Lockheed: Defense Superstar

07/30/2004 12:00 am EST

Focus:

Karim Rahemtulla

Options Strategist, The Oxford Club

"One of the under-performing sectors since the launch of the Iraq War is, ironically, defense," says Karim Rahemtulla, in The Oxford Communique. "However, the 'big guns' have seen revenues and profits rise, and share prices are poised to follow suit."

"After 9/11 (but before the war) defense stocks had run up sharply, outperforming every index over that same period. Then the party stopped, and share prices leveled off sharply. Nonetheless, profitability among the nation’s defense contractors continued growingunabated. B ut the investing public has not factored the extent and enormity of the conflict in Iraq and Afghanistan, and the need for massive military resupply. Put plainly, investors have not caught on. In fact, there is more defense spending on the books now and for the foreseeable future than at any other time in recent history. And one company is set to get the lion’s share of this cash infusion, and make a lot of money for its shareholders.

"Lockheed Martin (LMT NYSE) is at the top of my list. It is a defense superstar and undervalued to boot. It was the company selected for developing the Joint Strike Fighterthe next-generation fighter plane to be used across the armed forces. This is a contract worth billions. Then, last month, the company won a joint tactical missile contract worth over $5 billion. The Joint Common Missile (JCM) system is billed as the next-generation air-to-ground missile. This project represents the absolute cutting edge when it comes to military technology. And with a $5 billion cash infusion behind it, JCM is set to not only help our forces better defend themselves; it will also help drive Lockheed’s earnings higher. And that’s always good news for shareholders. Keep in mind, also, that these two major projects are in addition to contracts for transport planes, other missile systems, satellites, smart bombs, aviation systems, and a host of other high-ticket, in-demand items.

"All this current and future work is well and good. But what is it doing for the company’s prospects as an investment? Quite a bit, as it turns out. LMT has reported strong growth in sales and profits for several quarters. And it continues to raise guidance for future quarters. In its latest quarter, LMT blew away earnings expectations by 20%. Meanwhile, revenues rose by 15%. The company is confident that the year ahead will be better than expected. All this, and yet the shares barely budged on the news. The shares are trading at 18 times projected earnings for 2004, in line with the company’s peers, but much lower than the market multiple for earnings, which, for the benchmark S&P 500, is right around 28 for 2004. And, the company also boosted its dividend from 12 cents per quarter last year to 22 cents per quarter, a further indication of confidence in its prospects. The shares are currently yielding almost 2%. This is very positive news.

"Part of the company’s confidence about its future performance lies in the fact that its profits come from a surprisingly diverse range of products and services. Lockheed’s prospects are, in fact, not just connected to missiles and planes. In the last quarter, the company recorded a 24% gain for sales in its information-technology unit. (Lockheed provides everything from maritime surveillance products to fingerprint-ID technology.) Given IT’s role in anti-terrorist campaigns, it’s no surprise that Lockheed’s training and simulation division is busy these days. It is, in fact, one of the biggest beneficiaries of the massive spending related to Homeland Security. And as Iraq and Afghanistan have shown, fighting in the years ahead will require increasingly stronger emphasis on technology and innovative military techniques. Already, the government is outsourcing much of this type of training to companies like LMT.

"I'd caution that the company is always subject to governmental oversight and 'headline risk' can depress the share price in the short term. In the long term, however, the company’s bottom-line performance is what counts. Looking forward, regardless of which administration takes power in January, defense spending will likely be boosted in the years ahead. For 2005, the company is expected to earn $3.40 per share on the high side, and $3 on the low side. At $3.40 it is trading at only 14 times next year’s earnings. That is cheap in any book and in any market. Add to that the possibility of further dividend increases and more defense spending by developing nations, and you have the setting for super price appreciation in the years ahead. Lockheed is a buy at current levels. My target price for the shares is $65 to $70 over the next 18 to 24 months."

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