Lockheed Martin: Robust Backlog Points To Sustained Growth (NYSE:LMT)

Record backlog

My goal for this article is to argue for a buy thesis on Lockheed Martin (NYSE:LMT). I will argue that the stock presents a solid buying opportunity considering the demand for its products with all the ongoing geopolitical conflicts, the record backlog reported in 2023 Q4, and also the attractive P/E. The many geopolitical tensions around the globe could lead to increased defense spending, directly benefiting LMT. And this is reflected in the record backlog reported in Q4 2023 (see the chart below). Its current backlog sits at a whopping $160.57B. As commented by its President and CEO Jim Taiclet,

Our solid finish to 2023 and full-year results reflect continued strong demand for our all-domain portfolio of advanced defense tech solutions. Backlog reached a record $160.6 billion and sales increased 2 percent year-over-year to $67.6 billion…

I agree with the CEO optimism for continued demand for LMT’s products. To cite a few notable examples, outstanding orders at the Aeronautics division exceed $60 billion. U.S. and allied demand are favorable, most notably, for F-35 and F-16 fighter jets. Missiles and Fire Control has over $32 billion of business in the hopper. The U.S. Army and European forces are keen to modernize their precision strike and interceptor systems. Rotary and Mission Systems has a backlog of nearly $38 billion. In the meantime, international demand (from a long list of allies including Spain, Norway, India, Greece, South Korea, and Singapore) are all planning to augment their air capabilities, very likely with LMT systems. All told, I believe the record backlog and future demand will translate to sustained profit growth for LMT in the years to come.

Yet, the stock is still trading at a very reasonable valuation and thus offering excellent return potential, as detailed in the next section.

Valuation and projected returns

The next chart shows consensus estimates for Lockheed Martin’s future EPS over the next 4 years. As seen, analysts estimate that LMT’s EPS will decline slightly in fiscal year 2024 to $26.0 (i.e., a decrease of 6.55% YOY). However, after that, EPS is then expected to rebound and grow steadily over the next four years. By fiscal year 2027, analysts estimate that EPS will reach $30.88, representing a CAGR growth of ~6% between 2024 and 2027.

Given the growth catalysts mentioned above, I think such a CAGR is very feasible in the next few years. As an independent approach, I also estimated LMT’s long-term growth rate from its ROCE (return on capital employed) and reinvestment rates (“RR”). LMT has been maintaining a ROCE of around 35% in recent years and a RR of around 10%. As a result, the real growth rate is projected to be 3.5% (which comes from ROCE * RR = 35% * 10% = 3.5%). Adding an inflation escalator of 2~3% will lead to a notional growth rate of about 5.5% to 6.5%.

If we can agree on the above long-term growth rate, then the projection of the long-term future return is quite simple. Our approach is details in this free blog article and the gist is summarized here:

• The long-term ROI for a business owner is simply determined by two things: A) the price paid to buy the business and B) the growth rate of the business (which reflects its quality and moat).
• More specifically, part A is determined by the owner’s earning yield (“OEY”) when we purchased the business. Part B is determined by the ROCE and RR in the long term.
• That is, Longer-Term ROI = OEY + Growth Rate = OEY + ROCE*Reinvestment Rate

The application of the above approach for LMT is summary in the table below. Here, I am approximating its OEY (owners’ earning yield) with the earning yield to be on the conservative side. At its current FY1 P/E of 17.15x, LMT offers an OEY of ~5.8%. As mentioned earlier, assuming it can maintain a ROCE of 35% and RR of 10% sustainably, its real growth rate would be close to 3.5% per annum. Thus, the total expected return – the real return before inflation – would be in the 9%+ range. Adding an inflation escalator could push the return to be above 10%+. This is far above what I expect from the overall market under its current elevated valuation (and lower ROCE) as shown in the table below.

Other risks and final thoughts

In addition to the positives mentioned above, it is important to note that there are other risks, some of them common to LMT and its peers but others more particular to LMT. Defense spending is highly dependent on global tensions, which are ultimately unpredictable. If conflicts de-escalate or defense budgets tighten, it could negatively impact sales for LMT and other defense contractors as well. The defense contractors also compete against each other. For LMT, bidding wars for contracts and competition from other major players like Boeing and Northrop Grumman can squeeze profit margins.

In terms of risks more particular for LMT, its heavy reliance on the F-35 program is at the top of my list. The F-35 program is a major source of revenue for LMT. Delays or problems with the program could disproportionately impact LMT compared to peers with a more diversified product portfolio. LMT also relies on a complex network of suppliers for parts and materials. Disruptions in the supply chain, especially due to geopolitical events, could significantly impact production for LMT. And as of now, there are indeed a few software and hardware-supply glitches likely will delay deliveries of upgraded F-35 models in the next 1~2 year, which could affect its consolidated sales growth.

All told, I see the above issues mostly temporary. The only exception is competition – which has been and will always be there, but then LMT has a wide and stable moat with its technologies and customer relations. Looking past these near-term issues, I see an excellent business for sale at a reasonable price. In particular, it currently sits on a record backlog, providing a good indication of the robust demand for its products and a strong support for sustained growth in the years to come.