LOCKHEED MARTIN CORP quarterly report, Q3 FY2014

Business context and reporting period

Lockheed Martin Corporation filed this unaudited Form 10-Q for the quarter ended September 28, 2014, with comparative results for the quarter and nine months ended September 29, 2013. The company operates in five segments: Aeronautics, Information Systems & Global Solutions (IS&GS), Missiles and Fire Control (MFC), Mission Systems and Training (MST), and Space Systems. Its principal customer is the U.S. Government.

Financial performance and position

Metric	Q3 2014	Q3 2013	Nine months 2014	Nine months 2013
Net sales	$11.114bn	$11.347bn	$33.070bn	$33.825bn
Operating profit	$1.392bn	$1.254bn	$4.250bn	$3.671bn
Net earnings	$888m	$873m	$2.710bn	$2.493bn
Diluted EPS	$2.76	$2.66	$8.39	$7.63
Operating cash flow	Not stated for quarter	Not stated for quarter	$4.067bn	$3.608bn

• Gross profit was $1.275bn for Q3 and $3.987bn for the first nine months. Reported cost of products sales was 89.0% of product sales in Q3 (87.6% prior year); cost of services sales was 88.7% of services sales (88.5% prior year).
• Nine-month investing cash outflow was $1.064bn, including $622m for acquisitions and investments; financing cash outflow was $2.657bn, including $1.676bn of share repurchases and $1.286bn of dividends paid. Cash increased $346m to $2.963bn.
• At September 28, cash was $2.963bn, current assets $13.684bn and current liabilities $12.133bn. Long-term debt, net, was $6.165bn; the company reported $7.0bn outstanding principal before unamortized discounts. Stockholders’ equity was $4.574bn.
• The company contributed $1.0bn to qualified pension plans in the first nine months and expected another $1.0bn contribution in Q4 2014. Accrued pension liabilities were $9.556bn.

Material changes versus prior comparable periods

• Quarterly sales declined 2%; nine-month sales declined 2%. Product sales fell in both periods, while service sales rose slightly in Q3 but declined for the nine months.
• Operating profit rose 11% in Q3 and 16% year to date despite lower total business-segment operating profit: segment profit was down 7% in Q3 and 3% year to date. The consolidated increase chiefly reflected a favorable swing in unallocated pension adjustments: FAS/CAS pension income of $84m in Q3 and $255m year to date versus expense of $121m and $362m in 2013.
• Net earnings and diluted EPS increased; EPS also benefited from about four million fewer shares outstanding year over year, primarily from repurchases. The 2013 comparison included $31m of discontinued-operations tax benefit.
• Segment sales and profit were mixed. Nine-month Aeronautics sales increased 5%, driven primarily by F-35 production, while IS&GS, MFC, MST and Space Systems sales declined. Nine-month operating profit fell at IS&GS, MFC and MST; Aeronautics and Space Systems were approximately flat.
• Nine-month operating cash flow increased $459m. Management cited improved operating results, lower pension contributions and working-capital timing, partly offset by higher net tax payments ($1.0bn versus $387m).

Outlook, management commentary, risks and unusual items

• Management’s preliminary 2015 outlook was for net sales to decline at a low-single-digit rate from 2014 and total business-segment operating margin of 11.5%–12.0%. This assumes continued support and funding for key programs and a GFY 2015 budget consistent with the President’s proposal.
• For 2014, management expected Aeronautics sales to increase mid-single digits; IS&GS sales and operating profit to decline high single digits; MFC sales to decline low single digits and profit mid-single digits; MST sales to decline slightly and profit high single digits; and Space Systems sales to remain flat with profit down mid-single digits.
• U.S. Government budget constraints, sequestration beyond GFY 2015, continuing-resolution funding, contract delays or cancellations, price-based competition and reduced demand for services were identified as significant risks. The company noted that short-term service-oriented businesses are particularly exposed.
• F-35 program risks include supplier and partner performance, software development, cost of sustainment and warranties, timely production funding, flight testing and findings from testing. At quarter-end, 95 production aircraft had been delivered and 71 were in backlog.
• In June 2014, pension plan amendments began a phased freeze of future benefits for certain non-union employees. Re-measurement lowered obligations by $4.6bn from the pay-based freeze but increased them by $6.5bn from actuarial-assumption changes, including longevity and discount-rate changes. The net re-measurement increased other comprehensive loss by $735m after tax. Pension assumptions and investment returns could materially affect future expense and equity.
• The company repurchased 10.3m shares for $1.7bn year to date; the board increased authorization by $2.0bn, leaving $3.9bn available. Management anticipated at least $2.0bn of repurchases in 2015, subject to market conditions and discretion, and declared a Q4 dividend of $1.50 per share, 13% above Q3.
• Environmental liabilities were $963m, with $834m of related recovery receivables recorded. The company warned that tighter drinking-water standards could increase estimates and, for costs not recoverable through U.S. Government contract pricing, could affect earnings.
• Significant proceedings included the MTA contract dispute, whose bench trial began October 6, 2014, and False Claims Act/environmental allegations concerning the Paducah plant. The company disputed the allegations; it said a reasonably possible loss could not be estimated for the latter matter. It considered a material adverse effect on the company as a whole remote, while acknowledging individual matters could affect a particular interim period.
• Goodwill impairment risk was highlighted for IS&GS Civil and MFC Technical Services reporting units, whose estimated fair values exceeded carrying values by about 15%. The 2014 annual impairment test was due in Q4.
• Management noted that contract estimates and profit-booking adjustments are inherently judgmental. Net non-volume adjustments increased segment operating profit by approximately $400m in Q3 and $1.4bn year to date, versus $510m and $1.6bn in 2013.

Important facts for investors to verify

• Whether GFY 2015 appropriations and later defense-budget decisions support the company’s sales and margin assumptions.
• F-35 execution, funding, testing, supplier performance, delivery schedule and sustainment economics.
• Whether contract cost estimates, profit-booking adjustments and warranty reserves develop as expected, particularly in MST, MFC and Aeronautics.
• Pension funding needs and the sensitivity of pension expense, obligations and equity to discount rates, longevity assumptions and asset returns.
• Progress on the MTA and Paducah proceedings, environmental remediation estimates and potential changes in recoverable costs.
• Results of the Q4 goodwill impairment test for the Civil and Technical Services reporting units.
• Execution of planned buybacks and dividends alongside acquisition spending, pension contributions and liquidity needs.