Lockheed Martin Corp. LMT has won a contract, worth $8.5 billion, from the Department of Defense (“DoD”) for the production of 90 F-35 fighters. The contract price for the F-35’s 10th production batch represents the lowest rate to date for the company’s most expensive program.



Details of the Deal



The contract covers 76 F-35As at $94.6 million per unit after a 7.3% reduction from the ninth batch; 12 F-35Bs at $122.8 million after a 6.7% reduction; and two F-35Cs at $121.8 million after a 7.9% reduction.



Though Lockheed said that the contract is valued at $8.5 billion, the Pentagon's joint program office revealed a cost of $8.2 billion. It was, however, later clarified that the $8.2 billion figure excludes jet engines covered under another contract with Pratt & Whitney, a United Technologies UTX unit.



Compared to the lot 9 production, lot 10 represents a reduction of $728 million in costs.



According to Lockheed Martin, “the increase in the number of aircraft in this agreement enables us to reduce costs by taking advantage of economies of scale and production efficiencies.”



The Trump Factor



Recently, President Donald Trump announced plans to reduce the cost of 90 planes by $600 million in an attempt to make the “overtly expensive” F-35 fighter jets affordable.



Trump has always viewed F-35 as an exorbitant project by Lockheed Martin. In Dec 2016, Trump had even slammed the company for its 'tremendously' costly F-35 program and urged its aerospace rival The Boeing Company BA to 'price out' its F-18 Super Hornet.



Last week, Trump stated that after a month of negotiation with Lockheed Martin, he has finally managed to reach a suitable solution. The President informed that he has slashed the cost of lot 10 F-35 jets by $600 million after meeting with the company’s chief executive Marillyn Hewson. He strongly believes that this cost cut will save “billions and billions of dollars” for the U.S. government.



Even before Trump, in Dec 2016, the Pentagon’s F-35 program manager said that it has plans to negotiate prices for the 10th lot of F-35s. He added that the cost for each variant is intended to go down by 6% to 7%, which translates into cost savings of $550−$630 million. But Lockheed Martin said that Trump's participation hastened the negotiations.



F-35 Attributes



Lockheed Martin’s F-35 Lightning II is a single-seat, single-engine, 5th Generation fighter aircraft, which comes with an advanced stealth feature combined with enhanced fighter speed and agility, fully fused sensor information, network-enabled operations and advanced sustainment. Three variants of the F-35 are set to replace five fighter jets for the U.S. Air Force, Navy and Marine Corps, as well as a variety of fighter jets in at least 10 other countries.



With Lockheed being the primary partner, the F-35 program has been supported by an international team of leading aerospace majors. While Northrop Grumman Corp. NOC contributed its expertise in carrier aircraft and low-observable stealth technology to this program, BAE Systems plc’s BAESY short takeoff and vertical landing experience, and air systems sustainment supported the jet’s combat capabilities. Pratt & Whitney provided F-35s with the F135 propulsion system, the world's most powerful fighter engine.



Although this engine has led to delays, recently it was announced that engine removal for maintenance – a key measure of engine reliability – is over 90% and hence not required until 2020.



Our View



Notably, F-35 is the world's largest defense program built by some of the leading companies in the aerospace-defense space. To date, the U.S. government has awarded low-rate initial production contracts for smaller batches of F-35 jets, partly because of the huge costs associated with it. Meanwhile, as Lockheed Martin reduces the cost, the government may place larger orders which in turn will boost the company’s profits.



The U.S. government expects to spend approximately $400 billion in the upcoming decades to develop and purchase 2,443 F-35 jets. Again, three F-35s has already been delivered to the UK government for evaluation and testing, and the company has received commitment for up to 138 supersonic fighter jets.



Going forward, Lockheed Martin aims to increase F-35 deliveries to 53 this year, having supplied approximately 180 since the inception of the program. Management also adopted a cost-saving initiative to lower sustainment costs for F-35 by 10% over the next couple of years. This will result in cost savings of $1 billion over a five-year period. We believe that the latest contract will help in the company meet these targets.



Price Movement



Lockheed Martin’s stock has improved about 18.6% in the last one year, underperforming the Zacks categorized Aerospace/Defense industry’s gain of 25.7%. This could be because the earlier cuts have put pressure on the top line although the present defense budget is more in favor of the sector. Budget deficits and political uncertainty make future defense budgets vulnerable to cutbacks.

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