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Why Lockheed's Not in the Pentagon's Crosshairs

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US defense spending continues to be a target of government budget cuts on Capitol Hill. While this clearly impacts US defense companies, industry leaders like Lockheed Martin (NYSE: LMT  ) may do better than expected.

Home of the brave and their weapons
As the world's largest defense company, Lockheed Martin develops a range of defense technology and information systems, but is most renowned for aircraft, especially iconic U.S. fighter jets such as the F-16 Falcon, F-22 Raptor, and F-35 Lightning.  

According to the US Office of Management and Budget, total US defense spending fell from $879 billion in 2011 to $850 billion in 2012.  Spending is estimated to be $823 billion in 2013, and further reductions are expected in the years ahead. 

For a company like Lockheed Martin, this trend should be a red flag.  After all, the US Department of Defense is Lockheed's largest customer, and the company derives over 80% of it's revenue from the US government.  Sure enough, Lockheed has already lowered guidance for the year ahead, citing expected government budget cuts. 

However, the outlook for Lockheed may not be as bad as it seems.  Here are a couple of of reasons why. 

Lockheed in the trenches
First, consider what it takes to become the largest defense contractor for the US government.  In addition to large amounts of capital and resources, it also requires decades of specialized knowledge, experience, and connections related to working with the government.  Lockheed has literally dug itself in with US military and defense programs.

Even if the government wanted to, it would be difficult to switch vendors.   For example, Morningstar points out that after decades of using Lockheed as the sole provider of fighter aircraft, switching to another provider would mean totally revamping a program designed around generations of Lockheed systems and technology.  

Of course this isn't exclusive to Lockheed. The same can be said for other companies like Raytheon (NYSE: RTN  ) , a prominent defense technology firm.  Raytheon develops things like radar, communication, and missile systems that are crucial to modern day defense.  Like Lockheed, Raytheon is a leading vendor to the US government. 

The point is that these companies are so entrenched with existing defense programs that replacing them would be too costly and unpractical.   That makes a company like Lockheed an essential and virtually infallible partner of the US government.  

Proactive and effective management

A second consideration is that Lockheed has shown it knows how to successfully manage its business in different defense spending environments.  For example, in the third quarter Lockheed reported lower year-over-year revenue, which was widely expected.  However, both margins and earnings were actually higher than the year before.

This was the result of Lockheed taking quick and decisive actions to reduce costs as sales slowed.  This type of proactive management is part of why Lockheed has a strong track record of performance. The table below shows how Lockheed has grown revenue, income, and cash flow over the past ten years (all dollars in billions):

Measure 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Revenue  3.18  3.55  3.72  3.96  4.18  4.27  4.51 4.58  4.64  4.71
Income  1.05  1.26  1.82  2.52  3.03  3.21  3.02  2.64  2.66  2.74
Cash Flow  1.66 1.92  2.53  3.29  3.85  4.06  3.78  3.39  3.46  3.73 

Source: Standard & Poor's, BCM

Lockheed's strong performance can also been seen in measures like return on assets (ROA) versus its peers.  For example, leading defense technology firm Northrop Grumman (NYSE: NOC  ) , known for weapons like the Stealth B2 Bomber, has an average ROA of 5.71% for the past five years.  Raytheon has an average of 7.62%.  Meanwhile, Lockheed has an average ROA of 8.07%.  The five-year average for the Aerospace and Defense Industry is 6.27% (figures according to Thomson Reuters).

Lockheed also outperforms from a return on equity (ROE) perspective.  However, ROA may be more applicable, because Aerospace and Defense companies generally carry a lot of debt on their balance sheets.  ROE only uses equity in its calculation, but ROA considers both debt and equity.  That said, in this case, Lockheed shows more effective earnings generation in both measures.

In Summary
Shrinking defense spending will obviously have an impact on Lockheed's revenues. However, as long as the US maintains a military presence, a deep-seated incumbent like Lockheed will have a place at the government's table, and will receive ongoing (albeit fluctuating) orders from the defense budget.

Perhaps more important than the size of the government's budget is whether or not Lockheed can successfully manage operations through the changing defense spending cycles.  Based on Lockheed's track record of strong performance, the answer seems to be yes.

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Victor Lai

Victor K. Lai, CFA is an investment professional, a financial writer, and a life-long student of investing.

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