Lockheed Martin (LMT) is cheap

Shares of Lockheed Martin have been pressured all year by the shake-up in the U.S. defense budget. The firm’s stock has recently traded even lower on weaker-than-expected 2010 guidance, which has caused analysts to take a conservative view on long-term revenue growth and margins.

These concerns have pushed Lockheed’s valuation near historical lows, but the firm’s long-term potential remains intact. Much of Lockheed’s revenue is tied to the baseline defense budget, which is not the focus of U.S. defense spending cuts. The firm’s other main source of revenue is the next-generation F-35 Joint Strike Fighter plane, which serves as a very unique growth driver that other defense contractors envy.

Pension costs are another concern among investors, with significant headwinds likely in 2010 and 2011. However, the majority of pensions costs are covered by the government – pension expense is much less important for defense contractors than in companies with primarily commercial business.

Lockheed’s profitability is top-class. The company’s return on equity is over 50%, which means they generate more than 50 cents worth of profits from each dollar invested by shareholders. For comparison sake, the S&P 500’s trailing 12-month ROE is 3.62%.

The company also generates an impressive $8.74 of free cash flow per share of common equity. Free cash flow allows a company to reinvest in its own business for growth and, in turn, boost shareholder returns. Lockheed also does a great job of returning free cash flow to shareholders through stock buybacks and growing dividend payments.

Trading just above 9 times forward earnings, Lockheed remains very attractive assuming the baseline defense budget remains at least flat and that the outlook for F-35 funding and execution is sound. The baseline budget should remain strong given aging equipment and the need to address new threats. The higher risk lies in F-35 execution (just look at how Boeing’s stock has responded to delays with their new 787 Dreamliner).

Defense valuations are unusually low across the board, even when compared to prior periods of declining defense spending. Despite continual earnings growth and high levels of free cash flow, multiple compression implies a worsening long-term outlook for defense contractors. But defense companies are like insurance: no one knows when the next war or crisis will break out, but when it does, margins and sales rocket.
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Peter J. Lazaroff, Investment Analyst