Inside Wall Street: Don't fear for this defense stock

Despite facing worst-case scenario, Lockheed is flying high.

By Gene Marcial Feb 2, 2012 1:06PM

Plans by Defense Secretary Leon Panetta  to substantially slash the defense budget have  placed contractors, such as the makers of military aircraft and weapons, in a bind.


But the stock of Lockheed Martin (LMT) is still flying high. It closed unchanged at $83.52 a share on Feb. 1, 2012, almost at its 52-week high of $83.72 reached on Jan. 19, 2012. And it's way up from its 52-week low of $66.36, where it tumbled on Aug. 10, 2011.


What's keeping Lockheed up at a time when investors should be stampeding out of defense stocks as the industry faces its biggest challenge yet? Lockheed is the largest defense contractor and military weapons manufacturer in the world, so you would expect it to be the largest loser from the projected cuts.


Not so, assert the bulls. "Lockheed Martin is both a value stock and dividend play, even as the market is probably pricing in the worst-case scenario about defense spending," says Joseph F. Hunt, principal at Northwest Criterion Asset Management in Princeton, N.J., which owns shares. He says the market expects "automatic sequestration" or severe budget cuts because of the failure of the Super Committee in Congress to reach an agreement on additional deficit reduction.


So why are Hunt and others so staunchly bullish on Lockheed? After all, some 85% of the company's sales are to the U.S. military. Among Lockheed's top products are the F-35 fighter jets and other military aircraft, as well space and missile systems. Hunt believes that since the market has been hearing about defense department cuts for a few years now, that issue has already been baked into the price of Lockheed's stock. And he expects the stock to fly higher, not lower, toward his goal of more than $100 a share over the next 18 to 24 months. Such a target could be achieved, says Hunt, if earnings in 2013 come in at a "very reasonable $8 a share and the price to earnings ratio expands 'slightly' to 12.5 times (near the mid-point of its five-year average)."


That's about a 10% compounded annual rate "before you include the 4.8% dividend yield," Hunt points out. He remains enthusiastic about the demand for Lockheed's products. Hunt notes that Lockheed doesn't just manufacture the F-35 and other airplanes, but is also positioned to provide reconnaissance systems, the very effective unmanned drones, cyber security systems, defense missiles, and other equipment of importance to the U.S. "They are the weapons systems of choice for fighting the kind of wars we fear in the future according to the military experts," says Hunt.


And worth noting, he adds, is that the stock is cheap -- yes, cheap, despite its continued rise. Here is how Hunt sees it: Lockheed is trading at the "low end of its five-year p/e range, and below the S&P multiple which, he says, some pros consider to be low." In the meantime, annual revenues have been above $40 billion since 2007, and the company  ended 2011 with sales of $46.4 billion and an $80 billion order backlog. While Lockheed has reduced its workforce by 16% since 2008, it has been expanding sales to international clients. And equally important, Lockheed pays a healthy dividend yield of 4.88%. It has raised the dividend by 20% annually over the past five years. Free cash flow, another important financial metric, has stayed between $2.3 billion and $3.5 billion since 2005. Lockheed is a god buy despite the budget storm, says Hunt.


Analyst Ian Gendler of independent investment research firm Value Line, who ranks Lockheed as "above-average in timeliness," says demand for the company's various aircraft and electronics systems should remain strong despite defense budget cuts. Lockheed should be able to weather the looming storm better than its peers, says Gendler, mainly because "we consider many of its products as vital to the defense of the U.S."


For 2012, Gendler expects Lockheed will earn $8.60 a share on revenues of $47.5 billion, up from 2011's $7.85 on sales of $46.4 billion. For the long haul, Lockheed's total return potential is above the Value Line median, says Gendler.


Gene Marcial wrote the column “Inside Wall Street” for Business Week for 28 years and now writes for MSN Money’s Top Stocks. He also wrote the book "Seven Commandments of Stock Investing," published by FT Press.

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