Does Lockheed Martin Pass Buffett's Test?

We'd all like to invest like the legendary Warren Buffett, turning thousands into millions or more. Buffett analyzes companies by calculating return on invested capital, or ROIC, to help determine whether a company has an economic moat -- the ability to earn returns on its money above that money's cost.

In this series, we examine several companies in a single industry to determine their ROIC. Let's take a look at Lockheed Martin (NYSE: LMT  ) and three of its industry peers, to see how efficiently they use cash.

Of course, it's not the only metric in value investing, but ROIC may be the most important one. By determining a company's ROIC, you can see how well it's using the cash you entrust to it and whether it's actually creating value for you. Simply put, it divides a company's operating profit by how much investment it took to get that profit. The formula is:

ROIC = net operating profit after taxes / Invested capital

(Get further detail on the nuances of the formula.)

This one-size-fits-all calculation cuts out many of the legal accounting tricks (such as excessive debt) that managers use to boost earnings numbers, and it provides you with an apples-to-apples way to evaluate businesses, even across industries. The higher the ROIC, the more efficiently the company uses capital.

Ultimately, we're looking for companies that can invest their money at rates that are higher than the cost of capital, which for most businesses is between 8% and 12%. Ideally, we want to see ROIC above 12%, at a minimum, and a history of increasing returns, or at least steady returns, which indicate some durability to the company's economic moat.

Here are the ROIC figures for Lockheed and three industry peers over a few periods.

Company

TTM

1 Year Ago

3 Years Ago

5 Years Ago

Lockheed Martin

12.2%

12.8%

13%

18.4%

Raytheon (NYSE: RTN  )

12.3%

12.9%

13%

11.2%

General Dynamics (NYSE: GD  )

(9.7%)

12.2%

12.8%

15.3%

Northrop Grumman (NYSE: NOC  )

12.1%

13.2%

8.4%

7.1%

Source: S&P Capital IQ. TTM=trailing 12 months.

Lockheed Martin, Raytheon, and Northrop Grumman all offer returns on invested capital in the low 12% range. Lockheed's returns have pretty consistently declined over the five-year period, and are more than six percentage points lower than they were five years ago. While Raytheon's returns are currently higher than they were five years ago, they have gradually declined over the past three years. Northrop Grumman's returns on invested capital are lower than they were last year, they have increased by five percentage points from five years ago.

General Dynamics has negative returns on invested capital in the last year, due to some tax accounting that saw its effective tax rate balloon to 160% rather than a more typical 31-32%. Normalize that tax rate, and ROIC comes out to 11.1%, still down from last year but much better and above what it did three and five years ago.

Investors have worried about these companies recently in the face of potential cost-cutting at the Pentagon and among other major clients. However, it's worth noting that in the defense world "spending cuts" usually means a slowdown in growth of defense spending rather than an actual reduction in spending. Still, Lockheed Martin has looked to cut costs in hopes of protecting its current profit margins, and Northrop Grumman is expected to suffer from lower sales volumes over the next few years.

One factor that puts General Dynamics in a particularly tough position is its exposure to capital-intensive products such as tanks and warships. Losing buyers for these products could mean trouble for a company that has already invested a great deal of money into these products.

Raytheon stands out in this group due to its ability to maintain higher profit margins than most companies in the industry.

Businesses with consistently high ROIC show that they're efficiently using capital. They also have the ability to treat shareholders well, because they can then use their extra cash to pay out dividends to us, buy back shares, or further invest in their franchise. And healthy and growing dividends are something that Warren Buffett has long loved.

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