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Morningstar | Lockheed Reports Solid 3Q, but 2019 Margin and Revenue Outlook a Bit Below Our Expectations

Wide-moat Lockheed Martin reported its third-quarter 2018 that featured an earnings beat, and management also raised 2018 EPS guidance to $17.50 from $16.75-$17.05 previously. Operations drove 40 cents of the EPS guidance increase, while lower taxes generated the remainder. Encouragingly, growth across all of Lockheed’s businesses contributed to the EPS lift, and all units are now projected to come in at the high end of their previous guidance ranges for 2018 revenue and profits.

We also got a glimpse at 2019, and management's initial outlook was a bit lower than we expected for operating margins. Although revenue growth came in above consensus, it still looks conservative to us. We've refined our model, taking into account various puts and takes in 2019 and beyond, which on net were value-neutral. The $2 increase to our fair value estimate to $329 stems primarily from the time value of money since our last update.

Sales increased 16% year over year this quarter, with the aeronautics business driving growth (up 19.6% year over year) due to the F-35. Although backlog grew during the quarter thanks to $18 billion in order intake, Lockheed has been on the losing end of three high-profile competitions recently--the two largest were to Boeing on MQ-25 and T-X trainer. Our assessment was that Boeing bid aggressively on its recent wins and this was confirmed today by Lockheed, which stated that it would have lost $5 billion cumulative if it matched the winning bids that it faced in recent competitions.

Segment operating margins--profitability before FAS/CAS adjustments and corporate items--expanded 70 basis points to 11.1% this quarter thanks to space systems and rotary and mission systems. That said, F-35 had an excellent quarter, with strong incremental margins due to risk retirements and continued progress down the learning curve (management cites a mid-80% learning curve effect).

Management provided an initial outlook for 2019 that featured 5% to 6% revenue growth and segment operating margins of 10.5% to 10.8%. The year-over-year margin pressure anticipated for 2019 is coming mainly from lower ULA--the launch JV with Boeing--equity earnings due to fewer profitable Delta IV launches, and from a higher mix of cost-plus classified work, which is something we've heard from other major defense contractors. In response, we're trimming our margins slightly for 2019 but sticking with our growth forecast of around 6.5%. As we outlined in our recent report, "Investors are Hungover on Defense Stocks, but the Spending Party Hasn't Even Started Yet," we think accelerating Department of Defense outlays will fuel top-line growth for contractors like Lockheed.

Lockheed anticipates over $7 billion in cash from operations next year, and we were at $7.1 billion for cash flow going into the call. The management team also appears to view $7 billion as a floor for operating cash flow and that the company should be able to be at or above this level over the next three years despite some working capital growth next year and potentially in 2020. Capital expenditure guidance came in a bit higher than we anticipated, with management citing a $1.5 billion figure next year (our estimate stood at $1.3 billion) and hinting at further growth in 2020 before capital spending begins to taper in 2021. We're moving up our capital expenditures in 2019 and 2020.

Lockheed paid $1.5 billion in pension contributions this quarter, wrapping up its $5 billion of pension outlays for this year and allowing the company to take advantage of the tax deduction at the previous, higher U.S. corporate tax rates. We don't anticipate contributions in 2019, but management guidance suggests 2020 might see another, more modest round of pension contributions.