The Littoral Combat Ship, built by Lockheed Martin (NYSE:LMT) and Austal USA, has been plagued with cost overruns, design flaws, and a number of failures. In fact, the LCS performed so poorly that then-Secretary of Defense Chuck Hagel cut the Navy's LCS acquisition from 52 to 32 ships, and directed the Navy to appoint a Small Surface Combatant Task Force, or SSCTF, to "submit alternative proposals to procure a capable and lethal small surface combatant, consistent with the capabilities of a frigate."
The good news is Lockheed Martin addressed many of the issues plaguing the LCS, and now production is surging as the price has dropped. The bad news is the Navy has decided it wants a modified LCS -- which it's officially calling a frigate -- for ships 33-52. So, what does this mean for Lockheed Martin?
One of the LCS's big advantages is that it's a modular design. This allows it to be re-configurable and address three different primary missions -- surface warfare, anti-submarine warfare, and mine countermeasures . In addition, there are two different seaframes: the Freedom, built by Lockheed Martin, and the Independence, built by Austal.
Unfortunately, two of the LCS's big disadvantages include, "concerns over the ships' survivability (i.e., ability to withstand battle damage), [and] concerns over whether the ships are sufficiently armed and would be able to perform their stated missions effectively," states a recent Congressional Research Service report.
What's more, it was Lockheed Martin's Freedom variant that received the harshest criticism thanks to an additional range of issues including hull cracks and electrical failures, according to Breaking Defense.
The Navy wants a Frigate?
Because of the LCS's problems, the Navy's SSCTF recommended building a new small surface combatant ship, or SSC, based on a modified LCS. Furthermore, Secretary Hagel released a statement that said: "I accepted the Navy's recommendation to build a new small surface combatant (SSC) ship based on upgraded variants of the LCS. ... The more lethal and survivable SSC will meet a broader set of missions across the range of military operations, and addresses the Navy's top war-fighting priorities."
For Lockheed Martin investors, this naturally raises the question of who will build the Navy's new frigate? And the answer is ... the Navy hasn't decided. But Sean Stackley, the Navy's top acquisition official, did say that the Navy asked both Lockheed Martin and Austal to compete for the final 20 ships. However, when Stackley was asked if the Navy would continue to employ a 50/50 acquisition split (as is currently the case with the LCS), or if it will employ a new acquisition strategy, Stackley replied that it was too soon to say.
More mistakes on the horizon?
So far, the Navy hasn't released an acquisition strategy for the new frigate. Moreover, there are already concerns regarding the decision to acquire a modified LCS -- Ronald O'Rourke, a specialist in Naval Affairs, reported in a Congressional Research Service report that there are three things that should be done before an acquisition program is started:
- Perform an analysis to identify capability gaps and mission needs.
- Compare potential general approaches for filling those capability gaps or mission needs, so as to identify the best or most promising approach.
- Analysis to refine the approach selected as the best or most promising.
O'Rourke argues that one of the reasons the LCS program was inundated with problems is that the Navy didn't "perform a formal, rigorous analysis to show that a small, fast modular ship was not simply one way, but rather the best or most promising way, to fill the three littoral warfare capability gaps," before selecting the LCS. In other words, if the Navy had analyzed the LCS's capabilities before its decision to acquire it, it might have noticed that the LCS's survivability and lethality were an issue for its intended missions. O'Rourke continues by arguing that the Navy is making a similar mistake with the modified LCS.
What's more, the Senate Armed Services Committee seems to share his concerns, as it stated:
[T]he committee is concerned by the absence of analysis to identify the specific capability gaps and mission needs that the Navy is seeking to address, which would have been appropriate prior the Secretary of Defense's initial tasking. Without this analysis, it is unclear why the capabilities of the current LCS are inadequate and if the proposed modifications will be sufficient to address a defined warfighting gap.
The committee then directed the Navy to produce a report on LCS modernization, and an updated capabilities development document certified by the Joint Requirements Oversight Council, or JROC.
What we know
The Navy needs new ships -- whether that's the LCS, a frigate, or something else entirely. Further, Capt. Dan Brintzinghoffer, the frigate program manager, said the frigate is currently working its way through the JROC process, and a request for proposals with a detailed technical data package should go out in FY2017, according to USNI News. Of course, then Congress will have to approve its funding.
Nevertheless, if Congress gives the Navy the go-ahead, this contract could be worth a significant amount. For example, in the Navy's proposed FY2016 budget, it estimated that the combined procurement cost for three LCSs would be almost $1.5 billion, or an average of $479 million each. Add that to the fact that the Navy estimates that the modifications to the LCSs are expected to increase the procurement cost of each vessel by $60 million to $75 million, and you've got a contract that could be worth upwards of $10.8 billion for procurement alone. That's a significant amount of money, even by defense standards.
What to watch
Lockheed Martin's 2014 Annual Report doesn't specify how much the current LCS contract is worth to its overall portfolio or backlog. However, we do know that the LCS falls under Mission Systems and Training business segment, which in 2014 had net sales of $7.1 billion, and a backlog at year-end of $11.7 billion.
Moreover, Lockheed Martin lists the LCS as one of five major contracts under MST, and the latest DoD acquisition estimate for the 32 LCS seaframes is $21.8 billion. Simply put, the current LCS contract is pretty important to Lockheed Martin's bottom line, and a frigate contract would definitely add to that. Consequently, while there are a number of hurdles the new frigate needs to overcome before it's approved, this is something investors, especially Lockheed Martin investors, should keep tabs on.
Katie Spence has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.