Investing and life have a lot in common.
This shouldn’t be a surprise.
After all, life can be very businesslike in many respects.
One thing that I’ve consistently found in common between investing and life?
Quality matters.
Be it a career, a home, a spouse, or an investment, higher-quality options are always the best options.
High quality is worth more.
And it will treat you better over the long run.
This is a mantra I’ve lived by over the years as I’ve built out my own real-money stock portfolio, which I call the FIRE Fund.
The Fund produces enough five-figure passive dividend income for me to live off of.
And I happily live off of that passive dividend income.
Indeed, I was able to retire in my early 30s.
How?
I describe in my Early Retirement Blueprint exactly how I put myself in a position to live off of dividend income and retire so early.
A pillar of that Blueprint is, of course, the investing strategy I’ve used.
It’s dividend growth investing.
This is a strategy whereby you buy and hold shares in world-class businesses that pay reliable, rising dividends.
You can find hundreds of these stocks on the Dividend Champions, Contenders, and Challengers list.
This strategy, by its very nature, tends to funnel you right into some of the highest-quality companies out there.
That’s because a high level of quality is required to be able to consistently produce the growing profits necessary to consistently pay out growing dividends.
As important as quality is, valuation should never be overlooked.
No business, even a very high-quality one, is worth an infinite amount of money.
Price is what you pay. But it’s value that you end up getting.
An undervalued dividend growth stock should provide a higher yield, greater long-term total return potential, and reduced risk.
This is relative to what the same stock might otherwise provide if it were fairly valued or overvalued.
Price and yield are inversely correlated. All else equal, a lower price will result in a higher yield.
That higher yield correlates to greater long-term total return potential.
This is because total return is simply the total income earned from an investment – capital gain plus investment income – over a period of time.
Prospective investment income is boosted by the higher yield.
But capital gain is also given a possible boost via the “upside” between a lower price paid and higher estimated intrinsic value.
And that’s on top of whatever capital gain would ordinarily come about as a quality company naturally becomes worth more over time.
These dynamics should reduce risk.
Undervaluation introduces a margin of safety.
This is a “buffer” that protects the investor against unforeseen issues that could detrimentally lessen a company’s fair value.
It’s protection against the possible downside.
Investing in high-quality companies at favorable valuations sets you up for truly spectacular investment performance over the long haul.
What’s great about this is, it’s not that difficult to estimate fair value.
Fellow contributor Dave Van Knapp’s Lesson 11: Valuation, which is part of an overarching series of “lessons” on dividend growth investing, provides a valuation template that can be applied to almost any dividend growth stock.
With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to be undervalued right now…
Lockheed Martin Corporation (LMT)
Lockheed Martin Corporation (LMT) is the world’s largest defense contractor.
Founded in 1912, Lockheed Martin is now a $92 billion (by market cap) global defense monstrosity that employs over 100,000 people.
The company reports results across four segments: Aeronautics, 40% of FY 2020 revenue; Rotary and Mission Systems, 25%; Space Systems, 18%; Missiles & Fire Control, 17%.
The US Department of Defense accounts for approximately 65% of revenue. Nearly 25% of revenue is international. The remaining 10% comes from various US government agencies. Commercial sales are immaterial.
The company manufactures a range of major military aircraft, including the F-35 Lightning II, the F-22 Raptor, the F-16 Fighting Falcon, the SH-60 Seahawk.
The F-35, a fifth-generation combat aircraft, is the largest and most expensive military weapons system in the world.
In addition, their various missile programs are critical for both offensive and defensive capabilities.
Look, sovereign defense has been necessary for as long as there have been sovereign entities.
It was true when we were using arrows.
It’s still true now that we’re using missiles.
And that’ll likely remain true until the end of time.
Major defense contractors are practically guaranteed ongoing sales for a time period that stretches beyond my lifetime.
What’s particularly great about Lockheed Martin specifically is that it is the world’s largest defense contractor, headquartered in the world’s largest spender on defense products and services.
Morningstar sums it up really well: “In our view, Lockheed Martin is the highest-quality defense prime contractor due to its prime position on highly prioritized programs, particularly the F-35, and the company’s portfolio positioning toward areas of secular spending growth, especially missile-related and space technologies.”
This combination of scale, positioning, and quality is highly unique and advantageous.
And because of the way in which weapons programs continuously advance in terms of scale, technology, and cost, major defense contractors benefit from this progression layered onto built-in demand.
And I think that sets up Lockheed Martin to grow its revenue, profit, and dividend for many decades to come.
Dividend Growth, Growth Rate, Payout Ratio and Yield
As it sits, the company has already increased its dividend for 19 consecutive years.
In fact, they just increased their dividend yet again in late September by nearly 8%.
That’s not terribly far off from the five-year dividend growth rate of 9.8%.
The stock also yields 3.4%.
That yield, by the way, is 80 basis points higher than its own five-year average.
It’s a very appealing combination of yield and growth.
The payout ratio is a moderate 51.6%, easily covering the dividend.
I see the “sweet spot” for dividend growth stocks to be a yield of between 2.5% and 3.5%, paired with a high-single-digit (or better) dividend growth rate.
This stock is in that spot in the sweetest possible way.
Revenue and Earnings Growth
As great as these dividend metrics are, though, they’re looking backward.
But investors are always risking today’s capital for tomorrow’s rewards.
Thus, I’ll now build out a forward-looking growth trajectory for the business, which will later help when it comes time to estimate intrinsic value.
I’ll first show you what the company has done over the last decade in terms of top-line and bottom-line growth.
Then I’ll reveal a near-term professional prognostication for profit growth.
Comparing the proven past up against future forecast in this way should give us a good idea as to where the business might be going.
Lockheed Martin has increased its revenue from $46.499 billion in FY 2011 to $65.398 billion in FY 2020.
That’s a compound annual growth rate of 3.9%.
I like to see a mid-single-digit top-line growth rate from a mature business. Lockheed Martin is basically there.
Meantime, earnings per share increased from $7.81 to $24.30 over this period, which is a CAGR of 13.4%.
Fantastic.
The company has steadily expanded margins and bought back stock, which helped to propel the excess bottom-line growth.
For perspective, the outstanding share count is down by ~17% over the last decade.
Looking forward, CFRA anticipates that Lockheed Martin will compound its EPS at an annual rate of 7% over the next three years.
The risk of US DoD spending cuts hangs over Lockheed Martin like the Sword of Damocles. It’s been that way since I started investing in 2010. It’s still that way today.
CFRA believes the risk is overblown. They state: “However, we see this risk mitigated by LMT’s focus on DoD’s high priority, advanced technology programs, which are likely to avoid cuts even if total defense spending is reduced, in our view.”
The market apparently sees this risk as heightened with Democrats in power, which has undercut the stock throughout 2021 (it’s down YTD).
I’d argue the market is getting it wrong, discounting the stock for no good reason. CFRA would seem to agree, adding this: “This steep discount is driven by market fear of defense spending cuts under Democrats, in our view. But in fact, the Democrat-controlled Senate Armed Services Committee has already passed a 5% defense budget increase over the Trump-era level with overwhelming bipartisan support…”
All that said, much of this is missing the point.
The point is, Lockheed Martin doesn’t necessarily need much defense spending growth in order to grow their business at an acceptable rate. Besides, the company has a backlog of nearly $135 billion to work through.
CFRA adds granularity to this point: “Further, defense budget growth is not critical for LMT, as it grew EPS 10% annually during 2012-2015, even as defense spending fell 4% annually in those years.”
Now, the stock did fall somewhat dramatically after a so-so Q3 report that missed revenue expectations. Still, the company grew adjusted EPS by 11% YOY.
In the end, I see nothing to indicate that Lockheed Martin can’t or won’t continue to increase the dividend at a high-single-digit rate for the foreseeable future.
Combining that level of dividend growth with the 3%+ starting yield offers a great total package, in my opinion.
Financial Position
Moving over to the balance sheet, the company maintains a very solid financial position.
The long-term debt/equity ratio, at 1.9, is a bit high. That’s mostly because of low common equity (not a large debt load).
Their interest coverage ratio of over 15 is great and reveals no issues at all with servicing debt.
Profitability is robust and improving. Margins have been expanding nicely, although low common equity has juiced ROE.
Over the last five years, the firm has averaged annual net margin of 9.0% and annual return on equity of 303.6%.
I find very little to fault about this business.
It’s fundamentally excellent, the backlog is huge, their industry is an oligopoly, and it provides a necessary suite of products and services to very willing buyers with near-unlimited purchasing power.
And the company benefits from durable competitive advantages that include global scale, material barriers to entry, long-term contracts, unique government relationships, and technological know-how.
Of course, there are risks to consider.
Regulation, litigation, and competition are omnipresent risks in every industry.
A global oligopoly limits competition. On the other hand, direct government relationships can lead to more regulatory risk.
The very business model presents geopolitical risks.
Production execution has been a recent risk. For instance, they’ve had cost overruns with the F-35 program.
Any pressure on government spending, which would put pressure DoD spending, could reduce revenue and profits.
I view these risks as tolerable.
And with the stock 22% off of its 52-week high, I think the valuation is very appealing right now…
Stock Price Valuation
Shares are trading hands for a P/E ratio of 15.1.
That’s below the broader market by a good margin.
It’s also substantially lower than its own five-year average of 22.4.
There’s also the matter of the P/CF ratio of 13.5 being well off of its own five-year average of 17.3.
And the yield, as noted earlier, is significantly higher than its own recent historical average.
So the stock looks cheap when looking at basic valuation metrics. But how cheap might it be? What would a rational estimate of intrinsic value look like?
I valued shares using a dividend discount model analysis.
I factored in a 10% discount rate and a long-term dividend growth rate of 7.5%.
This DGR is on the higher end of what I typically allow for.
If there’s a business that deserves it, it’s this one.
Keep in mind, the DGR I’m accounting for is well below the company’s long-term proven growth across both EPS and the dividend.
It’s also lower than where their most recent dividend increase, announced only months ago, came in at.
With the payout ratio being moderate and CFRA expecting high-single-digit EPS growth for the next few years, I see this as a very achievable number for Lockheed Martin.
The DDM analysis gives me a fair value of $481.60.
The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.
The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.
It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.
I find it to be a fairly accurate way to value dividend growth stocks.
I don’t see my valuation as aggressive at all, yet the stock still looks cheap.
But we’ll now compare that valuation with where two professional stock analysis firms have come out at.
This adds balance, depth, and perspective to our conclusion.
Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system.
1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.
Morningstar rates LMT as a 4-star stock, with a fair value estimate of $402.00.
CFRA is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line.
They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.
CFRA rates LMT as a 5-star “STRONG BUY”, with a 12-month target price of $463.00.
I came out slightly high. Averaging the three numbers out gives us a final valuation of $448.87, which would indicate the stock is possibly 38% undervalued.
Bottom line: Lockheed Martin Corporation (LMT) is a high-quality business across the board. They provide necessary products and services within the framework of a global oligopoly, all but guaranteeing plenty of future growth. With a 3%+ yield, high-single-digit dividend growth, nearly 20 consecutive years of dividend increases, a moderate payout ratio, and the potential that shares are 38% undervalued, this is one of my best long-term ideas for dividend growth investors.
-Jason Fieber
P.S. If you’d like access to my entire six-figure dividend growth stock portfolio, as well as stock trades I make with my own money, I’ve made all of that available exclusively through Patreon.
Note from DTA: How safe is LMT’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 84. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, LMT’s dividend appears Very Safe with a very unlikely risk of being cut. Learn more about Dividend Safety Scores here.
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