Lockheed Martin Corporation (10-K) — Fiscal Year Ended December 31, 2016
Reporting scope: This is an annual filing, not a standalone fourth-quarter report. Unless otherwise stated, amounts are in U.S. dollars. The company operates in Aeronautics, Missiles and Fire Control (MFC), Rotary and Mission Systems (RMS), and Space Systems.
Business Context and Key Developments
- Lockheed Martin is a global aerospace and defense contractor. In 2016, 71% of sales came from the U.S. Government, including 59% from the Department of Defense; 27% came from international customers and 2% from U.S. commercial and other customers.
- On August 16, 2016, the company divested Information Systems & Global Solutions (IS&GS) in a Reverse Morris Trust transaction. 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; the company recorded a net gain of about $1.2 billion.
- In August 2016, Lockheed Martin increased its AWE Management Limited ownership to 51% and began consolidating the U.K. nuclear deterrent operator in Space Systems.
- 2016 sales were $47.248 billion. The F-35 was the largest program, representing 23% of consolidated sales.
Financial Performance
| Metric | 2016 | 2015 |
|---|---|---|
| Net sales | $47.248 billion | $40.536 billion |
| Operating profit | $5.549 billion | $4.712 billion |
| Net earnings from continuing operations | $3.753 billion | $3.126 billion |
| Diluted EPS from continuing operations | $12.38 | $9.93 |
| Net earnings, including discontinued operations | $5.302 billion | $3.605 billion |
| Total diluted EPS | $17.49 | $11.46 |
| Cash from operating activities | $5.189 billion | $5.101 billion |
| Capital expenditures | $1.063 billion | $939 million |
| Cash and cash equivalents at year-end | $1.837 billion | $1.090 billion |
| Net debt | $14.282 billion | $15.261 billion |
| Total equity | $1.606 billion | $3.097 billion |
Operating profit margin was approximately 11.7% (2015: 11.6%); gross margin was approximately 10.7% (2015: 11.1%). The effective tax rate on continuing operations declined to 23.2% from 27.3%, helped by tax benefits, including $152 million from adopting a share-based compensation accounting update and the nontaxable AWE gain. Total diluted EPS includes the IS&GS divestiture gain and should be distinguished from continuing-operations EPS.
Operating cash flow increased modestly year over year. Approximate cash from operations less capital expenditures was $4.1 billion. The company paid $2.048 billion in dividends and repurchased $2.096 billion of stock during 2016. The board raised the quarterly dividend 10% in the fourth quarter.
At December 31, 2016, backlog was $96.2 billion, including $66.0 billion funded; approximately $34 billion, or 35%, was expected to convert to sales in 2017. Current assets were $15.108 billion and current liabilities were $12.542 billion.
Segment Results
| Segment | 2016 sales | 2016 operating profit | 2016 margin |
|---|---|---|---|
| Aeronautics | $17.769 billion | $1.887 billion | 10.6% |
| MFC | $6.608 billion | $1.018 billion | 15.4% |
| RMS | $13.462 billion | $906 million | 6.7% |
| Space Systems | $9.409 billion | $1.289 billion | 13.7% |
Year-over-year comparisons are affected by the full-year inclusion of Sikorsky in RMS in 2016 versus a partial year in 2015, and by AWE consolidation from August 2016. Aeronautics sales and profit rose with F-35 activity; MFC profit and margin declined; RMS sales rose substantially with Sikorsky, while its margin fell; Space Systems profit benefited from the AWE step-acquisition gain and higher equity earnings.
Fourth-quarter 2016 sales were $13.752 billion, operating profit was $1.428 billion, net earnings were $988 million, and diluted EPS was $3.35.
Outlook, Commentary and Risks
- 2017 outlook: Management expected net sales to increase in the mid-single-digit range. Segment operating margin was expected to decline from 2016 to just above 10%, reflecting F-35 mix, MFC contract mix, lower AWE earnings after the 2016 gain, AWE intangible amortization, and lower Space Systems equity earnings. The outlook assumed U.S. Government support and funding consistent with the GFY 2017 budget.
- Segment expectations included low-double-digit sales growth at Aeronautics, mid-single-digit growth at MFC, low-single-digit growth at RMS, and a mid-single-digit sales decline at Space Systems. Management expected approximately $880 million of FAS/CAS pension adjustment in 2017 and no contributions to legacy qualified pension plans under then-current assumptions.
- F-35: The U.S. Government unilaterally definitized the LRIP 9 contract for 57 aircraft. The imposed terms could affect profit and cash flow on LRIP 9, the still-undefinitized LRIP 10 contract, and future negotiations. The program faced continuing scrutiny of costs, schedule, software, suppliers, sustainment and testing. A fuel-tank debris issue affected 57 aircraft; operational aircraft had been modified and remaining factory aircraft were to be corrected. The filing said the issue did not significantly affect 2016 results or cash flows.
- Government funding and customer concentration: At filing, the U.S. Government was operating under a continuing resolution through April 28, 2017. Delays, constrained appropriations, program cuts, or changed procurement terms could affect awards, sales, margins and cash flow.
- Accounting controls: Management identified a material weakness in Sikorsky’s contract accounting/revenue recognition, inventory and payroll controls, including IT controls. Management and the auditor concluded internal control over financial reporting was ineffective at year-end; the auditor issued an adverse ICFR opinion. The financial-statement audit opinion was unqualified, and no material errors or restatement were reported. Management expected remediation before the end of 2017.
- Pensions and balance-sheet sensitivity: Qualified pension plans were about 70% funded on a GAAP basis and 87% on an ERISA basis. The accrued pension liability was $13.855 billion. Lower discount and expected-return assumptions increased pension expense and obligation sensitivity; management estimated a 25-basis-point discount-rate change could alter the qualified pension obligation by about $1.5 billion.
- Contingencies: Environmental liabilities were $1.0 billion, with $870 million of recorded receivables for probable future recovery. The company disclosed potential exposure to stricter contaminant standards, an unresolved government False Claims Act suit relating to Sikorsky (government damages sought exceeded $45 million before potential trebling), and an MTA dispute in which the customer sought about $190 million. Management said outcomes could not be predicted with certainty.
- Other key risks include reliance on government contracts, fixed-price cost overruns, supplier and partner performance, international and offset obligations, cybersecurity, litigation and regulation. Sikorsky goodwill had an estimated fair-value cushion of about 10% over carrying value, leaving it vulnerable to deterioration in projected performance or market assumptions.
Important Facts for Investors to Verify
- Separate continuing-operations earnings and EPS from discontinued operations and the approximately $1.2 billion IS&GS divestiture gain.
- Assess the sustainability of 2016 operating cash flow and the 2017 sales and margin outlook, including the effects of F-35 production mix and AWE’s one-time gain.
- Track F-35 contract negotiations, government funding, delivery and sustainment progress, and any consequences of the LRIP 9 unilateral contract action.
- Monitor Sikorsky’s material control weakness, management’s remediation timetable, and any subsequent control findings or financial reporting adjustments.
- Review pension funding assumptions and sensitivity, debt maturities and interest obligations, environmental recovery assumptions, and the outcomes of disclosed legal matters.