Moody's Affirms Ratings on Lockheed Martin (LMT); Raises Outlook to Positive

Moody's Investors Service affirmed its ratings for Lockheed Martin (NYSE: LMT) and subsidiaries ("Lockheed Martin"), including the Baa1 senior unsecured and P-2 short-term debt ratings, and revised the rating outlook to Positive from Stable.

The change in the rating outlook to a positive bias reflects Moody's expectation that Lockheed Martin's credit profile will improve over the forward rating horizon, as the company benefits from (i) a comparatively protected position as the prime contractor on one of the few growing defense programs—the F-35 Lightning II—and Moody's view that the risk profile of that program has reduced, and (ii) a growing amount of cash flow likely over time related to the recovery of previously funded pension expenses from its principal government customer, another key differentiating factor in the broader context of its immediate peer group. Combined with anticipated strong execution as recently demonstrated on major programs and a measured approach to shareholder return initiatives, the prospect of an upgrade in the company's long-term senior unsecured debt rating to A3 being warranted over the coming 12-to-18 months is subsequently deemed to be elevated, as reflected in the rating outlook revision to Positive.

"As the largest US defense contractor, Lockheed Martin's leadership position across multiple mission area categories—including air, space, sea, and missile defense—continues to mitigate budget-driven earnings volatility which has been more notably evidenced by other contractors in the defense industry sector" said Russell Solomon, Moody's Senior Vice President and lead analyst for the company. "The company's continued strength in execution on key programs coupled with our expectation of now only modestly deteriorating defense end market fundamentals and increasing recovery of previously funded pension contributions over the forward rating horizon lend support to the positive outlook," Solomon added.

SUMMARY RATING RATIONALE

Lockheed Martin's Baa1 rating is broadly supported by: 1) the company's significant scale as the world's largest defense contractor, with about $45 billion of revenue this year, and as the leading IT provider for the US government; 2) the breadth and depth of its operations and strong market positions as the incumbent on a number of critical defense programs; 3) considerable barriers to entry given the high-technology nature of the industry and the classified status of many operations and programs; and 4) the benefits of good visibility afforded by the largest order book amongst defense contractor peers (nearly $77 billion as of September 2014). We expect modestly declining sales will stabilize in 2015 at about $44 billion and grow by about 3%-5% in 2016, as near-term revenues are likely to remain somewhat pressured by persistent budgetary constraints for Lockheed Martin's principal customer, the US Department of Defense (DoD). Even so, we expect this pressure will continue to be less severe for the company than for the broader defense market given its prime position on the sizeable and growing F-35 program. The risk profile on the F-35 program has reduced considerably in our view. While it remains exposed to further quantity reductions and affordability initiatives, the program now seems reasonably assured to continue, and at accelerating unit delivery levels, with renewed interest from global allies as cost reduction initiatives are increasingly scrutinized. Notably, even as annual revenues have declined nearly 4% from the 2012 peak, Lockheed Martin has generally maintained reported operating margins in excess of 9%. As a result, even with US defense spending under continued pressure we expect Lockheed Martin will comfortably generate at least $3 billion of free cash flow annually over the next several years, affording it the opportunity to both further strengthen the financial profile and still maintain sufficient flexibility to meet its shareholder return objectives.

Pension obligations remain substantial and were about $9.8 billion as of the 2014 mid-year pension remeasurement, notwithstanding some meaningful contributions exceeding minimum requisite funding levels, significant relief in the underfunded status stemming from rising interest (and ensuing discount) rates in 2013, and the company's second quarter announcement that it would freeze its salaried defined benefit pension plan in two stages (beginning January 2016 and concluding January 2020). Adjustments for the debt-like pension program shortfalls continue to adversely affect Lockheed Martin's debt metrics at more meaningful levels than for similarly rated peers, with pension adjustments representing more than one-half of the roughly $17 billion in Moody's adjusted debt for the company. This proportion is still much improved from about 65% at the end of 2012. And while rapidly growing pension expense recoveries from Lockheed Martin's principal government customer (the US DoD) related to historical outlays are expected to represent a meaningful cash flow differentiator for the company over the next few years, we remain watchful that higher costs embedded in the company's overhead rates may adversely affect its ability to price competitively on future bid activities.

RATING OUTLOOK

The rating outlook is positive, incorporating expectations that Lockheed Martin will sustain a solid financial profile over the intermediate term and execute profitably on its long-lived programs such that leverage continues to improve and trend towards 2.0x, all while a strong liquidity profile is maintained. While pressure on defense budgets is expected to persist, Lockheed Martin appears to be better positioned than most companies in the industry to preserve its top line and maintain a strong earnings profile as the leading global defense contractor with the prime position on the largest and most important contract.

WHAT COULD CHANGE THE RATING - UP

Sustained operating margins that exceed 10% coupled with evidence of continued deleveraging (trending towards 2.0x Debt-to-EBITDA) and broad-based improvement in other key credit metrics, concurrent with maintenance of a strong liquidity profile, could warrant consideration for a potential upward rating action. Further reduction (either organically or inorganically) of the large underfunded pension obligation continues to be a primary opportunity to strengthen the balance sheet in support of a prospectively higher rating.

WHAT COULD CHANGE THE RATING - DOWN

The outlook and/or rating could be pressured if execution problems (particularly with the F-35 program) lead to material contract cancellations and profitability falls more than anticipated, declining leverage trends reverse (approaching 3.0x Debt-to-EBITDA) and/or fiscal policies become more aggressive (including shareholder remuneration in excess of free cash flow) and the company's liquidity profile worsens.

The principal methodology used in these ratings was the Global Aerospace and Defense Industry Methodology published in April 2014. Please see the Credit Policy page on www.moodys.com for a copy of this methodology.

You May Also Be Interested In

• Lockheed Martin (LMT) Tops Q1 EPS by 53c, Beats on Revenue; Offers FY24 Guidance
• QNB Corp. (QNBC) Reports Q1 EPS of $0.71
• JPMorgan on Tesla (TSLA): 'See Risk of Further Negative Earnings Revisions'