The major area of concern for defense contracting companies continues to be the concern about cuts on military spending in the U.S. With the pull back from Iraq and the winding down of U.S. involvement in Afghanistan, defense spending is bound to be reduced in the next decade in the interest of reducing the budgetary deficit and the national debt. This will definitely have its impact on the business of Lockheed Martin and I will explore this aspect a little later.
Lockheed Martin is the largest defense contractor in the world and a number of factors are going to put pressure on both growth and operating margins over the next 10 years. The U.S. government currently accounts for over 80% of its business mainly from the Department of Defense. This business is bound to reduce as defense spending cuts take effect and major contractors will be competing for fewer dollars. Because pricing and contracting terms will be set by the U.S. government, I considered it obvious that Lockheed Martin's top-line growth will not be the same as it was in the past.
Lockheed Martin has already experienced cost overruns with the F-35 fighter jets because of problems with production as well as the increased cost of inputs. There is an increasing tendency for the US government to insist on fixed-price contracts and manufacturers will simply not be able to exceed their budgets. Clearly, Lockheed Martin's operating margins will shrink unless they are extremely efficient in hitting their targets for both production and costs. Pressure on margins is likely to continue when you consider the high debt-to-equity ratio and the consequent debt servicing costs as well as the increasing liability for pensions. However, I consider it unlikely that the dividend of 3.7% would be slashed in the foreseeable future.
Lockheed Martin focuses on the business of aerospace platforms and high-technology electronic systems. Over the last few years, the company has sold off businesses that do not fit its core competence of aircraft design, missiles systems and systems for global surveillance. This has enabled it to concentrate its energies and efforts white making the most of synergies. It also has partnerships with other defense contractors so that complete solutions can be provided to customers. Some jobs have already been cut to save costs and I expect that there will be more staff reductions depending on the size of the reduction in defense spending.
The majority of U.S. defense contracts go to six contractors namely Lockheed Martin, Boeing (NYSE:BA), Northrop Grumman (NYSE:NOC), General Dynamics (NYSE:GD), BAE Systems (BAESF.PK) and Raytheon (NYSE:RTN). The U.S. government policy is to distribute the business between these six to create competition as well as the safety of multiple suppliers. As we have already noted, the largest of these is Lockheed Martin and it should maintain this position if they continues to maintain their technology standards and keep their noses clean.
The U.S. government business despite the budget reduction is reasonably stable and should continue to be so despite the somewhat limited profitability. I should point out that the returns that commercial aerospace companies can generate are in excess of what defense contractors can hope to earn.
Obviously, any attempt on the part of Lockheed Martin to reduce its huge dependence on the U.S. government by pursuing the applications of military technology would go a long way in improving its margins and diversify its business. For example, about 50% of Boeing's revenues are derived from commercial aircraft and over a quarter of the revenues of General Dynamics come from non-American military customers. The company would do well to pursue defense contracts outside the U.S. as well. However, I should point out that the F-35 Joint Strike fighter, unmanned planes, missiles and systems will continue to take priority in defense spending and this should suit the strengths of Lockheed Martin.
It is clear that an increasing proportion of fixed cost contracts and no say in pricing, the company would have to be far more efficient in controlling its operating costs. Production is another major cause for concern and, in the year 2010, the company missed out on four out of five bonus is that it could have earned on the F-35 program because of problems with production.
There are some basic issues to be sorted out and I would have to point out that the company has not yet shown the ability to tackle these issues properly. However, the annual dividend payout of about $1 billion is well covered over by the yearly free cash generation of over $2 billion and the cash balances and, even in a gloomy low growth scenario, there should be no problem in maintaining the dividend. Despite all the defense spending concerns, I expect Lockheed Martin to continue to be profitable because a certain level of defense spending is inevitable, but the company needs to adjust to the new reality.
To sum up, I would certainly hold the stock if I have an existing investment because the dividend yield makes it attractive. Should emotions or other factors cause a temporary drop in the stock price, it will present an attractive buying opportunity. In fact, any sign that the company is coping with its production problems and enhancing its operating margins could also make it an attractive candidate for further investment.