Lockheed Martin Corporation — Q2 2016 Form 10-Q
Reporting period: Quarter and six months ended June 26, 2016; comparisons are to the quarter and six months ended June 28, 2015. Amounts are in millions of dollars except per-share data. Financial statements are unaudited and were reviewed, not audited, by Ernst & Young.
Business context
Lockheed Martin is a global aerospace and security contractor whose principal customer is the U.S. Government. It reported five segments: Aeronautics, Information Systems & Global Solutions (IS&GS), Missiles and Fire Control (MFC), Mission Systems and Training (MST), and Space Systems. 2016 results include Sikorsky, acquired in November 2015, while the 2015 comparison does not; this makes year-over-year growth, especially at MST, not fully comparable.
Key financial results
| Metric | Q2 2016 | Q2 2015 | Six months 2016 | Six months 2015 |
|---|---|---|---|---|
| Net sales | $12,914 | $11,643 | $24,616 | $21,754 |
| Gross profit | $1,424 | $1,371 | $2,659 | $2,634 |
| Operating profit | $1,566 | $1,445 | $2,863 | $2,801 |
| Net earnings | $1,021 | $929 | $1,919 | $1,807 |
| Diluted EPS | $3.32 | $2.94 | $6.23 | $5.68 |
| Operating cash flow | — | — | $3,140 | $2,220 |
- Q2 sales increased 10.9% and net earnings increased 9.9%; six-month sales increased 13.2% and net earnings increased 6.2%. Diluted EPS rose 12.9% for the quarter and 9.7% year to date.
- Gross margin was approximately 11.0% in Q2 and 10.8% for the first six months, versus 11.8% and 12.1%, respectively, in the comparable periods. Operating margin was approximately 12.1% in Q2 and 11.6% year to date, versus 12.4% and 12.9%.
- For the first six months, operating cash flow rose $920 million. Capital expenditures were $386 million; free cash flow, calculated as operating cash flow less capital expenditures, was approximately $2.75 billion. Working-capital cash use was $402 million, compared with $1.095 billion in 2015.
- Cash and equivalents were $1.269 billion at June 26. Current assets were $16.073 billion and current liabilities $15.595 billion. Debt was $14.8 billion net of discounts and financing costs; principal outstanding was $15.8 billion. The company repaid $452 million of notes in May and expected to repay about $500 million due in Q3 from cash.
- Six-month financing cash outflow was $2.634 billion, including $1.002 billion of share repurchases and $1.034 billion of dividends paid. The company repurchased 4.5 million shares; $2.6 billion remained authorized. Dividend declared per share was $3.30 year to date.
Material changes and segment performance
- Aeronautics: Q2 sales rose 6% to $4.375 billion and operating profit rose 8% to $478 million, primarily on F-35 production and sustainment. Six-month sales increased 13% to $8.174 billion. F-35 represented about 21% of Q2 consolidated sales.
- IS&GS: Q2 sales fell 5% to $1.337 billion, while operating profit rose to $151 million, aided by contract close-outs and prior-period reserves not recurring. Competitive pressure, completed programs, and delays on an international data-center project weighed on sales and performance.
- MFC: Q2 sales rose 2% to $1.680 billion, but operating profit fell 14% to $253 million. Six-month operating profit fell 18% to $474 million, reflecting lower risk retirements, contract mix, and a contractual reserve.
- MST: Q2 sales rose 53% to $3.303 billion, largely because Sikorsky contributed about $1.2 billion. Operating profit fell 23% to $202 million; Sikorsky recorded an approximately $30 million Q2 operating loss, primarily from acquired-intangible amortization and purchase-accounting adjustments.
- Space Systems: Q2 sales declined 3% to $2.219 billion, while operating profit rose 16% to $340 million, primarily on higher equity earnings, mainly from ULA. Six-month sales and operating profit declined 4% and 6%, respectively.
- Net segment profit adjustments not related to volume were about $435 million in Q2 and $840 million year to date, compared with $550 million and $1.0 billion in 2015. Management said these adjustments increased 2016 net earnings by approximately $280 million ($0.91 per share) and $545 million ($1.77 per share), respectively.
Outlook, risks, and unusual items
- Management forecast 2016 net sales growth in the high-single- to low-double-digit range versus 2015, driven by Sikorsky and F-35 volume, partly offset by declines in three segments. It expected segment operating profit to decline by a mid-single-digit percentage and segment operating margin to be 10%–10.5%, below 2015.
- Segment outlook was mixed: Aeronautics sales and operating profit expected to increase; IS&GS sales and profit expected to decline; MFC sales expected flat to slightly lower and profit down about 20%; MST sales expected to rise at a mid-double-digit rate but margins to decline; and Space Systems sales and profit expected to decline at mid-single-digit rates.
- The planned IS&GS separation and combination with Leidos was expected to close in Q3 2016, subject to conditions and approvals. Lockheed Martin expected a one-time $1.8 billion cash payment and anticipated a significant discontinued-operations gain, but neither closing, deal structure, share-count reduction, nor gain was assured. The filing notes an exchange offer announced July 11, after quarter-end.
- F-35 low-rate initial production contracts 9 and 10 were still under negotiation. As of June 26, the company disclosed approximately $900 million of potential cash exposure and $3.0 billion of termination-liability exposure while continuing work; it expected additional funding by year-end.
- A separate international air and missile defense contract remained under reassessment after prior reserves; further loss reserves could be material, and management said it could not estimate total expected costs. F-35 risks include software, suppliers, testing, schedule, cost, sustainment, and timely funding.
- Environmental liabilities were $1.0 billion, with $897 million of estimated recoveries recorded. A materially stricter drinking-water standard could increase estimated remediation costs. Other contingencies include a False Claims Act case related to acquired Sikorsky, for which the government sought about $148 million including treble damages and penalties, and an MTA dispute involving approximately $190 million in claimed damages; management disputed the claims.
- The company recorded $99 million of severance charges in Q1 2016. It early adopted new share-based compensation tax accounting, recognizing $115 million of additional tax benefit in first-half earnings and operating cash flow, including a $104 million reclassification from prior-period equity and financing cash flow. Lower effective tax rates also benefited from tax credits and deductions.
- Management cited dependence on U.S. Government funding, defense-budget and competition pressures, contract-estimate uncertainty, acquisition integration, divestiture execution, pension assumptions, legal and environmental matters, and foreign-exchange exposure. It said risk factors were not materially changed from its 2015 Form 10-K.
Important facts for investors to verify
- Separate Sikorsky’s acquired revenue from underlying growth and monitor whether Sikorsky-related amortization and integration costs continue to suppress MST profitability.
- Track F-35 contract funding and the disclosed $900 million cash and $3.0 billion termination-liability exposures, as well as program cost, delivery, testing, and sustainment risks.
- Confirm completion and final terms of the IS&GS–Leidos transaction, including the special payment, any share retirement, and the accounting gain.
- Assess the sustainability of earnings given the material contribution from contract estimate and other non-volume adjustments, and the $115 million year-to-date share-award tax benefit.
- Monitor MFC, IS&GS, and Space Systems performance against management’s weaker full-year outlook, along with cash conversion, debt maturities, and capital returns.