Stock analysts would probably describe the numbers that Lockheed Martin (LMT 1.71%) reported last week as a "mixed" quarter -- earnings above estimates, but revenue below them, and below consensus guidance besides. But investors' reaction to Lockheed's results was anything but mixed.
Thanks largely to its Q3 earnings report, shares of the defense giant surged to close last week 16.7% higher than they began the week. Clearly, investors were impressed with Lockheed's results -- but should they have been?
Lockheed by the numbers
Reporting $6.71 per share in net profit on sales of $16.6 billion, Lockheed Martin essentially transformed a rather modest 4% sales increase year over year into triple the profits it earned in the year-ago quarter.
Now, don't get too excited about the improvement. Last year's Q3 earnings were depressed by a charge for pension contributions, and without that charge weighing it down, Lockheed Martin's profits were free to rise this time around. What's more interesting about Lockheed's earnings, though, is that as big as the earnings number was when calculated according to generally accepted accounting principles (GAAP), the company actually produced a free cash flow number that was 50% bigger.
Total after-tax net income earned in Q3 at Lockheed, it turns out, came to $1.8 billion. Free cash flow for the quarter, however -- the company's actual cash profit -- came in at a much stronger $2.7 billion. And while that might not be literally triple the free cash flow number of a year ago, it still worked out to a 69% increase in cash profits. Not too shabby.
Cash is king
Why are cash profits better than the "accounting profits," as calculated under GAAP, that most investors focus on? Well, for one thing, cash is something a company can use to sign dividend checks, and pay for share buybacks, which reduce shares outstanding, resulting in larger per-share profits in quarters and years to come.
In that regard, Lockheed spent $2.1 billion of its $2.7 billion in free cash flow on dividend payments and share buybacks in Q3 ... and then proceeded to raise its dividend by 7%, and raise its share repurchase authorization to $14 billion. Other cash the company deployed to grow its capacity to build more of the kinds of weapons systems that have been so in demand during the Russia-Ukraine war -- Javelin antitank missiles and HIMARS rocket artillery systems, for example -- as well as F-35 stealth fighter jets.
Valuing Lockheed
With the financial year now three-quarters done for Lockheed Martin, management also updated investors on its financial expectations for 2022 as a whole. Unfortunately, the news on this front wasn't quite so good as the news up above.
Through year-end, Lockheed now expects its sales to top out around $65.2 billion, with $21.55 per share in net income and about $6 billion in free cash flow. Valued on a simple P/E ratio, that works out to about a 21.2 earnings valuation on Lockheed Martin stock, and a slightly cheaper free cash flow ratio of 20.
For a stock that most analysts polled by S&P Global Market Intelligence expect to grow earnings at only 6.5% over the next five years, that's a pretty pricey valuation, working out to PEG and price-to-free cash flow-to growth ratios of more than 3.0. (For context, you generally want a PEG or P/FCF/G ratio to be below 1.0 to be sure a stock is a bargain).
Granted, Lockheed does pay its shareholders a nice dividend yield -- about 2.6% at the stock's current share price. Granted, too, Lockheed's plan to repurchase as much as $14 billion worth of its stock -- more than 10% of shares outstanding -- promises to concentrate future earnings among fewer shares. If implemented in full, investors can expect this stock buyback to boost future earnings per share growth and potentially permit Lockheed to exceed expectations for 6.5% earnings growth.
All that being said, with a PEG ratio three times the usual threshold indicating fair value in a stock, about the most I can say for Lockheed Martin right now is that its Q3 earnings report makes it look like a better investment than it appeared to be one quarter ago. But I still cannot say definitively that it looks like a "good" investment.
