LOCKHEED MARTIN CORP quarterly report, Q3 FY2011

Business context and reporting period

Lockheed Martin Corporation filed this unaudited Form 10-Q for the quarter ended September 25, 2011; comparisons are with the quarter and nine months ended September 26, 2010. The company operates in Aeronautics, Electronic Systems, Information Systems & Global Solutions (IS&GS), and Space Systems, with the U.S. Government as its principal customer. About 85% of 2010 sales were to the U.S. Government.

Beginning January 1, 2011, the company applied percentage-of-completion accounting to U.S. Government services contracts; prior periods were adjusted. Management said the change was not material and did not affect cash flows. Ernst & Young reviewed, but did not audit, the interim financial statements.

Financial performance and liquidity

Metric	Q3 2011	Q3 2010	Nine months 2011	Nine months 2010
Net sales	$12.119 billion	$11.343 billion	$34.288 billion	$32.910 billion
Operating profit	$1.041 billion	$877 million	$2.898 billion	$2.934 billion
Net earnings	$700 million	$560 million	$1.972 billion	$1.917 billion
Diluted EPS, continuing operations	$1.99	$1.53	$5.72	$4.84
Diluted EPS, total	$2.10	$1.54	$5.73	$5.17

Q3 sales rose 7%; nine-month sales rose 4%. Q3 operating profit increased 19%, while nine-month operating profit declined 1%. Q3 operating margin was about 8.6% versus 7.7%; nine-month margin was about 8.5% versus 8.9%.
Nine-month gross profit was $2.716 billion versus $2.731 billion. Product cost as a share of product sales was essentially unchanged; services cost as a share of sales improved to 89.2% from 90.4%.
Net cash from operations was $3.038 billion, down from $3.387 billion. Capital expenditures were $443 million; operating cash flow less capital expenditures was approximately $2.595 billion. Cash and cash equivalents increased to $4.564 billion from $2.261 billion at year-end 2010.
At September 25, current assets were $14.669 billion and current liabilities $12.144 billion. Debt was approximately $7.0 billion carrying value, including $500 million current and $6.538 billion long-term net debt. Stockholders’ equity was $2.943 billion, down from $3.497 billion at year-end 2010.
The company issued $2.0 billion of fixed-rate notes in September. In October, after quarter-end, it redeemed $500 million of 2013 notes and expected to record a $26 million make-whole premium. A $1.5 billion revolving facility was available with no borrowings outstanding; the company reported compliance with debt covenants.
Nine-month share repurchases totaled $2.263 billion for 29.9 million shares; dividends paid were $770 million. EPS benefited from the lower share count. The quarterly dividend was raised to $1.00 per share, payable in December.

Material changes and segment results

Aeronautics sales increased 21% in Q3 and 13% year to date, led by C-130, F-35 low-rate initial production, F-16 support, and C-5 activity. F-22 sales continued to decline as the program approaches its expected 2012 final deliveries.
Electronic Systems sales rose 2% in Q3 and 5% year to date, with growth in air defense, tactical missiles, and logistics support, partly offset by lower ship and aviation systems activity.
IS&GS sales fell 8% in Q3 and 6% year to date, primarily because the 2010 census-related DRIS program had ended. Segment operating profit was broadly unchanged; backlog had declined to $8.3 billion.
Space Systems sales increased 10% in Q3 but 1% year to date. Satellite activity and missile systems partly offset the end of Space Shuttle external-tank production. Lower ULA and United Space Alliance equity earnings weighed on segment profit.
Across all segments, nine-month operating profit increased, but higher unallocated pension expense more than offset those gains. The FAS/CAS pension adjustment was $692 million for the first nine months, versus $331 million in 2010.

Outlook, management commentary, and key risks

Preliminary 2012 outlook assumes timely defense-budget approval at a level consistent with the President’s proposal and continued program funding. Management expected 2012 sales to be roughly flat with 2011 and consolidated segment operating margin around 11%.
For 2011, management expected Aeronautics sales growth in the upper-single-digit range with higher profit but lower margin; Electronic Systems results comparable with 2010; IS&GS sales down mid-single digits but profit up high-single digits; and Space Systems sales down low-single digits with profit and margin comparable to 2010.
The Budget Control Act, potential sequestration, defense-spending reductions, and continuing resolutions could delay procurement or reduce program funding. Management said the company could not predict the outcome of budget deliberations.
F-35 LRIP 5 remained a significant exposure: without additional funding or contract coverage, potential termination liability was about $750 million at quarter-end and estimated to reach about $1.2 billion by year-end 2011. Funding and contract negotiations were ongoing. Program risks also included flight testing, software, suppliers, schedule, cost, and the earned-value system review.
Pension assumptions pose a substantial sensitivity. Under management’s stated scenario of a 4.5% year-end discount rate and 5.0% 2011 asset return, pension liabilities could rise about $5.7 billion and accumulated other comprehensive loss about $3.5 billion, potentially producing negative year-end equity. This scenario was illustrative, not a forecast; management said it would not impair debt covenants or dividend-paying ability. 2012 pension expense and required contributions could also rise.
Contract accounting depends on estimates of total costs, revenue, schedule, technical performance, and incentives. Profit-booking adjustments increased operating profit by approximately $425 million in Q3 and $1.175 billion year to date, adding about $275 million and $775 million, respectively, to net earnings. These estimates can change and affect future results.
Environmental liabilities were $948 million, with $821 million of recorded assets for probable recovery. Potentially stricter standards for perchlorate and hexavalent chromium could increase estimated cleanup costs; unrecoverable amounts could affect earnings.
Other contingencies include securities and derivative shareholder actions, the U.K. Ministry of Defence Soothsayer contract dispute, the New York MTA contract dispute, False Claims Act matters, and environmental litigation. Management considered a material adverse effect on the company as a whole remote, but said individual outcomes could materially affect a quarter; loss ranges were generally not estimable.
The company committed to sell Savi Technology; Q3 discontinued-operations earnings included a sale-related tax benefit of about $50 million. QTC Holdings was acquired after quarter-end for approximately $420 million net of cash acquired.

Most important facts for investors to verify

Whether defense appropriations, sequestration, and continuing-resolution effects change program funding, awards, or procurement timing.
F-35 LRIP 5 funding, contract terms, termination exposure, and progress against schedule and cost milestones.
Whether contract estimate revisions and profit-booking benefits are sustainable, given their material contribution to reported earnings.
Year-end pension discount-rate and asset-return assumptions, resulting pension expense, equity, and cash contribution requirements.
IS&GS backlog and sales trajectory, and the company’s ability to offset pressure from government IT spending and program transitions.
Environmental recovery assumptions, legal-contingency developments, and the cash and balance-sheet effects of buybacks, dividends, debt issuance, and acquisitions.