On July 23, the Department of Defense announced that Lockheed Martin (LMT -0.32%) was awarded a $1.5 billion modification for its foreign military sales contract for Patriot missiles, and associated equipment. Specifically, Lockheed Martin will produce and deliver PAC-3 and PAC-3 MSE missiles for the Kingdom of Saudi Arabia, Qatar, the United Arab Emirates, the Republic of Korea, and Taiwan.
More importantly, while $1.5 billion is a fair amount of money, it's the fact that this is a foreign military sale that's especially good news for Lockheed Martin. Here's why.
The new piggy bank
In 2014, the United States spent almost $610 billion on military expenditure. Yes, $610 billion! That's a staggering amount of money. However, it's decidedly less than what the U.S spent in 2013 (almost $640 billion), 2012 (almost $685 billion), and 2011 (over $711 billion), according to the Stockholm International Peace Research Institute, or SIPRI. More importantly, this downward trend in military spending is expected to continue thanks to the 2011 Budget Control Act, or BCA.
For defense contractor like Lockheed Martin, the above is bad news because it means they'll likely see a reduction in profits given the fact that the U.S. government is their main source of funding. Luckily, while America is looking to shrink its military spending (although it still spends three times as much as China, the next top military spender), other countries are actively growing their military expenditure.
For example, in 2014, Saudi Arabia spent $80.8 billion on its military, which was a 17% increase from 2013. This was probably a reaction to escalating instability and conflict in the surrounding region, according to SIPRI. And while there aren't available figures for Qatar's 2014 military expenditure, last year it announced orders for $23.9 billion worth of weapons. Moreover, as a whole, the Middle East spent an estimated $196 billion on military expenditure in 2014, which was a 5.2% increase from 2013, according to SIPRI. Clearly, this is good news for defense contractors such as Lockheed Martin.
International markets to the rescue
The U.S. government will probably always be Lockheed Martin's No. 1 customer -- in 2014, 79% of Lockheed Martin's $45.6 billion in net sales were from the U.S. government -- but thanks to the uncertainty of the BCA, and future defense spending, strong international sales will become increasingly more important sources of revenue for defense companies.
In fact, Lockheed Martin states in its 2014 annual report: "In 2014, 20% of our net sales were from international customers. We have a strategy to grow international sales over the next several years." Lockheed Martin continues by saying it expects to grow international sales to 25% over the next few years.
Accordingly, Lockheed Martin's recent $1.5 billion PAC-3 Missile Interceptor deal is welcome news because it shows that Lockheed Martin is successfully expanding its international market -- Lockheed Martin states that the PAC-3 "currently provides missile defense capabilities for six nations -- the U.S., the Netherlands, Germany, Japan, United Arab Emirates, and Taiwan; and Lockheed Martin is on contract with four additional nations – Kuwait, Qatar, South Korea, and Saudi Arabia."
To sum it up
In response to decreased U.S. defense spending, Lockheed Martin states in its 2014 Annual Report, "[W]e are seeking to lessen our dependence on contracts with the U.S. Government by focusing on expanding into adjacent markets close to our core capabilities and growing international sales." Furthermore, Lockheed Martin lists the PAC-3 as a key element in helping to drive this international expansion; it states, "Our MFC business segment produces the Patriot Advanced Capability-3 (PAC-3) and Terminal High Altitude Area Defense (THAAD) air and missile defense systems, which continue to generate significant international interest."
Simply put, in order to help offset the decline in U.S. government spending, Lockheed Martin is expanding into other markets, and the PAC-3 is a key part of that strategy. Given the increase in military spending in countries like Saudi Arabia and Qatar, this expansion seems like a smart move.
More importantly, this strategy is already helping Lockheed Martin's bottom line. For example, according to Lockheed Martin's annual report, in 2013, Lockheed Martin made over $45.3 billion in net sales -- almost $37.2 billion was from the U.S. government, $7.7 billion was from international sales, and $417 million was from commercial and other sales. In 2014, Lockheed Martin made $45.6 billion in net sales, which was an increase from 2013. However, if you look closer you'll see that Lockheed Martin only made $36.1 billion from the U.S. government, which was a decrease of almost $1.1 billion in net sales. But, Lockheed Martin's international net sales offset that decrease -- in 2014, total international net sales came to a little over $9 billion.
Consequently, because of the increased importance of foreign military sales, investors would do well to continue to monitor Lockheed Martin's foreign military sales, and make sure that it is increasing, and not declining.