LMT - Lockheed Martin Corporation (LMT) 44th Annual Aerospace/Defense & Industrials Conference (Transcript)
Lockheed Martin Corporation (LMT)
44th Annual Aerospace/Defense & Industrials Conference Call
February 16, 2023 10:00 ET
Company Participants
Jay Malave - Chief Financial Officer
Conference Call Participants
Cai von Rumohr - Cowen
Presentation
Cai von Rumohr
I am going to move on and – you have heard about the F-35. You have the F-35 producer with us, Lockheed Martin, CFO, Jay Malave. Jay, welcome.
Jay Malave
Thank you, Cai. Great to be here.
Question-and-Answer Session
Q - Cai von Rumohr
Really appreciate it. So rather than start on the F-35, let’s talk about the Ukraine. So that’s changed demand prospects, particularly among the allies, walk us through maybe some of your foreign order potentials that you have got?
Jay Malave
Yes, let me just first start, I mean the obligatory Safe Harbor. So just as a reminder, my comments in this discussion will likely include forward-looking statements and those statements and projections are subject to risks and uncertainties that could vary materially from what I talk about today. And we have information in our 10-Q and 10-K SEC filings on risk factors that could affect those. And so getting right into your question there, Cai. And as far as upside, we mentioned on the first quarter – I am sorry, the fourth quarter call back in January that we saw about $1.5 billion of orders in 2022, that was related to kind of Ukraine in general orders. And we saw – had a line of sight to an incremental $5 billion in that ballpark of orders. For this year, we see – of that $5 billion, you’ve got a line of sight to about another $1.5 billion so far. And so we continue to have – it’s a pretty dynamic environment. You may have seen in the news, Poland is another way throughout a $10 billion number out there. Not all of that goes to Lockheed Martin, maybe half of that would be related to Lockheed Martin and a fair amount of that was already assumed in our projections. But nonetheless, you continue to see continued demand there. And so we are pretty excited about being able to deliver that capability for global security requirements. But what I would say is that as we continue to add to the backlog, the ability to convert on that backlog is going to take a little bit of time. And the reason for that is in areas that we are seeing this demand is in areas where we are already ramping up. And so we are trying to meet that with the supply chain and all that type of – that environment. It’s just going to take us a few years really – few years to convert on that backlog. But it’s certainly more significant than we had originally anticipated a year ago, even 6 months ago or 3 months ago.
Cai von Rumohr
So when you say $5 billion potential $1.5 billion in ‘23. Are you just talking about missile and fire control or you?
Jay Malave
Yes, that is mostly all missiles and fire control, yes, whether it’s things like HIMARS, GMLRS are the two big drivers, a little bit of Javelin as well, perhaps even PAC-3 on integrated air and missile defense. So those are, I would say, the primary drivers of that demand pretty much in MFC.
Cai von Rumohr
Right. Are you seeing more kind of people talking about buying things so that all of a sudden in 6 to 9 months we may see more orders?
Jay Malave
Well, as I mentioned, where we see – we came into the year thinking that it could be again, of that $5 billion of potential line of sight upside, we came into the year had thinking it could be maybe $500 million. Now we are thinking that it’s probably going to be $1.5 billion in 2023. This is orders. It will take some time to convert that to sales. And so yes, it could go higher than that. This Poland news could add to that $1.5 billion really in the back half of this year. And we will see. I mean that’s a pretty complicated, I think, buying. And so it could slip into 2024 as well. But yes, I mean there certainly could be more activity in the back half of the year.
Cai von Rumohr
So how do we get – if you have $10 billion, you have $5 billion of it, if you get $1.5 billion this year. I mean how does – I mean does that flow over 3 years in orders and then 4 years of deliveries or how does that work?
Jay Malave
Yes. I would say really, 5 years of deliveries probably where we would start probably seeing that really start to hit us in probably 20 – late ‘24 into ‘25. It just as I mentioned, it takes some time. It’s great to see the incremental demand, but these are areas where we were already increasing our ramp rates, our production ramp rates. And so the ability to step it up even higher, it’s just going to take us a little bit of time to do that.
Cai von Rumohr
So this is kind of direct as a result of Ukraine, but we are seeing requests from Ukraine for F-16s. Is there any kind of what I would call peripheral foreign demand that you are seeing that other countries in Eastern Europe are sort of warming up to buying more F-16s or buying any other products from you?
Jay Malave
Well, yes. I mean, so you have heard the request for F-16s in Ukraine. Turkey has also indicated that they would like to purchase more as well as upgrade the existing fleets that they have. And so there is – we have mentioned in the past that there is potential line of sight to additional orders of up to 300 aircraft or so even more than that. That is something that the process for that is – just takes a little bit of while there. That’s a state department decision as to whether or not a license would be granted, we really have to follow the government’s lead on those types of systems. And the demand we see there. India is another one on their F-21, where there could be some opportunity there. But again, it’s more of a government-to-government discussion and then we fall behind that discussion.
Cai von Rumohr
Any milestones like if Biden decides to send some Fs or to allow allies to send F-16s to Ukraine that will…
Jay Malave
Yes, I just wish I can give you a specific date by which...
Cai von Rumohr
Not a date, but those are the kind of milestones that would show greater demand. So foreign, refresh my memory, it’s about 30% of…
Jay Malave
About 30%, that’s right.
Cai von Rumohr
Any thoughts about where that’s going to go? Is that percent going to be moving up the next couple of years?
Jay Malave
Yes, it will grow. Absolutely, it will grow. We see just in international that growing over the next 3 to 5 years by a high single-digit rate.
Cai von Rumohr
So it should grow as a percent of the total.
Jay Malave
Well, that’s the growth rate, but the percent in total, I don’t know what that will equate to, but it’s 35% plus probably in terms of what that means in terms of the absolute, but yes, that’s a certain area. Besides Europe, Australia is another one, there is significant demand. We are competing currently for a program called AIR6500, which is a total really Joint All-Domain command and control type of system for the Australian forces. We were successful in defense of Guam, which is in U.S., but it’s kind of into Paycom. There is also opportunities in Japan as well. And so it’s not just Europe, there is Asia and Australia is a big one as well.
Cai von Rumohr
Got it. So what about space and directed energy, you are on transport layer one, I think you missed out on the tracking layer, what’s your potential on these and kind of those other LEO systems?
Jay Malave
Sure. So space transport layer is a communication system for STA. We are right now in the process of under contract for Tranche 0 and delivering on that. We are due to deliver 10 satellites on that and we expect those to launch midyear of this year. The follow-on Tranche 1 is another $42 million satellites and then when we get into Tranche 2, it could be even double of that. So a lot of opportunity there as they build out that constellation for STA transport layer. As far as tracking, I think it’s important to remember, we have the systems in GEO. So SBIRS OPIR, we are operating and we delivered our final satellite vehicle for SBIRS, but we are also now we have got 3 vehicles, space vehicles for OPIR that we will be delivering over the next few years. And then we have partnered with Raytheon Technologies on a MEO, missile warning and tracking system. And so we are going to be competing on that. We are excited about that opportunity. And then when you are thinking just about national security space in general, we have got a number of classified programs which are pretty substantial, which will drive growth in our space segment as well. Obviously, you can’t talk about those, but pretty strong demand for those important missions and those will drive growth in that segment.
Cai von Rumohr
Got it. I can’t go without asking you about Florida. So you have protested, I don’t know what you can tell us, but can you give us any color in terms of like what were you saying in terms of we should have had another shot or we should have wanted?
Jay Malave
Yes. I think it boils down to Cai is that what we saw based on the information that we had is an inconsistent application of the valuation criteria, that’s simply stated. And that really is the basis of the protest. The GAO, Government Accountability Office, GAO will have 100 days to make an evaluation and a recommendation on where you go from there. And we don’t take these things lightly. Lockheed Martin does not protest a lot of our record of protests very low. And so if we didn’t feel we had a basis for it, we would not have found the protest.
Cai von Rumohr
Got it. And do you expect that it will basically go to 400 days.
Jay Malave
Yes, I think it will.
Cai von Rumohr
Got it. Okay. And so on the execution side, what are you seeing in terms of supply chain, labor availability inflation?
Jay Malave
Supply chain is still a step forward and a step back, Cai, the best way I would describe it. And I will take maybe the fourth quarter and the first quarter of ‘23 as an example. In the fourth quarter, we over-delivered to our expectations in sales and really almost got exactly back to the original guidance we have provided back in January of ‘21 or ‘22. And part of that was just getting on contract, but part of it was better supply chain performance in the fourth quarter. As we have looked at our forecast now in the first quarter, we saw that taking a step back. And so we have got some calendarization pressure in the first quarter. Part of it is program schedules. Part of it is supply chain pressures there. So we are not out of the woods. It’s still touch and go. And we have got a calendarization issue a little bit here in 2023. We feel confident for the full year guide that we provided, but the first quarter is going to be a little bit bumpy partly due to supply chain.
Cai von Rumohr
Got it. And what about inflation, what’s – are you able to sort of...
Jay Malave
Yes. And let me, I guess break apart inflation into two areas: one being the labor inflation, our internal labor and the other one being in the supply chain. And just maybe taking a step back, when you look at our revenue exposure, almost 40% of our revenue exposure is cost plus. So that generally just flows through. The other 60% is some form of fixed price. And on those, in many cases, we go back to back with our suppliers. So our current contracts on the material escalation, we have fixed price from our suppliers. So we are not really – we have got some level of insulation against that. Where we did see impacts in 2022 is in our labor inflation, because we, in a few areas, on critical skill sets, we did midyear raises for either attraction or retention of employees and then when we did it to merit cycle here, the cycle for 2023, it was higher than what we had originally anticipated in our base contracts going forward in our EACs. But I would say that Lockheed Martin has got a pretty strong cost reduction program. And so we essentially mitigated most of that headwind through our cost reduction program. And I think – and so we’ve been able to manage that I think fairly well. Where I see it kind of being more of an issue going forward is as we look into new awards, because now we are seeing suppliers that are unwilling to provide multiyear fixed pricing. They want some type of escalation clause tied to it and rightfully so. I mean, it’s hard to criticize that type of request. And so the dialogue we are having with our customer is that we are looking for that to flow through. It’s in an area where we are unable to get a contractor, a subcontractor on a fixed price for whatever the reason it maybe, we are looking for the trade-off on our contract with our customer to flow through any type of escalation clause. And so there has been dialogue with – they are receptive to it. Of course, they are going to drive because their job is to drive the best result for the U.S. taxpayer, which is what they should be doing. But ultimately, they understand that we are in an environment where we’ve had material inflation and material escalation. And we are trying to do it so no one gets harmed.
Cai von Rumohr
Right. So if you look across the industry, I mean, as you are aware, Northrop’s 10-K, they indicated that the B-21 where they have been telling everybody, execution was good that they have the potential or a loss of over $1 billion on 5 lots. And so do you have any long-term contracts that are firm fixed where we should be nervous that this one might come back and create a problem?
Jay Malave
So yes. So I would say that we do have production options on contracts where we have got a particular one. In the first quarter call, we talked about MFC’s margins where they were declining. They did 14.5% in 2022, and we are around 13.7% in 2023. And then there is further pressure there from that. That’s fundamentally due to option – production option pricing on a classified program that we have. And so we are going to see continued pressure there, which is kind of a – it’s a known entity there. And so I’ve been talking about that their margins will want to go step down another 50 to 100 basis points from where we are in 2023. Now we will see what the mix benefit of this incremental demand is and whether or not that dampens that headwind and we will have to go through that planning cycle as we do during the summer and we’ll have a better feel for what those estimates are when we talk about – start thinking about 2024 in our October call. But there is certainly pressure there, which is due to a production program that has a challenged pricing in it. And we’re going from a low-margin kind of development contract to essentially a negative margin production for a period of time. And so that’s what’s driving MFC’s margins to want to continue to slide.
Cai von Rumohr
That’s a classified program?
Jay Malave
Classified program. And so we will go through that. I mean our job as a management team is to see what we can do to offset that, try to mitigate those, and that’s what we will go through over the next few months to see what we can do with that over the next few years. And so that’s the context when I’ve talked about in the past and just still get some continued margin pressure beyond ‘23. It’s really there is where we’re seeing it.
Cai von Rumohr
Mainly an MFC?
Jay Malave
Right.
Cai von Rumohr
Okay. And then you’ve talked about you and Northrop are talking about digital transformation in your case, 1 Lockheed Martin , where are you in this journey? And what impact do you think this could have on your profitability?
Jay Malave
Yes. Let me describe our program because it is an all-encompassing program. It is – it starts with engineering design systems. So it’s embracing and proliferating digital threat and digital twin engineering. It extends to our ERP. It extends to our manufacturing execution systems, it also extends to our human resource management systems. So this is a broad – it’s not like we’re just updating an ERP system. We’re going end-to-end all the way from development, all the way to sustainment of life cycle of our program, updating all of our systems. Where we’ve got a head start over the past few years is really on the engineering development side, where we’ve had a program adoption of the digital thread and digital twin systems.
We’ve got – we ended 2022 with about 112 programs that have now adopted this method of design. And the whole intent of doing that is being able to compress design schedules and the efficiencies that you get from that are you get better visibility. As you’re designing, you’re able to see a digital twin, what the hardware is a digital replica of that hardware. So you can understand – better understand dependencies you can better understand form, fit and function on components that you’re designing and that should not maybe necessarily eliminate, but significantly reduce rework in the engineering cycle and the design cycle. What that ultimately will culminate to us, for us is just a more competitive company. And so we see that’s going towards as being a really a ticket to play in the future. These are the type of design cycles that we’re going to have to operate under a tighter design cycle, delivering a capability earlier to our customer and doing it such a way that’s affordable and it reduces risk for both us as well as the customer. And so it’s not necessarily a margin play per se, but we will see cost reduction, but it will make us a more competitive company.
Cai von Rumohr
And it’s predominantly, I would guess, on newer programs other?
Jay Malave
Yes, legacy programs will have the previous product life cycle management systems. You can’t really disconnect those because of where they originated.
Cai von Rumohr
Right. Right. So – you talked of the pillar – the four pillars of growth, programs of record, hypersonics, classified new awards. Walk us through maybe the relative growth we should think about for each of those relative trends?
Jay Malave
Yes. When you look at our four pillars of growth, it’s about almost $20 billion to $18 billion to $19 billion bucket of sales. And our biggest ones there are our programs of record, just to select the programs of record are around $8.5 billion to $9 billion of that $18 billion to $19 billion of sales. We see that growing at a high single digit clip. And the reason for that is the demand cycle as well as we’ve pushed some of these schedules to the right. And so when you talk about things like CH-53K, PAC-3, Fleet Ballistic Missile and our space business and F-35 is a sustainment, all of those, we feel very comfortable that ring to grow because we have the visibility to the programs of record there.
And then you tack on what we’ve seen now in some of these legacy MFC programs is going to drive that growth rate to the higher end of the high single digit number. The next one is classified. Classified again is about an $8 billion portfolio for us all in. And whether it’s an arrow, whether it’s in space or an MFC, we see some pretty significant growth there. It’s probably closer to maybe in the mid-single-digit range. between this is over – these are 5-year CAGRs that I’m talking about. And so those are the two biggest drivers that we will see in those three business areas really fundamentally driving that; Hypersonics is another one. We’ve talked about that. That growth rate is a little bit lower than the other two, but that will contribute to growth. And then last one is new awards. In new awards, we just talked about FLRAA assuming that, that the decision holds, we still have next-gen interceptor is a big program for us. There is FLRAA behind that, which is what we expect to down select in 2025. And those are two. And then we have an international missile – Integrated Air and Missile Defense System that is pretty sizable in the Middle East that we expected that we can win that as well. So when you put those all together, that $18 billion – $18 billion to $19 billion portfolio of sales. We expect that to grow in the mid-single digit growth – I’m sorry, high single-digit growth area that will drive us in fuel us for the next few years.
Cai von Rumohr
So the international air missile defense. That’s a sale of a existing equipment or a new program?
Jay Malave
It would be a new program. New capability for us, yes.
Cai von Rumohr
New capability. Okay. And so all told, I think what are the downers? I mean, certainly, C-130J looks like it’s going flat to down. F-16, which I think was looking down is now moving up. Talk about – the other...
Jay Malave
Well, if you – yes, if you go run a portfolio, if you look at – if I start with Aero, I mean, production enough 35 is actually down this year flat to up next year. But in the grand scheme, it just – it’s flat. When you think about that, production is a $12 billion portfolio in and of itself, just F-35 production. So it’s a big number. As you mentioned, F-16 is growing. We – we’ve got a first delivery here in the first quarter on the F-16 aircraft. We will ramp that rate up. We have about 20 aircraft in WIP today, and so that will continue to grow over the next few years for us. C-130, yes, when we delivered, I think it was 24 last year, that will drop to about 20% between now and 2027. So we will see a little bit of pressure there, but it’s not dropping all that significantly. And so Arrow will have, I think, a stable portfolio to slightly up over the next 5 years.
MFC is where we’ve talked a lot about we had ramping programs and we talked about things like PAC-3 and some of these other areas of demand, whether they be GMLRS JASSM or LRASM are other areas that we are growing. They’ll continue to grow over. And so we see a solid mid-single-digit growth rate there over the next 5 years. RMS, yes, they had the FLRAA we will see what happens with there. But they still – Sikorsky still has enduring Hawk or what we would call it. We still think there is opportunity for further deliveries and further extension of the Black Hawk program there. And then you’ve got FLRAA in ‘25. And then there is also international opportunities, both in the Black Hawk an international Black Hawk as well as some of our X2 technology there at Sikorsky. And then when you go outside of Sikorsky, this is where our battle management systems are our joint all-domain command and control systems are Aegis. So we see a lot of opportunity there when we talk about joint all-domain operations for them to provide both domestic and international systems and be a driver of growth. We also have some new radar systems. Jim announced in his prepared remarks on the fourth quarter call, our TP way system with Norway. And so I think there is pretty good – we feel pretty good there and kind of maybe low to mid-single digit there, growth rate at RMS.
And then finally, it’s space. Space is dealing with some – there is some – the programs that we’ve had in the past, we’ve just been fundamentally great programs for our SBIRS, OPRs, as I mentioned before, those are going to want to trend back down. Orion, even though we have production contracts that will want to normalize as well. And so while they have got solid growth in national security space, they have got a little bit of overhang from these two programs. It will limit their growth a little bit. So I’d say probably low single digits there in that ballpark.
Cai von Rumohr
Now RMS what’s the growth look like if you don’t win FLRAA? What difference does FLRAA made?
Jay Malave
Well, I mean, FLRAA, I would say where we are right now, given what we know, we’re probably looking at a low single-digit growth rate without FLRAA.
Cai von Rumohr
Without FLRAA. Okay. And mid-singles, if you do get for – because basically, if you lose FLRAA, you get the mission systems on the V-280 correct.
Jay Malave
Yes. But the contribution of sale is nowhere near what the overall – but yes, we get some work, yes.
Cai von Rumohr
Right. Okay. And so – as we look out, should we see acceleration in your growth, 24%, 25%, I would assume sequentially…
Jay Malave
Absolutely – you should, I’m sorry.
Cai von Rumohr
Both years. I mean…
Jay Malave
Yes, we should certainly – this year, our guide in 2023 was for sales to be down roughly 1% flattish to down. Well I expect us to resume growth of 2024, right now, I think the starting point for that would be a low single-digit growth rate, and then we will go from there. Again, we have to go through our planning cycle during the summer. We will get much better visibility to all the things that are going on, as we mentioned earlier, related to kind of Ukraine demand, Poland and see what that means. It’s really a question of when those opportunities can convert into sales.
Cai von Rumohr
Right, right. So on the cost side, what about hiring, hiring has been an issue. I think a lot of – a number of people are talking about, well, attrition is starting to come down. Talk to us about kind of your hiring?
Jay Malave
Yes. I think that certainly, attrition, I think is, so far, we’re seeing some indications that’s better. Hiring is still a challenge. I mean some of these critical skill sets that we’re looking for, particularly software engineering remains a challenge for us, particularly in the defense environment and aerospace. And so we’ve been working that and it’s, I would say, the indications are it’s better, but it’s – we haven’t really seen, we haven’t turned a corner and flooded and look at our headcount last year, we grew by 2,000 heads. A lot of that is in the critical skill sets. We have demand though for higher than that. And so we’re still – it’s a very competitive marketplace for those critical skill sets, and we still haven’t seen the labor market really loosen up there?
Cai von Rumohr
But so if attrition is down, I did say attrition is down a little bit. So if attrition is down, I know some of the other guys have said, well, Mike actually had Parsons and they said that their wage growth this year is less than last year because they had to pay to keep some folks. Do you think the rate of wage growth is basically flattening out or?
Jay Malave
I don’t know. If you think about – if you kind of use almost like a 3% as a benchmark historical, I don’t know that we will slip exactly right back to 3% as we think about 2024 planning. We were higher than that for our 2023 planning. And we still got a number of months before we kind of think about what that’s really going to be. But I’m not sure that it dips right back to three for 2024 planning – it may step down, but not exactly back to what it had been last 10 years.
Cai von Rumohr
Right, right. So F-35, you’ve had some issues, the engine problem that’s really Pratt’s problem. I mean, Tier 3 software delays. Where are you on those? And when do they think you’ll be resolved? And what impact more importantly, does it have on your revenues and your profit accrual and what sort of risk?
Jay Malave
So for Tier 3, we certainly – we’ve got a number of software drops that are happening over the next few months into the test program. And so we have to do – we’ve done in our doing lab testing. They will also go into flight testing. We believe that we’re still on track for the cut-in of TR3 capability. So that would be hardware and software for the back half of this year in Lot 15. So that’s our objective. That’s our target. We remain on track and it’s tight. The program itself has had, as you know, has been delayed. And so there always could be some type of learning between now and then, but right now, we’re on track.
Cai von Rumohr
Got it. Okay. And the engine issue, I assume that’s basically Pratt’s issue. You are still building planes. So that should have relatively little impact.
Jay Malave
Yes. I mean I think that we will see a cash flow impact this quarter because it affects our ability to deliver aircraft to our final customer. And so there is a final payment that’s tied to aircraft delivery that are going to fall outside the quarter that we will see some pressure here. It’s timing in the year and knock on what we believe that they are on track to complete their root cause collective action investigation and get us back on good...
Cai von Rumohr
So, I guess we will hear with the budget drop, whether we get a new engine for the F-35 or whether we go with a derivative, does it matter to you in terms of your financial performance on the program that one might be more difficult than the other?
Jay Malave
Well, so right, you have got these two different solutions, either upgrade or a brand-new engine. I think either require – or has some level of risk to them. I don’t know what that cost trade-off is with the joint program offsets. That’s a decision that they make because they have all that information and all that data. And I am sure that they will make the best one they think for the program. What we have done is provided what we believe is necessary for cooling requirements. For this new hardware that’s being cut in these capabilities as well as the thrust requirements. And we have given them technical data as far as the trade-offs, but ultimately, it’s their decision there. We would prefer, I think to the lowest risk solution, so that you don’t have to deal with delays and things like that. But again, it’s really the performance requirement that’s important as well. And so I think there is going to be trade-offs at the Joint Program Office going to have to make with their service customers. There again, we give them the requirements and that is there call at the end of the day.
Cai von Rumohr
Right. So, I guess still going to 156, and you get there in ‘25?
Jay Malave
‘25.
Cai von Rumohr
‘25. Now, I think the last time we talked, I had been thinking there would be a pickup in revenues, but the – what is the revenue profile between here and…?
Jay Malave
Yes. The interesting thing is when you think about deliveries, so this year, we are assuming that this issue gets behind us, will be between $147 million and $153 million. It’s kind of the same range that we provided for next year as well. We talked about that, I think, in the summer. And then we get to 156 in 2025 there. And so – the interesting thing there is, though when you go back 2 years to 3 years, we were – when you think to talk about a lead time, you are talking multiple years, 2 years to 3 years, you have to order materials, start bringing it in and all that type of stuff. We are operating under assumption that the program volumes could be as high as 170 aircraft. And so we were running a production ordering system and material ordering system at that level of demand. And as we settle it back in at 156, there is a level that we have to essentially allow the delivery schedule to catch up to that inventory bill. And so you are seeing lumpiness in sales this year, our production sales will be down about 5% because of that phenomenon. It will be flat to slightly up next year as we kind of normalize this. And so I think over the next few years, it will normalize back on once we get kind of on track with this 156. But we are kind of coming down this kind of inventory reduction cycle is probably will, and that’s what’s causing the sales lumpiness.
Cai von Rumohr
But if you have inventory burn off this year for next year, does that mean that ‘25, you are kind of – everything is back in sync. And so as the rate go – delivery rate goes up that the sales also should pick up in ‘25, or is it still…?
Jay Malave
May be a little bit in ‘24, I think it will be marginal. You are not – I don’t think we will see a big step-up in sales on the production – on F-35 production.
Cai von Rumohr
Got it. And then I think we just had the F-35 preview [ph], and I think you are talking about going from 48 depots to 71. I think it was by ‘26, ‘27. What sort of a growth does the growth rate for sustainment kind of accelerate here, flatten out, or how should we think?
Jay Malave
Well, it’s interesting – that’s right. We have these things called just separate contract is called site activation and hardware, which is predominantly for these depots. And it’s been a little bit slower than we originally had planned. I think if you go back a year, what we have said is our F-35 sustainment on a 5-year CAGR would grow around 6%. We still believe that to be the case. And while you do see, as General Schmidt talked about, higher depot and in stocking inventory and those types of things. At the same time, we are also taking costs out, so reducing the cost of sustainment. And so you have got the growth with the higher – with the growing fleet. You got depot requirements and partially offsetting that is you have got better cost performance. And so we are proud of that. I mean we have got big targets that we have been assigned to deliver, and we believe that we are delivering our piece of those reductions. And so that you have got this counterbalancing and counterbalances it intuitively don’t say, well, should it be growing high-single digit or even 10% plus there you have got the reductions associated with cost reduction would try to back down.
Cai von Rumohr
When you talk of 6%, is that kind of every year is 5% to 7%, there is no big lumpiness or is there?
Jay Malave
I don’t – no, I don’t see any type of huge lumpiness now.
Cai von Rumohr
Got it. And so I think you indicated that EACs as a percent of EBIT should be about 25% this year, flat with ‘22. This ratio has been trending down over the past couple of years. To what extent is inflation eating into the cushion you have in your accrual rates?
Jay Malave
It’s a good question, and it goes back a little bit to what we said – what we were talking about before, Cai is, on the materials side on our existing contracts, we really haven’t seen that much impact on existing contracts. It’s really been we would have to assume or we put in higher labor escalation for our internal labor into our contracts. We have been doing that over the past year. What I would say is Lockheed Martin has a very good cost reduction program. And we really have offset those impacts in there. So, it’s not where we have necessarily reduced our management reserve buffers. Yes, sure. That’s happened in certain cases. But I think our cost reduction performance has helped us really offset a lot of the headwind that we have seen. And so I think that on existing contracts, where we have performed quite well, and we have been able to manage this well, and I get credit to our operations and our programs teams for being able to do that, anticipated and deal with it and manage it and drive our cost reduction programs higher. And so I think overall, we have been managing that. What I would say is that 25% is probably a good equilibrium. This is probably where we will be around that ballpark this year in 2023 as well. And what I would say about that as well is that what we are seeing is our recurring margins are increasing. And this is just really more of a function of program life cycles. As these programs mature, you just are running at a higher recurring rate, just kind of call it more learned out. And so your opportunity for EAC benefits has come down, but you are operating at a higher margin rate to begin with. And so as you see, we do have margin pressure, but margin pressure is not due to that. Margin pressure is due to these production options, I talked about. It’s more of kind of a contract mix issue that we have to work throughout.
Cai von Rumohr
Got it. So, cash flow conversion is expected to ease below 100% this year. When do you think you can get to back over 100%?
Jay Malave
When you look at our cash flow over the next few years, our goal is going to be to increase our absolute cash flow and continue to reduce our share count, so we can deliver a solid free cash flow per share growth rate. Over the next few years, we will have some cash flow pressures. Our CapEx is still in excess of depreciation over the next few years. We have got potential pension contribution in 2025. So, we have to overcome some of those headwinds to still deliver absolute free cash flow growth, and that’s our goal. I am not sure between now and 2025, that I can tell you that we will get right back to net income, but our goal is to actually continue to grow it is where we are.
Cai von Rumohr
And so one of the issues of cash flow has been Section 174, and you have taken a different tack, I think on R&D, where basically you have not so paid on R&D and costs on cost-plus contracts. So, when does – and although Northrop and RTX have, how should we think about does the IRS kind of say, Lockheed, you got to pay, or how does that get resolved?
Jay Malave
It’s a great question. Let me just maybe explain the basis of our position for a moment and then get into what we expect could happen. We view this as essentially a cost of goods sold. And it’s a cost of delivering the revenue to a particular customer. We are providing engineering packages or design to an end customer. And so we don’t view that as R&D. We view it as cost of sales. And that provides a certain level of symmetry to the R&D tax credit, which is viewed as in the same exact way. We don’t take those types of cost and take credit for those when we are calculating for credit purposes. We have no risk because our customer is actually bearing that risk of the development. We also have – while you do a benefit and you get some type of knowhow benefit, that benefit can be transferred to any other third-party because the customer owns it as well. And so we view that that’s a sound basis for the position that we have taken. We have had multiple law firms validate our position. They agree with us. And so it’s not something like we just decided we are going to take a position and just plant a flag. I think it was very thoughtful, very well researched and we have a sound basis for it. As far as where the IRS is, we believe that there could be some guidance, general guidance that goes out sometime this year. But we are not sure that they will specifically address this issue. And so it could linger beyond this year, we will see. We have asked them if they had any thoughts of providing guidance. And we just haven’t seen it. They have got a lot of priorities that they are working through. And I think so that what we may see just general guidance related to this 174 issue, not necessarily specifically addressing this issue that we are dealing with.
Cai von Rumohr
Got it. So, in terms of cash deployment, you have been aggressive in stock repurchase the last couple of years. Any thoughts looking forward, those priorities change at all?
Jay Malave
Well, we still have $10 billion remaining in our share repurchase authorization. We expect $4 billion this year. Right now, our planning assumption would be $4 billion in 2024 and then $2 billion in 2025. And if you think about that, that’s – when you add both ‘23 and ‘24, that’s about $7 billion in each year of deployment between that and the dividend, which exceeds our free cash flow estimates in both years. And so I think we have got a pretty robust and pretty healthy capital deployment plan over the next 2 years. We will continue to reevaluate it. When we came out with our share repurchase program in the third quarter, we went through just our planning cycle during the summer. We will do that again this summer. And I will sit down with Chairman, have a discussion, provide him a recommendation, present something to our Board, and we will go from there.
Cai von Rumohr
Got it. So, this has been terrific. Any final thoughts that we should keep in mind as investors think about Lockheed Martin?
Jay Malave
This is a pretty comprehensive discussion. Kind of really appreciate your time.
Cai von Rumohr
It has been a terrific job.
Jay Malave
Thank you and it’s been a great dialogue. And as I mentioned, we are pretty laser-focused on returning and resuming growth in 2024. And we are making sure that we can drive our free cash flow. As we just mentioned, to growth, continue to take down the share count and provide an adequate, and what you think is a reasonable free cash flow growth over the next few years. And between that and our industry-leading dividend, pretty good for us to return as we really start to re-crank the flywheel on growth.
Cai von Rumohr
Excellent.
Jay Malave
I appreciate everyone’s time.
Cai von Rumohr
That was perfect.
Jay Malave
Thank you.
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Lockheed Martin Corporation (LMT) 44th Annual Aerospace/Defense & Industrials Conference (Transcript)