General Dynamics and Lockheed Martin Comparison

cosmopolitan ki interlockingics and Lockheed Martin ComparisonFinancial bid Analysis familiar dynamics vs. Lockheed MartinExecutive SummaryThis analysis professional personvides a comparison of both major companies at bottom the Aerospace and Defense pains, General dynamics and Lockheed Martin. General ki lootics had an roe of 25% whereas Lockheed Martin was 49% demonstrating LMT has a high(prenominal) spread and gene charge per unitd a higher amount of slide by above its price of faithfulness capital as compared to GD. GD generates a higher NOPAT coast oer LMT (9.4% and 7.8%, respectively) allowing GD to contribute more to ROE as a outgrowth of the decreased effect post expenses remove on brighten income with respect to total gross gross revenue revenue enhancement. LMT has a considerable advantage for generating increase summation turn all over, by generating $1.37 for every vaulting horse as compared to GDs $1.08 for every dollar spent on company additions. Ge neral kinetics storage is extremely undervalued (estimated $77.71 compared to finish set of $57.79) whereas Lockheed Martins stock was slightly overvalued ($85.93 compared to closing price of $84.08). integrity rating indicates that investors were overly optimistic in LMTs earning potential and pessimistic for GDs earning potential. Despite the valuation, the destiny of this industriousness remains dependent on judicatures decisions to decrease military disbursement, which will stick out a negative impact on both companies. However, expansion of commercialised tonal patternlines and accompliceships with healthcare industries will have a positive effect on these companies and boilersuit this sedulousness will have a neutral outcome for the upcoming year.General Dynamics (NYSE GD)General Dynamics is the sixth largest defense contractor in the world and the second largest maker of corporate jets. The company maintains four pedigree conclaves including aerospace, attac k systems, marine systems and information systems and technology. give the axe earnings for the company change magnitude from 2006-2008 ($1.86 to $2.46), a 24% increase over 3 years. Sales for all groups increased from $24.1 to $29.3 trillion from 2006-2008, a 17% increase. The company is based in Virginia and gets 67% of its revenue from the Department of Defense.The aerospace group generated $5.5 billion (19%) in gross sales in 2008, mostly cod to Gulfstream business jet, which include long-range and ultra-long-range jets. In response to the tidy sumturn in the economy, the intersectionion of large-body and medium-size subscriber linecraft were reduced from 87 to 73 and 69 to 24, respectively, in 2008. In product emergence, Gulfstream introduced 2 additions, which are the ultra-large-cabin, ultra-long-range G650 and the super-mid-size G250. production of both of these aircrafts, which enter into service in 2011 and 2012, are foreseeable income generators based on orders pl aced in 2008.The combat systems group generated $8.2 billion (28%) in sales in 2008, mostly driven by demand for combat vehicles, specifically Mine-Resistant, Ambush-Protected (MRAP) vehicles. The combat system group makes, repairs and supports wheeled and bring in armored vehicles and munitions. Combat system product lines include combat vehicles, guns and ammunition systems, mobile bridge systems, armor, chemical, biological and explosion detection systems. Future opportunities include delivering hundreds of tanks and armored vehicles to Saudi Arabia between 2010 and 2012.The marine systems group generated $5.6 billion (19%) in sales in 2008, extremely productive as compared to 2007. The group delivers destroyers, submarines, logistic ship and the initiative commercial product carrier. Upcoming contracts include doubling production to two submarines per year beginning in 2011, which is predicted to increase revenue and earnings over the close terce years.The information system s and technology generated $10 billion (34%) of sales in 2008 its biggest achievement developing a battlefield communications canwork program and stick Tactical Radio System (JTRS). Customers include federal civilian agencies and commercial customers, which chiefly focus on electronics for land, sea and air-based weapons systems. The acquisition of two companies in the tactical communications and healthcare information technology field are declarative of the direction this group will be reservation in the upcoming years. cultivation gathered from Morningstar1, SP500 patience depicts2 and www.generaldynamics.com3Lockheed Martin (NYSE LMT)Lockheed Martin is the worlds largest military weapons maker, deriving 84% of its net sales from the unify States judicature, including the Department of Defense. The company is comprised of four operating systems including aeronautics, electronic, space and information systems and orbiculate services. dough sales increased 7.3% from 200 6 to 2008 ($39.6 to $42.7 billion) and earnings increased 21.8% over three years ($2.5 to $3.2 billion). The company operates in Maryland and employs 146,000 people.The aeronautics share generated 27% of sales ($11.5 billion) in 2008. The segments primary production are the F-35 Lightning II combat aircraft which is intercommunicate to be completed in 2010. The aeronautics segment is foc utilise on making fighter jets and military transport planes and on unmanned military aircraft. The segment also operates the Global Sustainment enterprise to ensure success throughout the career motorbike of its aircraft.The electronics systems segment also generated 27% of sales in 2008 and primarily makes land, sea and air-based missiles and missile defense systems. Specifically, this segment is focused on maritime systems and sensors, missiles and dismiss control, and platform, training and energy. This system also manages and operates the Sandia National Laboratories for the US Department of Energy. on-going projects include the Terminal Altitude Area Defense System (THAAD), the Ballistic rocket Defense system and the firehead control system for the Apache helicopter.The space systems segment generated 19% of sales ($8.2 billion) in 2008. This segment is comprised of satellites, strategic and defensive missile systems, and space transfer of training systems. The US government customers accounted for 96% of this segments sales in 2008. An ongoing partner is NASA the LMT-built Phoenix Lander will continue to rove on Mars. An early(a) venture is with Boeing, the United Launch Alliance, which provides satellite launch services to the US government.Information systems and global services segment account for 27% of sales in 2008. This segment contains bursting charge solutions, information systems and global services. The US government customers accounted for 93% of the segments sales in 2008. Major products/programs include communication systems, mission and combat su pport solutions, civil confidence programs (US Census), the FAA Automated Flight Service Station, the FBIs Sentinel IT program, and various NASA programs.Collaborations and partnerships with companies around the universe enable Lockheed Martin to grow its international business both with government and industry. The establishment of Lockheed Martin Australia in 2009 indicates an international interest to grow and expand.Information gathered from Morningstar1, SP500 intentness reports2 and www.lockheedmartin.com4 exertion Outlook Aerospace DefenseThe aerospace and defense industry relies heavily on US government allocation and the upcoming year will likely bring budget cuts to the defense budget in 2010. However, there are predictions that the conventional military equipment is maturation and once the Iraq war ends, there will be a involve for repair and replacement. Due to the high levels of deficit spending and an increasing trend for societal spending, it is likely there wi ll be cuts in defense spending and the outlook for this industry will decline.On the other hand, it is estimated that there will be an increased ingathering of global passenger air traffic in 2010 as compared to a decline in 2009. This is based on positive air traffic egression since comparison between 2009 and 2010. Aircrafts that are little fuel-efficient in the US will also bespeak to be upgraded and replaced with vernaler aircraft. The industry predictions are anneal production cuts at Boeing and Airbus, and declines in the business jet markets payable to locomote corporate profits.The industry outlook is therefore at a neutral rating, due to decreased military budget but increased commercial air traffic for 2010. Competition in the industry (Boeing, Northrop Grumman, Honeywell and Raytheon) will strive for contracts within the industry. many an(prenominal) of these defense contractors will face uncertainty from upcoming government decisions in the next year and hence t he neutral outlook for this industry.Information gathered from Morningstar and SP500 fabrication ReportsFinancial Statement AdjustmentsThe following table contains information on the accumulative adjustment to General Dynamics and Lockheed Martins financial Statements.AdjustmentsGeneral DynamicsLockheed MartinIncome Statement make up Net Income by $19 one billion million from loss from discontinued trading operations net of value Increase Net Income by $196 million from deferred portion of income tax income Decrease Net Income by $70 million for gain on sale of LKEI and ILS net of tax Decrease Net Income by $56 million for gain on land sale Increase Net Income by $215 million to reverse impairment charge (215 = 314(1-.316) Increase Net Income by $72 million to comb out deferred taxes Subtract $246 million from Net Income for Pension Income ease tag Increase assets by 75% of PV of capitalized leases ($709 million) Decrease assets by $7 million to depressurise taxes (DTA) Adj ustments for LIFO reserve not added to sum summations. Added in denominator of ITR and occurrent addition in Current Ratio Added 100% of PV of capitalisation of leases to jibe Liabilities ($946 million) Subtracted 25% of PV of capitalized leases to SE ($236 million) Decrease SE by $7 million to unwind deferred taxes effect (-DTA +DTL) Increase assets by 75% of PV of capitalized leases ($699 million) Decrease assets by $5,390 million to unwind deferred taxes (DTA) Increase liabilities by 100% of PV of capitalized leases ($932 million) Decrease SE by 25% of PV of operating leases ($233 million) Decrease SE by $5,390 million to unwind deferred tax (-DTA +DTL)Caveats vector sum of A-12 program in 1991 is an dissimilarly contingency of $690 and is currently on appeal in the Appeals Court. woo of Equity swellHistorically, LMT common stock has proven slight small to the broad stock market. With a beta of .923 and exploitation the Capital Asset Pricing Model (CAPM), LMT investors require an annual rate of reelect of 10.2%. Although this is press down than the pass judgment market return of 10.8% (see appendix for calculation and arrogances), it is greater than its industry (Guided Missile Space Vehicles) expected return of 8.7%. However, although LMT may be more vaporizable as a stock than its competitors, it enjoyed a Return on Equity (ROE) business firmificantly higher than the industry median(a).In 2008, LMT had an ROE of 49.2% while the industry followed with a 23.4% average ROE. Just as significant and telling is the comparison of LMTs ROE to its own ask rate of return. This spread of 39% is an important-looking sign as it demonstrates the amount of return LMT generated above its court of truth capital. This is also impressive to investors at first glance, and will warrant a deeper interest from prospective investors. more than the same can be said for GD when comparing its required rate of return to its ROE. Although the spread was only 12 .9%, it is unagitated a good sign that GD generates such a return above its cost of equity.However, unlike LMT GD has a beta greater than 1 and is therefore more sensitive to stock market moves and has an expected return less than its industry return by about 1.25%.NOPAT MarginWhen we analyze the potential net income in the absence of debt, NOPAT, we observe that General Dynamics (9.4%) generates a higher margin over Lockheed Martin (7.8%), which allows General Dynamics to contribute more to ROE in comparison to Lockheed Martin as a result of the decreased effect interest expenses have on net income with respect to total sales revenue. However, when comparing NOPAT performance to the rest of their industry (Ship Boat Building Repair), General Dynamics comes in slightly to a lower place the 9.9% average that was established for 2008, but does not necessarily signify any under-performance in this area since the industry data only takes into account two firms when generating per sistence NOPAT margin averages. Lockheed Martin was similarly compared to assiduity data, generated by two firms as well, in which NOPAT margins were preserve that were more than double of what was found for similarly classified companies (Guided Missiles Space Vehicles 3.69%).Asset TurnoverThis portion of the ROE evaluates the efficiency to prove revenue based on the investment in assets made by the company. When we begin to evaluate the modify Asset TO values provided by the multiplicative decomposition of ROE, we observe a observable advantage by Lockheed Martin since they reportedly generate $1.37 for every $1.00 spent on assets. General Dynamics generate slightly lower values at $1.08 for every $1.00 spent on company assets. We then continued to analyze Asset TO, now based on the additive decomposition of ROE to see how other variables affect the employee upset rates. When this approach is taken, average assets for both companies in 2008 mandatory to be adjusted, and w as done so by pulling out all non-interest military strength liabilities (NIBL). This is where we noticed that NIBLs for Lockheed Martin ($20,742) were 62.8% higher than those reported by General Dynamics ($12,735). As a result, the Asset TO ratios increased significantly for both companies (LMT 2.05 and GD 4.09) with respect to assets dollars invested by for individually one company. As we can observe, unexpected losses in each companys allowance fund had led them to classify their losses as liabilities since they will still needed to be accounted for in the near future. The 32% look across in the fair value of the LMT pension fund ($27,259 down to $18,539) in 2008 and the 35% neglect in the fair value of the GD pension fund ($7,452 down to $4,823)was felt somewhat more extensively by LMT, since the higher amount befuddled reflects LMTs larger workforce of 140,000 employees. GD, although enduring a similar percentage drop in fund value, only accommodates a workforce of 91, 000, and therefore lost less in overall value amount.LeverageWhen we analyze leverage, we are analyzing each companys ability and efficiency in exploitation interest coach debt to generate revenue. The higher the leverage value, the better the ability of a company is at using invested funds (IBLs) to obtain desired revenues. When evaluating LMTs and GDs effect of leverage as a result of their 2008 results, we observe that the totals generated by LMT (0.17) are over three multiplication higher than those generated by GD (0.05) during the same time period. As we continue to recitation down into the effect of leverage, we notice that ROA is also higher for LMT as a result of the large variation in NIBLs between the two companies. Although a higher leverage effect value may indicate that LMT relies more on interest bearing debt to generate more sales revenue, an analysis of interest bearing liabilities for both LMT and GD was performed based on data available at the end of 2007 and 2008. This analysis revealed that LMT had reduced their interest bearing liabilities ($4,407 down to $3,805) while GD, whom enter a smaller leverage effect, had done the opposite and showed to have increased their interest bearing liabilities ($2,791 increased to $4,024) by the end of 2008.Selected Ratio ComparisonAccounts receivable DaysGeneral Dynamics manufacturingLockheed MartinIndustry39.5132.5043.6257.12From the results presented above, General Dynamics demonstrates that it under-performed the rest of the industry by exceeding the average account due day times by 7 geezerhood. In contrast, Lockheed Martin out-performed the rest of its industry by having save an account receivable average of 43.62 eld, which means LMT was collecting from customers on an average of 13.5 long time ahead of the rest of the industry.Accounts Payable DaysGeneral DynamicsIndustryLockheed MartinIndustry33.8831.5020.0919.66 GD is collecting from customers on average over 2 days past the industry average of 31.50 days LMT is collecting just day over the industry average of 19.66 daysInventory DaysGeneral DynamicsIndustryLockheed MartinIndustry25.9756.6217.3513.55 GD is number inventory on average over 30 days under the industry average of 56.62 days LMT is turning inventory on average over 3 days over the industry average of 13.55 daysInterest CoverageGeneral DynamicsIndustryLockheed MartinIndustry29.5730.4314.495.49 GD could cover its yearly interest expenses 29.57 times in 2008, just under its industry average of 30.43 times LMT could cover its yearly interest expenses 29.57 times in 2008, significantly over its industry average of 5.49 timesEquity ValuationThe equity valuation of General Dynamics for 2008 produced an estimated share price of $77.71. This price is significantly higher than the closing per-share price of $57.59 for 2008 showing the companys stock was extremely undervalued. According to analyst reports5, some concerns about growth for General Dynamics ste m from shrinking credit markets, which would impair the ability to finance business jets. Additionally, it is possible that investors were concerned the aerospace and defense industry would decline with a shift from government defense spending to social spending and deficit spending.Abnormal net income was computed as predicted net income less the cost of equity capital. Predicted net income was computed using 2008 pro forma net income of $2,674 and implementing annual growth rates suggested by Goldman Sachs earnings forecasts5. The growth rates from 2009 through 2013 were -2.9%, 7.3%, 5.2%, 7.3% and 7.8% respectively. The same earnings forecasts were used to calculate the predicted dividends. The predicted dividends from 2009 to 2013 are 577, 617, 643, 671 and 700 respectively. The perch value assumption used in computing abnormal net income was the competitive equilibrium on incremental real sales assumption. This strategy was chosen because the government is one of General Dyna mics most significant customers, comprising approximately 67% of the companys revenue. This lead to the assumption that General Dynamics may not need to invest a large amount of resources in developing new customers and that most of their future growth would be lead by existing customers. This assumption provided a close value of $21,999. The cost of capital for General Dynamics was calculated using a beta of 1.119, a risk salvage rate of 5% and a market risk premium of 4%. This produced a cost of capital of 9.5%. The present value of abnormal net income was calculated to be $20,265, by dividing abnormal net income by a discounting factor derived using the cost of capital.The present value of abnormal net income was combined with the initial bind value of $9,810 to produce an estimated predicted price of $30,075. This price was divided by the number of shares outstanding according to the 2008 annual report to arrive at an estimated share price of $77.71.The equity valuation for L ockheed Martin for 2008 produced an estimated share price of $85.93, which is slightly higher than the veritable share price as of the end of 2008 of $84.08. This shows the stock was slightly overvalued. This shows investors may have been overly optimistic in their opinion of Lockheed Martins earnings potential.Abnormal net income was computed just as that of General Dynamics. Using analysts reports6, estimated (negative) growth rates of (6%), (7%), (6.6%), 11% and 8.92% were apply to the 2008 pro forma net income of $3,114. The same terminal value assumption was used for Lockheed Martin as was used for General Dynamics. The US government is a substantial customer of Lockheed Martins, which lead to the assumption that a large portion of future growth could be attributed to existing customers and few resources could be devoted to developing new customers. The terminal value assumption provided a terminal value of $41,132. The cost of equity capital was calculated using a beta of .9 23, a risk free rate of 4% and a market risk premium of 5%. The 8.7% cost of capital was used to find the present value of abnormal net income of $37.936. This present value was combined with an initial book value of ($2,758) to produce an estimated price of $35,178. The estimated price divided by the number of shares outstanding per the Lockheed Martin annual report to arrive at a per-share price of $85.93.References1www.Morningstar.com2www.netadvantgage.standardandpoors.com3www.generaldynamics.com4www.lockheedmartin.com5Richard Safran, Noah Poponak, Goldman Sachs, January 26, 2009. Noah Poponak, Chun-Yai Wang, Sai Krishna, Goldman Sachs, January 27, 20106Richard Safran, Noah Poponak, Goldman Sachs, January 22, 2009. Noah Poponak, Chun-Yai Wang, Sai Krishna, Goldman Sachs, January 29, 2010APPENDIXCAPM = Rf tempo + (Beta*Rmrkt)Given DataRisk Free rate = 3.77% (10 Year Treasury as of 2/18/10)Market Premium (Rmrkt) = 7% (given on scallywag 26 of class notes) LMT Beta =0.923Industry Beta =0.697GD Beta =1.119Industry Beta =1.298CAPM advisementsLMT = .0377 + .923*.07LMT =10.23%Industry = .0377 + .697*.07Industry =8.65% GD = .0377 + 1.119*.07GD =11.60%Industry = .0377 + 1.298*.07Industry =12.86% Financial Statement Analysis GDLMT 20082008 Beginning assets25,73328,926 Ending assets28,37333,439 Beginning equity11,7689,805 Ending equity10,0532,865 Beginning interest-bearing liabilities2,7914,407 Ending interest-bearing liabilities4,0243,805 Net income (pro forma)2,6743,114 Sales revenue29,30042,731 Other revenue00 Research development expense4741,220 Selling, general administrative expense1,7002,344 Income tax expense1,1261,485 Income tax rate0.310.32 Interest expense133341 Beginning inventory1,6211,718 Ending inventory2,0291,902 Cost of goods sold25,64738,082 Beginning accounts receivable2,8744,925 Ending accounts receivable3,4695,296 Beginning accounts due2,3182,163 Ending accounts payable2,4432,030 Shares outstanding386393 Closing price per share57.5984.08bloo mberg.com fair(a) assets27,05331,183 Average equity10,9116,335 Average interest-bearing liabilities3,4084,106Average non-interest bearing liabilities12,73520,742 Average accounts receivable3,1725,111 Average inventory1,8251,810 Average accounts payable2,3812,097 After-tax interest rate0.030.06Multiplicative bunkum of ROE ROE0.250.49 Net profit margin0.090.07 Asset turnover1.081.37 Leverage2.484.92Additive Decomposition of ROE ROE0.250.49 Market-to-book2.2111.53NOPAT Margin0.090.08 Asset turnover2.054.09 ROA0.190.32 Spread0.170.26 Leverage0.310.65 Effect of leverage0.050.17 Gross profit margin0.120.11RD to revenue0.020.03SGA to revenue0.060.05Accounts receivable days39.5143.65Inventory days25.9717.35Operating cycle65.4861.00 Accounts payable days33.8820.09 Cash-to-cash cycle31.6040.91 Interest coverage29.5714.49 Debt ratio0.650.91 accompaniment CGeneral DynamicsLockheed MartinFinancial Statement AdjustmentsCumulative Financial Statement Adjustments Summary of Income Statement Adjust mentsSummary of Income Statement AdjustmentsNet Income as account$ 2,459Net Income as Reported$ 3,217Discontinued operations19Loss on sale of property,(126) unsnarl tax effect196land, equipment adjust Net Income$ 2,674 empty of Impairment charge215 Unwind tax effects72 Pension Income(264) familiarized Net Income$ 3,114Summary of Balance Sheet AdjustmentsSummary of Balance Sheet Adjustments total Assets as reported$ 28,373Total Assets as reported $ 33,439Constructive capitalisation of709Constructive capitalization 699operating leasesof operating leasesUnwind tax effects (DTA)(7)Unwind tax effects (DTA)(5,390)familiarised Total Assets$ 29,075 familiarized Total Assets$ 28,748 Total Liabilities as reported$ 18,320Total Liabilities as reported$ 30,574Constructive capitalization946Constructive capitalization932of operating leasesof operating leasesAdjusted Total Liabilities$ 19,266Adjusted Total Liabilities$ 31,506Total SE as reported$ 10,053Total SE as reported$ 2,865Constructive ca pitalization(236)Constructive capitalizationof operating leases(233)of operating leasesUnwind tax effects(5,390)Unwind tax effects(7)(DTA+DTL)(DTA+DTL)Adjusted Total SE$ (2,758)Adjusted Total SE$ 9,810Adjusted Total Liabilities + SE$ 29,075Adjusted Total Liabilities + SE$ 28,748General DynamicsPension Income Pro Forma Calculation1Net pension cost (benefit)$ 20 Net postretirement plan cost56 Total cost$ 76Net earnings$ 2,459 component3.1%20082007 2Funded condition pensions$ (2,922)$ 383 Funded status other postretirement plans(640)(642) Total funded status(3,562)(259) Difference$ (3,303)3Rate of return on U.S. plan assets8.1% judge return593 Implied asset base7,330= 592 / .081 Actual return percentage-32.20%= 2360 / 73304Implied asset base$ 7,330 Pro forma expected rate7.0%Given Pro forma expected return513 less(prenominal) Original expected return(593) Difference (reduction in pension income)(80) 1 trenchant tax rate68.8%=1-.312 Adjustment (reduction) to net income$ (55)OR (.08 1-.070)*7,330 * (1-.312) =$ 55Adjusted income$ 2,404= 2,459 55 Lockheed Martin Pension Income Pro Forma Calculation1Net pension cost (benefit)$ 462 Net postretirement plan cost46 Total cost$ 508Net earnings$ 3,217 Percentage15.8%20082007 2Funded status pensions$ (11,882)$ (879) Funded status other postretirement plans14262017 Total funded status(10,456)1,138 Difference$ (11,594)3Rate of return on U.S. plan assets8.5% Expected return$ 2,184 Implied asset base25,694= 2184 / .085 Actual return percentage-28.62%= 7354 / 256944Implied asset base$ 25,694 Pro forma expected rate7.0%Given Pro forma expected return1,799 Less Original expected return(2,184) Difference (reduction in pension income)(385) 1 Effective tax rate68.4%=1-.316 Adjustment (reduction) to net income$ (264)Adjusted income$ 2,953= 3,217 264General DynamicsCapitalization of Operating drives Enter interest rate on a lower floor0.039Enter operating lease commitments below (in millions)2009205.0 2010174.0 2011131.0 201297. 0 201370.0 2014 thereafter405.0Solution founder value of operating lease commitments$ 945.9 Calculation of Present Value of Operating Lease Payments0205.01.000205.0 1174.01.039167.5 2131.01.080121.3General Dynamics and Lockheed Martin ComparisonGeneral Dynamics and Lockheed Martin ComparisonFinancial Statement AnalysisGeneral Dynamics vs. Lockheed MartinExecutive SummaryThis analysis provides a comparison of two major companies within the Aerospace and Defense industry, General Dynamics and Lockheed Martin. General Dynamics had an ROE of 25% whereas Lockheed Martin was 49% demonstrating LMT has a higher spread and generated a higher amount of return above its cost of equity capital as compared to GD. GD generates a higher NOPAT margin over LMT (9.4% and 7.8%, respectively) allowing GD to contribute more to ROE as a result of the decreased effect interest expenses have on net income with respect to total sales revenue. LMT has a considerable advantage for generating increased asset turnover, by generating $1.37 for every dollar as compared to GDs $1.08 for every dollar spent on company assets. General Dynamics stock is extremely undervalued (estimated $77.71 compared to closing price of $57.79) whereas Lockheed Martins stock was slightly overvalued ($85.93 compared to closing price of $84.08). Equity valuation indicates that investors were overly optimistic in LMTs earning potential and pessimistic for GDs earning potential. Despite the valuation, the destiny of this industry remains dependent on governments decisions to decrease military spending, which will have a negative impact on both companies. However, expansion of commercial airlines and partnerships with healthcare industries will have a positive effect on these companies and overall this industry will have a neutral outcome for the upcoming year.General Dynamics (NYSE GD)General Dynamics is the sixth largest defense contractor in the world and the second largest maker of corporate jets. The company maintains four business groups including aerospace, combat systems, marine systems and information systems and technology. Net earnings for the company increased from 2006-2008 ($1.86 to $2.46), a 24% increase over 3 years. Sales for all groups increased from $24.1 to $29.3 billion from 2006-2008, a 17% increase. The company is based in Virginia and gets 67% of its revenue from the Department of Defense.The aerospace group generated $5.5 billion (19%) in sales in 2008, mostly due to Gulfstream business jet, which include long-range and ultra-long-range jets. In response to the downturn in the economy, the production of large-body and medium-size aircraft were reduced from 87 to 73 and 69 to 24, respectively, in 2008. In product development, Gulfstream introduced 2 additions, which are the ultra-large-cabin, ultra-long-range G650 and the super-mid-size G250. Production of both of these aircrafts, which enter into service in 2011 and 2012, are foreseeable income generators based on or ders placed in 2008.The combat systems group generated $8.2 billion (28%) in sales in 2008, mostly driven by demand for combat vehicles, specifically Mine-Resistant, Ambush-Protected (MRAP) vehicles. The combat system group makes, repairs and supports wheeled and tracked armored vehicles and munitions. Combat system product lines include combat vehicles, guns and ammunition systems, mobile bridge systems, armor, chemical, biological and explosion detection systems. Future opportunities include delivering hundreds of tanks and armored vehicles to Saudi Arabia between 2010 and 2012.The marine systems group generated $5.6 billion (19%) in sales in 2008, extremely productive as compared to 2007. The group delivers destroyers, submarines, logistic ship and the first commercial product carrier. Upcoming contracts include doubling production to two submarines per year beginning in 2011, which is predicted to increase revenue and earnings over the next three years.The information systems an d technology generated $10 billion (34%) of sales in 2008 its biggest achievement developing a battlefield communications network program and Joint Tactical Radio System (JTRS). Customers include federal civilian agencies and commercial customers, which primarily focus on electronics for land, sea and air-based weapons systems. The acquisition of two companies in the tactical communications and healthcare information technology field are indicative of the direction this group will be making in the upcoming years.Information gathered from Morningstar1, SP500 Industry reports2 and www.generaldynamics.com3Lockheed Martin (NYSE LMT)Lockheed Martin is the worlds largest military weapons maker, deriving 84% of its net sales from the United States government, including the Department of Defense. The company is comprised of four operating systems including aeronautics, electronic, space and information systems and global services. Net sales increased 7.3% from 2006 to 2008 ($39.6 to $42.7 b illion) and earnings increased 21.8% over three years ($2.5 to $3.2 billion). The company operates in Maryland and employs 146,000 people.The aeronautics segment generated 27% of sales ($11.5 billion) in 2008. The segments primary production are the F-35 Lightning II combat aircraft which is projected to be completed in 2010. The aeronautics segment is focused on making fighter jets and military transport planes and on unmanned military aircraft. The segment also operates the Global Sustainment enterprise to ensure success throughout the life cycle of its aircraft.The electronics systems segment also generated 27% of sales in 2008 and primarily makes land, sea and air-based missiles and missile defense systems. Specifically, this segment is focused on maritime systems and sensors, missiles and fire control, and platform, training and energy. This system also manages and operates the Sandia National Laboratories for the US Department of Energy. Current projects include the Terminal A ltitude Area Defense System (THAAD), the Ballistic Missile Defense system and the firehead control system for the Apache helicopter.The space systems segment generated 19% of sales ($8.2 billion) in 2008. This segment is comprised of satellites, strategic and defensive missile systems, and space transportation systems. The US government customers accounted for 96% of this segments sales in 2008. An ongoing partner is NASA the LMT-built Phoenix Lander will continue to rove on Mars. Another venture is with Boeing, the United Launch Alliance, which provides satellite launch services to the US government.Information systems and global services segment account for 27% of sales in 2008. This segment contains mission solutions, information systems and global services. The US government customers accounted for 93% of the segments sales in 2008. Major products/programs include communication systems, mission and combat support solutions, civil agency programs (US Census), the FAA Automated Fl ight Service Station, the FBIs Sentinel IT program, and various NASA programs.Collaborations and partnerships with companies around the globe enable Lockheed Martin to grow its international business both with government and industry. The establishment of Lockheed Martin Australia in 2009 indicates an international interest to grow and expand.Information gathered from Morningstar1, SP500 Industry reports2 and www.lockheedmartin.com4Industry Outlook Aerospace DefenseThe aerospace and defense industry relies heavily on US government allocation and the upcoming year will likely bring budget cuts to the defense budget in 2010. However, there are predictions that the conventional military equipment is aging and once the Iraq war ends, there will be a need for repair and replacement. Due to the high levels of deficit spending and an increasing trend for social spending, it is likely there will be cuts in defense spending and the outlook for this industry will decline.On the other hand, i t is estimated that there will be an increased growth of global passenger air traffic in 2010 as compared to a decline in 2009. This is based on positive air traffic growth since comparison between 2009 and 2010. Aircrafts that are less fuel-efficient in the US will also need to be upgraded and replaced with newer aircraft. The industry predictions are moderate production cuts at Boeing and Airbus, and declines in the business jet markets due to falling corporate profits.The industry outlook is therefore at a neutral rating, due to decreased military budget but increased commercial air traffic for 2010. Competition in the industry (Boeing, Northrop Grumman, Honeywell and Raytheon) will strive for contracts within the industry. Many of these defense contractors will face uncertainty from upcoming government decisions in the next year and hence the neutral outlook for this industry.Information gathered from Morningstar and SP500 Industry ReportsFinancial Statement AdjustmentsThe follo wing table contains information on the cumulative adjustment to General Dynamics and Lockheed Martins financial Statements.AdjustmentsGeneral DynamicsLockheed MartinIncome Statement Increase Net Income by $19 million from loss from discontinued operations net of tax Increase Net Income by $196 million from deferred portion of income tax Decrease Net Income by $70 million for gain on sale of LKEI and ILS net of tax Decrease Net Income by $56 million for gain on land sale Increase Net Income by $215 million to reverse impairment charge (215 = 314(1-.316) Increase Net Income by $72 million to unwind deferred taxes Subtract $246 million from Net Income for Pension IncomeBalance Sheet Increase assets by 75% of PV of capitalized leases ($709 million) Decrease assets by $7 million to unwind taxes (DTA) Adjustments for LIFO reserve not added to Total Assets. Added in denominator of ITR and Current Asset in Current Ratio Added 100% of PV of capitalization of leases to Total Liabilities ($946 million) Subtracted 25% of PV of capitalized leases to SE ($236 million) Decrease SE by $7 million to unwind deferred taxes effect (-DTA +DTL) Increase assets by 75% of PV of capitalized leases ($699 million) Decrease assets by $5,390 million to unwind deferred taxes (DTA) Increase liabilities by 100% of PV of capitalized leases ($932 million) Decrease SE by 25% of PV of operating leases ($233 million) Decrease SE by $5,390 million to unwind deferred tax (-DTA +DTL)Caveats Termination of A-12 program in 1991 is an unlikely contingency of $690 and is currently on appeal in the Appeals Court.Cost of Equity CapitalHistorically, LMT common stock has proven less sensitive to the broad stock market. With a beta of .923 and using the Capital Asset Pricing Model (CAPM), LMT investors require an annual rate of return of 10.2%. Although this is lower than the expected market return of 10.8% (see appendix for calculation and assumptions), it is greater than its industry (Guided Missile Space Vehicles) expected return of 8.7%. However, although LMT may be more volatile as a stock than its competitors, it enjoyed a Return on Equity (ROE) significantly higher than the industry average.In 2008, LMT had an ROE of 49.2% while the industry followed with a 23.4% average ROE. Just as significant and telling is the comparison of LMTs ROE to its own required rate of return. This spread of 39% is an impressive sign as it demonstrates the amount of return LMT generated above its cost of equity capital. This is also impressive to investors at first glance, and will warrant a deeper interest from prospective investors.Much the same can be said for GD when comparing its required rate of return to its ROE. Although the spread was only 12.9%, it is still a good sign that GD generates such a return above its cost of equity.However, unlike LMT GD has a beta greater than 1 and is therefore more sensitive to stock market moves and has an expected return less than its industry return by appr oximately 1.25%.NOPAT MarginWhen we analyze the potential net income in the absence of debt, NOPAT, we observe that General Dynamics (9.4%) generates a higher margin over Lockheed Martin (7.8%), which allows General Dynamics to contribute more to ROE in comparison to Lockheed Martin as a result of the decreased effect interest expenses have on net income with respect to total sales revenue. However, when comparing NOPAT performance to the rest of their industry (Ship Boat Building Repair), General Dynamics comes in slightly below the 9.9% average that was established for 2008, but does not necessarily signify any under-performance in this area since the industry data only takes into account two firms when generating Industry NOPAT margin averages. Lockheed Martin was similarly compared to Industry data, generated by two firms as well, in which NOPAT margins were recorded that were more than double of what was found for similarly classified companies (Guided Missiles Space Vehicle s 3.69%).Asset TurnoverThis portion of the ROE evaluates the efficiency to produce revenue based on the investment in assets made by the company. When we begin to evaluate the simplified Asset TO values provided by the multiplicative decomposition of ROE, we observe a noticeable advantage by Lockheed Martin since they reportedly generate $1.37 for every $1.00 spent on assets. General Dynamics generate slightly lower values at $1.08 for every $1.00 spent on company assets. We then continued to analyze Asset TO, now based on the additive decomposition of ROE to see how other variables affect the turnover rates. When this approach is taken, average assets for both companies in 2008 needed to be adjusted, and was done so by pulling out all non-interest bearing liabilities (NIBL). This is where we noticed that NIBLs for Lockheed Martin ($20,742) were 62.8% higher than those reported by General Dynamics ($12,735). As a result, the Asset TO ratios increased significantly for both companie s (LMT 2.05 and GD 4.09) with respect to assets dollars invested by each company. As we can observe, unexpected losses in each companys pension fund had led them to classify their losses as liabilities since they will still needed to be accounted for in the near future. The 32% drop in the fair value of the LMT pension fund ($27,259 down to $18,539) in 2008 and the 35% drop in the fair value of the GD pension fund ($7,452 down to $4,823)was felt somewhat more extensively by LMT, since the higher amount lost reflects LMTs larger workforce of 140,000 employees. GD, although enduring a similar percentage drop in fund value, only accommodates a workforce of 91,000, and therefore lost less in overall value amount.LeverageWhen we analyze leverage, we are analyzing each companys ability and efficiency in using interest bearing debt to generate revenue. The higher the leverage value, the better the ability of a company is at using invested funds (IBLs) to obtain desired revenues. When eva luating LMTs and GDs effect of leverage as a result of their 2008 results, we observe that the numbers generated by LMT (0.17) are over three times higher than those generated by GD (0.05) during the same time period. As we continue to drill down into the effect of leverage, we notice that ROA is also higher for LMT as a result of the large variation in NIBLs between the two companies. Although a higher leverage effect value may indicate that LMT relies more on interest bearing debt to generate more sales revenue, an analysis of interest bearing liabilities for both LMT and GD was performed based on data available at the end of 2007 and 2008. This analysis revealed that LMT had reduced their interest bearing liabilities ($4,407 down to $3,805) while GD, whom recorded a smaller leverage effect, had done the opposite and showed to have increased their interest bearing liabilities ($2,791 increased to $4,024) by the end of 2008.Selected Ratio ComparisonAccounts Receivable DaysGeneral D ynamicsIndustryLockheed MartinIndustry39.5132.5043.6257.12From the results presented above, General Dynamics demonstrates that it under-performed the rest of the industry by exceeding the average account receivable days by 7 days. In contrast, Lockheed Martin out-performed the rest of its industry by having recorded an account receivable average of 43.62 days, which means LMT was collecting from customers on an average of 13.5 days ahead of the rest of the industry.Accounts Payable DaysGeneral DynamicsIndustryLockheed MartinIndustry33.8831.5020.0919.66 GD is collecting from customers on average over 2 days past the industry average of 31.50 days LMT is collecting just day over the industry average of 19.66 daysInventory DaysGeneral DynamicsIndustryLockheed MartinIndustry25.9756.6217.3513.55 GD is turning inventory on average over 30 days under the industry average of 56.62 days LMT is turning inventory on average over 3 days over the industry average of 13.55 daysInterest CoverageG eneral DynamicsIndustryLockheed MartinIndustry29.5730.4314.495.49 GD could cover its yearly interest expenses 29.57 times in 2008, just under its industry average of 30.43 times LMT could cover its yearly interest expenses 29.57 times in 2008, significantly over its industry average of 5.49 timesEquity ValuationThe equity valuation of General Dynamics for 2008 produced an estimated share price of $77.71. This price is significantly higher than the closing per-share price of $57.59 for 2008 showing the companys stock was extremely undervalued. According to analyst reports5, some concerns about growth for General Dynamics stem from shrinking credit markets, which would impair the ability to finance business jets. Additionally, it is possible that investors were concerned the aerospace and defense industry would decline with a shift from government defense spending to social spending and deficit spending.Abnormal net income was computed as predicted net income less the cost of equity c apital. Predicted net income was computed using 2008 pro forma net income of $2,674 and implementing annual growth rates suggested by Goldman Sachs earnings forecasts5. The growth rates from 2009 through 2013 were -2.9%, 7.3%, 5.2%, 7.3% and 7.8% respectively. The same earnings forecasts were used to calculate the predicted dividends. The predicted dividends from 2009 to 2013 are 577, 617, 643, 671 and 700 respectively. The terminal value assumption used in computing abnormal net income was the competitive equilibrium on incremental real sales assumption. This strategy was chosen because the government is one of General Dynamics most significant customers, comprising approximately 67% of the companys revenue. This lead to the assumption that General Dynamics may not need to invest a large amount of resources in developing new customers and that most of their future growth would be lead by existing customers. This assumption provided a terminal value of $21,999. The cost of capital f or General Dynamics was calculated using a beta of 1.119, a risk free rate of 5% and a market risk premium of 4%. This produced a cost of capital of 9.5%. The present value of abnormal net income was calculated to be $20,265, by dividing abnormal net income by a discounting factor derived using the cost of capital.The present value of abnormal net income was combined with the initial book value of $9,810 to produce an estimated predicted price of $30,075. This price was divided by the number of shares outstanding according to the 2008 annual report to arrive at an estimated share price of $77.71.The equity valuation for Lockheed Martin for 2008 produced an estimated share price of $85.93, which is slightly higher than the actual share price as of the end of 2008 of $84.08. This shows the stock was slightly overvalued. This shows investors may have been overly optimistic in their opinion of Lockheed Martins earnings potential.Abnormal net income was computed just as that of General D ynamics. Using analysts reports6, estimated (negative) growth rates of (6%), (7%), (6.6%), 11% and 8.92% were applied to the 2008 pro forma net income of $3,114. The same terminal value assumption was used for Lockheed Martin as was used for General Dynamics. The US government is a substantial customer of Lockheed Martins, which lead to the assumption that a large portion of future growth could be attributed to existing customers and few resources could be devoted to developing new customers. The terminal value assumption provided a terminal value of $41,132. The cost of equity capital was calculated using a beta of .923, a risk free rate of 4% and a market risk premium of 5%. The 8.7% cost of capital was used to find the present value of abnormal net income of $37.936. This present value was combined with an initial book value of ($2,758) to produce an estimated price of $35,178. The estimated price divided by the number of shares outstanding per the Lockheed Martin annual report t o arrive at a per-share price of $85.93.References1www.Morningstar.com2www.netadvantgage.standardandpoors.com3www.generaldynamics.com4www.lockheedmartin.com5Richard Safran, Noah Poponak, Goldman Sachs, January 26, 2009. Noah Poponak, Chun-Yai Wang, Sai Krishna, Goldman Sachs, January 27, 20106Richard Safran, Noah Poponak, Goldman Sachs, January 22, 2009. Noah Poponak, Chun-Yai Wang, Sai Krishna, Goldman Sachs, January 29, 2010APPENDIXCAPM = Rf Rate + (Beta*Rmrkt)Given DataRisk Free rate = 3.77% (10 Year Treasury as of 2/18/10)Market Premium (Rmrkt) = 7% (given on page 26 of class notes) LMT Beta =0.923Industry Beta =0.697GD Beta =1.119Industry Beta =1.298CAPM CalculationsLMT = .0377 + .923*.07LMT =10.23%Industry = .0377 + .697*.07Industry =8.65% GD = .0377 + 1.119*.07GD =11.60%Industry = .0377 + 1.298*.07Industry =12.86% Financial Statement Analysis GDLMT 20082008 Beginning assets25,73328,926 Ending assets28,37333,439 Beginning equity11,7689,805 Ending equity10,0532,865 Beginning in terest-bearing liabilities2,7914,407 Ending interest-bearing liabilities4,0243,805 Net income (pro forma)2,6743,114 Sales revenue29,30042,731 Other revenue00 Research development expense4741,220 Selling, general administrative expense1,7002,344 Income tax expense1,1261,485 Income tax rate0.310.32 Interest expense133341 Beginning inventory1,6211,718 Ending inventory2,0291,902 Cost of goods sold25,64738,082 Beginning accounts receivable2,8744,925 Ending accounts receivable3,4695,296 Beginning accounts payable2,3182,163 Ending accounts payable2,4432,030 Shares outstanding386393 Closing price per share57.5984.08bloomberg.comAverage assets27,05331,183 Average equity10,9116,335 Average interest-bearing liabilities3,4084,106Average non-interest bearing liabilities12,73520,742 Average accounts receivable3,1725,111 Average inventory1,8251,810 Average accounts payable2,3812,097 After-tax interest rate0.030.06Multiplicative Decomposition of ROE ROE0.250.49 Net profit margin0.090.07 Asset tur nover1.081.37 Leverage2.484.92Additive Decomposition of ROE ROE0.250.49 Market-to-book2.2111.53NOPAT Margin0.090.08 Asset turnover2.054.09 ROA0.190.32 Spread0.170.26 Leverage0.310.65 Effect of leverage0.050.17 Gross profit margin0.120.11RD to revenue0.020.03SGA to revenue0.060.05Accounts receivable days39.5143.65Inventory days25.9717.35Operating cycle65.4861.00 Accounts payable days33.8820.09 Cash-to-cash cycle31.6040.91 Interest coverage29.5714.49 Debt ratio0.650.91Appendix CGeneral DynamicsLockheed MartinFinancial Statement AdjustmentsCumulative Financial Statement Adjustments Summary of Income Statement AdjustmentsSummary of Income Statement AdjustmentsNet Income as Reported$ 2,459Net Income as Reported$ 3,217Discontinued operations19Loss on sale of property,(126)Unwind tax effects196land, equipmentAdjusted Net Income$ 2,674Reverse of Impairment charge215 Unwind tax effects72 Pension Income(264) Adjusted Net Income$ 3,114Summary of Balance Sheet AdjustmentsSummary of Balance She et AdjustmentsTotal Assets as reported$ 28,373Total Assets as reported $ 33,439Constructive capitalization of709Constructive capitalization 699operating leasesof operating leasesUnwind tax effects (DTA)(7)Unwind tax effects (DTA)(5,390)Adjusted Total Assets$ 29,075Adjusted Total Assets$ 28,748 Total Liabilities as reported$ 18,320Total Liabilities as reported$ 30,574Constructive capitalization946Constructive capitalization932of operating leasesof operating leasesAdjusted Total Liabilities$ 19,266Adjusted Total Liabilities$ 31,506Total SE as reported$ 10,053Total SE as reported$ 2,865Constructive capitalization(236)Constructive capitalizationof operating leases(233)of operating leasesUnwind tax effects(5,390)Unwind tax effects(7)(DTA+DTL)(DTA+DTL)Adjusted Total SE$ (2,758)Adjusted Total SE$ 9,810Adjusted Total Liabilities + SE$ 29,075Adjusted Total Liabilities + SE$ 28,748General DynamicsPension Income Pro Forma Calculation1Net pension cost (benefit)$ 20 Net postretirement plan cost5 6 Total cost$ 76Net earnings$ 2,459 Percentage3.1%20082007 2Funded status pensions$ (2,922)$ 383 Funded status other postretirement plans(640)(642) Total funded status(3,562)(259) Difference$ (3,303)3Rate of return on U.S. plan assets8.1% Expected return593 Implied asset base7,330= 592 / .081 Actual return percentage-32.20%= 2360 / 73304Implied asset base$ 7,330 Pro forma expected rate7.0%Given Pro forma expected return513 Less Original expected return(593) Difference (reduction in pension income)(80) 1 Effective tax rate68.8%=1-.312 Adjustment (reduction) to net income$ (55)OR (.081-.070)*7,330 * (1-.312) =$ 55Adjusted income$ 2,404= 2,459 55 Lockheed Martin Pension Income Pro Forma Calculation1Net pension cost (benefit)$ 462 Net postretirement plan cost46 Total cost$ 508Net earnings$ 3,217 Percentage15.8%20082007 2Funded status pensions$ (11,882)$ (879) Funded status other postretirement plans14262017 Total funded status(10,456)1,138 Difference$ (11,594)3Rate of return on U.S. p lan assets8.5% Expected return$ 2,184 Implied asset base25,694= 2184 / .085 Actual return percentage-28.62%= 7354 / 256944Implied asset base$ 25,694 Pro forma expected rate7.0%Given Pro forma expected return1,799 Less Original expected return(2,184) Difference (reduction in pension income)(385) 1 Effective tax rate68.4%=1-.316 Adjustment (reduction) to net income$ (264)Adjusted income$ 2,953= 3,217 264General DynamicsCapitalization of Operating Leases Enter interest rate below0.039Enter operating lease commitments below (in millions)2009205.0 2010174.0 2011131.0 201297.0 201370.0 2014 thereafter405.0Solution Present value of operating lease commitments$ 945.9 Calculation of Present Value of Operating Lease Payments0205.01.000205.0 1174.01.039167.5 2131.01.080121.3