Lockheed Martin's (LMT -0.75%) latest presentations highlight the puts and takes from investing in the stock. There's a case for buying and a case for selling the stock, and it's somewhat nuanced on either side. In that line of thought, here's a brief look at each side of the story so you can decide before putting money to use in the stock.
The bulls' case for Lockheed Martin stock
Given the heightened geopolitical tension in the world right now, there's no shortage of interest in military spending. That's the case whether it's based on replenishing equipment provided in existing conflicts or procuring equipment for future defense needs. Indeed, Lockheed Martin continues to grow its backlog, now at $156 billion.
Data source: Lockheed Martin presentations. Chart by author.
On top of that, the bulls will argue that Lockheed Martin and other defense companies have a margin growth opportunity from easing the tough cost conditions they've suffered in recent years.
The cost pressures come from two interconnected sources. The first is the ongoing supply chain pressures resulting from the economic dislocations caused by the lockdowns and the conflicts. Aerospace and defense companies face continuing issues with procuring materials and labor availability.
The second is working through legacy contracts inked in a far less inflationary environment -- a significant problem on fixed-price contracts, as Boeing investors know all about. Unfortunately, costs have risen much more than expected when the deals were signed.
As you can see below, margins have definitely been an issue for Lockheed Martin this year, and none of its four segments has improved profit margins so far this year. That said, that's where the company is now, but it's where it is going with its profit margins that really matter.
|
Operating Margin |
First Nine Months 2022 |
First Nine Months 2023 |
|---|---|---|
|
Aeronautics |
10.6% |
10.4% |
|
Missiles and fire control |
14.8% |
14.2% |
|
Rotary and mission systems |
11.8% |
11.2% |
|
Space |
10% |
9.2% |
|
Total business segment operating margin |
11.5% |
11% |
Data source: Lockheed Martin presentations.
Putting these points together, the bullish argument is that supply chain issues will continue to ease, and defense companies will work through legacy contracts as they sign new deals and increase the margin profile in their backlogs. As such, they look set for increased revenue growth (due to end demand and delivering on backlogs) and a more favorable cost environment.
The bears' case for Lockheed Martin
The bearish argument accepts Lockheed's potential for near-term margin expansion. However, it points out that despite the increased interest in defense spending and the growing backlog, Lockheed Martin is still a low-single-digit growth business. In addition, its margin challenges are occurring in the business (missiles and fire control, or MFC), growing its backlog the fastest.
Looking closely at the first chart above and interpolating the data (by assuming that the September backlog is the same at year end) shows that the space and the rotary and mission systems segments have grown backlog at a low-single-digit compound annual growth rate since 2019 (in line with the total backlog growth), aeronautics has slightly declined, and MFC is the only segment that's grown backlog at a mid-single-digit rate.
Unfortunately, there appear to be some potential near-term issues with the MFC segment's margins related to a classified missile program the company is working on. The subject matter came up on the recent earnings call with CFO Jesus Malave: " ... it's been a headwind. It's something that we've talked about for the upcoming number of years, including next year. And in fact, we are seeing some of the headwind this year," he said.
CEO James Taiclet argued that "it will be massively NPV positive over that longer time frame." NPV means net present value, meaning that future earnings and cash flows will offset current losses after discounting for the cost of capital. In other words, you can assume some near-term losses here from the classified program, which will negatively impact the MFC segment margin.
Thinking longer term, there's no guarantee that defense spending will continue to grow at the current rate or that governments will be able or willing to fund it over the long term. If you buy defense stocks, you have to accept political risk.
Image source: Getty Images.
Is Lockheed Martin stock a buy?
Ultimately, Lockheed Martin looks like a mature, low-growth company trading on 18 times its estimated 2023 free cash flow. While it does have a margin expansion opportunity from easing supply chains and working through legacy contracts, it also has uncertainty around the impact on margins from a classified missile program.
On that basis, the stock looks slightly undervalued. That may not prove to be a compelling conclusion, as everyone prefers to buy a stock when it's undervalued. Still, at the least, the stock is worth monitoring with a view to buying on any significant market-led weakness.
