Lockheed Martin Corporation — Q3 2016 Form 10-Q
Reporting period: Quarter and nine months ended September 25, 2016; comparisons are to periods ended September 27, 2015. Figures are in U.S. dollars; financial statement amounts are in millions unless stated otherwise. Interim financial statements were reviewed, not audited.
Business context
Lockheed Martin is a defense and aerospace contractor serving primarily U.S. Government and international customers. Its continuing operations comprise Aeronautics, Missiles and Fire Control (MFC), Rotary and Mission Systems (RMS), and Space Systems. The F-35 represented approximately 23% of continuing-operations sales in both comparative periods.
- On August 16, 2016, the company completed the IS&GS divestiture and merger with Leidos; IS&GS results are presented as discontinued operations. The transaction included a $1.8 billion special cash payment and retirement of about 9.4 million Lockheed Martin shares.
- On August 24, Lockheed Martin increased its AWE ownership to 51% and began consolidating the U.K. nuclear deterrent venture. RMS includes Sikorsky, acquired in November 2015; its results are not included in the prior-year comparison.
Financial performance
| Metric | Q3 2016 | Q3 2015 | 9M 2016 | 9M 2015 |
|---|---|---|---|---|
| Continuing net sales | $11,551 | $10,060 | $33,496 | $29,016 |
| Gross profit | $1,384 | $1,097 | $3,709 | $3,355 |
| Operating profit | $1,588 | $1,192 | $4,121 | $3,612 |
| Net earnings from continuing operations | $1,089 | $756 | $2,794 | $2,309 |
| Diluted EPS, continuing operations | $3.61 | $2.42 | $9.13 | $7.30 |
| Net earnings from discontinued operations | $1,306 | $109 | $1,520 | $363 |
| Total net earnings | $2,395 | $865 | $4,314 | $2,672 |
| Total diluted EPS | $7.93 | $2.77 | $14.10 | $8.45 |
Continuing sales rose 14.8% in Q3 and 15.4% year to date, driven largely by Sikorsky and F-35 volume. Operating margin was approximately 13.7% for Q3 versus 11.8%, and 12.3% for the nine months versus 12.4%. Gross margin was approximately 12.0% for Q3 versus 10.9%, and 11.1% year to date versus 11.6%. Total earnings growth includes the approximately $1.2 billion after-tax IS&GS divestiture gain; it should not be read as growth in recurring continuing earnings alone.
- Segment results, Q3 2016: Aeronautics sales/profit $4,188/$437; MFC $1,737/$289; RMS $3,346/$247; Space Systems $2,280/$450. Segment operating profit is not the same as consolidated operating profit.
- Cash flow, 9M: Operating cash flow was $4,460, versus $3,737; capital expenditures were $627, versus $500; operating cash flow less capital expenditures was $3,833, versus $3,237. Financing cash use was $2,104, including $1,280 of share repurchases and $1,518 of dividends. Ending cash was $2,895, versus $3,300 a year earlier.
- Balance sheet, September 25: Cash was $2,895; current assets $17,110 and current liabilities $14,425 (current ratio approximately 1.19). Long-term debt, net, was $14,304, compared with $14,305 at year-end 2015; reported debt principal was $15.3 billion. Stockholders’ equity was $2,323, with total equity of $2,430 including noncontrolling interests.
- Tax and interest: Continuing-operations effective tax rate was 23.7% for Q3 and 23.1% year to date, versus 30.6% and 30.4%. Interest expense rose to $162 in Q3 and $492 year to date, primarily reflecting debt issued to fund Sikorsky.
Material changes and management outlook
- Q3 operating profit increased to $1,588 from $1,192. AWE contributed a $127 million pretax operating gain; other income also benefited from the $104 million noncash net gain on the step acquisition. Segment operating profit was up in Aeronautics and Space Systems, broadly flat in RMS, and down in MFC.
- Management expected 2016 continuing sales to increase in the low-double-digit percentage range from 2015 and segment operating profit to be slightly higher. Expected 2016 operating cash flow was at least $5.0 billion or $5.7 billion, depending on the timing of F-35 collections.
- Preliminary 2017 outlook: sales growth of approximately 7% over 2016, segment operating margin of 10.0%–10.5%, and operating cash flow of at least $5.0 billion or $5.7 billion depending on F-35 collection timing. Assumptions included continued U.S. Government support and funding; management cautioned that budget developments could change the outlook.
- Management expected a 2017 FAS/CAS pension benefit of about $800 million under stated assumptions and no contributions to legacy qualified pension plans in 2017. It anticipated a year-end 2016 pension-related noncash, after-tax equity reduction of approximately $3.2 billion; revised longevity assumptions were expected to reduce obligations and increase 2017 earnings.
- Capital returns: the quarterly dividend was raised 10% to $1.82 per share, and the repurchase authorization was increased by $2.0 billion, leaving $4.3 billion available at quarter-end. The company said a projected equity deficit could limit distributions under Maryland law, although it did not expect to prevent dividends or buybacks based on anticipated earnings.
Risks, contingencies and unusual items
- F-35 funding and execution: Delayed customer collections could shift cash flow between years. The company reported approximately $950 million of potential cash exposure and $2.3 billion of termination-liability exposure on LRIP 9 and 10 while funding negotiations continued. An insulation issue affected 42 aircraft in production and 15 delivered aircraft; delivered aircraft were temporarily grounded, and about 10 additional deliveries were expected to be delayed. Management did not expect a significant 2016 earnings or cash-flow impact.
- Government funding: GFY 2017 was operating under a continuing resolution through December 9, 2016. Delays, extended restrictions, or a shutdown could affect procurement, orders and backlog; the company noted that a full-year resolution might have limited 2017 sales, earnings and cash-flow impact because much backlog work was already funded.
- Contract estimates: Net adjustments unrelated to volume increased segment operating profit by approximately $405 million in Q3 and $1.1 billion year to date. The filing also describes an international integrated air and missile defense contract with continuing performance and customer-funding uncertainty; additional loss reserves could be material, but the amount could not be estimated.
- Environmental matters: Recorded environmental liabilities were $1.0 billion, with $896 million of receivables for probable recovery. Materially stricter drinking-water standards could increase estimated liabilities and, for unrecoverable costs, affect earnings.
- Legal and guarantees: The filing discusses a False Claims Act suit seeking more than $45 million plus potential trebling and penalties, and an MTA dispute in which the MTA seeks about $190 million while Lockheed Martin asserts about $95 million in claims. The company also had $3.8 billion of outstanding letters of credit, surety bonds and third-party guarantees; it reported no material amounts recorded for third-party guarantees.
- Other notable items: The final IS&GS gain remained subject to post-closing working-capital and tax adjustments. Sikorsky purchase accounting was preliminary and could change. The company early adopted share-based-payment accounting changes that added $137 million of tax benefits to nine-month earnings and operating cash flow.
Important facts for investors to verify
- Separate recurring continuing-operations performance from the IS&GS divestiture gain and AWE acquisition gain; confirm final transaction adjustments.
- Track F-35 production, aircraft remediation and delivery timing, customer funding, collections, and the disclosed LRIP 9/10 exposures.
- Compare realized 2016 cash flow with management’s conditional cash-flow outlook, and monitor the 2017 budget and continuing-resolution assumptions.
- Assess pension discount-rate, asset-return and longevity assumptions, the projected equity deficit, and any effect on dividends or repurchases.
- Monitor the air and missile defense contract reassessment, environmental standards, and the outcomes of the disclosed legal proceedings and guarantees.
- Check Sikorsky integration and purchase-accounting effects, segment margins, and whether forecast sales and margins are achieved without one-time gains.