Solid growth looks assured for the next few years, but what happens after that is questionable.
Whether the company is a buy is an interesting question, because it strikes at the heart of the bull-and-bear debate over Lockheed Martin (LMT 1.19%) stock. Here's how long-term investors should think about investing in the defense contractor.
Investors often like buying stock in defense contractors because of the surety of their end market customers; after all, you can't get a more reliable customer than the U.S. government (usually responsible for about 70% of its total sales) and sovereign governments worldwide. In addition, defense spending tends to be relatively stable and free of cyclical peaks and troughs that impact most equities.
These qualities make them solid candidates for a balanced portfolio. Throw in a medium-term growth kicker from the need to replenish equipment transferred to Ukraine, record U.S. defense budgets, and the concomitant hike in global defense spending (not least by existing and new NATO allies), and there's a strong case for buying the stock.
That said, every stock has its value, and a quick look at Lockheed Martin's valuation suggests it's being priced with some pretty positive assumptions in mind.
As the chart demonstrates, the stock is priced on a forward price-to-earnings ratio above 20 times earnings and an enterprise value (market cap plus net debt) to earnings before interest, taxation, depreciation, and amortization (EBITDA) valuation that looks relatively high compared to Lockheed Martin's recent valuations. In addition, on a price-to-free cash flow basis, the stock trades at slightly less than 22 times Wall Street estimates for free cash flow (FCF) in 2024.
In a nutshell, Lockheed Martin isn't being priced in as a mature industrial company with long-term revenue growth prospects in the low-single digits and relatively stagnant margins. Instead, it's being priced in as something more than that.
Due to events of the last couple of years, the company's backlog stood at a record at the end of 2023, and management expects it to increase in 2024 even as it expects its sales to grow 5% in 2024. However, Wall Street has Lockheed Martin's sales growth slowing to 4.2% in 2025 and then 3.7% in 2026. As such, the company is set to revert to the kind of low-single-digit sales growth that characterizes the industry.
That wouldn't be so bad an outcome if investors could point to margin expansion, which implies earnings could grow at an accelerated pace. Unfortunately, the future of defense industry margins is a hot subject now. Whether it's Boeing's defense business, RTX's defense business, or Lockheed Martin itself, the major defense contractors are facing margin pressures.
The issues come down to a combination of raw material price increases, supply chain difficulties, and, more concerning from a long-term perspective, executing problematic fixed-price development projects.
The latter point may be a structural issue: The U.S. government uses its buying power to force defense contractors into fixed-price projects that ultimately pressure margins.
Management recently spoke at the Morgan Stanley Laguna conference, and CEO Jim Taiclet implied there could be a growth and margin opportunity coming from international sales, which currently represent around 27% of sales. He expects international sales to be "anywhere between the next three to five years to have a growth rate that could be anywhere from mid-single digit to high end of the high-single-digit."
That's fine, but he also said that international sales come with "pretty much U.S. government-type margins because they're under the same contracting regime." As such, it's reasonable to assume that the increase in international sales in the next few years will not lead to any notable margin improvement.
He also said that after a few years, "we get into specific country requirements, you'll see a lot more direct commercial sales, and that's where the opportunity for our margins will come in." However, direct commercial sales are such a small part of Lockheed Martin's sales that they are unlikely to increase margins significantly.
All told, despite the current favorable conditions, Lockheed Martin doesn't look like a business set to significantly improve its long-term growth rate above the low single-digit range. There are also question marks around its margins and overreliance on the F-35 program for growth.
As such, the valuation, although reflective of a solid growth environment over the next few years, doesn't look overly attractive.