The recent results from defense contractor Lockheed Martin(NYSE: LMT) led to a sharp sell-off in the stock, and it now trades sharply below the $615 level it was at before its release. Is this a buying opportunity or a potential value trap? Here's the lowdown.
Lockheed Martin's big news
Defense contractors are typically seen as safe investments. After all, it's hard to find a more reliable customer than the U.S. government, and defense spending tends to be stable through the economic cycle. Moreover, there's no shortage of geopolitical conflict in the world right now, and that's stimulating defense spending, whether it's to replenish equipment used in disputes or to support increased defense needs. Furthermore, Lockheeds's fastest-growing segment over the next few years, missiles and fire control, is also its highest-margin business.
Operating Margin | Net Sales | Nine Months' Operating Margin | Operating Profit |
|---|---|---|---|
Aeronautics | $20.6 billion | 10.1% | $2.1 billion |
Missiles and Fire Control | $9.3 billion | 13.1% | $1.2 billion |
Rotary and Mission Systems | $13 billion | 10.8% | $1.4 billion |
Space | $9.5 bllion | 9.9% | $943 million |
Total business segment operating margin | $52.4 billion | 10.8% | $5.6 billion |
Data source: Lockheed Martin presentations.
Framed this way, investing in Lockheed Martin is attractive. Still, every stock must be valued on a risk/reward basis, and this defense stock is no different.
Valuation still matters
A mature, low-growth, stable company should arguably trade on a valuation multiple of about 20 times free cash flow (FCF) or, put another way, an FCF yield of 5%. This yield is above the benchmark 10-year Treasury rate of 4.2% and offers some extra reward over a risk-free rate.
Lockheed Martin's management expects $6.2 billion in FCF in 2024, which puts the company at 21.6 times FCF in 2024 or an FCF yield of 4.6% based on the current market price. In addition, management outlined their medium-term outlook for FCF growth on the recent earnings presentation, calling for a baseline scenario of a compound annual growth rate in the low single-digit range. Plugging in the middle of the low single-digit range, i.e., 1.5% into FCF growth, leads to $6.4 billion in FCF in 2026, meaning Lockheed Martin trades on 21 times 2026 FCF.
As such, the stock does not look like a good value unless some of the upside catalysts referred to in the presentation -- "campaign wins, production ramps, and budgets & funding" -- come through to raise sales, margin, and FCF expectations.
Risk and reward for Lockheed Martin
Unfortunately, it's not easy to see a pathway to those catalysts. First, the U.S. Department of Defense's proposed budget for 2025 is a record $849.8 billion, and given the state of government debt levels, both in the U.S. and elsewhere, it's hard to see how this can grow significantly from here.
As for production ramps, the reality is the leading defense contractors, including Lockheed Martin, notably with the F-35 and its technology refresh, have suffered cost overruns and margin pressures in recent years. The increasing complexity of defense technology, married with tougher bargaining by the government, notably over fixed-price development programs, has pressured margins all over the industry.
Image source: Getty Images.
Legal issues and the termination of a fixed-price development contract caused a $1.5 billion hit to RTX's FCF outlook earlier in the year. Boeing's defense business reported another loss in the third quarter , and Lockheed Martin has had its own pressures.
Indeed, Lockheed Martin's management believes it won't be until 2027 that it gets back to its more "normal range of around 11%" return on sales (operating margin) compared to its current outlook for 10.5% margin in 2024.
Image source: Getty Images.
Is Lockheed Martin Stock to buy?
Lockheed Martin is an attractive company, but the stock's valuation makes it hard to see significant upside. Its valuation appears to have growth expectations baked into it that are not representative of a mature, low-growth company. In other words, investors expect a lot from a company whose management tells them its FCF is likely to only grow at a low single-digit rate over the medium term.
Moreover, a relatively tepid outlook for margin expansion highlights the difficulties defense companies are having with margins. All told, despite the recent decline, Lockheed Martin still isn't an outstanding value stock.
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Lee Samaha has no position in any of the stocks mentioned. The Motley Fool recommends Lockheed Martin and RTX. The Motley Fool has a disclosure policy.
