Revenue growth is expected to slow down with potential congressional budget cuts. The jury is still out on how government budget concerns are going to affect defense spending. Congress enacted a deficit reduction plan calling for $487 billion in defense cuts over the next 10 years to reduce federal deficits. I am not sure how that will play out yet — conventional military equipment such as planes, tanks and ships are aging and need to be replaced so I am not really sure were defense spending will be cut. The DOD also faces a $500 billion "sequestration" starting in February 2013, which will further reduce spending over 10 years. However, Congress has the power to remove this sequestration.
The majority of Lockheed's sales come from the U.S. government. From a historical stand point, the defense budget almost never faces substantial cuts. Even with the all the congressional talk of spending cuts, when the rubber hits the road I doubt that defense spending will be cut as much as expected. Historically, the defense department's budget expands 8% annually.
As improvements continue in the global economy, commercial air traffic should increase. According to airline trade associations, passage air traffic grew 5.9% in 2011 and demand for passenger jets is increasing in developing markets. In the U.S. and other mature passenger markets, planes are aging and need to be replaced. Growth in demand for passenger jets is evidenced by back orders of six to seven years at both Boeing (BA) and Airbus, and both have seen significant increases in production. Boeing and Airbus both expect to see revenue growth of 40% over the next three years.
The aeronautic segment accounted for 30% of Lockheed's operating profits primarily through the sales of fighter plans and military transports. Fighters account for 68% of segment sales. Fighters produced by Lockheed include the F-35, F22 and F-16. Production of the F-22 will be completed in 2012. Sales of the F-35 to the U.S. government account for 12% of total sales.
The aeronautics segment is also home Lockheed's famous "Skunk Works" research and development laboratories. The electronics segment made up 34% of operating profits and is a major producer of navel combat systems for surface ships and submarines. Products include the Aegis Weapon System, the primary missile system for the navy. This segment also operates that Sandia National Laboratories for the U.S. Department of Energy. Space systems account for 19% of operating profits. Satellites made up 70% of revenue for space operations and the U.S government accounted for 97% of satellite sales. 17% of operating income came form information systems sales. Products include systems to support operations at the U.S. Department of Energy, a Ballistic Missile Defense System and the Airborne Maritime Joint Tactical Radio System.
Financially, Lockheed is in good shape. Free cash flow was 6% of revenue, or nearly $3 billion. With the exception of General Dynamics (GD) trading around $72, Lockheed's free cash flow as a percentage of revenue was higher than Boeing's 2.8% and Northrop Grumman's (NOC) 4%. Grumman trades around $61. General Dynamic's free cash flow was 9% of sales. The industry average was 6.7%. Lockheed's current ration is 1.2 with a ROA of 7.3%. Boeing has a current ration of 1.2 and a ROA of 5.4%. Lockheed's and Boeing's current ration of 1.2 compare favorable with Grumman's 1.3 and General Dynamics 1.4. ROA was 7.3% at Grumman and 7.6% at General Dynamics. With an ROE of 113.3%, Lockheed trades at 11.1 times 2012 estimated earnings of $8. Lockheed is trading at a discount to the industry average P/E of 13.
Currently Lockheed, Grumman and General Dynamics all trade at a discount to Boeing. Boeing trades at a premium of 17 times earnings. General Dynamics and Grumman both have a P/E that is similar to Lockheed's. Based on 2013 estimated earnings Lockheed should trade around $96 during the next 12 to 24 months, with a dividend yield of 4.52%.
Sales at Lockheed are expected to decline 2% in 2012, with revenue estimates of $45.57 billion. Grumman also expects a 5% decline in revenue. Both Lockheed and Grumman expect to see weaker revenues from reduced defenses spending. Revenues are expected to grow modestly at General Dynamics. Boeing on the other hand is expecting to see a 15% increase in revenue growth. Growth is going to be driven primarily by sales to commercial airlines. Boeing expects to deliver more commercial aircraft in 2012. Boeing expects to deliver 35 737s a month in 2012 compared to 31.5 in 2011. The company also expects to deliver more 747s and 787s.
I am expecting Lockheed's operating margins to increase slightly in 2012. Operating margins for 2012 are expected to be 8.7% up from 8.6% in 2011. This improvement is the result of a change in how Lockheed accounts for pension expense. General Dynamics' operating margins will fall slightly from 2011's. General Dynamics' operating margin is estimated to be 11.9% in 2012, down from 12.3% from the previous year. General Dynamics states that this reduction is from pricing pressures in its IT segment.
Operating margins at Grumman should decline half a percent to 11% in 2012. The company blames pricing pressure form existing contracts to be the cause of the decline. Boeing's operating margins are expected to decline 1.5% down to 7% from last year's 8.5%. Boeing cites lower margins on 787s and 747s and an increase in pension expenses as the causes for lower operating margins in 2012.
S&P estimates that Lockheed will earn $8 a share in 2012 and $8.7 in 2013. EPS growth will be driven primarily by Lockheed repurchasing shares. In 2011 Lockheed bough back $2.4 billion in shares and paid out $1.1 billion in dividends. Based on a P/E of 11.1 over the next 24 months Lockheed should trade between $88 and $97 a share.
I would be a buyer of Lockheed below $90. I think there is risk to stocks in the defense sector because of the uncertainty over U.S. budgetary issues that could result in weaker defense spending and if the global economy weakens, there could be a decline in airline spending. With a dividend yield of 4.52%, Lockheed provides a good alternative to fixed rate investments with a lower yield. As stated earlier I am a buyer below $90 because of the dividend and expected price appreciation over the next 24 months. With eight quarters of dividends at $4 annually and a gain of $7 a share, that gives a total return of 8% annually. This gain is based on receiving $8 in dividends over the next two years, selling the stock at $97 with a purchase price of $90.
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