DISCLAIMER: This article is not directed at, nor intended to be relied upon by any UK recipients. Any information or analysis in this article is not an offer to sell or buy any securities. Nothing in it is intended to be investment advice and it should not be relied upon to make investment decisions. Cestrian Capital Research Inc or its employees or the author of this article or related persons may have a position in any investments mentioned in this article. Any opinions or probabilities expressed in this report are those of the author as of the article date of publication and are subject to change without notice.
We cover Lockheed Martin (LMT) as part of our space-sector focus. Now, the space sector is certainly exciting insofar as SpaceX (SPACE) launches come with box-office appeal for free – re-usable rockets landing on drone ships was the stuff of science fiction not so long ago – but from an investor’s standpoint space is most interesting because it is the bleeding edge of the defense industry. And in case you hadn’t noticed, the world is getting a little uglier of late – this is probably a bad thing overall but it’s good news for the defense sector, so we will take our wins where we can find them.
LMT announced its Q4 2019 earnings today – a very strong set of results. We summarize the numbers below. But what really stood out for us today with this stock were two things.
Firstly, the stock barely moved on the day. At the time of writing the stock is sat in the aftermarket at $437, up just 1% on yesterday’s close. We believe the stock is a buy at this price and we have it at Buy – Long Term Hold as a result.
Secondly, on the earnings call the management team talked up the cashflow generation over the next couple of years and confirmed an analyst question about the potential for dividend growth. Still the stock did not react.
Now, to quote the CFO on the earnings call today, he said “half our shareholders are income investors”. As well they might be. For despite the big run-up in the stock price in 2019, and consequent reduction in yield, the company still pays a 2% yield with ample cover. The company also has, we believe, a very bright future ahead of it. Defense companies have pretty good visibility into future revenues, earnings and cashflows, and this company is now delivering on the major next-gen fighter aircraft program for the Allied countries – winning orders far beyond the US armed services. It also provides some essential building blocks in the US’s campaign to win the second Cold War, which is quietly building in the background.
So we think this is a compelling income stock. Clearly 2% is a modest yield, but we think that the forward yield is likely to rise as a result of dividend increases ; and we think there is substantial capital gain potential too. Here’s why.
Here’s LMT’s numbers going back to 2013.
This is what good looks like for a company of this size. 11% revenue growth – all organic – in 2019, solid EBITDA margins, big conversion of EBITDA into unlevered pretax cashflow, and rapid deleverage after a big acquisition (in 2015, LMT paid $9bn for Sikorsky, taking leverage up to 2.4x TTM EBITDA; that leverage is now down to just 1.1x).
In defense companies, as you probably know, forward visibility is much clearer than in many other sectors. They all publish their ‘backlog’, which usually means orders placed which cannot yet be recognized as revenue. Backlog never translates directly into revenue, for many reasons (some orders are not at all certain, some are of uncertain quantity or value, some are not yet backed by a federal budget at the customer, etc etc). But generally speaking, particularly for the better-managed companies – of which LMT is surely one – backlog up = good news.
Here’s the backlog story from LMT.
Source: YCharts.com, Company SEC filings, Cestrian Analysis
Consistent growth every quarter over a couple of years – at the same time as growing revenue. (That means they are both selling stuff – taking orders – AND delivering stuff – recognizing revenue and collecting cash. Needless to say – that’s good).
Now turning to valuation. Even after a huge runup of late – see our last note on the topic – the multiples are still reasonable in the light of the growth.
Source: YCharts.com, Company SEC filings, Cestrian Analysis
Dividend History And Outlook
Here’s the last ten years’ worth of trailing yield for LMT and its comparator stocks Raytheon (RTN) and Northrop Grumman (NOC), both of which we cover, together with the dividend yield of the S&P500 as a baseline comparison.
For pretty much the whole period, LMT has paid between 2-4x the yield of the S&P, and more than RTN and NOC too. This is impressive in the light of the stock price performance of the group.
NOC has delivered superior capital gain over those ten years, but LMT has delivered over 2x the S&P500 and about a third more gain than RTN too.
So as a stock to own on a total return basis, LMT has been compelling for a decade.
We think that can continue.
The company guided today to around 6-7% growth in revenue for 2020 vs. 2019. Given that they are in production mode for the single most important revenue line, F-35 fighter jets, we anticipate that this will deliver improved operating margin too. Defense companies get hit on the margin line when developing product; and reap the reward on margins when shipping. F-35 is gaining share in most corners of the Allied countries and we expect it will be a very successful and long-lived line. So we think the stock price will be taken care of by growth in both revenue and margins. Save for a general market correction, we believe LMT to be a sound place to seek capital gains whilst somewhat protecting that capital too.
Here’s a few notes from the earnings call today. They come from our notes as the call happened, but you can see the points verbatim in the transcript too.
Management were asked by Goldman Sachs and others whether operating cashflows can continue to grow over multiple years. Answer: yes, based on our 3-year forecasts, cashflow will grow through 2021 and again in 2022. Could be a little impact from Tax Reform Act hit to R&D accounting in 2022 but overall that’s not a major issue. Cashflow is strong from F-35 unwinding contract assets [that means moving into production mode] and from Sikorsky developments moving into production.
Cashflow return to investors?
Management said they anticipate $1bn share repurchases in 2020 and an 8%+ increase in dividend. They said they may refinance whole balance sheet or may repay the $1.2bn of near-term maturity debt from 2015 Sikorsky deal, but that this won’t impact repurchases or dividend increase. They said they will be opportunistic (buy low) with buybacks, as they did in Q4 2018.
One analyst (Cai von Rumohr at Cowen – we’ve seen him ask smart questions at one of the other defense stocks we cover, Science Applications International Corp (SAIC) ) said – even if you increase the dividend by 10% – you still have an awful lot of cash left. Management confirmed this was the case and said, “50% of our shareholders are yield investors, so the dividend matters”. And, as a direct quote, they said, “we WILL use cash – it’s not going to sit on our balance sheet”.
There was talk of M&A from the CFO, more so than is normal on these calls, but the CEO sat on that a little, saying they were happy with the current product portfolio.
So our takeaway was that the forward yield can move up to say 2.2-2.3% on a constant-stock-price basis (an 8%-10% increase in dividend payout from the current trailing yield of 2.06%). And although we ourselves don’t much like stock buybacks (we think they’re not really in shareholders’ interest – better to do something productive with the cash or pay it out to shareholders, one or the other – yes we know this is a minority view), we can’t argue that the market does tend to like them. And so any uptick in buybacks will probably be supportive of the stock price.
A Word On The Stock Price
We were surprised at how glum many of the analysts sounded on the call. Not one “congratulations guys” or similar, odd given the stellar 2019 performance. On the numbers above, you’d expect some increased price targets, and with those, a bump in the stock. Maybe those analysts know something we don’t. But on what we know – we’d say this is a going-up stock. We own the stock personally and we added to our holding as the market opened this morning (after the earnings were announced, but before the earnings call). So if you’re thinking of availing yourself of the rising yield potential, you might factor that into your timing.
Cestrian Capital Research, Inc – 28 January 2020.
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Disclosure: I am/we are long LMT, NOC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: We are long LMT and NOC on a personal account basis.