When you're thinking of investing in a defense industry stock but don't know quite where to start, here's one obvious choice: Lockheed Martin (LMT 3.08%).
The biggest pure-play defense contractor in the world today, and one of the leading forces in the broader aerospace and defense industry as well, Lockheed Martin boasts annual revenue streams worth nearly $45 billion. That makes Lockheed one-third bigger than the defense arm of chief rival Boeing, whose space and defense businesses produced "only" $33.6 billion in 2013.
Lockheed is also a very profitable operation, earning a cool $3 billion profit last year. According to S&P Capital IQ data, that was up 8.5% from 2012 -- a neat trick in a world in which defense budgets are falling. This strong financial performance is probably the key reason why Lockheed Martin stock has outperformed the S&P 500 by nearly a factor of two over the past 52 weeks, rising more than 40%.
And yet, for all the pluses surrounding Lockheed Martin's stock, the company has a few minuses as well -- minuses that in time could begin pulling its share price back down to earth. Here are three of them.
Artist's rendering of Lockheed Martin "OTEC" green energy platform in China. Source: Lockheed Martin.
Revenue diversification projects may wash out
Being the world's largest defense contractor isn't always a good thing. For example, you've probably heard by now that defense budgets are being cut -- not just in the United States, but around the world. Obviously, that's not great news for Lockheed Martin, which saw revenue tumble 3.9% in 2013 and then fall a further 2.3% (year over year) through the first half of 2014.
The good news is that Lockheed Martin is taking steps to diversify away from defense, adding new revenue streams from such "trendy" business lines as desalination, green energy, and even robotics. The bad news is that, so far, these new lines of business are too small to "move the needle." Buried within a business as big as Lockheed Martin, they don't even register on an income statement dominated by billion-dollar line items such as aeronautics, missiles and fire control, and space systems.
Here be Dragons, and Lockheed Martin had better watch out. Photo: SpaceX.
Watch your 6 -- SpaceX is gunning for Lockheed Martin
Speaking of space, for as long as anyone can remember, Lockheed Martin has been one of the two top companies involved in the space race. Alongside partner Boeing, Lockheed Martin simply dominates the business of space launches for commercial and government customers, raking in more than $8 billion in revenue last year. Lockheed is the No. 2 recipient of contracts from NASA, booking upward of $1.75 billion in contracts in 2013.
But now, much of this revenue may be at risk.
In June, Lockheed Martin consultant Loren Thompson complained in the pages of Forbes magazine that new legislation under consideration in Congress threatens to "effectively bar [Lockheed Martin] from the military launch market." As Thompson described it, a bill aimed at cutting ties with Russia in punishment for its actions in Ukraine would forbid awarding Pentagon space launch contracts to companies that use Russian-supplied engines in their rockets. Lockheed Martin, which along with Boeing forms the United Launch Alliance that currently sends most Pentagon satellites into space, uses such Russian rockets. SpaceX does not -- and SpaceX's desire to upset United Launch Alliance's monopoly over Pentagon space launches is well-known, and well-documented.
If the legislation in question passes in its present form, Lockheed Martin could lose the right to bid on billions of dollars' worth of space work for the government. That would take a big chunk out of that $8 billion space business -- the company's second-most profitable segment, as calculated by operating profit margin. Granted, the risk of Congress "accidentally" shutting Lockheed out of the space business in this manner seems slim. But the company, at least, appears to believe it is real.
Lockheed's last "Lightning" fighter was the P-38 (right). To its left is the plane that some say will be the last manned fighter plane, period. Photo: Lockheed Martin.
A big, fat bull's eye for budget cutters
Moving from "slim" to fat, let's finally look at Lockheed Martin's F-35 stealth fighter jet. The "JSF," as it's commonly known, is a marvel of technology. It's nigh-invisible to radar, can fly at speeds up to Mach 1.6, and one version of the plane can even launch and land vertically. Reviewing the plane's specs, Adm. Mike Mullen, then-chairman of the U.S. Joint Chiefs of Staff, exclaimed in wonder: "There are those that see JSF as the last manned fighter. I'm one that's inclined to believe that."
And yet, in an era of declining defense budgets, the very fact that the F-35 was designed to be "the last manned fighter" -- and to replace the U.S. military's varied fleets of F-15s, F-16s, F-18s, and so on, with a single do-it-all fighter jet -- has turned the F-35 program into the largest weapons acquisition project in the nation's history. Experts estimate the F-35 will cost American taxpayers upward of $1.1 trillion over the next 60 years.
That humongous price tag makes the F-35 a big fat target for congressional budget cutters, and it doesn't help that the program is over-budget and behind-schedule. Already, some analysts are decrying the F-35 as "a colossal waste of taxpayers' money" and suggesting it's time to kill the program before it gets any bigger. Add the fact that every once in awhile the odd F-35 might spontaneously burst into flames, and you can see why Lockheed Martin's biggest advantage just may be the biggest liability for its stock as well.
Foolish takeaway
To sum up: In Lockheed Martin stock we have the opportunity to own the world's largest defense contractor and a defense business that has shown it can grow profits even as revenue streams shrink. Those are two big attractions. But Lockheed Martin stock also brings significant risks.
Chief among these is the risk that Lockheed's luck will one day run out, and the company will find itself unable to keep profits growing as defense revenues decline. Multiplying that risk is the likelihood that Lockheed's biggest potential source of revenue, the F-35 fighter jet program, will come under continual attack from congressional budget cutters -- threatening to accelerate the revenue decline. Add in the unlikely, but still possible, scenario in which Congress accidentally kills off Lockheed's space launch franchise, and it's clear that the stock, seemingly priced at a modest 18 times earnings, might not be as cheap as it looks.
Caveat investor.
Some might say that Lockheed Martin has struck gold with the F-35 contract. But not all rainbows end in a pot of gold. Photo: Lockheed Martin.
