Important disclosures appear on the last page of this report. Krause Fund Research Fall 2020 Industrials and Materials Recommendation: BUY Analysts Jack Tucker [email protected]Chandler Bruce [email protected]Davis Deboom [email protected]Company Overview Lockheed Martin (LMT) is an industry leading Aerospace and Defense contractor operating in Aeronautics, Missile and Fire Control, Rotary and Mission Systems, and Space segments. Founded in 1995 after a merger between the Lockheed and Martin Marietta Corporations, Lockheed Martin has since gone on to become one of the largest defense companies in the world. Stock Performance Highlights 52 week High $442.53 52 week Low $266.11 Beta Value 0.98 Average Daily Volume (90 day) 451.3 m Share Highlights Market Capitalization $105.5 b Shares Outstanding 280 m EPS (2019) $22 P/E Ratio 17.7 Dividend Yield 2.4% Dividend Payout Ratio 40.74% Company Performance Highlights ROA 17.98% ROIC 32.93% Sales $59.81 b Financial Ratios Current Ratio 1.22 Quick Ratio .96 Total Asset Turnover 1.26 One Year Stock Performance: Lockheed Martin (NYSE:LMT) November 17, 2020 Current Price $377.13 Target Price $450-460 LMT Investment Thesis We recommend a BUY rating for LMT because our model suggests the current price of the stock undervalues the company. The reason for this undervaluation could be due to any number of reasons, but most likely it is a slight overreaction to the risks COVID-19 puts on the market. Historically, the aerospace and defense industry has proven resistant to short-term market events due to the long-term nature of their contracts, as well as predictable defense spending by the government. Drivers of Thesis: x Defense spending does not dramatically differ between Democratic and Republican administrations. In 2020, President Trump requested $6 billion less on defense spending than what was approved in a bipartisan agreement between the House and Senate. The congressional Budget Office (CBO) recommends steady real growth in spending between 3-5%. 1 x Defense spending at its current percentage of GDP is sustainable and has room for growth should new conflicts arise. As a percentage of GDP, defense spending is currently just over 3%, below the average of 4% in the Bush and Obama administrations. 1 Risks to Thesis: x With a Joe Biden administration the most likely outcome for 2021, there is a risk he may opt to decrease military investment expenditures. Beginning in President Obama’s second term in which Biden was vice president, National Defense consumption and gross investment declined by 11.08% over 4 years. If Biden takes a similar approach, Lockheed Martin could see a decline in revenues. 2 x Lockheed Martin’s signature product, the F-35 fighter jet, has a growing number of unaddressed design flaws. Documents obtained by the project on government oversight show that there are currently 162 design issues with the jet that have no plans of being addressed. Lockheed Martin expects that revenues from F-35 contracts will be their fastest growing revenue stream in the years ahead. 3 1
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Krause Fund Research Fall 2020 Industrials and Materials Recommendation: BUY Analysts Jack Tucker [email protected]
Company Overview Lockheed Martin (LMT) is an industry leading Aerospace and Defense contractor operating in Aeronautics, Missile and Fire Control, Rotary and Mission Systems, and Space segments. Founded in 1995 after a merger between the Lockheed and Martin Marietta Corporations, Lockheed Martin has since gone on to become one of the largest defense companies in the world. Stock Performance Highlights 52 week High $442.53 52 week Low $266.11 Beta Value 0.98 Average Daily Volume (90 day) 451.3 m Share Highlights Market Capitalization $105.5 b Shares Outstanding 280 m EPS (2019) $22 P/E Ratio 17.7 Dividend Yield 2.4% Dividend Payout Ratio 40.74% Company Performance Highlights ROA 17.98% ROIC 32.93% Sales $59.81 b Financial Ratios Current Ratio 1.22 Quick Ratio .96 Total Asset Turnover 1.26 One Year Stock Performance:
Lockheed Martin (NYSE:LMT)
November 17, 2020
Current Price $377.13 Target Price $450-460
LMT Investment Thesis
We recommend a BUY rating for LMT because our model suggests the current price of the stock undervalues the company. The reason for this undervaluation could be due to any number of reasons, but most likely it is a slight overreaction to the risks COVID-19 puts on the market. Historically, the aerospace and defense industry has proven resistant to short-term market events due to the long-term nature of their contracts, as well as predictable defense spending by the government. Drivers of Thesis: Defense spending does not dramatically differ between
Democratic and Republican administrations. In 2020, President Trump requested $6 billion less on defense spending than what was approved in a bipartisan agreement between the House and Senate. The congressional Budget Office (CBO) recommends steady real growth in spending between 3-5%.1 Defense spending at its current percentage of GDP is
sustainable and has room for growth should new conflicts arise. As a percentage of GDP, defense spending is currently just over 3%, below the average of 4% in the Bush and Obama administrations.1
Risks to Thesis: With a Joe Biden administration the most likely outcome
for 2021, there is a risk he may opt to decrease military investment expenditures. Beginning in President Obama’s second term in which Biden was vice president, National Defense consumption and gross investment declined by 11.08% over 4 years. If Biden takes a similar approach, Lockheed Martin could see a decline in revenues.2 Lockheed Martin’s signature product, the F-35 fighter
jet, has a growing number of unaddressed design flaws. Documents obtained by the project on government oversight show that there are currently 162 design issues with the jet that have no plans of being addressed. Lockheed Martin expects that revenues from F-35 contracts will be their fastest growing revenue stream in the years ahead.3
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ECONOMIC OUTLOOK:
Defense Spending:
Defense spending is currently the second largest
budgetary item for the United States following
Social Security. This is the most important
economic metric for companies in the aerospace
and defense industry since a majority of these
company’s revenues are derived from defense
contracts (70% and 71% for Lockheed Martin in
2018-19). The Department of Defense and the
Congressional Budget Office recommend real
defense budget growth of 3-5% every year in
order to meet policy goals1. However, the
COVID-19 pandemic has drastically accelerated
growth in the national deficit and budget cuts will
eventually take a toll on all aspects of government
spending, likely starting with defense spending.
The deficit for the fiscal year ended September
2020 was a record 3.1 trillion4. As a response,
former defense secretary Mark Esper estimates
that the 2022 budget will include a 5% cut to
defense spending. This cut would not have as
severe a consequence as the budget cuts of 2012-
13 had on the defense industry, because the
defense department has made a commitment to
plan for them this time around. In 2012-13, the
defense department refused to plan for the cuts
under the justification that planning for them
would make them more likely to occur.4
Real GDP:
With the defense budget being closely linked to
real GDP, roughly 3%, growth in real GDP is an
important indicator for the defense contractors
such as Lockheed Martin. Due to the pandemic,
Real GDP in 2020 is expected to fall by nearly
6% according to the Congressional Budget Office.
GDP is not expected to return to its
“prepandemic” level until halfway through the
year 2022. While there appears to be optimism for
the pandemic to be concluded by summer 2021,
the damage already done will have effects that last
through the decade. Uncertainties remain
regarding how the drop in Real GDP will affect
businesses in the aerospace and defense industry,
it is likely there will be some form of decline in
revenues, or profits.5
(Source: Congressional Budget Office)
Producer Price Index:
The bureau of Labor Statistics defines the
producer price index as “a measurement for the
average change in prices received by producers
for their inputs.”7 Prices included in the PPI are
often the first commercial transactions for many
products and services. Over the course of the
pandemic the producer price index for total
manufacturing industries has remained steady,
experience a decline of only -1.48%.6 In an
economic environment where businesses are
struggling for cash, it makes sense that the prices
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producers pay for their inputs should drop to meet
the new demand.
(Source: St. Louis Federal Reserve)
The PPI for commodities used in the production
of aerospace and defense contracts such as steel,
aluminum, and crude oil have all experienced
similar declines in the index. If COVID-19
continues to have contracting effects on the
economy, it is likely that the index will continue
to have a marginal decline. This would imply
possibly lower operating costs which could result
in higher profits or be offset by a slowing growth
in revenues.
Federal Funds Rate:
The Covid-19 pandemic has created an economic
environment that is incredibly sensitive to the
changes in interest rates. As a response to the
economic hardships many companies are
experiencing, the federal reserve has adapted their
policy to create a near-zero interest rate
environment. Interest rates have a large effect on
the cost of capital for a company. The Aerospace
and defense industry is very capital intensive due
to the high costs of research and development, as
well as the inputs that go into products. Because
the economic effects of COVID-19 are likely to
last well into the next decade, it is likely that the
federal reserve will keep interest rates low to
stimulate lending and economic growth. However,
there are some concerns that if the national deficit
continues to grow at its current pace, with little to
no economic growth, it will become
unsustainable. In this scenario interest rates could
need to be raised to service the cost of the national
debt.
(Source: St. Louis Federal Reserve)
Industrial Production:
The Industrial Price Index (IPI) is an economic
indicator developed by the Federal Reserve Board
(FRB) used to measure real monthly outputs of
United States based manufacturing, mining,
electric and gas industries. Production levels are
indexed according to a base year, with data
sourced from reports of actual inputs and outputs,
as well as hours logged by production workers
when input/output information is unavailable.
When the pandemic began in late February
Industrial production in the United States fell by
-16.5% through March and has since risen by
13.08%. These figures indicate that production
has still not returned to “pre-pandemic” levels,
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and growth in recent months show it may be some
time before they do.
(Source: St. Louis Federal Reserve)
Capital Markets Outlook:
2020 has been a wildly volatile year for capital
markets across the globe. The covid-19 pandemic
and the ensuing lockdowns have created immense
challenges for companies of all sizes. Similar to
real GDP, we estimate that it may not be until
midway through 2022 that capital markets return
to a normal growth state. In the interim we expect
above average volatility as a result of upcoming
economic stimulus negotiations, as well as the
likely renegotiation of trade talks with China
under a new Biden administration. With this being
said, we expect the Aerospace and Defense
industry to be more stable than the broader market
because of the long-term nature of government
contracts and predictable defense budgeting.
INDUSTRY ANALYSIS:
Aerospace and Defense Overview:
The Aerospace and Defense industry consists of
companies that design, develop and manufacture
civil/military aircraft, space vehicles and products,
as well as defense equipment, parts, and products.
The industry consists of products that are
categorized into five main segments: commercial
and general aviation, military aircraft, space
systems, ground defense, and ship building.8
Revenue from this industry is primarily driven by
government contracts awarded by the Department
of Defense. The commercial side of this industry
is cyclical and extremely sensitive to macro-
economic trends. For example, commercial
airlines were some of the hardest hit companies
when the pandemic disrupted economic activity.
On the other hand, the defense industry is more
resilient to short-term economic trends due to the
long-term nature of government contracts.
Markets and Competition:
Porter’s Five Forces
Competition: There is a moderate level of
competition in the Aerospace and Defense
industry. Large firms like Lockheed Martin,
Northrop Grumman, Boeing, Raytheon, GE
Aviation, and General Dynamics bid against each
other for long-term government manufacturing
contracts. Because of the long-term length and
high costs associated with the contracts, firms
must bid far in advance to ensure steady future
cash flows.
Bargaining Power of Customers: There is high
Bargaining Power for Customers. The Pentagon is
the largest customer in the Aerospace and Defense
industry. Under the Trump administration, the
Pentagon’s budget increased from $670 billion to
$712 billion in 2020, an increase of 6.27%9. The
massive budget of the Pentagon creates leverage
over firms in the Aerospace and Defense industry,
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causing them to undercut each-others bids
whenever possible.
Bargaining Power of Suppliers: Suppliers have
low to moderate bargaining power in the Industry.
Because the pentagon is the largest buyer in the
industry, firms must try to match their costs to the
national defense budget. However, because the
industry is comprised mostly of large contractors,
they can together shape the prices of the products.
As seen in the graph below, a handful of major
firms control the overall market and set the
market standard for prices in the industry.
(Source: Statista)
Threat of Substitution: Medium threat of
substitution in the industry. Many major contracts
span the length of several years, restricting the
ability of buyers to switch producers. However,
the size and scope of the national defense budget
means there are always smaller contracts up for
bid which smaller producers fight over. The
process purchasers undergo in the industry is
similar to a “waterfall-phased lifecycle”.10 If a
company were to opt-out of a contract in favor of
a substitute for whatever reason, they would lose a
sizeable portion of the purchase price from the
fixed costs. Additionally, major contractors face a
variety of risks ranging from international supply
chain management, capacity to innovate, exposure
to cybersecurity events, and many more. Failure
to address these appropriately can cause the threat
of substitution to increase for future bids10.
(Source: NC State University, Robert Handfield)
Threat of New Entry: The threat of new entrants
into the industry is low. It takes a substantial
amount of capital and resources to develop
aerospace and defense equipment. Most new
startups will not be able meet the capacity and
capital demands of most Aerospace and Defense
contracts. Large firms also have to ability to
outbid smaller entrants to keep competition at a
stable level. This is a large component of why
M&A activity in the industry is so high compared
to that of other sectors.
Catalysts for Growth:
The global demand for defense equipment is
rising. Most developed countries want to
modernize due to global security concerns
regarding cybersecurity, terrorism, and national
defense. Global defense spending is expected to
rise throughout the next five years due to
companies continually upgrading their products
and developing countries replacing old equipment
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with modern products. Global defense spending is
estimated to grow at a compound annual growth
rate of 3%11. While defense spending does face
the risk of budget cuts in the domestically, the
demand for products abroad is expected to
continue rising over the next five years.
Another avenue for growth in the industry is
being spurred by rising innovation in space-based
technologies and services. In the most recent 2021
budget, the new space force branch of the United
States military was awarded $15.4 billion12,
highlighting the surging interest in the products
and services. While most of the investment in the
area is towards projects in the proof-of-concept
phase, it is a segment that is expected to grow
over the next ten years.
COMPANY OVERVIEW:
Lockheed Martin was formed by the merger of
Lockheed Corporation with Martin Marietta in
1995. It is a leading global security and aerospace
company operating in 4 segments: aeronautics,
missiles and fire control (MFC), rotary and
mission systems (RMS), and space. Lockheed has
over 375 facilities globally and operates in every
state of the U.S. (headquartered in Bethesda,
MD). Lockheed’s mission is to be the global
leader in supporting customers’ missions,
advancing scientific discovery, and helping
customers keep people safe. They do so by being
engaged in the research, design, development,
manufacture and integration of advanced
technology systems, products and services.
Lockheed does a majority of its business with the
U.S. Department of Defense and U.S. federal
government agencies providing military and
rotary-wing aircraft to all five branches of the
U.S. armed forces.13
LMT Factset 14
Aeronautics
Aeronautics is engaged in the research design
development, manufacturing, integration,
sustainment, and support and upgrade of advanced
military aircraft.16 Aeronautics generated net sales
of $23.7 Billion in 2019. This number has grown
by an average of 10.1% annually since 2017. This
is LMT’s biggest segment and accounts for 40%
of their total consolidated net sales.14 The product
driving most of their revenue in this segment is
the F-35 which accounts 69% of aeronautics net
sales, and 27% of LMT’s total consolidated net
sales.16 This shows LMT’s dependence on the
continuance of F-35 production. LMT is also
highly dependent on the US government for sales
across all four of their business segments. LMT’s
customer breakdown in this segment is as follows:
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U.S. Government – 62%, International
Governments – 37%, and US Commercial and
other – 1%.16
Missiles and Fire Control (MFC)
MFC provides air and missile defense systems,
tactical missiles and air to ground precision strike
weapons, logistics, fire control systems, mission
operations support readiness and integration
services, manned and unmanned ground vehicles,
and energy management solutions. It also
contracts for classified programs for the U.S.
Government.16 MFC generated net sales of $10.1
Billion in 2019 growing by an average of 15.4%
annually since 2017.14 MFC’s sales account for
17% of LMT’s total consolidated net sales. Some
of MFC’s major product programs include the
Apache, Patriot advanced capability 3 (PAC-3),
Multiple Launch Rocket Systems (MLRS), and
Hypersonic Programs. The U.S. Government
accounts for 75% of sales in this segment. This is
followed by International Governments
accounting for 24%, and US Commercial and
Other accounting for 1%.16
Rotary and Mission Systems (RMS)
RMS Provides design, manufacture, service and
support for a variety of military and commercial
helicopters, ship and submarine mission and
combat systems, mission systems and sensors for
rotary and fixed wing aircraft, sea and land-based
missile defense systems, radar systems, littoral
combat ship (LCS), simulation and training
services, and unmanned systems and
technology.16 RMS generated net sales of $15.1
Billion in 2019. This number has grown by an
average of 4% since 2017. Sales generated by the
RMS segment account for 25% of total
consolidated net sales for LMT. 14 Some of
RMS’s major product programs in this segment
include the Blackhawk and Seahawk helicopters,
CH-53K King Stallion Helicopter, the Aegis
Combat System, and the VH-92A helicopter.
Sikorsky helicopter programs are a main driver of
revenue in this segment and the overall company.
They accounted for 9% of LMT’s net sales for
2019. The U.S. Government represents 72% of
sales in this segment. International Governments
represent 25%, and U.S. Commercial and Other
represent the remaining 3% of RMS’s net sales.16
Space
Space is engaged in the research, design,
development, engineering and production of
satellites, space transportation systems, and
strategic, advanced strike, and defensive systems.
It provides network-enabled situational awareness
and integrates complex space and ground global
systems to help with intelligence data.16 Space
generated net sales of $10.9 Billion in 2019 and
accounted for 18% of LMT’s total net sales. Their
net sales in this segment have grown by an
average of 5% annually since 2017.14 Some of
Space’s major product programs include: The
Trident II D5 Fleet Ballistic Missile System
(FBM), Space Based Infrared System (SBIRS),
and the Orion Multi-Purpose crew vehicle (Orion)
which is used by NASA. Space satellites have
been a major part of LMT’s overall sales
accounting for 11% of net sales in 2019. The U.S.
Government is a major consumer in this segment
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accounting for 86% of sales. International
Government sales accounted for the remaining
14%.16
Lockheed Martin 10-K16
Backlog
Backlog is an important aspect of Defense
companies as it is a strong indicator of contracted
future sales. Since aircrafts are such a main
component of LMT, it is important to keep a
steady backlog and maintain production of these
products. As of December 31st, 2019, they had a
total backlog of 374 aircrafts. Lockheed reported
that they had a total backlog of $144 Billion in
2019 growing from $130.5 Billion in 2018.
Lockheed plans on recognizing 39% of this
through 2020 and the remaining 61% of this
through 2021.16 This is promising as it shows that
that will have steady production through all of
2021.
Lockheed Martin’s 10-k16
Risk Factors
While LMT has proven to have continued growth
in revenue and earnings, they still face many risks
which could result in negative impacts on their
operations. One risk to note is COVID-19 and the
continued government spending on relief. With
such large spending on things like the CARES
act; it leads to a larger budget deficit which could
in turn lead to cuts from the government on
defense spending. Another thing to note would be
the new Biden Administration in January. The
President has a high influence on overall budget
and defense spending. While keeping historical
democratic policies in mind, Biden will likely
decrease defense spending which will face the
aerospace and defense industry with issues. Since
LMT has a high dependence on Government
spending this could have a negative impact on the
company. Lastly, an important thing to note
would be geopolitical risks. An example of this
would-be Turkey’s removal from the F-35
program. Being that Turkey was one of eight
international partners on the program, this will
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have a negative impact on sales. Turkey
previously had committed to purchase up to 100
F-35 aircrafts.16
SWOT
Strengths
Lockheed Martin largest strength is its ties to the
Pentagon. The U.S. Government accounted for
nearly 70% of Lockheed Martin’s revenues for the
year 2019.16 This relationship provides Lockheed
Martin with stable revenue growth despite
uncertain market conditions or recessions. The
budget for defense is the most important metric
for analyzing future revenue growth and neither
political party has shown an overt desire to
significantly decrease the budget. Republican
administrations tend to increase the defense
budget at faster rates than democrats, but the
national security concerns associated with the
industry incentivize both parties to keep it at
steady levels.
Weaknesses
The F-35 program, which accounts for nearly
27% of Lockheed Martin’s total net sales, is
expected to represent a higher portion of the
company’s sales in the future.16 This puts more
emphasis on the current challenges of the program
such as supplier and partner performance,
software development, the availability and receipt
of funding for production contracts on a timely
basis, execution of future flight tests and findings
resulting from testing and operating the aircraft,
the level of cost associated with life-cycle
operations and sustainment and warranties,
continuing to reduce the unit production costs,
and achieving cost targets. Any significant issues
among these variables and Lockheed could be
exposed to larger downside risk than it faces with
its current sales mix.
Opportunities
Lockheed Martin is currently exploring the
opportunity for larger international production
contracts for their F-16 Block 70 aircraft. The
aircraft is seeing a significant increase in demand
and the countries of Bahrain, Slovakia, and
Bulgaria have all placed production orders for the
delivery of these aircraft. In addition, the U.S.
State Department approved the sale of 25 aircraft
to Morocco.16 The increase in demand for the
aircraft will present Lockheed Martin with more
international opportunities on the coming years.
Threats
Lockheed Martin is not certain they can protect
their intellectual property and software from cyber
security incidents. In the annual report, Lockheed
Martin emphasizes, “Our efforts to minimize the
likelihood and impact of adverse cybersecurity
incidents and to protect data and intellectual
property may not be successful and our business
could be negatively affected by cyber or other
security threats or other disruptions”.16 The
company faces frequent cybersecurity threats such
as Distributed-Denial-of-Service attacks, attempts
to gain access to sensitive information, and insider
threats. The company takes a variety of
precautions to protect their systems and data but
due to the ever-changing nature of the threat their
efforts are not guaranteed to protect their systems
and data. Another issue for Lockheed Martin is
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their F-35 program. In February, a document from
the Joint Strike Fighter Program Office’s
Deficiency Report Metrics showed 883 design
flaws and over 160 of them have no plan for
correction.15 The contractors are claiming no
problem exists which means there will not be
changes until the government pays for them.
Lockheed Martin faces challenges ahead with the
F-35 being one of their biggest contracts for the
company.
VALUATION:
Revenue Decomposition:
The revenue decomposition for Lockheed Martin
was broken down into 4 business segments:
Aeronautics, Missiles and Fire Control, Rotary
and Mission Systems, and Space. Growth for
each of these segments was forecasted
individually based on information from the annual
reports and the short-term budget outlook for the
United States. The Aeronautics and Space
segments were forecasted to have the largest
growth rates because of recent years trends and
long-term term prospects.
According to the 2019 annual report, Lockheed
Martin expects product and service growth to
account for a growing percentage of the
company’s revenue growth. The space segment is
also expected to continue a similar growth
trajectory compared to the other segments as it
has in years past.
Because the US defense budget is expected to be
cut in the near-term, growth rates had to be
adjusted to lower levels while still maintaining the
percent of total trend from years past in our
model. A weighted average was taken to
determine the average growth rate for each year
and was then used to project future sales revenues.
Key Income Statement and Balance Sheet
Assumptions:
Expenses:
Expenses were forecast as a ten-year historical
average percent of sales. We do not anticipate any
unexpected declines in COGS as a percent of
sales so it was determined a ten-year average
would be the best approach to estimating these
costs. For the depreciation and amortization
costs, we had to manually back these costs out
ourselves because they were unlisted on the
income statement. To do this we found the
historical depreciation and amortization expense
from the changes in accumulated depreciation and
intangible assets on the balance sheet, then took
an average percent change to apply to future
expense accounts. We found an average of 2.42%
depreciation rate and 6.09% amortization rate on
relevant balance sheet accounts.
To calculate Income Tax, we used the average
effective tax rate of 2018 and 2019 (since the
change in the federal corporate tax rate).
Shares Outstanding and Dividends:
Lockheed Martin ended its employee stock option
program in 2012, but it still has 1,793,625 options
outstanding, with an average maturity of 2.08
years and exercise price of $79.76. This results in
a valuation exceeding 500 million that will need
to flow into the share change worksheet over the
next 2.08 years. These options are expected to
increase the common stock account by 6.89
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million per full year, while treasury stock
repurchases of $1747 (ten-year average) are
expected to continue.
We forecast the dividends in this model by taking
a ten-year average payout ratio then multiplying
this by the number of shares outstanding.
Common Balance Sheet Items:
Most common balance sheet items were forecast
as a percent of sales or assets. Gross PPE was
forecasted by once again using 2019’s capital
expenditures, then growing this amount by the
average growth rate of revenues. Accumulated
depreciation was projected using the previous
forecasted depreciation expense accounts; the two
were then used to determine net PPE.
Long-term debt and current maturities of Long-
term debt were taken using a historical average of
Long-term debt to assets then multiplied by the
forecasted years amount of assets.
DCF and Economic Profit Model:
The backbone of our valuation model was based
on the discounted cash flow and economic profit
analysis. Based on Free Cash Flows estimated by
our NOPLAT and Invested Capital drivers, we
found Lockheed Martin to have an implied price
of $472.51. This price is 25.29% higher than
where the stock currently trades today, but not far
off from the 52 week high of $442.53. The reason
for this valuation to be more than what the actual
price is today can be for several reasons stemming
from a market overreaction to the pandemic, or
uncertainty over future budget cuts to the
Department of Defense. On a fundamental basis
Lockheed Martin’s financial position implies it is
currently undervalued in the market.
Dividend Discount Model:
Based on our dividend discount model, Lockheed
Martin’s implied price today is $459.54. This
valuation is very similar to the discounted cash
flow valuation. The assumptions used in this
model were a CV growth of EPS at 1.76%, a CV
year ROE of 66.03%, and a cost of equity of
6.06%. Using estimated earnings per share as our
cash flows, we found a future stock price of
$534.77 that when discounted by the cost of
equity turned out to be $459.54.
WACC:
To find the weighted average cost of capital we
began by finding the cost of equity. We used the
yield of a ten year U.S. T-bond as our risk free
rate (.88%), a 2 year monthly beta of .98, and
Answath damodaran’s equity risk premium
estimate of 5.29% to calculate a cost of equity at
6.06%. Then using the YTM on a 2050 LTM
corporate bond times 1-effective tax rate for the
firm, we found an after tax cost of debt at 2.35%.
These inputs were used to find a WACC value of
5.67%.
Relative Valuation:
In our relative valuation model we used eleven
different publicly traded firms operating in the
aerospace and defense sector. Using EPS data and
estimates for these firms we found average P/E
multiples of 25.34 and 22.73, that when
multiplied by Lockheed Martin’s EPS gave the
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following valuations. A PEG multiple was also
calculated, but 6 firms had to be excluded from
these calculations because their multiples were
too extreme for an accurate measurement.
We chose to include as many comparable
companies as we could to ensure that the
valuation estimate would be as accurate as
possible. Some of these companies focus on
different segments that LMT, but there is enough
overlap to justify including them in the model.
SENSITIVITY ANALYSIS:
WACC and CV Growth of NOPLAT:
The weighted average cost of capital and
continuing value growth of NOPLAT are
components used in determining the DCF and
economic profit valuation. When calculating
continuing value, the CV year cash flow is
multiplied by 1-CV growth of NOPLAT/CV year
ROIC which is then divided by the WACC-CV
growth of NOPLAT. Slight changes in either of
these percentages can cause a lot of variation in
the valuation process. As the cost of capital
decreases, the CV growth results in a higher
valuation. On the other hand, if the cost of capital
increases, there needs to be a proportionate match
Important disclosures appear on the last page of this report.
Works Cited
(in order of appearance)
1. 1O'Hanlon, Michael E. "In an Era of Partisan Rancor, Republicans and Democrats Seem to Agree on Overall Defense Policy." Brookings, 20 Feb. 2020, www.brookings.edu/blog/order-from-chaos/2020/02/20/in-an-era-of-partisan-rancor-republicans-and-democrats-seem-to-agree-on-overall-defense-policy/. Accessed 17 Nov. 2020.
2. 2"Federal Government: National Defense Consumption Expenditures and Gross Investment." Federal Reserve Economic Data | FRED | St. Louis Fed, 29 Oct. 2020, fred.stlouisfed.org/series/FDEFX.
3. 3Grazier, Dan. "F-35 Design Flaws Mounting, New Document Shows." Project On Government Oversight, www.pogo.org/investigation/2020/03/f-35-design-flaws-mounting-new-document-shows/. Accessed 17 Nov. 2020.
9. 9Macias, Amanda. "Here's the Firepower the Pentagon is Asking for in Its $705 Billion Budget." CNBC, 11 Feb. 2020, www.cnbc.com/2020/02/11/what-the-pentagon-is-asking-for-in-its-705-billion-budget.html. Accessed 17 Nov. 2020.
10. 10Handfield, Robert. "Is the FAR Getting in the Way of Early Supplier Involvement in Defense Projects?" SCM | Supply Chain Resource Cooperative (SCRC), 8 Feb. 2018, scm.ncsu.edu/scm-articles/article/is-the-far-getting-in-the-way-of-early-supplier-involvement-in-defense-projects. Accessed 17 Nov. 2020.
11. 11"2020 Aerospace and Defense Industry Outlook." Deloitte United States, 29 Sept. 2020, www2.deloitte.com/us/en/pages/manufacturing/articles/global-aerospace-and-defense-industry-outlook.html. Accessed 17 Nov. 2020.
14
Important disclosures appear on the last page of this report.
12. 12"DOD Releases Fiscal Year 2021
Budget Proposal." U.S. DEPARTMENT OF DEFENSE, 10 Feb. 2020, www.defense.gov/Newsroom/Releases/Release/Article/2079489/dod-releases-fiscal-year-2021-budget-proposal/. Accessed 17 Nov. 2020.
13. 13About Us. (2020, February 7). https://www.lockheedmartin.com/en-us/who-we-are.html
14. 14Factest Research Systems. (2020) From Factset Database.
15. 15Grazier Dan Grazier is the Jack Shanahan Military Fellow at the Center for Defense Information at POGO., D. (2020, March 11). F-35 Design Flaws Mounting, New Document Shows. https://www.pogo.org/investigation/2020/03/f-35-design-flaws-mounting-new-document-shows/
16. 16Lockheed Martin’s Website (2020).
17. 17Lockheed Martin’s 10-k
15
Important disclosures appear on the last page of this report.
Important Disclaimer This report was created by students enrolled in the Security Analysis (6F:112) class at the University of Iowa. The report was originally created to offer an internal investment recommendation for the University of Iowa Krause Fund and its advisory board. The report also provides potential employers and other interested parties an example of the students’ skills, knowledge and abilities. Members of the Krause Fund are not registered investment advisors, brokers
or officially licensed financial professionals. The investment advice contained in this report does not represent an offer or solicitation to buy or sell any of the securities mentioned. Unless otherwise noted, facts and figures included in this report are from publicly available sources. This report is not a complete compilation of data, and its accuracy is not guaranteed. From time to time, the University of Iowa, its faculty, staff, students, or the Krause Fund may hold a financial interest in the companies mentioned in this report
Fiscal Years Ending Dec. 31 2020E 2021E 2022E 2023E 2024E 2025(CV)Operating ActivitiesNet Earnings 5,630 5,796 5,947 6,104 6,266 6,411 Adjustments to reconci le net income to net cash provided by operating activi ties :Depreciation and Amortization 661 701 741 783 825 869 Changes in assets and liabilitiesContract assets (244) (251) (257) (264) (271) (247)Receivables (63) (64) (66) (68) (70) (64) Deferred income taxes - - - - - - Inventories (723) (117) (120) (123) (126) (115) Other current assets (515) (228) (34) (35) (36) (33) Accounts payable 942 113 121 129 138 139 Current maturi ties of long-term debt 30 127 54 39 40 41 Customer advances and contract l iabi l i ties 1,133 220 226 232 238 217 Deferred taxes 738 (76) (69) (72) (74) (67) Other non-current Liabi l i ties 505 114 117 120 124 113 Accrued pens ion l iabi l i ties 3,597 483 496 509 523 476 Other Current Liabi l i ties 413 244 261 279 298 300 Net cash provided by operating activites 12,104 7,061 7,416 7,633 7,874 8,041
Investing ActivitesCapita l Expenditures (1,484) (1,524) (1,565) (1,607) (1,650) (1,689) Other non-current Assets (1,218) (172) (177) (182) (186) (170) Change in Intangible assets (286) (291) (296) (302) (307) (313) Net cash used for investing activities (2,988) (1,987) (2,038) (2,090) (2,144) (2,172)
Financing ActivitiesCommon stock 2 3 (4) (4) (4) (3) Long-term debt (1,415) 738 477 434 441 447 Accumulated other comprehensive loss / income - - - - - - Repurchase of common stock (1,747) (1,747) (1,747) (1,747) (1,747) (1,747) Common stock dividends pa id (2,971) (3,059) (3,138) (3,221) (3,306) (3,383) Non-control l ing interest in subs idiary (10) (8) (6) (5) (4) (3) Net cash provided by financing activities (6,141) (4,072) (4,418) (4,542) (4,620) (4,690) Increase (Decrease) in cash & cash equiva lents 2,976 1,002 960 1,000 1,110 1,178 Cash & cash equiva lents , beginning of year 1,514 4,490 5,491 6,451 7,452 8,562 End of the Year Cash Balance 4,490 5,491 6,451 7,452 8,562 9,740
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Lockheed MartinHistorical Cash Flow Statement
Fiscal Years Ending Dec. 31 2017 2018 2019Operating ActivitiesNet Income / Starting Line 2002 5046 6230Depreciation, Depletion & Amortization 1195 1161 1189Deferred Taxes & Investment Tax Credit 3432 -244 222Other Funds -113 269 138Funds from Operations 6516 6232 7779Extraordinaries 0 0 0Changes in Working Capital -40 -3094 -468Net Operating Cash Flow 6476 3138 7311Investing ActivitiesCapital Expenditures -1177 -1278 -1484Net Assets from Acquisitions 0 0 0Sale of Fixed Assets & Businesses 0 0 0Purchase/Sale of Investments 0 0 0Other Funds 30 203 243Net Investing Cash Flow -1147 -1075 -1241Financing ActivitiesCash Dividends Paid -2163 -2347 -2556Change in Capital Stock -1930 -1492 -1200Issuance/Reduction of Debt, Net 0 -150 -1500Other Funds -212 -163 -72Net Financing Cash Flow -4305 -4152 -5328Exchange Rate Effect - - -Miscellaneous Funds 0 0 0Net Change in Cash 1024 -2089 742
Lockheed MartinWeighted Average Cost of Capital (WACC) Estimation
Cost of Equity: ASSUMPTIONS:Risk-Free Rate 0.88% U.S. 10 Year T-bondBeta 0.98 3 Year monthly betaEquity Risk Premium 5.29% Damodaran equity risk premiumCost of Equity 6.06%
Cost of Debt:Risk-Free Rate 0.88% U.S. 10 Year treasurtImplied Default Premium 1.84% 2050 LMT Corporate bond yield minus risk free ratePre-Tax Cost of Debt 2.72% YTM on 2050 LMT Corporate Bond
13.76% Effective Tax RateAfter-Tax Cost of Debt 2.35%
Market Value of Common Equity: MV WeightsTotal Shares Outstanding 280 Current Stock Price $377.13MV of Equity 105,596.40 89.30%
Market Value of Debt:Short-Term DebtCurrent Portion of LTD 1250Long-Term Debt 12259PV of Operating Leases 1150MV of Total Debt 12,654.00 10.70%
Market Value of the Firm MV of Firm 118,250.40 100.00%
WACC 5.67%
25
Lockheed MartinDividend Discount Model (DDM) or Fundamental P/E Valuation Model
Value of Operating Assets: 161763.2Non-Operating AdjustmentsExcess Cash 318Current portion of LT debt -1250LT debt -12259Provision for risks/charges -14381Other non-current Liabilities -3745Non-controlling Interest 44ESOP -503PV of operating leases -1150Value of Equity 128837.3Shares Outstanding 280.0Intrinsic Value of Last FYE 460.13$ Implied Price as of Today 474.78$
EP Model:Economic Profit (EP) 5507.6 4766.7 4851.3 4942.4 5039.1 5129.8Continuing Value (CV) 156347.1PV of EP 5212.0 4268.9 4111.5 3964.0 3824.7 118667.4
Total PV of EP 140048.4Invested Capital (last FYE) 21714.8Value of Operating Assets: 161763.2Non-Operating AdjustmentsExcess Cash 318Current portion of LT debt -1250.0LT debt -12259.0Provision for risks/charges -14381.0Other non-current liabilities -3745.0Non-controlling Interest 44.0ESOP -503.1PV of operating leases -1149.5Value of Equity 128837.3Shares Outstanding 280.0Intrinsic Value of Last FYE 460.13$ Implied Price as of Today 474.78$