Lockheed Martin – Wait For A Better Valuation

I have reviewed Lockheed Martin (LMT) in several previous posts accessible through the FFJ Archives. My most recent post was on April 19, 2022 at which time I considered LMT to be unattractively valued.

I now revisit LMT following the July 19, 2022 release of Q2 2022 results.

Financials

Q2 2022 Results

LMT's Q2 2022 results and FY2022 guidance are reflected in material released on July 19.

Q2 sales of $15.4B were lower than expected due to the delay in the contract agreement on the F-35 and supply chain impacts. However, new business activity and order flow were favourable; management continues to anticipate an order backlog at FYE2022 significantly above FYE2021 levels.

LMT's Q2 results fell short of expectations with $1.16 in GAAP EPS suggesting LMT had an abysmal quarter. Investors, however, need to look closely at what contributed to this low EPS level.

Debt Refinance

On May 5, 2022, LMT refinanced some of its debt that was to mature over the next few years to lower its near-term exposure to interest rate risk. 

Looking at the Consolidated Statements of Cash Flows, LMT received net proceeds of ~$2.3B from a debt issuance of senior unsecured notes. These notes consist of:

• $0.8B of 3.90% Notes due 2032;
• $0.85B of 4.15% Notes due 2053; and
• $0.65B of 4.30% Notes due 2062.

The net proceeds from this debt offering were used to redeem all of the outstanding $0.5B of 3.10% Notes due 2023, $0.75B of 2.90% Notes due 2025, and $1B of its $2B 3.55% Notes due 2026; LMT incurred a $34 million charge ($26 million, or $0.10 per share, after-tax) on these transactions.

LMT's debt balance at the end of Q2 2022 remained unchanged after this refinancing was completed.

Pension Liability Transfer

Over the past several years, many companies with defined benefit pension plans have sought to eliminate their legacy pension liabilities and costs when markets are favourable.

Many organizations that sponsor one or more defined benefit pension plans have a significant portion of their balance sheet and income statement tied to and influenced by the volatility of pension liabilities and assets. Accounting for the long-term nature of these liabilities has always been complex thereby making it difficult to interpret operating results when pension finance is blended into the numbers. ASU 2017-07 was designed to provide more transparency in the sponsoring entity’s (LMT in this case) operating results while providing more alignment between pension accounting under US GAAP and international accounting standards.

In Q2 2022, LMT undertook a pension liability transfer with the purchase of group annuity contracts from Athene Holding Ltd., a leading retirement services company. Under the contracts, LMT has transferred ~$4.3B of its gross pension obligations and related plan assets for ~13,600 U.S. retirees and beneficiaries to Athene. The contracts were purchased using assets from LMT's master retirement trust and no additional funding contribution was required as part of this transaction.

This is LMT's 7th such transaction to reduce long-term risk and volatility of pension trust asset returns. Looking at LMT's Q2 Balance Sheet, the long-term accrued pension liabilities declined from ~$8.32B at FYE2021 to ~$5.81B at the end of Q2 2022. On the Q2 2022 Consolidated Statements of Cash Flows, we see a $1.47B Pension settlement charge. This is a noncash, non-operating settlement charge.

In FY2021, LMT recorded a $1.665B Pension Settlement charge and its long-term accrued pension liabilities declined to ~$8.32B from ~$12.874B at FYE2020.

Free Cash Flow (FCF)

In Q2, LMT's cash from operations was $1.3B and CAPEX amounted to ~$0.304B leaving ~$1B in Q2 FCF versus $1.142B in FCF in Q1 2022. The Q2 2022 operating and free cash flows were comparable to Q2 2021.

LMT continues to aid its suppliers by accelerating payments. In Q2, LMT accelerated payments of $1B to suppliers.

Once again, cash deployed to shareholders exceeded FCF. In the first half of FY2022, LMT returned 178% of FCF through dividends and share repurchases.

Outlook

Management's FY2022 outlook revision stems partially from supply chain challenges. These headwinds will likely to continue for the remainder of FY2022.

When LMT released Q1 2022 results on April 19, 2022, management indicated its FY2022 outlook did not include any impact from potential debt refinance or pension liability transfer actions that were under evaluation.

The expectations for segment operating profit and FCF flow remain unchanged despite a lower sales outlook. This reflects solid YTD results and management's focus on operating performance.

The reason FY2022 sales have been lowered by ~$0.75B to ~$65.25B is that 3 of 4 of LMT's business areas are experiencing supply chain headwinds. Furthermore, there have been changes to the timing of contracts being awarded and program schedule shifts. The impact of lower anticipated sales volume, however, is expected to be offset by improved margins for the year.

The $5.15 reduction in projected adjusted diluted EPS for FY2022 reflects the impact of one-time items, such as the pension transfer, debt refinancing and year-to-date mark-to-market adjustments. This revised outlook also assumes an agreement is finalized in Q3 on the Lots 15 - 17 F-35 production contract (see below).

F-35 Contract Update

On July 18, LMT signed a bilateral record of negotiation with the US government, reaching an agreement on the Lots 15 - 17 F-35 production contract. Through a collaborative effort, the major parameters of the program address inflationary and pandemic-related issues unanticipated at the start of the negotiation process. This new agreement supports LMT's long-term objective to produce 156 F-35 aircraft a year.

COVID impacts have required LMT to modify its near-term production plan. Deliveries over the next 2 years are expected to remain in the 147 - 153 range of aircraft, similar to the 2022 plan before achieving the 156 aircraft delivery target in 2025 and the foreseeable future.

The total value of the contract is likely to be ~$30B. Investors, however, should note this agreement is a starting point for finalizing contract pricing and award. The awarding of the contract will likely not be locked in for several weeks or months so the value of the total contract is uncertain. The final aircraft quantity in this agreement might change based on any adjustments made by the US Congress in the FY2023 budget and any orders requested by international partners.

The most common version of this fighter jet is the F-35A which flies conventionally from runways. The first aircraft of that version came off the production line in 2007 and each jet cost ~$0.221B. Subsequently, production quantities and know-how have increased thereby helping the price of each stealthy fifth-generation fighter to fall to $79 million as it has gained buyers; the F-35 has had several recent successes in jet fighter competitions, including Finland, Switzerland and Germany. Potential customers include Greece and the Czech Republic.

A previous Pentagon 3-year 'block buy' versus annual contracts, signed in 2019, was for 478 F-35 fighter jets. This allowed LMT to buy larger quantities of components to reduce costs by about 8%, to $34B.

Credit Ratings

There has been no change to LMT's senior unsecured domestic currency debt ratings from the time of my previous review.

• Moody's: A3
• S&P Global: A-
• Fitch: A-

These ratings are the lowest tier of the upper-medium investment-grade level and define LMT as having a STRONG capacity to meet its financial commitments. It is, however, somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than obligors in higher-rated categories.

Dividends and Share Repurchases

Dividend and Dividend Yield

In Q2, LMT distributed ~$0.744B in dividends versus ~$0.767B in Q1 and $0.762B and $2.9B during Q4 and FY2021.

When I reviewed LMT on October 27, 2021, the yield was ~3.4%.

At the time of my January review, shares were trading at ~$380 and the $2.80 quarterly dividend yielded ~3%

I last reviewed LMT on April 19, 2022 at which time shares were trading at ~$460; the $2.80 quarterly dividend yielded ~2.4%.

LMT is currently trading at ~$390 thus resulting in a dividend yield of ~2.9%.

LMT repeatedly states its commitment to reward shareholders through dividend increases (see dividend history); the $2.80 dividend payable on September 23 will be the 4th at this level. The past several dividend increases have been ~$0.20/share. I anticipate LMT will announce a $3.00 quarterly dividend in September (payable toward the end of December).

LMT generates ample Operating Cash Flow and Free Cash Flow to service its dividend.

Share Repurchases

LMT is a prolific acquirer of its issued and outstanding shares. The weighted average number of issued and outstanding shares in FY2011 - FY2021 (in millions rounded) is 340, 328, 327, 322, 315, 303, 291, 287, 284, 281, and 277. In Q1 2022 this had declined to 269.2 with a further decline to 265 at the end of Q1. The weighted average diluted shares outstanding in Q2 2022 was 266.7 but at the end of Q2, this had dropped to 264.

LMT has targeted ~$4B in share repurchases in FY2022. In Q1, it executed a $2B accelerated share repurchase agreement. In Q2, LMT's capital deployment included the repurchase of 9 million shares for ~$0.356B. This excludes 6 million shares received upon settlement of an accelerated share repurchase agreement (ASR) in April 2022 for no additional consideration.

I remain confident LMT will continue to strategically repurchase a prudent number of shares at favourable valuations to enhance long-term shareholder returns.

Valuation

In FY2013 - 2021, LMT's diluted PE levels were 16.02, 19.47, 19.27, 18.81, 26.04, 24.80, 18.51, 15.16, and 16.38.

When I wrote my July 26, 2021 post, LMT traded at ~$368. Using the $26.85 mid-point of management's FY2021 guidance, the forward adjusted diluted PE was ~13.71.

In addition, FY2021 and FY2022 guidance from 24 brokers was:

• FY2021 - mean of $26.68 and low/high of $26.46 - $27.25. Using the current share price and the mean, the forward adjusted diluted PE is ~13.8.
• FY2022 - mean of $27.89 and low/high of $26 - $29.77. Using the current share price and the mean, the forward adjusted diluted PE is ~13.2.

When I wrote my October 27, 2021 post, LMT traded at ~$332. Management's FY2021 diluted EPS guidance was ~$22.45 resulting in a ~14.8 forward diluted PE. Its adjusted diluted EPS guidance was ~$27.17 thus giving us a forward adjusted diluted PE of ~12.2.

In addition, the two discount brokerage platforms I use reflected the following broker guidance although I believed this guidance would likely be adjusted shortly to account for the most recently released financial results.

• FY2021 - 17 brokers - mean of $22.78 and low/high of $21.88 - $27.17. Using the current share price and the mean, the forward adjusted diluted PE is ~14.6.
• FY2022 - 20 brokers - mean of $27.19 and low/high of $25.02 - $29.15. Using the current share price and the mean, the forward adjusted diluted PE is ~12.2.
• FY2023 - 14 brokers - mean of $28.52 and low/high of $26.88 - $30.05. Using the current share price and the mean, the forward adjusted diluted PE is ~11.64.

At the time of my January 25, 2022 post, LMT shares were trading at ~$380. LMT has just reported FY2021 diluted EPS of $22.76 giving us a diluted PE of ~16.7.

Management's FY2022 guidance called for $26.70 in diluted EPS. Using the ~$380 share price at the time of that post, the forward diluted PE was ~14.2.

The adjusted earnings estimates on the two discount brokerage platforms I use had not yet been adjusted to reflect the most recent results and guidance. Based on the information currently available, however, I arrived at the following forward adjusted diluted PE levels.

• FY2022 - 20 brokers - mean of $26.27 and low/high of $24.14 - $27.50. Using the current share price and the mean, the forward adjusted diluted PE is ~14.5.
• FY2023 - 16 brokers - mean of $27.81 and low/high of $25.46 - $29.05. Using the current share price and the mean, the forward adjusted diluted PE is ~13.7.
• FY2024 - 6 brokers - mean of $28.13 and low/high of $27.60 - $28.80. Using the current share price and the mean, the forward adjusted diluted PE is ~14.

Using Q1 2022 results, the FY2022 outlook of $26.70 in diluted EPS, and a current share price of ~$462, the forward diluted PE was ~17.3 when I wrote my April 19, 2022 post.

Furthermore, the following were the forward adjusted diluted PE levels based on the adjusted earnings estimates reflected on the two discount brokerage platforms I use.

• FY2022 - 18 brokers - mean of $26.80 and low/high of $26.52 - $27.20. Using the current share price and the mean, the forward adjusted diluted PE is ~17.2.
• FY2023 - 20 brokers - mean of $28.19 and low/high of $25.90 - $29.10. Using the current share price and the mean, the forward adjusted diluted PE is ~16.4.
• FY2024 - 14 brokers - mean of $28.84 and low/high of $26.62 - $30.00. Using the current share price and the mean, the forward adjusted diluted PE is ~16.

LMT's valuation was less appealing than at the time of prior reviews.

LMT is now trading at ~$390 and management's revised FY2022 adjusted diluted EPS outlook is ~$21.55. This leads to a forward-adjusted diluted PE of ~18.1.

The following are the forward adjusted diluted PE levels using the adjusted earnings estimates from the two discount brokerage platforms I use.

• FY2022 - 11 brokers - mean of $22.67 and low/high of $21.75 - $26.70. Using the current share price and the mean, the forward adjusted diluted PE is ~17.2.
• FY2023 - 19 brokers - mean of $28.38 and low/high of $26.56 - $29.25. Using the current share price and the mean, the forward adjusted diluted PE is ~13.7.
• FY2024 - 13 brokers - mean of $29.19 and low/high of $28 - $30.16 Using the current share price and the mean, the forward adjusted diluted PE is ~13.4.

I expect revisions to these broker estimates over the coming days.

IF we add back the $4.33 one-time pension settlement to management's new ~$21.55 FY2022 adjusted diluted EPS guidance, we get $25.88 (versus the previous $26.70). With shares trading at ~$390, the forward adjusted diluted PE is ~15.07. This valuation is approaching levels reflected in my late-2020 and 2021 posts at which time I was acquiring LMT shares.

Final Thoughts

LMT was my 8th largest holding when I completed my Mid 2022 Investment Holdings Review. This ranking has undoubtedly changed after the end of June but LMT is likely still a top 20 holding.

LMT's products are indispensable especially when you consider the high probability of increased conflict over the coming years.

Despite a ~$90 share price pullback from the ~$480 52-week high, investors looking to invest in Lockheed Martin should wait for a better valuation.

Based on my analysis, I will patiently wait for a better valuation before adding to my position.

I wish you much success on your journey to financial freedom!

Note: Thanks for reading this article. Please send any feedback, corrections, or questions to [email protected].

Disclosure: I am long LMT.

Disclaimer: I do not know your circumstances and am not providing individualized advice or recommendations. I encourage you not to make any investment decisions without conducting your research and due diligence. You should also consult your financial advisor about your specific situation.

I wrote this article myself and it expresses my own opinions. I do not receive compensation for it and have no business relationship with any company mentioned in this post.