Recent second quarter results from Lockheed Martin (LMT, Financial) were generally positive. The defense company’s revenue increased by 7% to $13.4 billion versus the same period of the previous year. Earnings per share increased by 23.5% to $4.05, with all four of its main divisions recording profit growth.
Aeronautics remains its largest division, accounting for 40% of total revenue in the quarter and generating 8% growth versus the same period of the previous year. The company’s Missions and Fire Control segment was its strongest-performing, delivering growth of 17%.
The company increased its guidance for the full year. It now expects to record sales of between $51.6 billion and $53.1 billion, with earnings per share forecast to be between $16.75 and $17.05.
Improving outlook
Since the release of its second quarter results, the company’s stock price has risen by 2%. It has gained 7% in the last year, which is significantly lower than the S&P 500’s 18% rise in the same time period.
The prospects for the global defense industry appear to be positive, and could act as a catalyst on Lockheed Martin’s financial performance. The U.S. military budget is set to increase by 7% to $716 billion in the 2018 fiscal year. Further growth is likely to be ahead in future years, with President Trump saying that he would like to raise spending on the military from the current level of 3.1% of GDP to as much as 4%.
Trump is also seeking to lift defense spending among NATO allies. In 2010, NATO countries agreed to spend at least 2% of GDP on defense, with at least 20% of that total being earmarked for modernization. Since his election, though, Trump has called for an increase to 2% immediately, as well as a 4% long-term target.
Since only five NATO countries including the U.S. spend 2% or more of their GDP on defense, there could be significant growth in defense spending on a global basis over the medium term. This could lead to rising demand for Lockheed Martin’s products, which could catalyze its bottom line.
Competitive advantage
One area that could provide the company with significant growth is hypersonic technology. This sector encompasses weapons and interceptors that are able to travel at five times the speed of sound. They are becoming an increasingly important area for the U.S. military, with Russia and China seemingly ahead of them in terms of development. This means that significant investment could be set to take place over the next few years as the U.S. attempts to play catch-up to its global rivals.
Lockheed Martin looks set to be a major beneficiary of the situation. It was recently awarded a $480 million contract to develop a hypersonic air-launched rapid response weapon (ARRW). This followed a $928 million contract award in April to develop a hypersonic conventional strike weapon (HCSW). The company was able to beat its rivals to those contracts at least partly because it is further along in the development process of key areas such as the air-launched booster and ordnance subsystems that are required. This competitive advantage could lead to further contract wins in what may prove to be an area of growing importance for the U.S. military, given the progress made in recent years by its rivals.
Potential threat
A possible threat facing Lockheed Martin is the tariffs being put in place by the Trump administration. These could cause NATO allies to focus on building up their domestic defense capabilities as part of a wider program to protect domestic jobs and industry.
Politicians in countries such as Germany, France and other NATO members may find it relatively easy to sell the idea of awarding defense contracts to domestic companies and employers to their electorate. This could make it more difficult for U.S. defense companies such as Lockheed Martin to win new contracts internationally.
Despite this risk, the overall prospects for the company appear to be positive. It is in the process of reducing costs for the F-35, which remains a key driver of its revenue and profit growth. For instance, the recent decision to change the supplier of a key sensor system could save more than $3 billion.
The company is aiming to reduce the cost of the F-35 to below $80 million by 2020, compared to $95 million currently. This could help it to become increasingly competitive versus international rivals. It has also promised to work closely with international industrial companies to help build up their local capabilities. This could help to increase its appeal to NATO members over the medium term, since awarding contracts to Lockheed Martin could indirectly boost the local economy.
Verdict
With the defense industry expected to grow significantly over the medium term, Lockheed Martin could enjoy a tailwind. It seems to have a strong position in areas such as hypersonic technology, while it may be able to win further international contracts in spite of fears surrounding tariffs. With cost reductions on the F-35 set to come through over the next few years, its revenue and profitability could be positively catalyzed by further project wins. As a result, its shares could deliver improved performance versus the S&P 500 over the medium term.
