I was born in 1982.
Over the course of four decades, I’ve witnessed a lot of uncertainty.
In fact, every day of my life has been rather uncertain.
I’ve also been investing for more than 25% of my entire lifespan.
As an investor, I’ve learned that companies which benefit from uncertainty practically have a license to print money.
Is uncertainty a feature or a bug of the human condition?
I don’t know.
What I do know is, it’s constantly present.
As such, it’s a never-ending source of demand for many businesses.
And that often makes these businesses perfect for the dividend growth investing strategy.
This strategy espouses investing in world-class businesses that pay reliable, rising dividends to their shareholders.
These reliable, rising dividends are, of course, funded by reliable, rising profits.
As you might imagine, it takes a special kind of business to be able to consistently do that for years and years on end.
You can see what I mean by checking out the Dividend Champions, Contenders, and Challengers list.
I’ve filled up the FIRE Fund with plenty of these stocks.
That’s my real-money portfolio, and it produces enough five-figure passive dividend income for me to live off of.
I’ve actually been living off of dividends for years.
In fact, I retired in my early 30s – exchanging a paycheck for dividends.
My Early Retirement Blueprint spills the beans on how I did that.
Suffice it to say, dividend growth investing is a pillar of the Blueprint.
But it’s more than just buying the right stocks.
You also have to think about the right valuations.
Price only tells you what you pay. It’s value that you get.
An undervalued dividend growth stock should provide a higher yield, greater long-term total return potential, and reduced risk.
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.
Buying high-quality dividend growth stocks that benefit from uncertainty, and doing that buying when undervaluation is present, sets up an investor for extraordinary success, wealth, and passive dividend income over the long run.
To be fair, spotting the presence of undervaluation would mean that you already understand valuation.
But this isn’t super complicated.
Fellow contributor Dave Van Knapp has made it easier than ever to understand valuation, via Lesson 11: Valuation.
Part of a larger, more comprehensive series of “lessons” on dividend growth investing, it lays out a valuation model that can be used to estimate the fair value of 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) is the world’s largest defense contractor.
Founded in 1912, Lockheed Martin is now a $104 billion (by market cap) global defense monster that employs nearly 115,000 people.
The company reports results across four segments: Aeronautics, 40% of FY 2021 revenue; Rotary and Mission Systems, 25%; Space, 18%; Missiles & Fire Control, 17%.
The US Department of Defense accounts for approximately 62% of revenue. Nearly 25% of revenue is derived from foreign government militaries. The remaining 10% comes from various US government agencies. Commercial sales are immaterial.
The company manufactures a range of major military aircraft platforms, 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.
Uncertainty is part of our everyday lives.
In my 40 years of being alive, I can’t remember a single day that wasn’t uncertain in some shape or form.
Lockheed Martin benefits from this constant uncertainty, as the company provides the sovereign defense tools necessary for nations to protect themselves against possible outside threats.
Because uncertainty is a bottomless well to draw from, and because conflict is part of the human condition, defense contractors are practically guaranteed ongoing sales for a time period that stretches beyond my lifetime.
Furthermore, these sales become increasingly larger in terms of dollar figures – defense tools continue to grow more complex and more expensive over time.
It’s inherent progression layered onto built-in demand.
What’s especially powerful about Lockheed Martin is that it is the world’s largest defense contractor, headquartered in the world’s largest spender on defense products and services.
Lockheed Martin has a unique combination of scale, positioning, and quality.
This sets them up to deliver growth across its revenue, profit, and dividend for many years to come.
Dividend Growth, Growth Rate, Payout Ratio and Yield
Already, the company has increased its dividend for 19 consecutive years.
The 10-year dividend growth rate of 12.5% further shows what a stalwart Lockheed Martin has been.
Along with that double-digit dividend growth rate, the stock offers a competitive, market-beating 2.8% yield.
This yield, by the way, is 20 basis points higher than its own five-year average.
And with a balanced payout ratio of 52%, based on the company’s EPS guidance for this fiscal year, the dividend is healthy and positioned to continue growing.
I like dividend growth stocks in what I refer to as the “sweet spot” – a yield of between 2.5% and 3.5%, paired with a high-single-digit (or better) dividend growth rate.
Both the yield and dividend growth rate are great and clearly in that sweet spot.
Revenue and Earnings Growth
As great as these dividend metrics are, though, they’re largely looking backward.
However, investors must risk today’s capital for the possible rewards of tomorrow.
Thus, I’ll now build out a forward-looking growth trajectory for the business, which will later be of great help when it comes time to estimate the stock’s intrinsic value.
I’ll first show you what this business has done over the last decade in terms of its top-line and bottom-line growth.
I’ll then unveil a professional prognostication for near-term profit growth.
Blending the proven past with a future forecast in this manner should tell us quite a bit about where the business might be going from here.
Lockheed Martin escalated its revenue from $47.2 billion in FY 2012 to $67.0 billion in FY 2021.
That’s a compound annual growth rate of 4%.
I like to see mid-single-digit top-line growth from a mature business like this.
The company delivered.
Meanwhile, earnings per share grew from $8.36 to $22.76 over this period, which is a CAGR of 11.8%.
Strong bottom-line growth here.
It’s great to see that the 12%+ dividend growth has been fueled mostly by like earnings growth.
This shows prudence on the part of management, with a clear eye on sustainability.
A lot of the excess bottom-line growth was driven by share repurchases.
The company’s outstanding share count has been reduced by 18% over the last decade.
Looking forward, CFRA believes that Lockheed Martin will grow its EPS at a CAGR of 6% over the next three years.
So we can spot a clear disconnect here.
This forward-looking growth forecast from CFRA is about half of what Lockheed Martin has demonstrated over the last 10 years.
Well, I think there’s a push-pull dynamic going on here.
Labor shortages, material shortages, and overall supply chain issues are impacting the business in a material way.
Recent quarters have been impacted by these challenges.
Offsetting these difficulties is a very strong core business, which is only getting stronger on the back of a geopolitical environment that has become red hot after Russia’s invasion of Ukraine.
Open war in Eastern Europe has the world on notice, and defense spending almost across the board is rising.
That obviously bodes well for the world’s largest prime defense contractor.
After all, the company provides a necessary suite of products and services to willing buyers who have near-unlimited purchasing power. And it does so while sitting atop a powerful oligopoly.
Indeed, Lockheed Martin’s contracts just keep piling up – the latest news is that the company is nearing the closing of a $30 billion deal with the US DoD for several hundred F-35 jets over the next few years.
The backlog is already sitting at $135 billion.
Lockheed Martin is not short on work.
While the next year or two could be choppy, as the global supply chain is still straightening itself out, the company’s long-term prospects are fantastic.
I don’t find CFRA’s take on near-term EPS growth as unreasonable.
But that still sets us up for high-single-digit dividend raises over the next few years.
Then, as the business gets back to full strength, we could see a nice acceleration in dividend growth.
That paints a nice picture, in my view, when you’re already starting off with a near-3% yield.
Moving over to the balance sheet, the company sports a rock-solid financial position.
The long-term debt/equity ratio is 1.1, while the interest coverage ratio is over 16.
Profitability is fairly robust, and it’s been steadily improving.
Over the last five years, the firm has averaged annual net margin of 8.7% and annual return on equity of 279.2%.
ROE has been greatly helped by the balance sheet, but the improvement in net margin (routinely in the 6% range a decade ago) is notable.
They say the strong only get stronger.
Lockheed Martin is a classic case of this.
The current geopolitical environment is leading to even more dollars flowing toward a powerful oligopoly where Lockheed Martin reigns supreme.
And with global scale, high barriers to entry, long-term contracts, unique government relationships, R&D, IP, and technological know-how, the company benefits from durable competitive advantages.
Of course, there are risks to consider.
Regulation, litigation, and competition are omnipresent risks in every industry.
The industry’s oligopoly does limit competition.
On the other hand, direct government relationships can lead to more regulatory risk.
The very business model presents geopolitical risks.
Production execution is a risk. For instance, cost overruns on the F-35 program have plagued the firm.
Any reduction in US government spending, which would put pressure on DoD spending, could weigh on the company’s revenue and profit.
That said, CFRA has found that “government defense spending has historically increased regardless of recessions.” Moreover, CFRA cites Lockheed Martin’s focus on “advanced technology programs, which are likely to avoid cuts even if total defense spending is reduced.”
I see these risks as acceptable, especially when lined up against the quality and appeal of the business.
And with the stock down nearly 20% from its 52-week high, the valuation only serves to make this name that much more appealing…
Stock Price Valuation
The forward P/E ratio is sitting at 18.5, based on the company’s EPS guidance for this fiscal year.
For a world-class operation like this, I think that’s more than acceptable.
For the sake of comparison, the stock’s five-year average P/E ratio is 22.0.
We can also see that the P/CF ratio of 12.1 is well off of its own five-year average of 17.1.
And the yield, as noted earlier, is 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 high end of what I typically allow for, but it’s not as high as I’ll go.
I see this as a highly realistic expectation for Lockheed Martin’s dividend growth path from here.
It’s not far off from the dividend raises the company has been handing out of late.
Keep in mind, the most recent dividend increase came in at 7.7%.
Supply chain kinks will likely put a low ceiling on dividend raises over the next few years, but the moderate payout ratio and strength in the underlying business should allow dividend growth to climb higher when we look out further.
I think Lockheed Martin could very well exceed this mark over the long term, but I’d warn that the near term may be bumpy.
Either way, I like to err on the side of caution.
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.
The stock looks very cheap 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 $447.00.
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 3-star “HOLD”, with a 12-month target price of $414.00.
I came out on the high end, but we all agree that the pricing seems too low right now. Averaging the three numbers out gives us a final valuation of $447.53, which would indicate the stock is possibly 12% undervalued.
Bottom line: Lockheed Martin Corporation (LMT) sits atop a powerful oligopoly that is benefiting and profiting from current global affairs. The growing backlog already exceeds the company’s entire market cap, indicating no shortage of work now or at any time in the future. With a market-beating yield, double-digit dividend growth, a moderate payout ratio, almost 20 consecutive years of dividend increases, and the potential that shares are 12% undervalued, this looks like a compelling idea for long-term 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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