LOCKHEED MARTIN CORP quarterly report, Q2 FY2016

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

MetricQ2 2016Q2 2015Six months 2016Six 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.