Pentagon officials are growing frustrated with the pace of negotiations with Lockheed Martin (NYSE:LMT) over the next batch of F-35 joint strike fighters, highlighting the delicate balance between the contractor's desire to maximize its profit on the fighter and the government's push to bring down costs as much as possible.
On Feb. 28, Vice Adm. Mat Winter, the program executive officer of the F-35 Joint Program Office according to Defense News told reporters Lockheed "could be much more cooperative and more collaborative, and we could seal this deal faster," but said instead the company "choose not to" as a "negotiating tactic."
Winter had originally hoped to have a deal in place for 130 fighters, known as Lot 11, by last October, later pushing that goal back to year's end.
Winter said the Pentagon is "nowhere near" considering forcing a so-called unilateral contract agreement on Lockheed that would compel the company to abide by terms set by the government. The Department of Defense employed that rarely used tactic in November 2016 on Lot 9 of the F-35, a sign of how contentious negotiations have been over the most expensive weapons platform in history. The F-35 is expected to bring in more than $1 trillion in revenue for Lockheed and its partners over the next half-century or more.
Lockheed Martin surprised some watchers when it did not challenge the Lot 9 decision in court. The political climate surrounding the F-35 and other weapons programs was delicate at the time, with then President-elect Donald Trump tweeting about the high-cost of the F-35 and his preference to augment the fleet with lower-cost BoeingF-18 Super Hornets as a way of saving money.
Following those comments, it behooved the Pentagon to show that the cost of the F-35 was coming down, and Lockheed Martin was in a poor position to publicly challenge those efforts. Trump's rhetoric might also helped speed negotiations on Lot 10 of the jet, which were completed in about one year, with Lockheed in February 2017, after the agreement was announced, saying, "President Trump's personal involvement in the F-35 program accelerated the negotiations and sharpened our focus on driving down the price."
Lot 10 was significant because for the first time, the price of one variation of the F-35 came in below $100 million per jet. Winter would not tip his hand by saying publicly what price he is targeting in this negotiation.
What does it mean for investors?
There's almost zero chance that this dispute could ever cause funding for Lockheed's $1 trillion fighter program to evaporate. Indeed, at the same time as the frustrations over negotiations became public, the Pentagon was awarding Lockheed $158.2 million for support of modification and retrofit activities for F-35 air systems.
But that doesn't mean investors need not pay attention. Lockheed needs to hold the line here the best it can, because every subsequent batch of F-35s ordered will likely cost less than the previous one. If the company gives up too much here, the overall profitability of the aircraft over its lifespan will be diminished.
J.P. Morgan last year noted that the expectation for the F-35 is that it would achieve double-digit margins heading into the 2020s, but said that that projection would depend on the profitability of upcoming contracts.
Meanwhile, despite all the promise of the F-35, the plane has become an ongoing source of frustration inside the Pentagon. Nearly two decades after development of the fighter began, military testers are still complaining about issues with the aircraft, with the DoD's operational testing unit in January calling efforts to improve the F-35 "stagnant."
Following Trump's praise of the F-18, the Navy said in its fiscal 2019 budget outline that it plans to buy 110 Super Hornets over the next five years. Those jets won't completely erase the need for the F-35 -- the Navy wants to buy nearly 200 F-35s for it and the Marine Corps during the same period -- but contentious discussions could limit the fighter's upside.
Given that the F-35 already accounts for more than 25% of Lockheed sales, and that that percentage is expected to only rise in the future, this sort of uncertainty makes shares of Lockheed Martin less appealing than those of rivals like Raytheon or General Dynamics.
The sky isn't falling, but pay attention to the gathering storm clouds.