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AMM Dividend Letter #42: Lockheed Martin (LMT)
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Welcome to the 7th episode of the AMM Dividend Growth Podcast. I’m Glenn Busch a portfolio manager with American Money Management and the lead portfolio manager for the AMM Dividend Growth Strategy. In this episode, I’ll break down our investment in Lockheed Martin, the subject of the 42nd issue of the AMM Dividend Letter. I’ll get into why we classify Lockheed as a dividend stalwart, how safe its dividend is, the catalysts for future price appreciation and dividend growth, the risks to our investment, and at the end I’ll tell you our estimate of fair value.
For the full show notes, transcripts, and links please head to www.amminvest.com/episode7. I’ll provide a link in the description too.
Let’s do the disclaimer and then get on with the episode.
[disclaimer]
This is our second investment in Lockheed Martin.
We first bought Lockheed Martin back in 2012 on the fears of a government shutdown and defense spending sequestration. The entire defense contracting sector sold off and picked up a couple names with Lockheed Martin being one of them.
When we first started the AMM Dividend Growth strategy we used a covered call option strategy to generate extra return. One of the challenges with a covered call strategy is that a position that has risen in price above the option’s strike price can be called away. Basically sold. The additional premium from selling covered calls is nice but too often we found that good businesses were getting called away.
After a year of ownership, we started selling covered calls against our Lockheed Martin position and of course Lockheed’s price rose above the strike price. Instead of buying back the calls or rolling the position, we let our position in Lockheed Martin get called away. The reasoning was we could always buy back the stock when it was a good value again.
It took a few years but we recently added Lockheed Martin back to portfolios as it appears to be a compelling enough value again.
As promised this episode features a dividend stalwart. Lockheed Martin has paid a dividend since 1995. And since 2002 the company grew its dividend at a compound annual growth rate of 20.06%. That rate has dropped down to 8.35% over the last five years. This is growth rate we expect with dividend stalwarts. High single digits with the occasional year of double-digit growth.
For dividend safety we have a checklist of 5 items. Again if you want to see the checklist or any charts mentioned in this episode you can download the Lockheed Martin Dividend letter through a link in the show description.
The first item is the dividend payout ratio. We want this below 60%. Lockheed’s recent payout ratio was 42.57%.
The second item is the cash dividend payout ratio. Again we want this below 60%. Lockheed’s cash dividend payout ratio is 67.04%. These cutoffs are more like guidelines and not hard and fast rules. We’re comfortable with Lockheed’s free cash flow growth and its current payout ratio.
The third item is free cash flow to equity coverage ratio. We want this over 100% ad Lockheed comes in at 373.14%.
The 4th item is the debt to equity ratio. We want this less than 1. Lockheed doesn’t pass. It’s debt to equity ratio is 5.17. The elevated debt to equity ratio comes after its recent purchase of Sikorsky Aircraft. We expect the debt to equity ratio to continue to decline over the years as Lockheed pays down debt and builds equity post-merger.
Lastly Lockheed Martin’s interest coverage ratio is well above the 2 times we’re looking for. It is 10.98 right now. Lockheed’s high interest coverage ratio also helps get more comfortable with their current debt to equity ratio.
The first catalysts for future price appreciation and dividend growth is a big one for Lockheed martin. The F-35.
The F-35 is the only 5th generation fighter in production right now. The F-22 raptor is the other 5th generation fighter in the U.S. arsenal but it is not in production right now. The F-22 is also built by Lockheed Martin.
So far only 350 of the total 2,400 F-35s ordered by the U.S. have been delivered. The delivery, revenue, and costs of the remaining aircraft will be spread over the next 5-10 years.
Then there are the F-35 sales to Australia, Canada, Denmark, Italy, Netherlands, Norway, the U.K., Israel, South Korea, and Japan. Japan has the largest order of F-35s with 147 planes.
Then there are also potential sales to Singapore, Greece, Romania, Spain, and Poland. Poland is freeing itself from its old soviet era equipment and its former status as a Warsaw pact country.
Then there are also potential sales to Persian Gulf countries like Saudi Arabia.
Over the next decade it is possible that Lockheed Martin is operating the only production line for manned aircraft in the Western World.
Lockheed benefits not only from the sale of the fighters but the long-term service of the planes and the need to upgrade the F-35’s avionics and weaponry.
And the F-35 is poised to become an aerial combat platform. The Loyal Wingman program is an effort to outfit the F-35 with its own squa of unmanned AI piloted drones. The drones would cost much less than a full F-35 and the drones could scout ahead, jam radars, carry extra and launch extra weapons, and maneuver itself to take a hit instead of the F-35 and its human pilot.
Kratos is in the lead right now with the XQ-58A Valkyrie. There is an Australian company working on it too.
The F-35 as a combat platform means the F-35 will be the dominant aerial fighter for a long-time and a large source of revenue and profits for Lockheed Martin.
Our second catalyst is missile defense.
This is another big military spending program that Lockheed is involved in.
Raytheon and Lockheed Martin are the duopoly in missile defense. The current missile defense system is designed to track ICBMs. It is not suited to track the new class of hypersonic missiles that Russia and China have developed.
Lockheed designed both the THAAD and Aegis systems so they won the contract to upgrade and modernize both systems.
The critical nature of missile defense and fire control and the expertise needed creates high switching costs. Governments are highly unlikely to switch to other contractors and risk disruption to their firing systems.
Missile defense is such high a need area right now that the U.S. and its allies are willing to spend more now to get the upgrades done.
The third catalysts is return on invested capital growth.
Lockheed’s return on invested capital dipped as it invested in the F-35 program. Then its return on invested capital dipped further after it bought Sikorsky Helicopters.
There is a chart in the full write up of Lockheed Martin’s return on invested capital over the last 10 years.
Now the F-35 build out is complete and sales of the F-35 are ramping up. Lockheed Martin’s return on invested capital should continue its recent growth back to historical levels. Growing return on invested capital combined with growing sales builds shareholder value and generates excess capital that Lockheed Martin can return to shareholders with higher dividends and share buybacks.
Lastly, just to circle back on its business moat. Lockheed Martin has decades of experience working with the department of defense and working within the military procurement process. It is the primary defense contractor for our combat systems. It is building our main fighter jet. Lockheed Martin also builds and launches the highly classified satellites our department of defense needs.
Lockheed Martin is a highly trusted partner because of its expertise and its ability to build what our defense department wants. And to do so with the upmost secrecy. The department of defense would be hard pressed to switch to other providers that it doesn’t have decades of working experience and trust with. It is because of this that Lockheed Martin has built a large business moat. It would be tough to win business away Lockheed Martin.
Now the risks.
If it’s the biggest catalysts, it is the biggest risk too. I’m talking about the F-35.
The F-35 is going to be the largest driver of revenue and profits for Lockheed in the foreseeable future.
It is a controversial jet based on its costs and its effectiveness. I by no means have the expertise to tell you if the F-35 is bad or good. I’ll provide a couple links in the show notes that can fill you in on the arguments for the F-35 and the arguments against the F-35.
The crux of the argument against the F-35 is it tries to be all things to everyone. Which is a problem with the current procurement process. The book The Pentagon Wars which was also made into a pretty funny movie with Kelsey Grammar and Carey Elwes gives you a look into the mess as through the development of the Bradley Fighting vehicle. Spoiler alert, the Bradley was a complete failure.
Aeronautics is 38% of Lockheed’s revenue and 30% of its operating profits. The F-35 accounts for 70% of aeronautics revenue and the bulk of its future growth. If the F-35 is the new Bradley Fighting vehicle then it will be a financial disaster for Lockheed Martin.
The good news is the Bradley fighting vehicle didn’t pass its field test. The F-35 has.
The F-35 is also a manned aircraft. It will eventually get is AI drones as support craft. The question is how long before all aircraft are unmanned?
If this switch comes sooner rather than later then the F-35 will also suffer.
The nest risk is the U.S. Nuclear Arsenal.
Our nuclear arsenal is old. I think this is still the case but as of 2016, the coordination of the U.S. nuclear triad ran on 1970scomputers and floppy disks.
Our nuclear arsenal needs an expensive overhaul to modernize old warheads, modernize delivery systems, and expand its capabilities.
The program is expected to cost$1.2 trillion over the next 30 years. This includes the replacement for the Ohio class submarine, the new B-21 bomber, and a replacement for the Minuteman 3 ICBM.
Lockheed, unfortunately, does not have a program for this major project. It will be involved with ancillary systems but nothing major. The big blow was Lockheed lost its joint bid with Boeing for the new B-21 bomber. This is a large revenue pool for Lockheed to miss out on.
For the second risk, I need to give you a little set up.
You have a billionaire industrialist that is building spaceships to start a post-Earth colony in a bid to escape a global catastrophe.
Are you thinking that this sounds like the plot to the James Bond movie Moonraker?
It’s not.
This is part of SpaceX’s vision. They want to build interplanetary spaceships to colonize Mars. The goal is to prevent human extinction is something happens to the Earth.
Side note. It’s incredible how far apart the movie Moonraker is from the original book.
Space is the new playground for billionaires. Jeff Bezos has Blue Origin. Elon Musk has SpaceX. And Sir Richard Branson has Virgin Galactic that is about to be publicly traded.
Lockheed and Boeing in partnership run the United Launch Alliance. This is about 15-20% of Lockheed Martin’s Space systems. SpaceX and Blue Origin want a piece of the government launch business. SpaceX’s launch prices drastically undercut United Launch Alliance. A Falcon 9 launch costs around $57 million versus an estimated cost of $380 million per launch for Lockheed’s Atlas rocket.
SpaceX is private company. Despite it claim that they are profitable, there are indications that SpaceX is pricing its services at a large loss to win business.
Both SpaceX and Blue Origin are pushing the reusability of their rockets. Reusable rockets have a standard design with not a whole lot of room for customization. Government launches tend to need more room for customizations to facilitate the satellites they want to launch. So we’ll see how much business SpaceX and Blue Origin can win away from United Launch Alliance.
To value Lockheed Martin we used a discounted cash flow model and we come to a value of $410 per share. Currently, the company is trading at a slight discount to our estimate of fair value and we’re still adding it to new accounts and existing accounts that are below its portfolio target weight.
If you’re an individual investor or a financial advisor that is interested in the AMM Dividend growth strategy. Give me a call at (858) 755-0909. Our minimum for accounts is $50,000 if you’re an individual and we offer a separately managed account if you’re an advisor.
Thank you for listening. If you enjoyed this episode please leave us a rating and review in your favorite podcast player to help others find us. Again if you want to subscribe to the AMM Dividend Newsletter and download the full write-up on Lockheed Martin there is a link in the show description.
Until next time.
