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Stocks  | October 26, 2020

Lockheed Martin (NYSE: LMT) exceeded expectations in the third quarter, yet the stock still sold off by more than 2% on the news.

It's an election year, and defense investors are bracing for the worst in terms of future budgeting trends. Lockheed Martin's report only reinforced those concerns, causing the stock to sell-off. For patient, long-term investors, that fear has created an opportunity.

Good Quarter, But Then What?

Lockheed Martin earned $6.25 per share in the third quarter on revenue of $16.5 billion, topping analyst expectations of $6.09 per share in earnings on sales of $16.1 billion. The company reported strength across its portfolio, with missile sales up 14%, aeronautics and helicopters both up 8%, and space up 6%.

The company generated an operating margin of 10.7% for the quarter, in line with expectations, and billed slightly more than it booked. Lockheed Martin's last 12-month book-to-bill ratio is 1.2, and the company ended the quarter with a backlog of more than $150 billion in future orders.

But markets were more focused on the guidance. Lockheed Martin expects net sales "greater than or equal to" $67 billion in 2021, which is short of the $68 billion consensus. That might have been dismissed as a rounding error in more normal times, but with investors already worried about the future trajectory of defense spending, the modest guidance was not welcome news.

The Pentagon has been telegraphing a flattening budget, and there is concern trillions in unexpected COVID-19 spending will cause the government to cut further. Fears of post-election Washington gridlock run high: Investors have memories of Lockheed Martin and other defense contractors struggling during the middle of the last decade as partisan budget battles led to a freeze in spending.

Focus On The Long Term

Investors can't be blamed for hitting the panic button. After all, Lockheed Martin in its release said the disappointing guidance assumes "there will not be significant reductions in customer budgets" or changes in U.S. funding priorities. That implies there could be downside to that guidance should things go wrong.

But it's worth noting the 2021 outlook, though short of expectations, isn't bad. Lockheed Martin's forecasted revenue implies 2.5% growth over the $65.25 billion in net sales expected in 2020.

The company also expects to generate $8.1 billion in cash from operations in 2021, net of $1 billion in planned pension contributions. That's in line with the $8 billion expected this year, and the guidance is up $300 million from what was expected three months ago.

Part of the issue for Lockheed Martin is this -- after years of strong growth in its missiles division as the U.S. government restocked, that business is beginning to normalize. There are also timing issues involving expected revenue from key programs.

It's important not to get caught up in one year's results. Lockheed Martin's massive backlog provides revenue predictability into the latter years of this decade, and the company has several large potential contracts that could come its way.

Lockheed Martin remains at the forefront on hypersonics, missiles traveling much faster than the speed of sound, is a finalist for two major helicopter awards, and is even considering dabbling in new areas like 5G networking. It also reported strong growth in its classified businesses, which could hint at something big up ahead.

A New Plane Deal Coming?

Earlier this month I speculated that it is Lockheed Martin that's working with the Air Force on the development of a new fighter plane, a potentially lucrative contract. It's a classified program, and neither contractors nor the Air Force is talking much about it now, but management during the post-earnings call provided hints that suggest it is indeed Lockheed on the deal.

CFO Kenneth R. Possenriede said, "We anticipate seeing strong double-digit growth at our Skunk Works, or classified advanced development programs" in its aeronautics segment. And CEO James Taiclet said "much of what spent this year" is related to classified programs in both aeronautics and space.

That Lockheed Skunk Works facility in California is one of the most well-respected research labs in aerospace and could be working on any number of new fighter or spy planes for the government.

But the timing of both the expenditures and the potential future revenue lines up well with the development of the Air Force's Next Generation Air Dominance (NGAD) prototype, meaning Lockheed Martin could have another new big payday waiting in the wings.

Ignore The Noise; Lockheed Is A Buy

There is still a lot of uncertainty clouding 2021. Lockheed Martin is down 4% for the year, underperforming the S&P 500 index but doing better than the SPADE Defense Index. Investors came into earnings season looking for reassurance their concerns were overblown, but the company did little to ease that anxiety.

LMT Chart

That said, even if 2021 is up only slightly, Lockheed Martin has the backlog and the portfolio in place to generate steady growth in the years to come; it should have billions in cash at its disposal for share repurchases, acquisitions, and to support and grow its decent 2.5% dividend yield. And there is a lot of potential in new programs that could add to that backlog and boost future revenue.

The 2021 guidance looks conservative, and I expect Lockheed Martin to easily exceed it. But even if the company is not able to grow revenue as quickly as I hope, this is a best-of-breed industrial with a visible growth trajectory that should outperform over the years.

The markets overreacted. For those willing to look past the current cycle, Lockheed Martin remains a solid buy.

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