While already enjoying the throne as the largest U.S. defense contractor by sales, major manufacturer Lockheed Martin (LMT 1.63%) received a big boost today in the form of a spectacular third-quarter earnings report. The actual numbers paint a pretty picture for the defense giant, but as an investor, you need to know how this success will propel this company forward -- particularly with looming budget cuts threatening the defense industry at large. So what from today can we glean about Lockheed's prospects -- and what must you watch for to trust this company's future?
Expand electronics
Forget if you can about the weekly drama that is the F-35 jet fighter. While the aircraft certainly will deliver huge piles of cash to Lockheed from governments around the globe, a different, less-heralded division of the company has stepped forward to lay the foundation of the corporation's future.
Lockheed's Electronic Systems division, which seemingly produces everything under the sun -- from unmanned vehicles to missiles and fire control systems to providing logistics and training -- has grown to become the company's top-selling branch . It's outstripped more heralded divisions, such as its aeronautical branch and information and global systems division, and it was the only one of the company's four units to post annualized sales growth this quarter.
This isn't an isolated Lockheed trend, either. Defense supplier Rockwell Collins (COL +0.00%) also reported its commercial systems division, including the development of electronics systems, growing revenue even while sales growth lagged. Northrop Grumman (NOC 2.44%) provided an exception to this trend during this busy earnings week for defense corporations, but Northrop's earnings drop -- as compared with earnings growth at Lockheed, Rockwell, and other major companies -- suggests a deeper problem for the company.
Regardless, this is a division that Lockheed will have to keep growing as time goes on, and investors should expect the company to continue succeeding here. Selling costly aircraft such as the F-35 can take considerable time and investment that governments will at times back out of -- such as with Boeing's (BA 1.10%) F-22, which saw orders drastically reduced over its sales life.
However, electronics systems and related developments not only match the Department of Defense's shifting priorities of war, but also won't slam the department's budget as much as costly, shiny aircraft and tanks. Given that Lockheed made the best operating margin off its electronic systems branches, it seems the company should continue to invest here.
The company did announce it will split the division into two at of the end of the year -- Missiles and Fire Control (MFC) and Mission Systems and Training (MST). You'll want to keep your eyes on these in future quarters, but as an investor, you'll also need to look outside just America for Lockheed's growth.
Diversify internationally
Whether or not the federal government manages to hold off budget cuts, Lockheed will have to expand sales outside the United States. Currently, the company records more than 80% of net sales to the U.S. government, around the norm for many defense companies -- but not a sustainable number if Lockheed wants to prepare for the worst and greatly increase its growth potential.
Fortunately, the company has already made a few steps in the right direction. Company COO Chris Kubasik, who will take over as CEO next year, announced that 25% of this quarter's orders arose from outside the United States. That's a key step forward to Lockheed's goal of generating 20% of sales outside the country within two years.
Other companies have caught on to the plan as well. Competitor Raytheon's (RTN +0.00%) CEO William Swanson, in his company's recent quarterly report, emphasized the payoff of its own international expansion. Like Lockheed, Raytheon was able to expand margins even in the face of declining sales -- a key note to take advantage of if these companies do in fact manage to successfully spread to more overseas customers.
While the F-35, which has program partners in the United Kingdom, Italy, the Netherlands, Australia, and other nations, should help the drive, the company will need to continue diversifying globally. Given that the Pentagon already has planned budget cuts of $490 billion over the next 10 years even without sequestration's huge budget bludgeon, Lockheed won't be able to sustain domestic sales growth without either some drastic action or increased focus overseas.
Do something, Congress!
Unfortunately, a big chunk of Lockheed's future will rest on whether the U.S. government can hammer out an agreement regarding the fiscal cliff. CEOs from virtually every industry have blasted the looming budget nightmare, but the effects of sequestration -- with up to $1 trillion ready to come off the defense budget over 10 years -- could cripple Lockheed and its peers.
Indeed, much of even this good quarter probably could be chalked up to the DoD's considerable spending. The Defense Department grew spending by 13% between July and August, boosting much of Friday's surprising 2% growth in GDP and no doubt channeling much of that money into Lockheed and rivals' coffers. Even with that, Lockheed still took in reduced sales; imagine what happens if that spending falls dramatically. More diversified competitors such as Boeing have already taken steps to hedge against this possibility, but Lockheed, concentrated almost entirely in the defense sphere, must hold on to hope.
Granted, this company isn't in terrible shape if the government fails to act. By growing margins and reducing workforce, Lockheed should be able to hang on to its vaunted spot atop the defense ladder. Still, if you want to continue seeing the kind of growth that this company's shares have experienced in the past year, hope with all you have that the federal government can put an end to the budget madness.
Keep watching
Despite its great quarter, Lockheed clearly has work ahead of it to continue its solid growth. No doubt, this company can continue to stay atop the leader board of U.S. defense contractors if it makes the right moves and transitions leadership effectively next year. However, unless it manages to spread its influence around the globe while maximizing its most profitable divisions -- and getting a little help from the government while at it -- Lockheed could find itself in trouble. I have faith in this company for the future, but as a smart investor, stay alert for any developments that could dent this defense titan's armor.
