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We currently remain on the sidelines with Lockheed Martin Corporation (LMT - Analyst Report) due to the impact of the Budget Control Act. The Act has two main parts that would affect future defense spending. The first part dictates a $487.0 billion reduction to the previously planned defense spending over the next decade. The second part is a sequester mechanism that would impose an $500.0 billion additional cut on defense spending if the overall U.S. budget deficit is not reduced. This keeps the risk high for further cutbacks in defense budgets. However, we believe market pessimism is fully accounted for in this defense behemoth’s current valuation, which is priced at a discount to both industry peers and the overall market.

Lockheed Martin is the largest U.S. defense contractor with a platform-centric focus that guarantees a steady inflow of follow-on orders from a leveraged presence in the Army, Air Force, Navy and IT programs. We expect the company to benefit from a strong defense focus on a number of its platform programs, such as the C-130 Hercules & C-5 Galaxy transport aircraft, F-16 Fighting Falcon multi-role jet, MH-60 Helicopters, the Advanced Extremely High Frequency & the Global Positioning Satellite III system satellites, the Littoral Combat Ship, and the Aegis Weapons System.

Going forward, we believe Lockheed Martin has significant upside potential based on the Obama administration’s focus on Intelligence Surveillance Reconnaissance (ISR), unmanned systems, force protection, cyber-security and missile defense. It was already sitting on an order backlog of approximately $75.6 billion at the end of the first nine months of 2012.

Lockheed Martin has one of the strongest balance sheets among its peers with a stable long-term debt-to-capitalization of 78.0% after the end of the first nine months of 2012. Lockheed continues to be a strong cash generator with its operating cash flow reaching approximately $4.3 billion during fiscal 2011. Management is also prudent in returning a substantial portion of its free cash flow to shareholders through share repurchases and incremental dividends. The company closed the first nine months of 2012 with cash and cash equivalents of $4.7 billion, and a $1.5 billion revolving credit facility expiring in August 2016. Total long-term debt of approximately $6.4 billion was mainly in the form of fixed interest bearing securities (notes and debentures). All these justify the Zacks #2 Rank, which translates into a short-term “Buy” recommendation.

On the flip side, we must remember that a large percentage of Lockheed Martin’s business comes from the U.S. government (82% of sales in 2011). Budget deficits and political uncertainty make future defense budgets vulnerable to cutbacks. Going forward, Pentagon is seeking to trim about $487 billion in defense spending over 10 years to meet deficit reduction targets. Also, U.S. economic fundamentals are basically being kept on a tight leash as the Euro-crisis continues to cast its spell over financial markets, risking further cutbacks in future defense budgets.

We are apprehensive about the $15 trillion national debt and unemployment rate of around 7.7% that would lead to the Budget Control Act’s dictum of automatic cutbacks across the board going forward. This would not result in anything extra for defense goliaths in general and Lockheed Martin in particular.

Given the budgetary cuts and overall scenario, it would not be too pessimistic to advise investors to adopt a wait-n-watch approach for the defense and aerospace major. Thus, considering the company’s business model and fundamentals, we maintain our long-term “Neutral” recommendation on the stock. This is in sync with its peers like The Boeing Company (BA - Analyst Report) and Northrop Grumman Corporation (NOC - Analyst Report).

Over the longer run, we expect the company to register a stable performance given its diversified presence in a plethora of defense platforms and IT know-how. Also, shareholder return will continue to be shored up by the company’s focus on debt repayment, its ongoing share repurchase program and the incremental dividend.

 

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