Lockheed Lands $1.2 Billion F-16 Contract

Three years ago, Lockheed Martin (LMT 0.01%) suffered a setback -- but Lockheed is back, baby!

From 1994 to 2004, the Republic of Korea paid $5.5 billion to Lockheed Martin to build 134 KF-16C/D fighter jets under license from the American defense contractor. Nearly a decade later, however, as those fighter jets were beginning to show their age, Korea hired not Lockheed, but its British rival BAE Systems (BAES.Y -2.50%) to upgrade the jets to a new KF-16V (for "Viper") configuration, featuring advanced Active Electronically Scanned Array radar systems, modernized avionics, a new high-resolution display, and greater data transfer speeds for communication.

Lockheed Martin calls the F-16 Falcon, in its F-16V configuration, "the most technologically advanced 4th generation fighter in the world." Image source: Lockheed Martin.

That upgrade contract was supposed to be worth $1.7 billion in sales to BAE, but it didn't take long for prices to begin spiraling out of control. Last week, this situation resulted in an upset for Lockheed Martin, when the U.S. Pentagon announced that Korea has chosen to take the F-16 contract away from BAE, and give the remainder of the work back to Lockheed Martin.

Data source: Yahoo! Finance.

What it means to Lockheed Martin

It's not 100% clear how much of BAE's original $1.7 billion contract it was able to bill before losing the business to Lockheed Martin. Certainly not all of it, because in its contract announcement, the Pentagon confirmed that Lockheed will receive $1.2 billion for its share of the upgrade work. So what does this mean to Lockheed?

$1.2 billion is equal to about 2.4% of the business that Lockheed Martin does in a year, and this money will flow into Lockheed's aeronautics business, which earns 10.7% operating profit margins -- implying profits from the contract could total $128 million or more.

In this particular instance, however, the $1.2 billion will be spread out over the course of the nine years it will take to complete upgrades on Korea's air force. Thus, this contract win, while sizable on the surface, actually works out to only about $133 million in extra incremental revenue for Lockheed, adding only roughly $14.2 million to Lockheed's annual profits -- or $0.05 per share.

Should you buy Lockheed Martin stock?

When you consider that Lockheed Martin earned $17.10 per share over the past 12 months, this adds further perspective to the F-16 upgrades contract. Simply put, within the context of a company as gigantic and profitable as Lockheed, no single contract -- even one worth $1.2 billion -- provides a compelling reason to buy the stock.

To know whether Lockheed Martin stock is a buy, therefore, you have to go back to the basics: You have to examine the valuation:

Data sources: Yahoo! Finance and S&P Global Market Intelligence.

Valued on its price-to-earnings (P/E) divided by growth, Lockheed Martin boasts a PEG ratio of 1.8. Factor in the 2.8% dividend yield, and the stock sells for a total return ratio of less than 1.3. Both those valuations seem a bit high (an impression reinforced by the 1.5 P/S ratio, which is about 50% more expensive than my rule-of-thumb valuation for defense stocks). The stock looks even more expensive once you factor in Lockheed's $11.4 billion net debt load.

Meanwhile, Lockheed Martin's free cash flow has been lagging reported net income lately, with the result that the company's price-to-free cash flow ratio (16.1) and enterprise value-to-free cash flow ratio (18.5) are even more expensive-looking than the plain-vanilla P/E.

So what's the upshot of all this? Lockheed Martin is a terrific company -- big, profitable, and winning huge contracts every day of the week. Lockheed Martin is not, however, a cheap stock. If you're looking for bargains in the aerospace and defense sector, you're best advised to look elsewhere.