Declining F-35 Prices Bode Well For Lockheed’s Future

Lockheed Martin (NYSE:LMT) recently announced that it has reached an agreement in principle with the U.S. Department of Defense (DoD) for the eighth production lot of F-35s. Importantly, the average unit price of F-35 in this lot 8 will be around 4% lower than that in lot 7. ^[1] Exact cost details will be announced once a definite agreement is reached between the company and DoD. However, in our view, the lower unit price of F-35 is a positive trend for Lockheed as it will help generate more orders from both the U.S. government and international partners of the F-35 program.

From the point of view of Lockheed, what is important is that the company must be able to generate its initially targeted 3,100 orders for the F-35. If the company is able to generate these many orders, then its upfront investment in research and development of the F-35 will provide a healthy return. But for the company to be able to achieve 3,100 orders – roughly 2,400 from the U.S. defense forces and the remaining from other countries – F-35’s unit price will have to come further down. In the previous production lot 7, F-35’s unit price came below $100 million. This was a significant improvement from initial production lots in which F-35’s unit price was well above $100 million. ^[2]

In our opinion, this steady decline in F-35’s price indicates growing program maturity. And, as the F-35 program shifts from low-rate initial production to full rate production over the next 3-4 years, we figure additional cost savings from improved manufacturing efficiencies will likely further lower F-35’s unit price.

We currently have a stock price estimate of $170 for Lockheed, around 10% below its current market price.

See our complete analysis of Lockheed here

Lower F-35 Prices Will Help Generate More Orders

The F-35 program constitutes about 18% of Lockheed’s revenue. So, success in this program is crucial for growth in the company’s overall results. And in our opinion, lower F-35 price is the single most important factor which will determine success of the F-35 program.

Production under Lockheed’s previous fighter jet program – F-22 Raptor – was terminated after just 195 production units due to high price of F-22 – about $150 million a unit – among other factors. ^[3] Although F-35 program is different from the F-22 program as F-35 has many international orders while the U.S. government banned exports of F-22, we figure further declines in F-35’s price is essential for this fighter jet’s success. And it seems Lockheed is on the right track on the cost front. In July, the company announced its blueprint for affordability agreement with the DoD under which the company would bring down the price of F-35 to under $80 million a unit by 2019. ^[4] We figure this is a huge boost for international buyers who will likely find it easier to make their purchase decisions with this improved foresight on prices.

Eventually, Lockheed expects to bring down the price of F-35 to the equivalent of today’s fourth-generation fighter jets. The company plans to achieve this price reduction through improved manufacturing efficiencies driven by higher production volume. Currently, F-35s are being produced under low-rate initial production, however, once testing and development is fully complete by around 2018, then the program will shift to full rate production improving manufacturing efficiencies. Another factor that will likely help reduce F-35’s price is declining employee costs for Lockheed. During the initial development years of F-35, Lockheed had raised a huge workforce of scientists, engineers and IT professionals. However, with significant development work over and complete development work expected to be over by around 2018, the company will likely reduce its development workforce. At the same time, the decline in development workforce is not expected to be fully offset by increase in the company’s production workforce. So, Lockheed will achieve cost savings from a reduced overall employee headcount as the F-35 program transitions from development phase to production phase in coming years.

Effectively, declining F-35 prices will propel international buyers and the U.S. government to place more orders for this fifth-generation fighter jet. It will also help address concerns of international buyers who in the past have expressed disappointment with F-35’s high procurement cost. Till now, ten countries apart from the U.S. have placed orders/commitments for the F-35. These countries include the U.K., Norway, Netherlands, Italy, Israel, Canada, Turkey, Australia, Japan and South Korea. From the point of view of U.S., more international orders will help save money for the government. This is so because with a larger production volume, overall development and fixed production costs will get spread over a larger number of fighter jets, lowering F-35’s unit price. Lower unit price in turn will help lower the government’s total procurement cost.

In all, if Lockheed is able to reduce F-35’s price to match that of today’s fourth generation fighter jets, then we figure the company should be able to generate its initially targeted 3,100 orders. This large production volume in turn will likely drive the company’s results through the next decade. So, declining F-35 prices bode well for Lockheed’s future.

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1. Lockheed and DoD announce principle agreement on purchase of F-35s, October 27 2014, www.lockheedmartin.com [↩]
2. Lockheed’s F-35 fighter jet program, November 11 2014, www.wikipedia.com [↩]
3. Lockheed’s F-22 Raptor, November 11 2014, www.wikipedia.com [↩]
4. Lockheed’s 2014 Q2 earnings transcript, July 22 2014, www.seekingalpha.com [↩]