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Flight Path for Lockheed Martin

Keith Schoonmaker, CFA

Keith Schoonmaker: Hello, I'm Keith Schoonmaker with Morningstar. I'm here today with our Lockheed analyst, Anil Daka. Anil, would you give us your general thesis on Lockheed?

Anil Daka: Sure. Lockheed Martin, as the largest defense contractor in the United States, is dependent on the defense budget to get its revenues. And defense budgets, we think, are going to stay stressed because the U.S. government is going to spend increasingly larger amounts on Social Security, Medicare, and other benefits, and with the foreign interest payments.

But that said, Lockheed has a very diverse platform, so it should withstand some budgetary disruptions. And along with that, it also has fast-growing programs, like the F-35, which should help it balance should there be any other problems with programs.

Schoonmaker: Anil, we've heard in the media recently that the F-22 was canceled. Can you give us an idea of how the F-22 and F-35 relate to each other?

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Daka: Sure. Both these jets are fifth-generation jets. That means they are stealthy, they can penetrate enemy radars, and they have advanced avionics. But the F-35 was supposed to provide more affordable stealth. And so, if you want to produce it in more quantities, you don't want to pay as much money as you want to pay if you want a fleet of F-22s, you are looking at the F-35.

Schoonmaker: I see. So the US will purchase a certain number, maybe 180-some F-22s...

Daka: 187.

Schoonmaker: 187, and supplement that with a larger fleet of F-35s.

Daka: That's correct.

Schoonmaker: Now, this larger fleet of F-35s, is this material to Lockheed? I think you've told me that this is the largest Department of Defense project on record. Is that correct?

Daka: That's correct. You're looking at close to $300 billion that the Department of Defense will spend over the next 25 years or so buying these airplanes. So it's a huge project with no historical comparisons. And with Lockheed, today they get just about 10% of their revenues from the F-35 program, but going forward, it could rise fast, to as much as 30%.

Schoonmaker: And as this revenue rises and goes through the time line of the lifespan of an F-35, there's a difference, isn't there, in the type of contract that the Department of Defense employs with its suppliers?

Daka: Right. At the start, when development work is being taken, it goes under a cost-plus kind of contract where the risk is more with the government than Lockheed. And with the gradual progress, it shifts to a fixed-price contract where the entire program just shifts to Lockheed.

Schoonmaker: I see. Anil, in this aircraft, there is a partnership with some other nations during development. Can anyone buy this aircraft? How does it work?

Daka: There are eight partner nations, most of them NATO nations, that are eligible to buy this aircraft. And right now Israel has also expressed some interest in purchasing the F-35.

Schoonmaker: Anil, are drones a threat to the success of this project, the unmanned aerial vehicles?

Daka: I think, over the long term, yes, because obviously you're not risking the pilot's life when you're flying a UAV, which is a huge benefit. And right now the drones are not as technologically capable as the manned systems are. But if youchart the progress of drones, then I think, over the long run, it will be a very significant threat to manned aerial systems.

Schoonmaker: Anil, your take, then, in general, is that despite the long-run threat of drones replacing some of the need for manned aircraft, that this project is still an extremely large project and quite material to Lockheed's success. Is that correct?

Daka: Absolutely, because development, it always takes time. Even for something like the F-35, they started the project in 2001, and after 10 years, they're just about done with the first batch of production. So development cycles run very long, and even before you have something that's capable of replacing an F-35 to come about, F-35 project will have run a very long course. This is going to go for a long time, and it's going to be very valuable for Lockheed.

Schoonmaker: Anil, given the materiality of this project, it seems like it could influence valuation significantly. Can you tell me about your thoughts on valuation of Lockheed at the moment?

Daka: At this point, Lockheed is trading for slightly less than our fair-value estimate. That said, we're looking for a very good margin of safety before we ask anyone to invest in stocks, and it still hasn't breached that barrier for the moment.

But Lockheed is what we think of as a wide-moat firm. By that, we mean--the F-35 project is a huge project, which is good. But more than that, the question we are asking ourselves is, does this firm have the ability to continuously win projects of that sort going forward? And we think Lockheed Martin, as a wide-moat firm, has that special quality. So we like the firm a lot, but we're still waiting for that margin of safety.

Schoonmaker: Thank you, Anil. Thank you for watching. I'm Keith Schoonmaker with Morningstar.