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Morningstar | Lockheed's Other Businesses Push F-35 Off Center Stage During 2Q

Wide-moat Lockheed Martin reported second-quarter results that featured an earnings beat and a full-year guidance upgrade across all its businesses for both revenue and profits. The upgrade confirms our view that growth will accelerate for defense names through 2019, as higher U.S. defense budget authority translates into outlays. In addition, under the new ASC 606 revenue recognition, nearly all contracts are using percentage of completion, which accelerates revenue (not cash flows). Although we're not moving up our long-term forecasts, we did increase our 2018 projections and anticipate our fair value estimate increasing to around $326 per share from $318.

Revenue rose 6.6% year over year with the missiles and fire control business leading the way, growing nearly 17% in the quarter. Management attributed MFC's performance to contract awards being booked as revenue thanks to ASC 606, and we also think that the shorter-cycle nature of MFC's business means that increasing budgets are turning into outlays a bit earlier here. Aeronautics posted respectable 8% growth in its top line thanks primarily to the F-35.

Margins in each segment contracted with the notable exception of rotary and mission systems, where operating margins expanded approximately 170 basis points due to cost reductions and related risk retirements. We think RMS will probably land at the high end of 2018 operating profit guidance of $1.235 billion. The C-5 drove most of the 80 basis points of margin contraction at aeronautics, not the F-35; we believe the fifth-generation F-35 remains in double-digit margin territory.

Earnings per share rose to $4.05 from $3.28 last year thanks to higher profits ($1.8 billion consolidated profit versus $1.7 billion last year), a lower tax rate, and fewer shares outstanding. We note that the $4.05 includes a $0.26 charge in RMS due to restructuring in Sikorsky's military business, as well as a charge on MFC's Warrior vehicle program with the United Kingdom.

Large U.S. Department of Defense competitions for Lockheed that may be awarded in the next six to nine months include the MQ-25 unmanned carrier aviation system for the U.S. Navy, the T-X trainer aircraft for the U.S. Air Force, and the UH-1 Huey replacement for the U.S. Air Force. The MQ-25 program looks to be decreasing in scope and budgeted dollars and therefore doesn't represent as large an opportunity as we previously thought. The T-X trainer program pits Lockheed against Boeing, and we continue to believe Lockheed has a slight edge, given the maturity of its aircraft design, coupled with the U. S. Air Force's desire to keep a lid on costs.

Despite upcoming program awards as well as strong MFC growth and solid RMS profits, we think the F-35 continues to drive Lockheed's stock price and estimate that the program is worth at least $33 per share (about 10% of our fair value estimate). As of mid-2018, Lockheed had delivered 309 F-35s; total quantities for the F-35 are projected at just over 2,400 for the United States and we think that at least another 1,000 deliveries will materialize for international customers over the life of the program. Although buys may be stretched out next decade, we don't think large cuts in total F-35 planned production will occur and note that Lockheed is likely to secure (probably around this time next year) a multiple-lot contract for the F-35, totaling about 450 aircraft. We think this acquisition approach is an innovative way to achieve multiyear procurement economics, and while Lockheed will need to share cost savings with the Department of Defense, the contract should still result in higher program margins in 2020 and beyond.

Management also discussed details of its FAS/CAS pension adjustments on the call. For investors, we think the key point is Lockheed's view that its CAS recoveries, which are best thought of as a receivable that unwinds, will be greater than pension outlays until at least 2025, which means the company will continue to benefit from a cash tailwind for the foreseeable future. Management believes its CAS benefit will hover around $2.4 billion until 2021-22.