Fitch Ratings has lowered Lockheed Martin's (LMT) ratings outlook last week to negative from stable. The downgrade in ratings outlook has been brought about by a combination of factors.

First, in-depth scrutiny of U.S. defense spending caused by rising concerns on high federal deficit. Second, Lockheed Martin's large cash payouts to fund its $13.3 billion pension deficit. And third, Lockheed Martin's debt, which has risen by more than $1.4 billion in 2011 and more than $2.8 billion over the last three years. Certain minor factors such as the ongoing labor strike at Lockheed Martin's Ft. Worth facility have also contributed to the downgrade.

We currently have a Trefis price estimate of $86 for Lockheed Martin, 5% above its current stock market price.

US defense spending under pressure

U.S. Department of Defense has come under pressure from U.S. legislators over its high defense spending. The legislators, in turn, are trying to control the mammoth federal deficit, $1.6 trillion estimated for the year 2011, exceeding 10% of the U.S. GDP, as mentioned in the budget for fiscal year 2012. The estimated outlay for National Defense stood at $768 billion for 2011. The important point to note, however, is that the estimated outlay for National Defense for 2016 is $679 billion, a fall of nearly $90 billion!

Lockheed Martin receives more than 80% of its revenues from U.S. government. Thus, a cut in U.S. defense spending is bound to impact sales figures of Lockheed Martin.

On the other hand, the ratings agency may revise its ratings outlook to stable in case U.S. defense spending cuts do not impact Lockheed Martin's main programs such as, F-35 Joint Strike Fighter.

Large cash payouts to fund pension deficit and to disburse dividends

Lockheed Martin contributed $2.3 billion and $2.2 billion of cash in 2011 and 2010 respectively to fund pension costs. However still, at the end of 2011 pension deficit stood at $13.3 billion. We anticipate large cash payouts to fund pension deficit over the next few years as well.

Also, Lockheed Martin has adopted a shareholder focused cash payout strategy over the last few years. Since 2009, the company has repurchased approximately $7 billion worth of stock, and paid dividends exceeding $1 billion annually. As a result, stock repurchases and dividend distributions have exceeded free cash flows for each of the past three years, and we anticipate large cash payouts towards stock repurchases and dividend distributions over the next few years as well.

The disproportionately high usage of cash to fund pension deficit and to disburse dividends have contributed to the downgrade in Fitch Ratings Outlook. However, very strong cash flows from operations, $6.5 billion in 2011 and $6.0 billion in 2010 have partially offset the impact of large cash payouts to pension deficit and dividend distribution.

It is also important to note that the ratings agency has maintained the company's long-term debt-rate at A-minus, and may revise its ratings outlook for the company back to stable, in case the company produces better than expected revenue figures supported by its huge backlog, reins-in its pension deficit and reduces the disproportionately high cash payout to shareholders. Until then, it has to live with a negative Fitch Ratings outlook.

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