Lockheed's Strategic Moves Impress, Backlog Raises Concern

We issued an updated research report on the prime defense contractor Lockheed Martin Corp. (NYSE:LMT) on May 20, 2016.

This defense giant not only reported better-than-expected first-quarter 2016 earnings in spite of incurring severance expenses, but also boosted its full-year outlook for earnings, revenues, operating profit and cash flow.

Lockheed Martin continues to be a strong cash generator, helping it to take important cash deployment decisions. The company had cash from operations of $1.56 billion in the first quarter of 2016, up 63.3% year over year. After spending about $151 million in capital expenditures in the quarter, it had $1.41 billion of free cash flow.

The company paid dividends of $533 million and repurchased shares worth $501 million. Thus, it returned $1 billion to its stockholders in the first quarter. It is important to note here that Lockheed Martin returned $5 billion to its stockholders in 2015, the largest in the company’s history, representing 120% of the year’s free cash flow.

Apart from its shareholder friendly moves, Lockheed Martin looks to focus on its core defense manufacturing business and strengthen its competitive position. The Sikorsky acquisition last year − the largest by Lockheed Martin in more than two decades − boosted its position as the world’s largest defense contractor, pushing it deeper into the military helicopter business.

Meanwhile, Lockheed Martin has agreed to separate and combine its Information Systems & Global Solutions or IS&GS division with Leidos using a Reverse Morris transaction valued at about $5 billion. Lockheed Martin’s shareholders will receive 50.5% of the equity value of Leidos (valued at $3.2 billion) and the company will receive a one-time cash payment of $1.8 billion.

The Leidos deal, which is expected to close in the second half of 2016, still needs approval from its shareholders. The company expects the portfolio to be faster growing with higher returns following the divestiture to Leidos. The new portfolio will have somewhat less exposure to short-cycle businesses that are more affected by budget volatility.

That said, budget deficits and political uncertainty make future defense budgets vulnerable to cutbacks. Although the present defense budget is more in favor of the sector, the earlier cuts have put pressure on the top line of these major contactors. A large percentage of Lockheed Martin’s business comes from the U.S. government (78% of sales in 2015) that includes 58% from the DoD.

Declining backlog is also a concern. Lockheed Martin had earlier stated that the 2016 backlog would decline $4–$5 billion year over year because of weaker Sikorsky commercial helicopter orders and the timing of orders in Space Systems. It expects a $90–$95 billion backlog for 2016. After a significant boost in 2015, maintaining almost a $100 billion backlog seems to be challenging. Lockheed Martin ended the first quarter (on Mar 27, 2016) with $97.9 billion in backlog, down 1.7% from $99.6 billion at 2015 end.

Zacks Rank

Lockheed Martin carries a Zacks Rank #3 (Hold). Some better-ranked stocks in the aerospace and defense equipment industry include TransDigm Group Incorporated (NYSE:TDG) , Engility Holdings, Inc. (NYSE:EGL) and CAE Inc. (TO:CAE) . While TransDigm sports a Zacks Rank #1 (Strong Buy), Engility and CAE carry a Zacks Rank #2 (Buy).

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