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Lockheed Martin Still Top of Defense Heap

Lockheed has a highly differentiated business, but its legacy pensions and budget cutbacks are an overhang.


Erik Kobayashi-Solomon: Hi, I'm Erik Kobayashi-Solomon, co-editor of Morningstar's OptionInvestor. Today, it's my great pleasure to welcome Neal Dihora, who is an analyst covering aerospace and defense companies here at Morningstar.

Neal, thanks for coming.

Neal Dihora: Thanks for having me, Erik.

Kobayashi-Solomon: So, just recently I have written a lot about Lockheed Martin. It was a successful option investment that we just closed, on large part because of your valuation. I wanted just to ask about Lockheed a little bit.

First thing is, Lockheed, most of its revenues are coming from one client, the Department of Defense. Right now, there's an enormous amount of wrangling going on about fiscal things. What's your take on the status of LMT's business right now?

Dihora: That's a great point. The current budget issues are a negative headwind for Lockheed, so let's just back up a little bit. Lockheed gets 60% of revenues from the Department of Defense, 85% from U.S. government as a whole, including other federal agencies, and 15% from international.

Kobayashi-Solomon: So, just in general--85% from the government, and the government is not doing so well in terms of liquidity.

Dihora: Yes, the Budget Control Act passed by President Obama in August outlined $350 billion of cuts over 10 years, starting in 2013 for DoD, but we don't even know what that number is for the rest of federal agencies.

So, yes, I think there is some headwind coming for Lockheed, but they do have some good things. They have the F-35, which is a very, very long program. They are on other platforms as well, and they are a pretty diversified company. They do business with a lot of different agencies. So, it's not like they are going to go away, it's just that they do see headwinds coming forward.

Kobayashi-Solomon: Sure. Now you just mentioned the F-35, this is the Joint Strike Fighter. There has been some news about it lately. It looks like the kind of hovering version of the F-35, some of the tests were good. What's your take on the F-35 project, and what do you think of the economic impact it's going to have?

Dihora: I'll start with the second portion. We think the F-35 is worth 31% of Lockheed's fair value, as you see it at, about $22 out of the $71 that we call out.

The F-35 is going to be a great program. It's just a matter of timing. What we are really going through right now is technology development. Lockheed is being asked by the government to come up with fancy, fancy things, is the way I'll say it. But at the same time as they find new issues with the program, they have to go back and fix them, at the same time they are trying to build this program. …

Kobayashi-Solomon: I have heard that there is just an enormous amount of software code and that this is one of the really complex things that they are having to deal with, right?

Dihora: Just imagine that we're trying to get a plane to hover and take off, and then turn its engine and just go at Mach 1.9 or whatever the top speed is. That's going to take a lot of time to figure out. And software, to your point, there are five different codes that have to be developed over the entire program, and right now we are at software one. And I think two is being tested. So, we are releasing these software things slowly, but surely. I think it's just a matter of timing. And prior versions of new aircraft, you have seen the same sort of issues. We started out thinking that F-35 is going to cost us $230 billion; it's at $380 billion. But this isn't really out of the norm. I think people are sort of worked up because it's a big number, and it is, but it's our only fifth-generation aircraft. So, I think it's going to be successful. It's just a matter of when it's going to be successful.

Kobayashi-Solomon: So, it has good prospects. It's a long-term thing, but there is a lot to go from A to B…

Dihora: Sure. I truly agree. We really believe that it's our only option that we have. It's the only fifth generation aircraft we have, and if we think about the world today, it's not getting any safer, and other countries want to develop next-generation technology.

So, we have put all of our eggs in this F-35 basket, but the reality is, Lockheed has done something fifth-generation, the F-22 Raptor.

Kobayashi-Solomon: The F-22, right.

Dihora: So, it isn't unprecedented, it's just taken a lot longer. And the issue really is that DoD continues to ask for more, not less, and Lockheed has to re-engineer some of these things. So, we're actually pretty positive on the F-35, but it is a matter of timing. So the timing does impact the net present value, and so we do have these issues.

Kobayashi-Solomon: Of course. So, talking about valuation, I think, one of the big changes--you've brought the fair value of LMT down some, and I think most of that change had to do with pension accounting. My eyes will roll back if you go into details of the pension accounting, but just briefly what kind of impacts do the pensions have?

Dihora: So, I'll do a per-share value of the impact of the pension. Lockheed has taken down its share count 19% over the last two years. So the impact is going to be more than what we thought it was two years ago nonetheless, even if we made no changes. But Lockheed has $11 billion of pension and postretirement expenses on their books of pension plans that they had issued before 2006, and those things represent nearly $35 of per share value. Whereas our prior thought was that it wasn't as big of an impact, we think the full $35 is now a negative impact. So, we've taken down our fair value to $71.

Kobayashi-Solomon: I guess, too, there is some kind of mechanism by which the government might pay some of this and now with ... more budgetary problems, this looks a little less likely?

Dihora: I'd look at it a little bit differently. I think the cost accounting system, which is how the government pays for it, it's a timing issue between how Lockheed actually gets paid. So, the more budget issues, the longer it may take for the government to refund these.

But all-in-all, Lockheed gets paid in pension just like any other institution; they charge somebody for it. And the difference in government is you have to point out exactly what the dollar amount is, whereas if you go out and buy a GM car, they don't tell you that you need to pay $1,100 for my pension, they just say it's somewhere in that price.

Kobayashi-Solomon: Well, Neal, thanks very much for coming in and talking to me about it.

Dihora: Thank you for having me.

Kobayashi-Solomon: Thank you for joining us. Please stop by the Morningstar OptionInvestor website, where you'll find many more Option ideas based on Morningstar's Fundamental Research.


Erik Kobayashi-Solomon does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.