A Defense Stock with Attractive Payload

12/23/2010 2:00 pm EST


Josh Peters

Editor, Morningstar DividendInvestor

Lockheed Martin’s generous dividend should stay airborne despite the coming federal budget cuts, write Josh Peters and Anil Daka of Morningstar DividendInvestor.

Since the early 1990s merger of Lockheed and Martin Marietta, Lockheed Martin (NYSE: LMT) has extended its lead in aerospace with products like the F-22 and F-35, which promise to dominate combat airspace unlike any other
fighter jets in the world.

The F-35 program in particular will be a huge growth driver. This multi-role stealth fighter will replace the aging fleet of Air Force F-16, Navy F/A-18, and Marines AV-8B aircraft. The F-35 program calls for a delivery of as many as 3,173 aircraft to eight countries. Overall, the project is worth as much as $1 trillion—$300 billion in new equipment and $700 billion in maintenance contracts—and will power earnings growth for years to come.

Lockheed is also poised to extend its expertise in the burgeoning information systems business. Modern warfare increasingly depends on systems to analyze threats and secure information assets. We forecast government funding to continue unabated in this sector and expect Lockheed’s $12 billion information systems revenue to increase commensurately.

Combating a Budget Squeeze
However, a tightening defense budget and a large unfunded pension plan will mar earnings growth. The mandatory portion of the federal budget—consisting of Social Security, Medicare, and Medicaid—will grow faster than federal revenue, straining budget allocations to non-mandatory spending. Consequently, defense spending will see a reduced budget allocation.

Large defense projects like the F-22 Raptor have come under the knife. Lockheed also carries an unfunded $11 billion liability, though there is considerable uncertainty surrounding the cash required to fund this liability. Around 65% of the firm’s contracts are of the cost-plus type that allows pension cost reimbursement from the federal government. We think Lockheed’s pension-related cash outflow is mostly recoverable, though accounting earnings might paint a slightly different picture.

Based on our 2011 earnings forecast of $6.53 a share, a dividend payout ratio of 46% would offer a decent level of income security, and Lockheed’s modest net debt (less than six months’ worth of operating cash flow before pension contributions) does not appear threatening. However, the status of the firm’s underfunded
retirement plans will bear close watching.

The Dividend Arms Race
Lockheed’s quarterly dividend rate has risen 150% (20% annually) in the past five years, though a fair portion of this expansion has come by way of a higher payout ratio. While we applaud the firm’s move to devote more of its cash flow to dividends, additional upside from this source is limited. With pressures on defense spending likely to keep revenue roughly flat, we expect net income to stay around $2.5 billion over the next five years. But with much of the excess cash flow likely to be used for share repurchases, we see the potential for per-share earnings and dividends to rise at a 5% to 7% average pace over this period.

At our buy price of $70, Lockheed could provide a 4.3% yield with a long-run total return profile of 9% to 11%. But amid threats posed by US government finances and Lockheed’s pension, a larger margin of safety could prove beneficial. [Shares traded modestly above $69 Thursday, for a forward dividend yield of 4.3%--Editor.]
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