Lockheed Martin: A Big Buck for the F-35? (NYSE:LMT)

Lockheed Martin Corporation (NYSE:LMT) resumed F-35 deliveries in July this year. The resumption of delivery came after a one-year hiatus following problems with the TR-3 upgrade for the F-35. During this time, Lockheed Martin continued to build the F-35 as normal rate building a significant inventory. In my previous report, I flagged the restart of F-35 delivery as a driver of cash flow. However, the The Pentagon retains $5 million of the roughly $7 million in delivery payments for any F-35 which provides a complete TR-3 upgrade. In this report, I will discuss what the TR-3 upgrade is, estimate the inventory of delivered aircraft and the associated cash changes due to the significant reduction in delivery payments, as well as the possible impact on target prices.

What is the TR-3 upgrade for the F-35?

TR-3 upgrade or Technology Refresh 3 is an upgrade package to the F-35 that gives the F-35 more computer memory, processing power and displays, allowing the fighter to better identify targets, improve its electronic warfare capabilities and to carry more weapons. This TR-3 upgrade serves as the basis for the F-35’s Block 4 capabilities. Development of the TR-3 upgrade was expensive, at least $1 billion over budget.

While F-35 deliveries have restarted, the problem has become that the current TR-3 implementation is a truncated one. It is not a combat-ready TR-3 upgrade, and the Joint Program Office will retain a portion of the delivery payment for each of the fighters that do not feature the full upgrade, which is not expected until next year.

Modeling the impact of the F-35 delivery payment on Lockheed Martin’s stock price

For 2024, management’s guidance as well as analysts’ free cash flow estimates appear to be consistent with the assumption that delivery payments would be minimal. So I don’t see any major impact there, and if the F-35’s capabilities are on par next year, I’d say the price targets I outlined earlier continue to hold.

However, if deliveries of the full TR-3 upgrade change in 2026, there would be some pressure. For the second half of the year, Lockheed Martin expects to deliver between 75 and 110 fighters, with about 90 percent of deliveries being in the truncated TR-3 configuration. This would indicate that by the end of the year, the number of aircraft in the inventory will be between 87 and 118 fighters, with the rest being burned by 2026.

For 2024, there would be $340 million to $495 million in delivery payments that would be deferred. For 2025, there would be between 136 and 157 deliveries for which payment would be deferred if the TR-3 upgrade is not fully ready by a reasonable time in 2025. What this would essentially mean is that the payments withheld for 2024 and 2025 would total $1.125 billion to $1.175 billion, which would flow into 2026.

I modeled this in my stock analyzer as a pressure of $1.15 billion, which is the midpoint of the potential cash flow slippage, and added it in 2026. With the cash flow slippage, we can already know that any pressure there will be in 2025 will be offset in 2026. While analysts are placing significant emphasis on delivery payments, the reality is that a one-year slip would barely move the needle for Lockheed Martin, despite the amount being substantial measured in relation to cash flow. For 2025, we would see a share price impact of $2.66 to $3.64, which is just 0.2% to 0.5%. Because the price targets are based on a valuation of the company, it would not be fully recovered in terms of the 2026 price targets, but about half of the share price pressure could be added to the upside in 2026.

Bottom line: The potential F-35 cash flow squeeze is uncomfortable, but not major

The cash flow balance of $1.15 billion, which I think would be the worst-case scenario, would not provide substantial pressure on the established price targets, and I think that’s something to keep in mind. Withholding payments has been a point of interest for analysts and the media, but calculating the impact doesn’t put significant pressure on the price target, and it could very well be the case that Lockheed Martin gets a combat-ready TR-3. next year, which further reduces the cash flow impact. So, I feel comfortable with the buy rating and price targets on the stock that I have now set.