lockheed Martin to return close to 30%, outpacing the S&P 500.

 

As a result, LMT shares don’t look all that compelling from a valuation perspective.

 

For example, LMT’s forward PE ratio of 23.6 is not only much higher than the S&P 500’s 18.2 and the industry median of 22.6, but also the stock’s historical norm of 14.2.

 

Similarly, the stock’s dividend yield of 2.5% is lower than its historical median of 3.1%.

 

 

Conservative investors may be better off waiting for a pullback. In fact, given its solid growth potential and very safe dividend, a yield of 3% or better might even make Lockheed a solid choice for those looking to eventually live off dividends during retirement.

 

That’s not to say that Lockheed is necessarily trading in bubble territory, since even at today’s prices Lockheed has potential to generate 9.5% to 10.5% long-term total returns (2.5% yield plus 7% to 8% annual earnings growth) if everything goes as planned.

 

Conclusion

As the largest defense contractor in the world, Lockheed Martin enjoys substantial competitive advantages in numerous highly specialized and wide moat industries.

 

Combined with a large order backlog, which is likely to only grow over time, the company offers dividend growth investors a highly secure and steadily rising income stream that can make it an attractive choice for a diversified dividend growth portfolio at the right price.

 

However, due to LMT’s strong gains over the last year, today’s valuation, while not absurdly high, does suggest that many of the company’s positives could already be in the price.

 

Lockheed Martin seems better off on a watch list for now to wait for a better valuation. A price closer to $265 (from $315 today) would put the stock’s forward P/E ratio below 20 and its dividend yield near 3%, which would provide a greater margin of safety.