The Government Accountability Office (GAO) has advised the Pentagon to hold off moving into full-rate production with the F-35 fighter until the plane's crucial issues are resolved, a potential new delay before lead contractor Lockheed Martin (LMT 1.63%) is able to fully cash in on the long-troubled program.
The GAO, in an annual report on the program, lists 966 open deficiencies in the F-35 as of January, and said that about 20% of them will not be resolved before full-rate production under the Pentagon's current schedule. The Department of Defense is currently testing the F-35s that have been built, and is scheduled to decide on whether to formally move the program into full production in October 2019.
A F-35 flies inverted during firing drills. Image source: Lockheed Martin.
"In its rush to cross the finish line, the program has made some decisions that are likely to affect aircraft performance and reliability and maintainability for years to come," the GAO wrote, referring to plans to resolve crucial deficiencies after full-rate production begins. "Resolving these deficiencies outside of the developmental program may contribute to additional concurrency costs, which also carries affordability implications."
There's almost no scenario where the United States abandons the F-35, but the GAO report is a fresh reminder that even after 17 years of tests and refinements, the plane remains a complicated (and expensive) mess. Given that the F-35 already accounts for about one-third of Lockheed Martin's revenue and is expected to generate about $1 trillion in sales for the company and its subcontractors over the next 50 years, investors need to stay on top of the issues even if cancellation is highly unlikely.
Yet another speedbump
The Pentagon responded that it agrees with the GAO recommendations and will follow them, though it stopped short of promising that all fixes will be complete before a decision on an order is made.
The F-35 has been billed as the last piloted fighter jet, to be used for the remainder of the century. And Lockheed's efforts to future-proof the plane have led to significant trial and error and more than $150 billion in cost overruns.
The report mentioned more than 100 so-called category 1 deficiencies that could put lives at danger, including ongoing issues with a helmet designed to display crucial information, but which tests have shown can limit the pilot's line of vision. Software updates and tweaks to the display are expected to solve those issues, but those efforts are still in progress.
The production decision would be the big payoff for Lockheed, with the United States expected to commit to buying upward of 100 jets per year over the next 12 years at a list price north of $80 million per jet. With the bulk of Lockheed Martin's development costs already baked in, and thanks to the higher margins that come with larger orders, the production phase for the F-35 would be the most profitable part of the program for the contractor.
Progress on the cost side
Lockheed has been under pressure to bring down the per-unit cost of the F-35, and the GAO said the contractor and United Technologies-owned (UTX 0.80%) Pratt & Whitney, maker of the plane's engines, have made good progress in that area. The average number of hours of labor needed to manufacture a baseline F-35A has dropped by more than half to 41,541, from 108,355 in 2012.
The average total hours spent on scrap, rework, and repair per aircraft has fallen to 6,237, from 20,125 in 2012, a sign that the companies are getting better at making the planes. And the planes are increasingly being manufactured in the proper production sequence as Lockheed has worked out bottlenecks with key suppliers, including Northrop Grumman, which is responsible for key radar components.
"These improvements in airframe manufacturing efficiency indicate that manufacturing processes are stabilizing and coming under control, and production capability is improving," the GAO concluded.
Relief, not a rally
Lockheed Martin shareholders can be relieved that there are not any deal breakers in the GAO report, just a checklist of items the Pentagon needs to consider before fully committing to the F-35. The fighter will almost certainly become a mainstay of the U.S. military for decades to come, and Lockheed Martin will profit from being the lead contractor.
The issue for investors is that by the time the F-35 production order comes, it will likely be greeted more with a sigh of relief than a share rally. Even after some recent weakness, Lockheed Martin trades near historic highs relative to earnings and commands the highest price-to-earnings ratio among U.S. primes.
Lockheed has other businesses that could help offset any F-35 production delays, but there are geopolitical concerns and other risks surrounding those businesses as well. The best-case scenario for Lockheed investors is for firm orders to come in as soon as possible, removing any uncertainty.
If you hold Lockheed Martin, there's no reason to sell. But there are better buys in defense right now, even if the F-35 is slowly making progress toward its destination.
