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Lockheed Martin: A Critical Partner to the U.S. Government and Overseas Allies

Founded in 1912 during the dawn of flight, Lockheed Martin (LMT) is the world’s largest defense contractor and supplier of fighter aircraft. Though best known for its F-35 joint strike fighter, Lockheed has four major divisions that combined to generate $60 billion in revenue last year:

  • Aeronautics (40% of sales): designs, manufactures, and services combat aircraft as well as military transport planes and unmanned air vehicles.

  • Missiles and Fire Control (16% of sales): provides air and missile defense systems, air-to-ground weapon systems, and ground vehicles

  • Rotary and Mission Systems (26% of sales): builds and services military and commercial helicopters in addition to sea-based combat systems

  • Space Systems (18% of sales): designs and builds satellites, strategic and defensive missile systems, and space transportation systems

The majority of Lockheed Martin's business is with the U.S. government (70% of sales). International governments contributed another 28% to Lockheed's top line, and global commercial clients made up the remaining 2% of revenue.

Lockheed has paid uninterrupted dividends since 1995 and raised its payout each year since 2003.

Business Analysis
The need to defend territory and the desire to wield power is as old as civilization, and military might has always played a major role in human affairs.

Today, even in times of relative peace and prosperity, nations around the world invest almost $2 trillion dollars each year to protect their people and national interests, project power, and gain leverage in negotiations.

In fact, the U.S. government, which whom Lockheed does the most business, routinely spends over $600 billion annually on defense to maintain its position on the world stage as a global superpower.

Essentially, Lockheed Martin's products solve a timeless problem, and one that its primary customer (the U.S.) cares deeply about.

Furthermore, the problem of defense is one that's never fully solved.

The modern era of industrial warfare is characterized by the rapid development and spread of new technology, with each innovation creating a new standard to top. The advent of airplanes begot anti-aircraft guns, ballistic missiles have led to the development of hypersonic missiles, drones engender the need for anti-drone technology, and so on.

In turn, defense contractors like Lockheed enjoy many opportunities to develop and market new and improved defense systems. There are no one-and-done solutions to defense.

Nevertheless, threats come and go, and so have many companies in the industry as defense budgets have shifted over time.

For instance, in the decade after the Cold War, the U.S. cut back on defense spending by 60%, forcing many defense firms out of business or into consolidation with rivals in order to achieve scale and remain profitable.

To survive the downturn, Lockheed Corporation and Martin Marietta, two independent corporations, merged in 1994 to form Lockheed Martin. The result was a powerhouse that is now the largest defense contractor in the world.

Today, Lockheed Martin enjoys a scale and reputation that makes the firm an ideal partner for the U.S. government and severely disadvantages rivals.

For one, the government's trust is hard to win, especially when it comes to developing complex and expensive weapon systems that are critical to national security. Few, if any, other firms have as much experience and capacity as Lockheed to take massive decades-long defense projects from start to finish.

Lockheed is also able to invest about $1 billion per year in research and development to keep the company on the cutting edge, a sum that smaller rivals can't match. Additional research and development work is funded by Lockheed's government customers, creating even more integrated relationships which are difficult to disrupt.

In addition, sizable upfront investments are required to enter many of the bids Lockheed participates in. Few rivals can afford to risk large investments on uncertain, binary outcomes, especially when they're up against Lockheed.

In the late 1990s, for example, Lockheed spent $1 billion to design a joint strike fighter and win the largest contract in government history. The prize was the sole right to develop, produce, and service the F-35, a lucrative, $1.5 trillion program that is set to run until 2070. Lockheed's only competition in the bid was Boeing.

Competition has dwindled more in recent years as the defense industry continues to consolidate. In 2015, Lockheed acquired Sikorsky Aircraft for $9 billion, giving Lockheed a reliable stream of cash flow from Sikorsky's large fleet of Black Hawk helicopters while further cementing Lockheed's position as the U.S. government's go-to contractor for much of its defense needs.

Lockheed hasn't found success only at home, either. Abroad, many nations are resource-constrained and don't have the budget to develop their own weapons. Instead, these nations find it easier to outsource their defense needs to a trusted U.S. contractor. F-35s have been sold to eleven U.S. allies, for instance.

Lockheed's scale provides advantages again in many of these markets as it allows the company to deliver more cost-effective technologies. In fact, Lockheed is twice as as big Europe’s major defense companies combined.

Looking ahead, conditions appear favorable for Lockheed in the coming years. U.S. military spending is on the rise due to a need to replace legacy technology from the Cold War and as tensions in the Middle East and the Korean peninsula mount.

Lockheed has good visibility into its sales pipeline due to the long-term nature of contracts signed with customers. The company's backlog currently exceeds $140 billion, more than twice Lockheed's annual revenue in 2019.

Management expects earnings per share to grow 8-10% in 2020 as production and delivery of F-35s ramp up, which should provide flexibility for Lockheed to continue raising its dividend at a healthy clip, just as it has for 17 years in a row.

In many ways, Lockheed has become too big and too important to fail — and not just to the U.S. government, but to many overseas allies.

However, that doesn't mean there aren't several risks that could put a damper on Lockheed's long-term growth prospects.

Key Risks
While defense is a timeless problem, it's also a rather subjective one. The nature of defense is that it's rarely used, at least to its full capacity. Furthermore, no one knows how significant a threat is until it materializes.

As a result, opinions vary widely on how much to spend on defense, with some politicians decrying a need to reduce the defense budget while others promote spending more to ensure the U.S. maintains its status as a superpower.

Indeed, during the Obama administration military spending was cut in an effort to reduce the national deficit. Lockheed's sales growth was much slower in those years, and margins suffered as well, reflecting high fixed costs. Management warned that a sustained reduction in defense spending could impair the company's long-term prospects.

Spending rebounded during the Trump administration, but there's no saying what budgets will be authorized by future administrations and congresses.

The bottom line is that defense spending can be highly cyclical and unpredictable, and there's no guarantee that Lockheed's nearly $60 billion in annual sales is tenable. At the very least, Lockheed's recent rapid top and bottom line growth may not be sustainable over the long-term.

Moreover, it's possible that the rules of modern warfare change dramatically, which could in turn render Lockheed's products and expertise obsolete. Former Secretary of Defense Robert Gates put the risk this way:

"What all these potential adversaries have in common – from terrorist cells to rogue nations to rising powers – is that they have learned over time that it is not wise to confront the United States directly or on conventional military terms."

Conventional warfare probably won't disappear anytime soon, but disruption in the defense industry is not out of the question.

Lastly, Lockheed has a high dependence a single product: the F-35 fighter jet (27% of sales). While the jet appears likely to be a safe source of cash flow for decades, as investors learned with Boeing's 737 MAX, a reliance on any one product exposes a firm to a lot of risk should anything go severely wrong.

Concluding Thoughts on Lockheed Martin
As the largest defense contractor in the world, Lockheed Martin enjoys substantial competitive advantages in highly-specialized industries that solve timeless problems. Rivals can't compete with Lockheed's scale, expansive product offering, and entrenched relationships with the government.

Furthermore, Lockheed's decades-long lead in R&D and obtaining lucrative government contracts should allow Lockheed to sustain its position as the industry leader for the foreseeable future while enabling the firm to continue paying a safe, growing dividend.

However, defense spending is somewhat discretionary, calling into question how sustainable Lockheed's current growth rate is. If nothing else, investors should be comfortable with the possibility that Lockheed doesn't always remain a high-growth dividend stock.

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