This article first appeared on Dividends & Income
It’s been a crazy, crazy year.
You don’t need me to remind you of everything that’s been going on.
Yet with President Donald Trump coming down with a case of COVID-19, things keep getting crazier.
And that’s why this is a great time as an investor to focus on certainty.
With cheap stocks abound, there’s no reason to go out on a limb and make a big bet on the uncertain.
I’d argue that the opposite might be the better course, where you get a good deal on a business model with built-in certainty.
This is something I’ve aimed to repeatedly do on my way to going from below broke at age 27 to financially free at 33, as I’ve laid out in the Early Retirement Blueprint.
I did so when valuations were attractive.
That allowed me to build my FIRE Fund.
The Fund is my real-money early retirement stock portfolio, which generates the five-figure passive dividend income I live off of.
It’s chock-full of high-quality dividend growth stocks.
A company puts itself in a position to pay those dividends when it’s run correctly, selling what the world demands, and increasing its profit.
The Dividend Champions, Contenders, and Challengers list contains invaluable data on more than 700 US-listed dividend growth stocks.
Now, dividend growth investing is more than looking at list.
An intelligent investor always does their homework.
That includes valuation.
Price is what you pay. But value is what you get.
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 businesses that offer some certainty, and doing so at attractive valuations, can build up substantial wealth and passive income over time.
Fellow contributor Dave Van Knapp has made the valuation process much easier via the introduction of Lesson 11: Valuation.
Part of a more comprehensive series of “lessons” on DGI, it provides a valuation template that you can use to value almost any dividend growth stock out there.
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) is the world’s largest defense contractor.
Founded in 1912, Lockheed Martin is now a $106 billion (by market cap) global giant that employs more than 100,000 people.
Fiscal year 2019 revenue is broken out by segment: Aeronautics, 40%; Rotary and Mission Systems, 25%; Space Systems, 18%; Missiles & Fire Control, 17%.
The US Department of Defense accounts for approximately 60% of revenue. International sales account for almost 30% of revenue. The remaining 10% comes from various US government agencies. Commercial sales are insignificant.
In terms of military weapons manufacturers, Lockheed Martin stands alone at the top.
Morningstar declares this: “We view Lockheed Martin as the highest-quality defense prime contractor, given its exposure as the prime contractor on the F-35 program and its missile business.”
Lockheed Martin produces an arsenal of major military aircraft, including the F-35 Lightning II, the F-22 Raptor, the F-16 Fighting Falcon, the SH-60 Seahawk.
In addition, the company provides a variety of offensive and defensive weapons, including missiles, missile defense systems, and electronics.
The F-35, a fifth-generation combat aircraft, is the largest and most expensive military weapons system in the world.
In a world of uncertainty, I can offer you a clear certainty: Global governments will continue to spend lots of money on sovereign defense and security.
In fact, this certainty is a counterbalance to global uncertainty.
The more uncertain things get, the more important defense and security becomes.
It’s that simple.
That bodes well for Lockheed Martin, its profit, and its stream of growing dividends.
Dividend Growth, Growth Rate, Payout Ratio and Yield
As it sits, the company has increased its dividend for 18 consecutive years.
The impressive 10-year dividend growth rate of 14.4% comes on top of the stock’s starting yield of 2.76%.
In fact, Lockheed Martin just increased its dividend by over 8% two weeks ago.
This growth comes on top of a market-beating yield.
And with a modest payout ratio of 45.6%, even after the dividend increase, the dividend is very secure.
Revenue and Earnings Growth
All well and good, but it’s ultimately those future dividends and dividend raises we care most about.
Investors are putting today’s capital at risk for tomorrow’s rewards.
To that end, it’s vital to estimate what kind of growth to expect, which will also help estimate intrinsic value.
I’ll now build out a growth trajectory for Lockheed Martin.
This trajectory will partially rely on the last decade of top-line and bottom-line growth from the company.
And I’ll then compare that to a near-term professional prognostication for profit growth.
Comparing the proven past against a future forecast in this manner should allow us to have a pretty good idea as to where this business is going.
Lockheed Martin increased its revenue from $45.803 billion to $59.812 billion between FY 2010 and FY 2019.
That’s a compound annual growth rate of 3.01%.
Meantime, they grew earnings per share from $7.81 to $21.95 over this time frame, which is a CAGR of 12.17%.
Margin expansion and buybacks combined to help propel excess bottom-line growth.
The outstanding share count is down by approximately 23% over the last decade, for perspective.
Looking forward, CFRA believes that Lockheed Martin will compound its EPS at an annual rate of 9% over the next three years.
CFRA specifically points to the company’s “focus on high priority defense programs that are not correlated to the broader economy or fiscal deficits” as a key advantage.
Indeed, I think CFRA’s near-term EPS growth forecast could end up on the conservative side.
Lockheed Martin is one of the few businesses out there that is almost bulletproof. Not even this pandemic can stop them.
Their Q2 FY 2020 report showed 22% YOY EPS growth and a $150 billion backlog.
Then only weeks ago, the company raised its dividend by over 8% and added $1.3 billion to the buyback program.
This kind of profit growth, along with the modest payout ratio, sets the dividend up to easily grow in the high-single-digit range over the foreseeable future.
Moving over to the balance sheet, the company has a solid financial position.
While the long-term debt/equity ratio of 3.65 looks high, that’s due to low common equity from buybacks.
The interest coverage ratio of over 12 indicates no issues with its debt costs.
Profitability is fairly robust, and there’s been a definitive margin expansion in recent years.
Over the last five years, the firm has averaged annual net margin of 8.55%. Return on equity is N/A because of low common equity.
Overall, there’s so much to like about Lockheed Martin because there’s so little to dislike about it.
I find almost nothing to fault about the business model or fundamentals.
And with global scale, massive barriers to entry, long-term contracts, technological know-how, and high switching costs, there are competitive advantages here.
Moreover, there’s an oligopoly in this industry. This ensures rational pricing.
Of course, there are risks to consider.
Litigation, regulation, and competition are omnipresent risks in every industry.
I think competition, thanks to the oligopoly, is a limited problem. On the other hand, regulation is a big risk. There is direct government oversight here.
There are unique geopolitical risks in place due to the very business model.
A leadership change in the US could result in more Democratic control, which might see some near-term pressure on defense spending.
Also, production execution has been a recent risk. Cost overruns around the F-35 program can be highlighted.
With these risks known, I still think Lockheed Martin is a great long-term investment.
But the stock has to be bought at an attractive valuation.
With the stock down 13% from its 52-week high, I’d argue the current valuation is attractive…
Stock Price Valuation
The P/E ratio is sitting at 16.78.
That’s quite a bit lower than where the broader market is at.
It’s also lower than the stock’s own five-year average P/E ratio of 23.7.
There’s also a big disconnect on the cash flow multiple; the P/CF ratio of 12.8 is well off of its three-year average of 20.0.
And the yield, as noted earlier, offers market-beating income.
So the stock does look cheap based on basic valuation metrics. But how cheap might it be? What would a reasonable 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 8%.
This DGR is at the high end of what I tend to allow for in a DDM analysis.
But I think Lockheed Martin deserves the benefit of the doubt. It’s arguably the best business in one of the most investable industries out there.
The modest payout ratio, product backlog, leadership position, EPS growth profile, and proven dividend growth to date all point to this kind of long-term trajectory.
The DDM analysis gives me a fair value of $561.60.
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.
This stock appears to be materially undervalued to me.
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 $433.00.
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 $504.00.
I came out high, but we all agree that the stock is undervalued and worthy of investment. Averaging the three numbers out gives us a final valuation of $499.53, which would indicate the stock is possibly 30% undervalued.
Bottom line: Lockheed Martin Corporation (LMT) is a high-quality leader in one of the most profitable industries in the world. And it’s poised to greatly benefit from global uncertainty. With a market-beating yield, almost 20 consecutive years of dividend raises, double-digit dividend growth, a modest payout ratio, and the potential that shares are 30% undervalued, this stock might be one of the very best opportunities in the market for dividend growth investors.
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.
The goal? To build a reliable, growing income stream by making regular investments in high-quality dividend-paying companies. Click here to access our Income Builder Portfolio and see what we’re buying this month.
Source: Dividends and Income