Lockheed Martin Is A Well-Positioned Defense Contractor, Budget And Geopolitical Uncertainties Aside

Equity Analyst

Nicolas Owens

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Aeronautics

Missiles and Fire Control

Rotary and Mission Systems

Space

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Lockheed derived more than 70% of its $66 billion in 2022 sales servicing contracts from the U.S. Department of Defense, the largest military budget on Earth, and stands to operate the largest defense procurement program ever awarded (F-35) through the 2060s. Thus, as a bet on the defense industry, Lockheed is hard to beat. Biggest isn't always best, but Lockheed (and investors) benefit from the sheer scale of its tens of billions of dollars of contracts that provide defined decadeslong revenue and profit streams.

Lockheed should benefit from recent and foreseeable increases in U.S. defense spending, driven in the short term by orders to resupply munitions to Ukraine as its forces expend them faster than they can be made. Longer term, the Pentagon has prioritized modernization of the military's ability to counter aggression from multiple so-called great power rivals, namely China and Russia, while also managing threats from terrorism and hot spots like Iran and North Korea. 

Defense budgets usually ebb and flow with a nation's wealth and its perception of danger. In the U.S., both have been on the rise, and among many allies, notably Germany and Japan, geopolitics is leading to larger military budgets than we've seen for decades. For perspective, we estimate that the portions of the U.S. defense budget relevant to contractors like Lockheed and its many subcontractors shrank between 2011-16 by 3.7% annualized while these budgets grew between 2016-22 by 6.6% annualized. We think the contracting budget will continue to grow with modernization, but more moderately around 3.0% over the next five years.

We think Lockheed Martin's exposure to the F-35 program, hypersonic missiles, and the militarization of space align it well with areas of spending prioritized in the U.S. defense budget. In the current environment, though, the constraint on the defense sector's opportunity is not access to defense spending or the size of budgets, but rather the ability to deploy enough skilled employees (often requiring security clearance) and specialized components and materials (that are lately in short supply) to execute on the programs on time and on budget.

Business Strategy & Outlook

The durability of economic profits in the defense sector may seem paradoxical: defense contractors invest in the billions to generate products on the cutting edge of technology, and unit pricing for their products is designed to decline over time. What's more, these companies primarily sell to a single buyer (referred to as a monopsony in economic texts, in this case the defense and procurement arms of the U.S. government)—one with rapidly evolving needs, a tendency to change product requirements, and intermittent squabbles over the bill. Despite these challenges, we observe that wide moats are prevalent in the defense business. They exist because of significant intangible assets: first among these is the extreme product complexity that thwarts new entrants, bolstered by decadeslong product cycles, contract structures that reduce risk for the contractor and lock out alternative suppliers, as well as the switching costs of a risk-averse customer facing significant time and risk to potentially switch products. 

We believe that intangible assets in the defense industry ensure that incumbent firms are the only companies capable of servicing the military’s large need to purchase arms (broadly defined), which manifests as a material barrier to entry. In terms of keeping competitors out, we believe the primary source of intangible assets is product complexity. First, the technology used in arms production requires extensive expertise, may be proprietary to one system and manufacturer, and usually lacks commercial viability outside of the defense industry (aside from commercial aerospace manufacturing), so a new entrant would likely need to develop this know-how entirely from the ground up. Second, the development of a military program is long and expensive; a would-be competitor would face material sunk costs ranging from the time spent developing a prototype to pitch for a contract, to the challenge of developing a workforce that has the required security clearances to enter the space. We note that the only serious outside threat to a small subsegment of this business, space launches, are the pet projects of multibillionaires. We refer to the Stockholm International Peace Research Institute’s data set on the arms industry as evidence that the arms production industry is insulated from outside competition: Lockheed Martin, Boeing’s defense unit, BAE Systems, Raytheon, Northrop Grumman, Airbus, and General Dynamics have essentially remained the top seven global arms producers for the past 15 years, with Lockheed Martin in the No. 1 spot (by revenue) for the last 13.

The second major intangible asset in the defense industry is the contract structure that allows excess return generation. Generally, defense contractors compete fiercely within initial bidding rounds to win a contract for a new program. After research, development, testing, and evaluation rounds, in which more than one competing contractor will deliver working prototypes to the customer, it is quite rare in the later development and delivery phase to see the government switch suppliers. During the early contracts, the government generally purchases using cost-plus contracts, taking on the financial risk of cost overruns, though the potential profit to the contractor is lower. Given the immense risk of cost overruns and iterative testing in designing complex products such as modular fighter jets, this dynamic frequently works in the contractor’s favor. As programs age to the production phase, they tend to move toward fixed-price contracts, often split into phases or lots, where the unit costs can decline over time as production can be scaled up for a successful program. Although fixed-price contracts carry more financial risk, because the burden of cost overruns now rests on the contractor, these contracts tend to be more profitable because manufacturing costs become better understood over time and can even decline significantly as a program ages and delivery volume increases. Considering the opportunity for additional revenue and profits from maintenance of delivered weapon systems ("sustainment" in the military contracting jargon), these mature program contracts often become long-standing cash cows because program life cycles can last decades.

Switching costs for the military customer are generally predicated on the mission-criticality of the product, extended product cycles, a lack of viable alternative products or suppliers, and the substantial time investment or risk involved in switching suppliers. The major products for U.S.-based defense contractors include military vehicles (including land, air, and sea-based vehicles), intelligence-gathering systems, radars and sensors, and munitions. The ability for a military to succeed at its strategic objectives and deter or defeat an adversary, as well as protecting the lives of soldiers and civilians, are contingent on these products working as intended, which we think protects the proven suppliers from upstart competition. Product cycles are a source of differentiation. We view the products with the longest procurement cycles, such as fighter jets and submarines, as the moatiest because contracts with decadeslong fulfillments provide extraordinarily long-term revenue and profit visibility. We see short-cycle products, such as IT contracting for the government, less favorably. As contracts for defense hardware essentially grant a monopoly on that product once the contract is granted, we also see some modest switching costs stemming from a lack of viable alternatives, but this is partially mitigated by the government’s right to license patents to third parties as well as the fact that product cycles for similar systems often overlap and may be provided by competing contractors. More important to us is the extended time required to replicate a product that fulfills a mission. Product development in this industry ranges from years to decades, and if the military is dissatisfied with the product, it is much faster and easier to work with the existing contractor to fix it than to fund the development of a greenfield replacement program.

Following this framework, we view the moatiest segments as those with the most difficult-to-replicate products with the longest upgrade cycles and the longest production cycles. We view Lockheed's aeronautics segment, dominated by the F-35 program, as wide moat for two primary reasons: Its long program life gives us visibility into future revenue and the product complexity gives us confidence that the incumbent producers will remain the leaders over the long haul. We estimate that the remaining aircraft in the U.S. government’s inventory objective would cover maximum F-35 production for about 12 years. This does not include production for international customers or replacement aircraft or the maintenance of the product, which should last until 2070. Second, the sheer complexity of developing a stealth multirole fighter jet should not be underestimated, and it remains a steep barrier to entry for all but a few firms. The aircraft took about 19 years from the contract award to the development of a prototype in 1996 to the point when the Marine Corps declared that the aircraft reached initial operational capability in 2015. We believe that the large development time that would need to be replicated for the military to switch to an alternative provider, as well as the mission-critical nature of the product, present a steep switching cost to the customer.

We also view the rotary and mission systems segment as having a wide moat. The biggest chunk of this segment comes from the Sikorsky helicopter business, which accounts for just under 40% of segment revenue. Lockheed, Boeing, and Textron share the U.S. military helicopter market. Though there are viable outside competitors for this product, namely Airbus, we think that the massive installed base of Sikorsky helicopter introduces switching costs to the customer, as it becomes more expensive for the military to maintain many different helicopter types due to commonality issues and training costs. Helicopter product cycles also last decades, so we believe incumbents’ installed bases will provide valuable servicing revenue as well. A second business within this segment is military shipbuilding via a joint venture with Fincantieri Marinette Marine, which benefits from the substantial required knowledge to enter the business, the steep fixed costs of building and operating a shipyard, and the decadeslong ship product cycle. The remaining chunk of this segment produces various sensors, missile defense products, and military communications. The complexity and replacement cycle length of these products varies, though we view them mostly favorably. The moatiest asset within this subsegment is the Aegis Combat System, a fast-reaction Navy missile defense product that has been deployed since the 1980s. As the system is deeply integrated with long cycle cruisers and destroyers, it is substantially more affordable for the military to upgrade, rather than replace, the product. Yearslong development cycles, commonality issues, training costs, and the potential for allied or civilian casualties from product failure give switching costs to each product line within this segment. 

We view the missiles and fire control segment as wide moat. While missiles are short cycle, as they must be purchased relatively frequently to replenish detonated munitions, we see durable switching costs in the integration of these missiles within longer-cycle products, such as ships and aircraft, and the mission criticality of the missile operating as intended. For instance, Lockheed’s Hellfire Missile program has been in service since the mid-1980s and the Joint Air-to-Ground Missile since 2009. The product complexity for missiles is quite high. Modern missiles require unique technology for high-speed propulsion over many miles and a variety of guidance technologies for targeting. An improperly functioning missile could cause civilian or allied soldier casualties. Finally, the customer tends to order these products in larger blocks, so the contractor must have substantial scale to satisfy customer needs. We believe the substantial technical know-how required to build missile systems and integrate them within various military vehicles provides a steep barrier to entry, and that non-defense contractors would be unwilling to make the substantial fixed cost investment required to enter this market. Given Lockheed’s proven expertise in this field, we don’t think it’s likely that the military will see a compelling reason to switch. 

We still view the space systems segment as having a wide moat. While SpaceX and Blue Origin’s reusable space launch devices are challenging the supremacy of United Launch Alliance’s launch vehicles and some commercial satellite offerings, Lockheed's space segment extends to some of the most-complex payloads on top of the rockets. Indeed, the lion’s share of revenue in this segment, around 55% in 2021, is from satellite products and services, generally to the Department of Defense for secure military communications and surveillance. Though there is increasing commercial interest in space from the likes of SpaceX and Blue Origin, we think the technical complexity of military-grade satellites remains a stiff barrier to entry for all but a few firms. We expect that the classified nature of this work also provides a stiff barrier to entry from outside competitors and the mission-critical nature of these products as well as the difficulty of replacing a potentially faulty product in orbit will prevent the customer from switching to unproven providers for quite some time. The Space segment also earns billions of dollars from sea-based intercontinental ballistic missiles, hypersonic missiles, and missile defense systems, none of which we expect the likes of SpaceX or Blue Origin to compete for. Six percent of the Space segment's operating profit results from the United Launch Alliance activities, with which SpaceX and Blue Origin directly compete. We agree that reusable launch vehicles are likely the future of launch vehicles, as they dramatically reduce the price of launching things into space, but we believe that given the immense cost of failure, the conservative customer will continue to include the United Launch Alliance on contracts until startups are much better proven. That noted, we believe the moatiness of the rest of the portfolio offsets the challenges with space launches.

Wide

Economic Moat

Lockheed Martin

Sikorsky Aircraft is an American aircraft manufacturer based in Stratford, Connecticut. Sikorsky manufacters airpanes, helicopters, as well as other aircraft and products.

Sikorsky Aircraft

Sandia National Laboratories is one of three National Nuclear Security Administration research and development laboratories. Their primary mission is to develop, engineer, and test the non-nuclear components of nuclear weapons.

Sandia National Laboratories

Lockheed Martin Corp. is a global security and aerospace company, which engages in the research, design, development, manufacture, integration, and sustainment of technology systems, products, and services. It operates through the following business segments: Aeronautics, Missiles and Fire Control (MFC), Rotary and Mission Systems (RMS), and Space. The Aeronautics segment researches, designs, develops, manufactures, integrates, sustains, supports, and upgrades advanced military aircraft, including combat and air mobility aircraft, unmanned air vehicles, and related technologies. The MFC segment is involved in air and missile defense systems, tactical missiles and air-to-ground precision strike weapon systems, logistics, fire control systems, mission operations support, readiness, engineering support and integration services, manned and unmanned ground vehicles, and energy management solutions. The RMS segment designs, manufactures, services, and supports various military and commercial helicopters, surface ships, sea and land-based missile defense systems, radar systems, sea and air-based mission and combat systems, command and control mission solutions, cyber solutions, and simulation and training solutions. The Space segment includes the production of satellites, space transportation systems, and strategic, advanced strike, and defensive systems. The company was founded in 1912 and is headquartered in Bethesda, MD.

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