While many are talking about the upcoming fiscal cliff, a perfect example of the market view for this serious issue comes through the CEO of Lockheed Martin Corp. (NYSE/LMT), Robert Stevens. Stevens went to Washington to inform politicians of the gravity of the situation. In essence, if nothing is done and spending cuts are enacted at the beginning of 2013, Stevens predicts massive layoffs, a drop in corporate earnings and an extreme disruption throughout the entire defense sector. If that’s not a negative market view, I don’t know what is. This is obviously impacting analysts as they generate estimates for corporate earnings over the next several years, a difficult task to do when much rests on political maneuvering.
The cost, though, is very real. Stevens estimates of the total $38.0 billion in government contracts Lockheed earns, $3.8 billion would be lost due to the upcoming government cuts. This will trigger not only job cuts within the firm, but also down the supply chain as Lockheed Martin deals with approximately 43,000 suppliers and they then see less revenue and significantly lower corporate earnings.
An interesting point raised by Stevens is that, on top of the hit to corporate earnings, the savings are not going to be as significant as some people think. Because many of these contracts with suppliers are fixed, Lockheed will bring any losses associated with breaking the contracts or renegotiating them to the Pentagon. He estimates this will be more than tens of millions of dollars that the Pentagon will need to compensate for the broken contracts. This is on top of the thousands of jobs that will be cut. Stevens estimates 10% of Lockheed Martin’s 123,000 employees will be laid off. There are some estimates that between governments and the defense industry, over 500,000 jobs will be lost due to these cuts.
Obviously, corporate earnings will be hit if these cuts are enacted, and this has caused a negative market view on the stock. However, perhaps there is a contrarian call here against this market view. I personally think a deal will be reached, making the cuts far less severe than was expected, if they happen at all. The politicians will feel increasing pressure from their constituents to do something about the economy.
The economic numbers continue to worsen and the rest of the world, from Europe to Asia, is slowing. This contraction worldwide has exacerbated the negative market view, but if all of these events are price into the stock then perhaps we may be nearing the bottom of a trading range.
Over the long term, the defense industry will have to reduce its size. However, if any slightly positive event occurs by the end of the year, this would be a very good sign for Lockheed Martin, a company that still generates significant corporate earnings. If none of the cuts are enacted through a deal, then Lockheed Martin ends up being a solid dividend-paying, long-term stock. This is a company with a forward dividend yield of 4.7%, and if all of the contracts continue as stated, strong corporate earnings.
Chart courtesy of www.StockCharts.com
The stock recently pulled back to its 61.8% retracement level. At that point, the market view of the stock was oversold as seen by the Relative Strength Index (RSI). Wait before jumping in, as I think we will see another retest of some of these retracement levels. As the year continues, political confusion will be the norm, clouding up the market view. This confusion, echoed by Stevens as he spoke about the fog of uncertainty, is going to make it a difficult trading environment. Be cautious about placing a large position when the outcome is based on politicians working together to get a deal done. That’s always been a big gamble.