General dynamics and Lockheed Martin

Executive Summary:

This analysis provides a comparison of two major companies within the Aerospace and Defense industry, General Dynamics and Lockheed Martin. General Dynamics had an ROE of 25% whereas Lockheed Martin was 49%, which can be primarily credited to LMT’s significantly higher sales revenue and ability to effectively use its debt. Yet, GD generates a higher NOPAT margin over LMT (9.4% and 7.8%, respectively) allowing GD to contribute more to ROE as a result of the decreased effect interest expenses have on net income with respect to total sales revenue. LMT has a considerable advantage with its increased asset turnover, by generating $1.37 for every dollar as compared to GD’s $1.08 for every dollar spent on company assets. General Dynamics stock is extremely undervalued (estimated $77.71 compared to closing price of $57.79) whereas Lockheed Martin’s stock was slightly overvalued ($85.93 compared to closing price of $84.08). Equity valuation indicates that investors were overly optimistic in LMT’s earning potential and pessimistic for GD’s earning potential. Despite the valuation, the destiny of this industry remains dependent on government’s decisions to decrease military spending, which will have a negative impact on both companies. However, expansion of commercial airlines and partnerships with healthcare industries will have a positive effect on these companies and overall this industry will have a neutral outcome for the upcoming year.

General Dynamics (NYSE: GD)

General Dynamics is the sixth largest defense contractor in the world and the second largest maker of corporate jets. The company maintains four business groups including aerospace, combat systems, marine systems and information systems and technology. Net earnings for the company increased from 2006-2008 ($1.86 to $2.46), a 24% increase over 3 years. Sales for all groups increased from $24.1 to $29.3 billion from 2006-2008, a 17% increase. The company is based in Virginia and gets 67% of its revenue from the Department of Defense.

The aerospace group generated $5.5 billion (19%) in sales in 2008, mostly due to Gulfstream business jet, which include long-range and ultra-long-range jets. In response to the downturn in the economy, the production of large-body and medium-size aircraft were reduced from 87 to 73 and 69 to 24, respectively, in 2008. In product development, Gulfstream introduced 2 additions, which are the ultra-large-cabin, ultra-long-range G650 and the super-mid-size G250. Production of both of these aircrafts, which enter into service in 2011 and 2012, are foreseeable income generators based on orders placed in 2008.

The combat systems group generated $8.2 billion (28%) in sales in 2008, mostly driven by demand for combat vehicles, specifically Mine-Resistant, Ambush-Protected (MRAP) vehicles. The combat system group makes, repairs and supports wheeled and tracked armored vehicles and munitions. Combat system product lines include combat vehicles, guns and ammunition systems, mobile bridge systems, armor, chemical, biological and explosion detection systems. Future opportunities include delivering hundreds of tanks and armored vehicles to Saudi Arabia between 2010 and 2012.

The marine systems group generated $5.6 billion (19%) in sales in 2008, extremely productive as compared to 2007. The group delivers destroyers, submarines, logistic ship and the first commercial product carrier. Upcoming contracts include doubling production to two submarines per year beginning in 2011, which is predicted to increase revenue and earnings over the next three years.

The information systems and technology generated $10 billion (34%) of sales in 2008; its biggest achievement developing a battlefield communications network program and Joint Tactical Radio System (JTRS). Customers include federal civilian agencies and commercial customers, which primarily focus on electronics for land, sea and air-based weapons systems. The acquisition of two companies in the tactical communications and healthcare information technology field are indicative of the direction this group will be making in the upcoming years.

Information gathered from Morningstar1, S&P500 Industry reports2 and www.generaldynamics.com3

Lockheed Martin (NYSE: LMT)

Lockheed Martin is the world’s largest military weapons maker, deriving 84% of its net sales from the United States government, including the Department of Defense. The company is comprised of four operating systems including aeronautics, electronic, space and information systems and global services. Net sales increased 7.3% from 2006 to 2008 ($39.6 to $42.7 billion) and earnings increased 21.8% over three years ($2.5 to $3.2 billion). The company operates in Maryland and employs 146,000 people.

The aeronautics segment generated 27% of sales ($11.5 billion) in 2008. The segment’s primary production is the F-35 Lightning II combat aircraft which is projected to be completed in 2010. The aeronautics segment is focused on making fighter jets and military transport planes and on unmanned military aircraft. The segment also operates the Global Sustainment enterprise to ensure success throughout the life cycle of its aircraft.

The electronics systems segment also generated 27% of sales in 2008 and primarily makes land, sea and air-based missiles and missile defense systems. Specifically, this segment is focused on maritime systems and sensors, missiles and fire control, and platform, training and energy. This system also manages and operates the Sandia National Laboratories for the US Department of Energy. Current projects include the Terminal Altitude Area Defense System (THAAD), the Ballistic Missile Defense system and the firehead control system for the Apache helicopter.

The space systems segment generated 19% of sales ($8.2 billion) in 2008. This segment is comprised of satellites, strategic and defensive missile systems, and space transportation systems. The US government customers accounted for 96% of this segment’s sales in 2008. An ongoing partner is NASA; the LMT-built Phoenix Lander will continue to rove on Mars. Another venture is with Boeing, the United Launch Alliance, which provides satellite launch services to the US government.

Information systems and global services segment account for 27% of sales in 2008. This segment contains mission solutions, information systems and global services. The US government customers accounted for 93% of the segments sales in 2008. Major products/programs include communication systems, mission and combat support solutions, civil agency programs (US Census), the FAA Automated Flight Service Station, the FBI’s Sentinel IT program, and various NASA programs.

Collaborations and partnerships with companies around the globe enable Lockheed Martin to grow its international business both with government and industry. The establishment of Lockheed Martin Australia in 2009 indicates an international interest to grow and expand.

Information gathered from Morningstar1, S&P500 Industry reports2 and www.lockheedmartin.com4

Industry Outlook: Aerospace & Defense

The aerospace and defense industry relies heavily on US government allocation and the upcoming year will likely bring budget cuts to the defense budget in 2010. However, there are predictions that the conventional military equipment is aging and once the Iraq war ends, there will be a need for repair and replacement. Due to the high levels of deficit spending and an increasing trend for social spending, it is likely there will be cuts in defense spending and the outlook for this industry will decline.

On the other hand, it is estimated that there will be an increased growth of global passenger air traffic in 2010 as compared to a decline in 2009. This is based on positive air traffic growth since comparison between 2009 and 2010. Aircrafts that are less fuel-efficient in the US will also need to be upgraded and replaced with newer aircraft. The industry predictions are moderate production cuts at Boeing and Airbus, and declines in the business jet markets due to falling corporate profits.

The industry outlook is therefore at a neutral rating, due to decreased military budget but increased commercial air traffic for 2010. Competition in the industry (Boeing, Northrop Grumman, Honeywell and Raytheon) will strive for contracts within the industry. Many of these defense contractors will face uncertainty from upcoming government decisions in the next year and hence the neutral outlook for this industry.

Information gathered from Morningstar1 and S&P500 Industry Reports2

Cost of Equity Capital

Historically, LMT common stock has proven less sensitive to the broad stock market. With a beta of .923 and using the Capital Asset Pricing Model (CAPM), LMT investors require an annual rate of return of 8.6%. Although this is lower than the expected market return of 9.0%, it is greater than its industry (Guided Missile & Space Vehicles) expected return of 7.5%. However, although LMT may be more volatile as a stock than its competitors, it enjoyed a Return on Equity (ROE) significantly higher than the industry average.

In 2008, LMT had an ROE of 49.2% while the industry followed with a 23.4% average ROE. Just as significant and telling is the comparison of LMT’s ROE to its own required rate of return. This spread of 40.6% is an impressive sign as it demonstrates the amount of return LMT generated above its cost of equity capital. This is also impressive to investors at first glance, and will warrant a deeper interest from prospective investors.

Much the same can be said for GD when comparing its required rate of return to its ROE. Although the spread was only 15.0%, it is still a good sign that GD generates such a return above its cost of equity.

However, unlike LMT GD has a beta greater than 1 and is therefore more sensitive to stock market moves; and has an expected return less than its industry return by approximately 1.5%.

NOPAT Margin

When we analyze the potential net income in the absence of interest expense, NOPAT, we observe that General Dynamics (9.4%) generates a higher margin over Lockheed Martin (7.8%), which allows General Dynamics to contribute more to ROE in comparison to Lockheed Martin as a result of the decreased effect interest expenses have on net income with respect to total sales revenue. However, when comparing NOPAT performance to the rest of their industry (Ship & Boat Building & Repair), General Dynamics’ comes in slightly below the 9.9% average that was established for 2008, but does not necessarily signify any under-performance in this area since the industry data only takes into account two firms when generating Industry NOPAT margin averages. Lockheed Martin was similarly compared to Industry data, generated by two firms as well, in which NOPAT margins were recorded that were more than double of what was found for similarly classified companies (Guided Missiles & Space Vehicles – 3.69%).

Asset Turnover

This portion of the ROE evaluates the efficiency to produce revenue based on the investment in assets made by the company. When we begin to evaluate the simplified Asset TO values provided by the multiplicative decomposition of ROE, we observe a noticeable advantage by Lockheed Martin since they reportedly generate $1.37 for every $1.00 spent on assets. General Dynamics generate slightly lower values at $1.08 for every $1.00 spent on company assets. We then continued to analyze Asset TO, now based on the additive decomposition of ROE to see how other variables affect the turnover rates. When this approach is taken, average assets for both companies in 2008 needed to be adjusted, and was done so by pulling out all non-interest bearing liabilities (NIBL). This is where we noticed that NIBL’s for Lockheed Martin ($20,742) were 62.8% higher than those reported by General Dynamics ($12,735). As a result, the Asset TO ratios increased significantly for both companies (LMT – 2.05 and GD – 4.09) with respect to assets dollars invested by each company. As we can observe, unexpected losses in each company’s pension fund had led them to classify their losses as liabilities since they will still needed to be accounted for in the near future. The 32% drop in the fair value of the LMT pension fund ($27,259 down to $18,539) in 2008 and the 35% drop in the fair value of the GD pension fund ($7,452 down to $4,823)was felt somewhat more extensively by LMT, since the higher amount lost reflects LMT’s larger workforce of 140,000 employees. GD, although enduring a similar percentage drop in fund value, only accommodates a workforce of 91,000, and therefore lost less in overall value amount.

Leverage

When we analyze leverage, we are analyzing each company’s ability and efficiency in using interest bearing debt to generate revenue. The higher the leverage value, the better the ability of a company is at using interest-bearing debt (IBL’s) to obtain desired revenues. When evaluating LMT’s and GD’s effect of leverage as a result of their 2008 results, we observe that the numbers generated by LMT (0.17) are over three times higher than those generated by GD (0.05) during the same time period. As we continue to drill down into the effect of leverage, we notice that ROA is also higher for LMT as a result of the large variation in NIBL’s between the two companies. Although a higher leverage effect value may indicate that LMT relies more on interest bearing debt to generate more sales revenue, an analysis of interest bearing liabilities for both LMT and GD was performed based on data available at the end of 2007 and 2008. This analysis revealed that LMT had reduced their interest bearing liabilities ($4,407 down to $3,805) while GD, whom recorded a smaller leverage effect, had done the opposite and showed to have increased their interest bearing liabilities ($2,791 increased to $4,024) by the end of 2008.

From the results presented above, General Dynamics demonstrates that it under-performed the rest of the industry by exceeding the average account receivable days by 7 days. In contrast, Lockheed Martin out-performed the rest of its industry by having recorded an account receivable average of 43.62 days, which means LMT was collecting from customers on an average of 13.5 days ahead of the rest of the industry, thus shortening their cash conversion cycle by said amount.

  • GD is paying its vendors on average over 2 days past the industry average of 31.50 days; and therefore decreasing its cash conversion cycle relative to its competitors.
  • LMT is paying just ½ day over the industry average of 19.66 days

Inventory Days

  • GD is turning inventory on average over 30 days faster the industry average of 56.62 days
  • LMT is turning inventory on average over 3 days slower the industry average of 13.55 days

Interest Coverage

  • GD could cover its yearly interest expenses 29.57 times in 2008, just under its industry average of 30.43 times
  • LMT could cover its yearly interest expenses 29.57 times in 2008, significantly over its industry average of 5.49 times

Equity Valuation

The equity valuation of General Dynamics for 2008 produced an estimated share price of $77.71. This price is significantly higher than the closing per-share price of $57.59 for 2008 showing the company’s stock was extremely undervalued - not uncommon for nearly all stocks as they were subjected to significant systemic risk during this time of economic crisis. However, according to analyst reports5, some concerns about growth for General Dynamics stem from shrinking credit markets, which would impair the ability to finance business jets. Additionally, it is possible that investors were concerned the aerospace and defense industry would decline with a shift from government defense spending to social spending and deficit spending.

Abnormal net income was computed as predicted net income less the cost of equity capital. Predicted net income was computed using 2008 pro forma net income of $2,674 and implementing annual growth rates suggested by Goldman Sachs earnings forecasts5. The growth rates from 2009 through 2013 were -2.9%, 7.3%, 5.2%, 7.3% and 7.8% respectively. The same earnings forecasts were used to calculate the predicted dividends. The predicted dividends from 2009 to 2013 are 577, 617, 643, 671 and 700 respectively. The terminal value assumption used in computing abnormal net income was the competitive equilibrium on incremental real sales assumption. This strategy was chosen because the government is one of General Dynamics’ most significant customers, comprising approximately 67% of the company’s revenue. This lead to the assumption that General Dynamics may not need to invest a large amount of resources in developing new customers and that most of their future growth would be lead by existing customers. This assumption provided a terminal value of $21,999. The cost of capital for General Dynamics was calculated using a beta of 1.119, a risk free rate of 5% and a market risk premium of 4%. This produced a cost of capital of 9.5%. The present value of abnormal net income was calculated to be $20,265, by dividing abnormal net income by a discounting factor derived using the cost of capital.

The present value of abnormal net income was combined with the initial book value of $9,810 to produce an estimated predicted price of $30,075. This price was divided by the number of shares outstanding according to the 2008 annual report to arrive at an estimated share price of $77.71.

The equity valuation for Lockheed Martin for 2008 produced an estimated share price of $85.93, which is slightly higher than the actual share price as of the end of 2008 of $84.08. This shows the stock was slightly overvalued. This shows investors may have been overly optimistic in their opinion of Lockheed Martin’s earnings potential.

Abnormal net income was computed just as that of General Dynamics. Using analysts’ reports6, estimated (negative) growth rates of (6%), (7%), (6.6%), 11% and 8.92% were applied to the 2008 pro forma net income of $3,114. The same terminal value assumption was used for Lockheed Martin as was used for General Dynamics. The US government is a substantial customer of Lockheed Martin’s, which lead to the assumption that a large portion of future growth could be attributed to existing customers and few resources could be devoted to developing new customers. The terminal value assumption provided a terminal value of $41,132. The cost of equity capital was calculated using a beta of .923, a risk free rate of 4% and a market risk premium of 5%. The 8.7% cost of capital was used to find the present value of abnormal net income of $37.936. This present value was combined with an initial book value of ($2,758) to produce an estimated price of $35,178. The estimated price divided by the number of shares outstanding per the Lockheed Martin annual report to arrive at a per-share price of $85.93.

Overall Summary

The preceding analysis provides a comparison of two major competitors within the Aerospace and Defense industry, General Dynamics and Lockheed Martin. General Dynamics proved to relatively more profitable (higher NOPAT), however, Lockheed Martin had a superior ROE due to its increased asset turnover and ability to leverage its debt. Investors undervalued the stock of General Dynamics, but overvalued that of Lockheed Martin. Despite the valuation, the destiny of this industry remains dependent on government’s decisions to decrease military spending, which will have a negative impact on both companies. However, expansion of commercial airlines and partnerships with healthcare industries will have a positive effect on these companies and overall this industry will have a neutral outcome for the upcoming year.

References:

  1. www.morningstar.com
  2. www.netadvantgage.standardandpoors.com
  3. www.generaldynamics.com
  4. www.lockheedmartin.com
  5. Richard Safran, Noah Poponak, Goldman Sachs, January 26, 2009. Noah Poponak, Chun-Yai Wang, Sai Krishna, Goldman Sachs, January 27, 2010
  6. Richard Safran, Noah Poponak, Goldman Sachs, January 22, 2009. Noah Poponak, Chun-Yai Wang, Sai Krishna, Goldman Sachs, January 29, 2010

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