Image Source: Lockheed Martin
By Callum Turcan
Known around the world as the manufacturer of F-35 stealth fighters and Blackhawk Helicopters, Lockheed Martin Corporation (LMT) is the world’s leading defense contractor and as of this writing yields a nice 3.0%. While burdened by a significant net debt load, Lockheed Martin has consistently been a free cash flow cow enabling the firm to sport decent dividend coverage. Last year, 70% of Lockheed Martin’s net sales came from the US government, highlighting how domestic annual defense spending levels are very important to the company’s financial performance.
Growing Backlog
Lockheed Martin’s order backlog stood at $130.5 billion at the end of 2018, up 24% or $25.0 billion from year-end 2017 levels. The company expects to realize 38% of that backlog as revenue this year and another 28% next year, with the remainder to be realized thereafter. More importantly, Lockheed Martin’s ‘funded backlog’ came in at $86.4 billion at the end of last year, up 17% or $12.3 billion from year-end 2017 levels.
Its funded backlog covers orders that have already had the necessary funds approved and appropriated by the customer, namely national governments, meaning those sales are near certain to happen unless something big changes. ‘Unfunded backlog’ covers orders that haven’t have the necessary funds approved and appropriated yet, making those sales less certain. Most of that backlog total likely comes from the US government, though it wasn’t explicitly stated as such in Lockheed Martin’s 2018 10-K (however, it’s clear that Lockheed Martin does most of its business with the American government and that is highlighted throughout the annual report).
The F-35 program represented over a quarter of Lockheed Martin’s net sales last year, highlighting the significance the trillion plus dollar upgrade of America/NATO’s fighter jets has on its business profile. Bloomberg reported that the Pentagon will request 78 F-35 fighters for the US government’s fiscal year 2020, six less than previously expected. Lockheed Martin delivered 91 F-35 fighters in 2018, up from 66 in 2017.
Senator James Inhofe of Oklahoma chairs the Armed Services Committee, and he aims to triple F-35 deliveries by 2024. That’s an ambitious goal which will be subjected to the various shifts in where the domestic political winds blow, and the result of several election outcomes set to occur over the next five years. All three types of F-35, which were designed to meet the unique needs of the Airforce (F-35A), Marine Corps (F-35B) and Navy (F35-C), are now ready for combat operations.
Free Cash Flow Outlook
For a large industrial company, Lockheed Martin runs a relatively light ship when it comes to setting its capital expenditure budgets. The company generated over $3.1 billion in net operating cash flow in 2018 versus less than $1.3 billion in capital expenditures, allowing for $1.9 billion in free cash flow generation.
However, due primarily to a negative $3.6 billion working capital movement relating to its postretirement benefit plans, note Lockheed Martin’s net operating cash flow fell by over 50% in 2018 versus 2017 levels. That precipitous drop reduced Lockheed Martin’s free cash flow generation from $5.3 billion in 2017 to $1.9 billion last year.
Lockheed Martin paid out $2.3 billion in dividends and spent $1.5 billion on share buybacks last year, indicating its free cash flow wasn’t enough to fully cover its payout to investors. As that largely was a function of special items relating to its pension obligations, that should be viewed in relation to its past free cash flow generation. On average, Lockheed Martin generated $3.8 billion in annual free cash flow from 2016 to 2018. Past performance isn’t indicative of future performance, but it does offer a good starting point as to why Lockheed Martin’s weaker net operating cash flow in 2018 was more of a one-off event than a sign of a fundamental weakening of the company.
The company posted $53.8 billion in revenue and $5.9 billion in ‘Segment Operating Profit’ (which is a non-GAAP metric) in 2018, up 15% and 8% year-over-year, respectively. Going forward, the company expects 5% annual top line growth at the midpoint indicating a relatively positive outlook on domestic defense spending this year. Its Segment Operating Profit is forecasted to grow by 3% this year at the midpoint, indicating management is expecting non-GAAP operating margins to contract modestly in 2019. On a GAAP basis, Lockheed Martin’s operating margin climbed by 14 basis points in 2018 year-over-year.
Image Shown: Lockheed Martin’s outlook for 2019 expects top line and non-GAAP operating income growth. Image Source: Lockheed Martin’s fourth quarter of 2018 IR presentation
The company is forecasting that its cash flow from operations will bounce back this year to $7.4 billion, barring any extenuating circumstances, as Lockheed Martin’s core business keeps growing. Keep in mind management commented that capital expenditures were set to move higher this year during the firm’s latest quarterly conference call, which will put downward pressure on free cash flow.
That being said, it appears Lockheed’s free cash flow generation is set to soar this year as its capital expenditures are only expected to climb by $0.3 – 0.4 billion year-over-year while net operating cash flow is set to rise by $4.2 billion during that period.
Dividend Coverage
Lockheed Martin ended 2018 with $0.8 billion in cash on hand versus $1.5 billion in short-term debt and $12.6 billion in long-term debt. Its net debt position of $13.3 billion hasn’t stopped Lockheed Martin from roughly doubling its quarterly payout since 2013. We give the company a good Dividend Growth rating as management continues to allocate free cash flow to rewarding shareholders. Longer term, paring that burden down would go a long way in enabling stronger payout growth and making its existing dividend more resilient to negative external forces such as a global recession (possibly weakening overseas demand for its offerings) or a reduction in American defense spending (its biggest customer).
In order to systematically evaluate the strength and sustainability of dividend payouts across all types of industries, we utilize our proprietary Dividend Cushion Ratio. This ratio takes into account the firm’s projected net operating cash flow and capital expenditures over the next five years (its expected free cash flow) minus net debt (vis-versa for net cash), divided by its expected dividend payments over that period. A ratio over 1.25x is considered good coverage.
Lockheed Martin earns a Dividend Cushion Ratio of just 1.1x, but we adjusted its Dividend Safety rating to a good on the back of its ability to tap capital markets and due to its strong free cash flow generation potential. The ability to generate decent amounts of net operating cash flow while spending minimal amounts on capital expenditures, relatively speaking, is a big plus.
Image Shown: Lockheed Martin’s deconstructed Dividend Cushion Ratio derived from our rigorous discounted cash flow analysis
The company’s net debt position is almost entirely a product of its acquisition activity and ongoing share buybacks. We think that Lockheed Martin would have been better served allocating capital towards improving its balance sheet over the past few years. In 2015, Lockheed purchased Sikorsky Aircraft for $9 billion to gain greater exposure to the helicopter manufacturing industry (this is how Lockheed Martin became the producer of Blackhawk helicopters). Those splashy deals grab headlines, but they lead to debt accumulation if free cash flow isn’t directed towards paying that burden off.
Pension Liability Shifts
As mentioned above, Lockheed Martin recorded a large negative working capital movement relating to its pension obligations last year (to the tune of $3.6 billion). Here are a few abbreviated (for your convenience) excerpts from the firm’s 2018 10-K report;
First, in December 2018, an upfront cash payment of $810 million was made to an insurance company in exchange for a contract (referred to as a buy-in contract) that will reimburse the plan for all future benefit payments related to $770 million of the plan’s outstanding defined benefit pension obligations for approximately 9,000 U.S. retirees and beneficiaries…
As a result, there is no net ongoing cash flow to the plan for the covered retirees and beneficiaries as the cost of providing the benefits is funded by the buy-in contract, effectively locking in the cost of the benefits and eliminating future volatility of the benefit obligation. The buy-in contract was purchased using assets from the pension trust and is accounted for at fair value as an investment of the trust…
Also, during December 2018, we purchased an irrevocable group annuity contract from an insurance company (referred to as a buy-out contract) for $1.82 billion to settle $1.76 billion of our outstanding defined benefit pension obligations related to certain U.S. retirees and beneficiaries. The group annuity contract was purchased using assets from the pension trust. As a result of this transaction, we were relieved of all responsibility for these pension obligations…
Long-term, these moves should remove a major obstacle for Lockheed Martin as pension liability risks are often the sleeping downside catalyst few see coming until it’s too late. Just ask Sears Holdings Corporation (SHLDQ).
Concluding thoughts
Rebounding free cash flow generation makes dividend growth all the more likely going forward, even though Lockheed Martin’s large net debt load needs to be monitored at all times. If the company attempts to makes another splashy purchase, its balance sheet may take on more than it can chew if free cash flow isn’t swiftly allocated to bringing that burden back down. In 2017 and 2018, Lockheed Martin spent $3.5 billion repurchasing its stock. We argue that going forward, the company should start allocating free cash flow to debt repayment. As of this writing, Lockheed Martin trades decently above our fair value estimate ($272 per share), meaning the company would be buying back shares at what we consider premium prices.
Aerospace & Defense – Prime: BA, FLIR, GD, LLL, LMT, NOC, RTN
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Related: GE, UTX, HON
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Callum Turcan does not own shares in any of the securities mentioned above. Some of the companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.