The investment proposition for Lockheed Martin (LMT -0.75%) stock is far from simple. Several puts and takes could impact its near- and long-term earnings growth trajectory. In that vein, investors must consider a few things before putting money to work in the stock.
Lockheed Martin's margin headwinds and tailwinds
Lockheed Martin and competitors like Boeing and RTX have shared one big thing over the last few years. Namely, ongoing supply chain issues have constrained their ability to deliver products and put pressure on margins. Boeing and RTX have both lowered their full-year defense business expectations on account of them. It's incredibly disappointing because all three have excellent backlogs and good order momentum.
It's especially problematic on fixed-price programs signed in less cost inflationary days -- the defense contractor is left trying to execute a program while costs are soaring. In theory, these headwinds should turn into tailwinds in the coming years as the supply chain bottlenecks ease.
The good news is the supply chain issues are easing, but the bad news is they have extended longer than most expected. It's hard not to think the same geopolitical tensions causing the increasing interest in defense spending are also causing issues in the global supply chain.
Near-term risk and opportunity
Due to the unfortunate events of the last couple of years, there's an enhanced awareness of the need to spend on defense. There's also a need to replenish equipment used in the conflict in Ukraine, and Lockheed Martin bulls will point to the company's $156 billion backlog as a growth opportunity.
On the other hand, Lockheed Martin also faces near-term risks to its earnings related to two important programs. The first is a classified missile program in its missiles and fire control (MFC) segment. CFO Jesus "Jay" Malave prepared investors for the potential for margin pressure when commenting on 2024 during the third-quarter earnings call recently: "On segment margins, we expect the underlying business to be relatively flat year over year but anticipate variability caused by the timing of impacts from the MFC classified program."
Image source: Getty Images.
He went on to say the program, which is expected to be initially loss-making, could bring about "25 to 50 basis points of headwind" in 2024. Given that management expects a segment margin of 11.1% in 2023, these kinds of headwinds (100 basis points equals 1%) could reduce profit margins and expected profit by a low-single-digit percentage next year.
The second issue is meeting expectations for F-35 deliveries. Management lowered its expectations for F-35 deliveries this year to 97 from a prior estimate of 100-120 due to delays in hardware and software upgrades on the F-35 known as Technology Refresh 3, or TR-3.
Management plans to reach a delivery rate of 156 F-35s by 2025, but it will have to play catch-up in 2024 (due to the delayed deliveries in 2023), and hitting its target will be a challenge. It will be an even bigger challenge if there are any delays in the validation of TR-3.
Lockheed Martin's long-term risk is the same as its opportunity
Investors like the defense sector because its customers are about as secure as can be. Investors talk of U.S. government debt as being risk-free, so it's fair to say the financial solidity of Lockheed Martin's primary customer, the U.S. government, which accounted for 73% of Lockheed's revenue in 2022, is risk-free too. The trade-off of security of income for low growth is often seen as favorable, and the stock's 2.8% dividend yield doesn't hurt either.
Image source: Getty Images.
That said, defense budgets are subject to political risk. For example, on the earnings call in mid-October, CEO Jim Taiclet said the status of the budget, geopolitics, and the economic environment meant "we will provide our expectations for our 2024 financial outlook during our full year 2023 earnings call in January."
In addition, ratings agency Fitch downgraded the U.S. default rating earlier in the year and Moody's recently lowered its outlook to "negative" from "stable."
All of which is not to sound alarmist; suffice to note that all it will take is an incremental reduction in long-term growth expectations due to budget caps, and it will have a disproportionate impact on the earnings outlook for a low-growth company like Lockheed Martin.
Image source: Getty Images.
A stock to buy?
Trading at 16.3 times its expected earnings in 2023, the stock looks slightly undervalued, but not by that much. That could change with more clarity on the 2024 outlook, the margin impact from the classified missile program, and the TR-3 validation/F-35 deliveries question. Until then, Lockheed Martin is probably on the watch list for most investors.
