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A Space Oddity Lockheed Martin NYSE: [LMT] See End for Analyst Team February 8th, 2018

LMT Close Last Three Months ($/Share) 375 350 325

Outlook: Hold

300 275

th

Lockheed Martin released its 2017 earnings on January 29 ,

250

reporting steady performance, with encouraging guidance for 2018. The company saw an 8% increase in overall sales, with sales of its signature

Last Close

F-35 fighter jet growing 18%. This brought the Aeronautics segment as a whole to 13% sales growth, with Missiles & Fire Control and Rotary

52 Week Range

& Mission Systems sales growing by 9% and 6%, respectively. EPS was

First Report

-$2.25 for Q4 of 2017 and $6.83 for the year, down from EPS of $17.49

Price Target

in 2016; however, management notes that this resulted from “recognizing a $1.9bn charge to earnings primarily to reflect the lower

$345.43 Low: $258.00 High: $361.79 $336.21

P/E Ratio

50.28

EPS (TTM)

$6.83

value of our deferred tax assets at the lower statutory rate of 21%.”

Shares

Management expects EPS to move up to the $15.20-$15.50 range at

Outstanding

year-end in 2018.

Market Cap

$98.64bn

Last Dividend

$2.00

Given Lockheed’s steady performance in 2017 and strong guidance for 2018, we have a positive outlook for the company; however we believe a material weakness has emerged in their space segment which will hinder their growth prospects for that part of the business. The private launch market became a whole new beast in recent

Ex-Dividend Date

286.73mm

2/28/2018

Sources: NASDAQ historical quotes, The Wall Street Journal figures as of 02/08/2018

years with major competitive threats emerging, which we believe pose a material risk to Lockheed and ULA, leaving the space segment dependent on AWE and other satellite contracts. We elaborate on this later. Besides the risk to the space segment, we will discuss the F-35’s recent performance and analyze how the Sikorsky marriage is fairing, now roughly two years after the deal closed. Produced by First Report Economic News -- Copyright 2017

www.firstreporteconomics.com


Page 2 of 8 Discounted Cash Flow Model ($ millions) Total Revenue

12 m onths Dec-31-2014A

12 m onths Dec-31-2015A

12 m onths Dec-31-2016A

12 m onths Dec-31-2017A

39,946.0

40,536.0

47,248.0

51,048.0

1.5%

16.6%

8.0%

35,263.0

36,044.0

42,186.0

45,500.0

2.2%

17.0%

7.9%

4,683.0

4,492.0

5,062.0

5,548.0

11.7%

11.1%

10.7%

10.9%

329.0

220.0

487.0

373.0

5,012.0

4,712.0

5,549.0

5,921.0

Growth Over Prior Year Cost Of Goods Sold Growth Over Prior Year Gross Profit Margin % Other Operating Income/(Expense) EBIT Margin % Income Taxes Depreciation & Amort. Change in NWC Capital Expenditure Total Cashflow s

Discounted Cash Flow Model ($ millions) Total Revenue Growth Over Prior Year Cost Of Goods Sold Growth Over Prior Year Gross Profit Margin %

12.5%

11.6%

11.7%

11.6%

1,424.0

1,173.0

1,133.0

3,340.0

406.0

1,026.0

0

(176.0)

(845.0)

(939.0)

3,149.0

3,450.0

EBIT Margin %

1,195.0 1,234.0

(1,063.0)

(1,177.0)

5,709.0

3,833.0

12 m onths Dec-31-2018E

12 m onths Dec-31-2019E

12 m onths Dec-31-2020E

12 m onths Dec-31-2021E

12 m onths Dec-31-2022E

50,000.0

49,648.9

49,970.9

50,969.9

52,677.4

(2.05%)

(0.70%)

0.65%

2.00%

3.35%

44,565.9

44,252.9

44,539.9

45,430.4

46,952.3

(2.1%)

(0.7%)

0.6%

2.0%

3.4%

5,434.1

5,395.94

5,430.93

5,539.51

5,725.09

10.9%

Other Operating Income/(Expense)

1,215.0 1,141.0

10.9%

10.9%

10.9%

10.9%

365.3

362.8

365.1

372.4

384.9

5,799.4

5,758.7

5,796.1

5,911.9

6,110.0

11.6%

11.6%

11.6%

11.6%

11.6%

1,623.8

1,612.4

1,622.9

1,655.3

1,710.8

Depreciation & Amort.

1,170.47

1,162.25

1,169.79

1,193.17

1,233.14

Change in NWC

(215.5)

Income Taxes

(12.3)

11.3

34.9

59.7

Capital Expenditure

(1,152.84)

(1,144.74)

(1,152.16)

(1,175.20)

(1,214.57)

Total Cashflow s

3,977.73

4,151.51

4,202.04

4,309.49

4,477.45

($ millions excluding share price) Tax Rate

28%

Riskfree Rate Terminal Grow th Rate Terminal Value WACC (Discount Rate) Enterprise Value

2.52% 2.30% $121,064.05 6.08% $107,804.62

Cash

2,861.0

Debt

14,263.0

Equity Value

$96,402.62

Number of Shares Outstanding

286,734

Share Price

$336.21

Sources: Company SEC filings, investor presentations, Thomson Reuters

Produced by First Report Economic News -- Copyright 2017

www.firstreporteconomics.com


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No Longer a Rocket Monopolist Lockheed had a near monopoly over the US private launch industry for over a decade and founded a joint-venture with Boeing called United Launch Alliance [ULA] in 1998. This provided Lockheed with a diverse rocket fleet, including the Atlas, Delta, and now the Vulcan programs. However, the industry has changed drastically in recent years. In 2014, the US government issued an official report condemning Lockheed Martin for allegedly abusing its monopoly power and grossly overcharging federal agencies for launch services. Lockheed structured its government contracts in two payments: 1) a fixed charge for constructing the vehicle and launch infrastructure, and 2) an incentive fee known as an ELC. While the ELC was technically a service fee for maintaining and operating a rocket prior to (and during) its launch period, in reality, nobody except the folks at Lockheed and ULA knew the true breakdown of that charge. The government suspected that Lockheed grossly overstated ELCs and pocketed huge profits for each launch. The report states that government agencies “lacked sufficient transparency and knowledge to negotiate fair and reasonable launch prices.” Lockheed’s excessive pricing becomes apparent when observing Air Force [USAF] cost estimates. An unclassified government budget report from 2017 estimated a single unit cost of just over $422mm. This implied a single rocket launch cost of over $422mm, while SpaceX pricing begins at $62mm to launch satellites into Geostationary Orbit.

Source: Department of Defense Fiscal Year 2018 Budget Estimates, page 109

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New competitors pose a serious threat to Lockheed’s launch businesses, namely SpaceX and soon Blue Origin. In the last several years, SpaceX in particular has enjoyed major growth in business from both US and international clients.

Source: Space Exploration Technologies website

Lockheed has largely failed to capitalize off of this new growth in the launch sector. Last year the defense contractor did not launch a single rocket, and its space segment saw a weak increase in net sales from $9.409bn in 2016 to $9.473bn in 2017. From Q4 of 2016 to Q4 of 2017, LMT’s space segment saw a decline in net sales of 12%.

Source: Company 10K filings

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Lockheed can, of course, adjust its pricing closer to that of its competitors, can’t it? Maybe not. While SpaceX was founded only several years after ULA, SpaceX took a different approach to its business. The rocket start-up spent years developing the re-usable Falcon 9, while Lockheed Martin focused on immediate profitability with the Atlas and Delta rocket programs. SpaceX saw its vision materialize in 2016 when it became the first program to successfully land a rocket on a barge floating in the ocean. This implies that SpaceX will undercut previous cost structures and eliminate the fixed cost associated with launching rockets, while Lockheed and ULA must still charge clients for building each rocket from scratch. Aside from earning a page in ‘Ripley’s Believe It Or Not’, SpaceX is now incorporating the selflanding Falcon 9 into a significantly more cost-effective business model. Additionally, Blue Origin is nearing completion of its BE-4 engine, which will be one of the most powerful boosters on the market when it begins service in 2019. Blue Origin has also successfully landed rockets, accelerating the industry shift toward re-usability. Meanwhile, Lockheed and ULA have not made significant technological leaps to address the growing exterior threats. This is particularly concerning given the long periods required to develop, test, and perfect cutting-edge rocketry. Perhaps the only advantage that Lockheed still retains over its new competitors is reliability. ULA’s Atlas program markets a 100% success rate with over 600 launches in the last 15 years, while the Delta II rocket has a 98.7% success rate with over 150 launches.

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That is a difficult score to beat, considering SpaceX has yet to complete 50 launches, and in past years, a handful of SpaceX rockets have made international news when exploding during takeoff. The launch business is high-stakes since it takes government agencies years and billions of dollars to build some satellites. Just last month, a billion dollar top secret government satellite was lost after being launched into geosynchronous orbit by a SpaceX Falcon 9 (SpaceX did remark that all of their systems functioned properly during this particular launch). However, risk management is not a sustainable advantage for Lockheed, as SpaceX is gradually approaching comparable reliability. We believe that Lockheed must either innovate quickly or carve out another part of the launch industry that SpaceX, Blue Origin, and Virgin Galactic are not pursuing. Given that Lockheed just levered-up to make the $9bn Sikorsky acquisition, it will face financial constraints to make a bolt-on acquisition of a rocket technology start-up, or even launch a major R&D campaign for its space segment. We believe AWE and the other satellite contracts will continue to bring steady business into the space segment; however, given SpaceX’s spike in launches in recent years and new competitors entering the market, Lockheed and ULA have clearly missed a major opportunity to significantly grow space segment earnings. Update on Sikorsky Lockheed Martin purchased the helicopter manufacturer in blockbuster fashion back in 2015. Funded through roughly $9bn of debt, Lockheed closed the acquisition and watched its leverage jump higher than that of all of its peers, at just over 2.1x Total Debt/EBITDA. However, Lockheed has largely enjoyed a positive outcome with respect to Sikorsky’s recent performance. Lockheed’s Rotary and Mission Systems saw an increase of net sales of $753mm with almost $680mm of that attributable to Sikorsky helicopters. The Sikorsky helicopter programs are thus the largest earners for Lockheed in this particular segment of the company. Also worth noting, Lockheed’s Rotary and Mission Systems saw nearly identical operating profit from 2016 to 2017. Sikorsky’s helicopter programs contributed an increase of $105mm to the operating profit, which means that without this technology, Lockheed would have seen a significant decline in operating profit.

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Lockheed’s helicopter sector as a whole saw similar numbers from 2016 to 2017 with respect to the number of government helicopter programs, and a decrease from 12 to 7 in commercial helicopter programs. However, international helicopter programs increased from 2 to 9 from 2016 to 2017. Executive Vice President and CFO Bruce Tanner was enthusiastic about the recent performance of Sikorsky and the outlook for 2018. Tanner mentioned that the last quarter of 2017 was “probably the highest quarter of profit" for the company throughout the entirety of 2017. In addition to profit, Tanner noted that the company saw “higher aircraft delivery in the (4th) quarter.” Overall, Tanner was bullish about Sikorsky, and the deal has proven to be mutually beneficial thus far. The F-35 Takes Off Lockheed Martin’s year-over-year aeronautics net sales increased 13.4% in 2017, bolstered by higher net sales of the F-35 and C-130 programs. The F-35 Joint Strike Fighter Program originated in the early 1990s as a DoD effort to re-define the next generation of affordable aircraft weapons systems. Lockheed Martin won the contract in 2001, but lost sales to Boeing’s F/A-18 Super Hornet through 2015 due to production delays. Now, the F-35 is nearing full production capacity and is Lockheed’s signature product. This jet will be essential to the aeronautics segment into the foreseeable future. In 2017, production of the F-35 increased by over 40%, totaling 66 jets. Management expects a 35% increase in production for 2018, bringing them to 90 jets for the year. By 2020, the F-35 is predicted to account for nearly 70% of Lockheed’s aeronautics revenue, or 30% of total revenue, according to Morningstar estimates. The F-35 could see additional unexpected sales this year. The Air Force is currently in talks with the United Arab Emirates to sell the ally country F-35s, and Saudi Arabia has also expressed interest in acquiring the jet. Congress must approve of these purchases, which will require further discussions with the US’s Middle East allies. If talks go well, Lockheed could get a significant bump in jet sales during 2018.

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Conclusion While Lockheed missed a major opportunity to see significant growth in the space segment, the strong F-35 performance and encouraging results from Sikorsky will propel the company forward for a strong 2018. The space segment is also clearly not dependent on launch services for revenue, so we expect performance to remain steady with AWE contracted through 2025. Recent volatility in financial markets also factored into our valuation which drove the price lower. If markets stabilize into 2018, we believe Lockheed’s share price could return to previous levels seen this year. Additionally, if new clients for the F-35 emerge in the Middle East, we believe that Lockheed shares could outperform the market. Taking a conservative approach, we suggest “hold� in the short-run until financial markets stabilize.

Analyst Team Andrew Stiles Joshua Gutierrez Matthew Cesare Jacob Engelman

Important note: The views expressed in this report are the opinions of the analysts above. The analysts do not have FINRA licensing and are not qualified in any legal capacity for financial advisory; First Report has not and does not receive payments for these reports. None of the analysts have positions in the companies discussed in this report. We advise that readers research these subjects on their own before making investment decisions.

Produced by First Report Economic News -- Copyright 2017

www.firstreporteconomics.com

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