Twenty-six down, 14 to go. That's the tally on the U.S. Navy's $29 billion Littoral Combat ship program so far.
Last month, as you may recall, the Navy awarded Lockheed Martin (NYSE:LMT) and rival shipbuilder Austal (OTC:AUTLY) twin $564 million contracts to build Littoral Combat Ship No. 25 ("LCS 25") and LCS 26, respectively. As of today, investors know who will be getting paid to build approximately 65% of the Navy's planned mixed fleet of 40 LCS warships and frigates (a derivation of LCS).
But what about the remaining 35%, worth about $10 billion in future revenue? What about the 14 ships that will still need to be built after LCS 26 slips into the water?
Change of plans
Late last year, Secretary of Defense Ashton Carter instructed the Navy to both slow its purchases of LCS warships, and cut its planned purchase amount from 52 vessels total, to just 40. More importantly for investors in the defense industry, SecDef Carter told the Navy to "down-select" just one design to be used for construction future ships -- and pick one company to build it.
Plans are still in flux, but last we heard, the Navy intends to build perhaps five more ships as LCS-variant minesweepers, and the final nine vessels as more heavily armed multi-mission frigates. The final decision on this change of plans won't be made until 2019. But if it comes to pass, no longer will LCS contracts be divided equally "one-for you, one-for-me" between Lockheed Martin and Austal. Rather, LCS will become a winner-take-all contract. Either Lockheed Martin will build the remaining ships, or Lockheed Martin will not.
And it's looking more and more like "not."
Could Lockheed lose?
Citing repeated "Corrective Action Requests" from the Navy, criticizing the quality of Lockheed Martin's shipbuilding, Bloomberg noted that Lockheed has yet to fix quality concerns dating as far back as May 2015. Importantly, Bloomberg reported that no similar CARs have been lodged against Lockheed's archrival on the LCS program, Austal.
Lockheed's response to these criticisms is that the three Freedom-class LCS vessels it has delivered to the Navy so far "have met or exceeded Navy specifications for quality and performance prior to acceptance." But that doesn't address the problems the ships have encountered after their acceptance. Specifically, two of the three ships USS Fort Worth (LCS 3) and the USS Milwaukee (LCS 5), have suffered breakdowns in the past six months. We haven't heard of any similar incidents afflicting Austal's Independence-class warships.
That's not an encouraging record of success. In a contest between two contractors, both vying for the same contract, and both charging roughly the same price for it, Lockheed Martin is making it far too easy for the Navy to decide to award future LCS contracts to Austal.
What it means to you
So what does it mean to investors? Lockheed Martin's revenue stream amounts to $48 billion in business every year. Losing $5 billion in expected LCS revenue, over a term of several years, will sting, but it won't inflict a mortal wound on Lockheed. In contrast, Austal does barely $1 billion in business a year as things stand. If Lockheed's lax quality controls end up handing the Australian shipbuilder the entirety of the remaining $10 billion in LCS funding, that will be a real windfall for the stock.
The upshot: Right now, the odds look to be in Austal's favor. Place your bets accordingly.