Lockheed Martin's (LMT 0.56%) stock has had an up-and-down year so far in 2013. Despite the looming threat of budget cuts from a cash-strapped Department of Defense, shares of this major military giant have still pulled in gains of more than 4% year to date. That hasn't kept up with many of the top stocks today, but considering the talk about devastating cuts late last year, investors have to be happy with this year's payoff so far.
The company reported earnings today, and while the financial data was solid, sequestration's arrival has only just begin. The good times could be ending soon for Lockheed and the rest of the defense sector if the worst of the budget cuts are still on the way. What do you need to know about this top defense stock's future? Let's dive into the details.
Sequestration looms large
Lockheed did well in its first-quarter earnings. The company grew its quarterly profit by 14% to top analyst projections, with one-time items weighing down those gains. Lockheed's revenue did fall slightly, but the company still easily beat Wall Street's estimates.
Fire control and missile systems did well for Lockheed, with sales at the unit growing 13%. Space system sales also grew by a more modest amount, and these growing businesses are a good sign for the company's future. They're all the more important after aeronautical sales fell 14% -- and that decline is still before major cuts are set to fall.
That drop wasn't enough to move Lockheed away from its earnings projections of between $8.80 and $9.10 for the full year, and investors were happy enough that the stock moved up more than 1% on the day. Still, company leadership is preparing for a huge blow from sequestration. How much are we talking? Try up to $825 million -- or nearly 2% of Lockheed's total projected sales of between $44.5 billion and $46 billion for the year.
Two percent may not sound like a lot -- it's less than many rivals are projecting, in fact -- but with all the challenges Lockheed's facing, that still-substantial hit could come back to haunt this stock.
Aeronautical sales facing a tough future
Sales of F-16 fighters and several cargo plane types weighed on Lockheed's aeronautical sales, and sequestration's substantial cuts could slam this business in future years. The F-35 fifth-generation fighter continues to be America's costliest defense boondoggle, and while the aircraft's development continues to slog along despite massive cost overruns and delays, it'll almost certainly see total U.S. sales slashed in the future.
Company CFO Bruce Tanner admitted that sequestration's next round of budget cuts will probably cut into F-35 production, with sales of the aircraft in 2014 and 2015 expected to be hit particularly hard. The DoD simply won't have enough financial resources at its disposal to afford significant numbers of the costly craft, particularly with military personnel benefits already under fire and planned defense employee furloughs generating plenty of controversy. Big-budget projects such as the F-35 can't evade the budget ax forever.
However, the company's hopes that international sales could ward off the worst of sequestration don't look promising. Fellow analyst Katie Spence outlined how major F-35 partners such as the Netherlands and Australia have already considered adjusting purchases of the aircraft because of its spiraling cost. However, new customers still thinking about buying into the program, such as South Korea, could be kept away by the F-35's overruns. The Asian nation is considering the fighter alongside Boeing's (BA 5.35%) F-15SE Silent Eagle -- part of the proven F-15 series, with Boeing boasting of lower costs and better value in the competition -- and BAE's (BAES.Y 0.75%) Eurofighter Typhoon, already a mainstay among many European air forces. The F-35's chances of winning South Korea's competition look slimmer with each cost overrun.
The changing nature of war won't help Lockheed's aeronautics division as the Pentagon searches for cuts. As warfare transforms from the massive military engagements of the 20th century to the insurgency- and cyber-dominated conflicts of today, cost-intensive programs such as the F-35 have less practical applications on the battlefield. As the DoD looks to invest in cyberwarfare and similar pursuits, expect big-budget projects in Lockheed's aeronautics branch to feel the pain.
It's far cheaper to build and supply a drone that can carry out an attack in a far-off country than to task a billion-dollar, fifth-generation fighter with the same role. Companies such as Northrop Grumman (NOC 0.54%), with its Global Hawk spy drone that has been heavily utilized in recent global security, have embraced this changing nature of aerial war. If Lockheed wants to turn around its aeronautical sales, it should do the same.
Dig in for the long haul
Sequestration doesn't mean Lockheed's dead in the water, however. The company's missile and fire control system should continue to perform well even with budget cuts, and the growing need for satellite launches in the public and private sectors should keep the company's space-launch sales moving higher.
However, the company won't escape without a scratch from budget cuts. In an industry where no player is safe from sequestration's blows, Lockheed -- and its costly, criticized F-35 program -- is facing its toughest challenge of the near future. This defense stock can still reward many investors in the long term, but if you buy, don't expect instant rewards in the DoD's budget cut-dominated climate.