UFOs Put Lockheed Martin In Spotlight, Overshadowing RTX's Navy Contracts

Investment Thesis

For years, the saucer-like silhouette has floated through popular culture into movies, books, and whispered accounts on news tabloids. Often dismissed as the products of overactive imaginations or Hollywood fiction, these iconic shapes have now resurfaced in a most unexpected place: declassified military surveillance footage, offering undeniable visuals of the very saucer-like shapes that have been the subject of both ridicule and wonder. Now, the lines between science fiction and reality seem more blurred than ever.

In Washington, there is a growing consensus on the need for transparency concerning the Department of Defence's 'DoD' handling of UFO incidents. The culture of dismissing or ridiculing such sightings has begun to shift. Policymakers and military personnel are now being urged to come forward with their accounts without fear of retribution or ridicule. There's a tangible effort to reverse decades of secrecy and stigma surrounding UFO sightings and encounters.

Along with the change in perception, there's also a potential economic transformation brewing. As the DoD commits to deeper research, the defense industry could be on the brink of unlocking vast economic potential. If these UFOs are cutting-edge technology from an adversary nation, we are looking at the dawn of next-generation propulsion engines, missiles, energy generation, and material technologies. On the flip side, if these sightings are mere atmospheric quirks or radar hiccups, it underscores the urgency to bolster military detection technologies. Either way, with the DoD poised for greater transparency and a public hungry for answers, we might just see an investment boom driven by the quest to seek answers. This opportunity coincides with a sharp decline in RTX Corporation's (RTX) and Lockheed Martin's (NYSE:LMT) shares this year, opening an attractive entry point to investors. While both companies face their unique challenges, Lockheed stands out as a more favorable investment pick.

SpaceX, Virgin Galactic, and Blue Origin

On the surface, commercial space exploration companies, such as SpaceX, Blue Origin, and Virgin Galactic (SPCE), appear to be appealing prospects to capitalize on the heightened interest in UFOs. They have tangible assets and infrastructure for space missions, which could be repurposed or expanded to embark on the exciting mission of looking for extra-terrestrial life in space.

As captivating as the notion of extra-terrestrial life might be, it's crucial to ground our expectations in reality. Investments and budget allocations will likely prioritize enhancing Earth's airspace surveillance over distant space expeditions. The central narrative around UFOs leans heavily on addressing national security implications, especially to US military forces sharing space with UAPs, rather than pure scientific exploration. Thus, the immediate economic focus will probably center around securing US skies, not what lies beyond. This narrows the investment scope to Aerospace and Defense contractors with a strong radar portfolio and ties to the Pentagon.

In any case, for those keen on tapping into the commercial space exploration market, there are avenues to use. SpaceX, the sector's frontrunner, remains privately held. Still, one can gain indirect exposure through Google (GOOG) (GOOGL), which holds an interest in SpaceX along with Fidelity. Blue Origin is also private, but investors might be able to acquire its shares (and SpaceX's, for that matter) through private equity brokerage platforms like ForgeGlobal and EquityZen. Virgin Galactic, the least favorable of the bunch, offers the most straightforward access route, being publicly traded and readily accessible for investment.

Best Ties to the US Navy

Starting in 2019, the Navy introduced a standardized mechanism for reporting Unidentified Aerial Phenomena, 'UAP,' a term now favored by military professionals. Given the Navy's operations in vast, open oceans with unobstructed views of the sky, the Navy is well-placed to lead UAP understanding. Additionally, their location in international waters also offers more freedom of movement and surveillance than land, which is limited by terrestrial obstacles (mountains, hills, skyscrapers), national boundaries, and international laws restricting surveillance.

The majority of the pictures circulating on news media are from the Navy forces and seem to be sourced from infrared or electro-optical sensors, the latter known for producing some of the clearest UFO images. The Director of National Security notes that 80 out of the 144 UAPs were captured by multiple radar systems and sensors. Video footage from at least one instance seems to have been captured by a pilot using a phone camera. Moreover, according to the DoD report, UAPs show characteristics of metal objects.

Most of the UAP reported probably do represent physical objects given that a majority of UAP were registered across multiple sensors, to include radar, infrared, electro-optical, weapon seekers, and visual observation. Office of the Director of National Intelligence - June 2021

These dynamics underscore the need to upgrade the US military's surveillance technologies.

The Catalyst

Looking at the footage and reflecting on questions from Congress, several conclusions can be made on the UAP's potential economic opportunity. First, the existing US military surveillance technology seems tailored to address the known capabilities of adversary nations. However, with the current investigation into UAPs, there's a growing realization of potential vulnerabilities in existing surveillance and counter-offensive technologies.

These revelations could catalyze a surge of investments, in the same way that the advent of hypersonic technology by China and Russia - the introduction of which took the Pentagon off guard - sent the military establishment scrambling for solutions to maintain the balance of power. RTX emerged as a winner in the hypersonic cruise missile arms race as the largest missile manufacturer in the US, with a $1 billion contract to develop hypersonic missiles awarded last September, setting it apart from Lockheed Martin, whose Hypersonic missile program was dropped by the DoD last March after failed testing.

Following RTX's success with hypersonic missile contracts, one can imagine contracts dedicated to UAP defense and surveillance, given the shared characteristics of speed and unpredictability between hypersonic missiles and UAPs. On the other hand, the ongoing investigation might end up leading to more reliance on satellite surveillance tech, where Lockheed has a more pronounced history and reputation, giving them an edge in this realm. Lockheed is the primary contractor for the Military's Space-Based Infrared System 'SBIRS', an advanced missile detection tech. The system uses geosynchronous satellites that remain stationary relative to a specific point on Earth, ensuring consistent coverage. I think SBIRS can be repurposed to provide a cost-effective approach to observing UAP activities over extensive areas while ensuring compliance with international surveillance regulations. To make things more complicated, one can also imagine a Lockheed-made stationary satellite with RTX sensors and radars, which brings us to the next point.

Who Has the Edge in Surveillance Technology?

The Defense and Aerospace market has consolidated in recent years. Raytheon merged with United Technologies in 2019, Northrop Grumman (NOC) acquired Orbital in 2018 and L3 Technologies acquired Harris Corp, forming L3Harris (LHX) in 2018, which then acquired Aerojet Rocketdyne last year. Smaller companies are also merging, following suit with larger firms in complementing their portfolios through horizontal expansion. One such example is Parker-Hannifin's (PH) acquisition of Meggitt in 2021.

When assessing the market dynamics of the surveillance sector, it's evident that no single company has a monopolistic hold over the entirety of naval radar systems. The Navy deploys a diverse range of assets, ranging from F-35, F-18s, Arleigh Burke destroyers to Ticonderoga cruisers. Each of these assets is equipped with a primary radar system from various suppliers. Furthermore, the Navy often switches between suppliers during radar system upgrades, adding to the sector's complexity.

Focusing on key contracts between RTX and Lockheed reveals intriguing dynamics. Historically, Lockheed held significant sway in the naval vessels' radar systems, primarily through its Aegis Combat System, which prominently features in the Navy's most influential vessels class: the 72 Arleigh Burke-class destroyers and 22 Ticonderoga-class cruisers.

Central to Lockheed's Aegis system is the SPY-1 radar. But in 2014, the tables began to turn. The Navy awarded the SPY-6 contract to RTX, marking a major change from SPY-1 to SPY-6 for the Navy's new vessel models, including the Flight III/IIA destroyers and the Constellation frigate. Lockheed disputed the award, highlighting the contract's significance and the fierce competition in the industry.

From my understanding, the SPY-6 radar is presently deployed on a limited number of Navy ships. As is typical with military contracts, the replacement process is gradual. The first Flight III destroyer sailed on a trial voyage last December. The Constellation-class frigate is still under development. We can expect to see an uptick in RTX's Intelligence & Space segment revenue in the coming quarters as the Navy gradually rolls in its next-generation vessels. Initially, the contract value for the SPY-6 stood at $1 billion. However, since then, RTX has benefited from several subcontracts related to the 2014 award, including $3.5 billion for new-class Flight IIA destroyers, awarded in 2022, and a $619 million contract for the same asset, awarded in March 2023.

The installation of SPY-6 in the coming years consolidates RTX's grip over the Navy's ships radar segment, given that RTX is also the manufacturer of the AN/SPS-49 and its older cousin, the SPS-48, which is found on the 11 Aircraft Carriers and 23 Amphibious assault ships.

F-18 Hornets/Super Hornets: RTX's APG-79 radars are used on the F18 Hornets and Super Hornets, the largest airborne fleet in the Navy, with a staggering fleet of 566 fighter jets. For now, the F18 is critical to the Navy's operations, and Boeing (BA) continues to receive contracts to supply the jets.

However, RTX's market position in the F-18 Super Hornet market is threatened. Boeing has signaled its intent to stop making the fighter jets by 2025, or in 2027 at the latest, if an international buyer decides to make an order. While there's potential for Boeing to retain RTX for radar supply, a change in supplier remains a real possibility.

Yet, the sheer volume of the F-18 fleet presents a vast economic prospect for the entire defense sector as the military commences its transition and upgrade process to next-generation fighter jets. Even if Boeing shifts away from RTX, the intricate web of the defense supply chain (as explained in more detail below) suggests that RTX could still gain from this large-scale fleet revitalization.

Lockheed's Niche in the Navy Radars Market

With RTX's SPY-6 radar widely integrated into the majority of Naval ships and their APG-79 prominently featured in the Navy's largest airborne fleet, one can mistakenly declare it as a winner in the surveillance space. While RTX's dominance might seem clear, Lockheed's prowess can't be overlooked. The above analysis focuses on airspace surveillance in one branch of the US military. Lockheed, for example, has recently won a $3.25 billion contract to supply the US Army with a tactical counterfire radar system, the TPQ-53. For naval vessels, Lockheed recently developed SPY-7 radar, which, while not widely used, has gained acceptance with the Japanese Navy.

Lockheed's radars are also used in the Navy's 97 Hawkeye jets. The Hawkeye is a surveillance aircraft known for its capability to detect airborne objects from great distances. Northrop, responsible for Hawkeye's design and its early radars, like the APS-96, 120, 139, and 145, made a notable change in 2019 when they subcontracted Lockheed to equip the Hawkeye with the APY-9 radars, replacing their own APS-145. Intriguingly, Lockheed's F-35 is equipped with Northrop Grumman's APG-81 radar.

Market Position

Both Lockheed and RTX shares have seen a decline this year. Although they trod similar paths, particularly before RTX's share drop last week, each company is navigating unique challenges.

Over the years, Lockheed and RTX's trajectories have diverged. RTX ventured into the commercial aerospace market following its 2020 acquisition of United Technologies, introducing it to the commercial jet engine manufacturing realm through Pratt and Whitney. Meanwhile, Lockheed has largely remained a dedicated defense contractor, with only a few commercial ventures.

For investors, RTX's exposure to the commercial sector translates to potential revenue boosts during economic highs and potential declines during lows. In contrast, military contracts, like those of Lockheed, are typically marked by stability. It's worth noting that almost half of RTX's sales in the first half of 2023 were commercial.

Currently, the commercial aerospace sector is experiencing a boom, with airlines placing record orders in response to the robust resilience of air traffic despite economic disruptions. The number of passengers traveling through US airports has returned to pre-pandemic levels (mind the seasonality)

Pratt and Whitney stands out favorably due to its strong footing in the narrow-body commercial jet market, which has seen rapid recovery post-pandemic. Its strong ties with Airbus through its A320Neo engine program give it a competitive edge compared to engine suppliers with higher exposure to Boeing, which continues to grapple with challenges ranging from safety concerns to supply chain disruptions. If you ask me, I believe this is a lost decade for Boeing, but that's a story for another time.

Additionally, beyond Navy radars, the two companies have different portfolios and exposure to the DoD budget. Lockheed is known for supplying comprehensive platforms such as Blackhawk helicopters and F-35 fighter jets, while RTX is known for supplying systems such as Radars and Standard and Guided missiles (Tomahawk missiles sell for $2 million per unit), but also missile systems such as the Patriot (shown below carried on what appears an Oshkosh (OSK) tactical vehicle).

The collaborative dynamics between RTX and Lockheed are notable, reflecting the consolidation within the defense industry. They often partner on projects or serve as suppliers to each other. For instance, RTX provides the AN/TPY-2 radar for the internationally-popular Lockheed-produced THAAD missile system. RTX also manufactures the engine for Lockheed's flagship F-35 aircraft. The two companies also collaborate directly on critical projects, such as the Javelin missile system, which has played a crucial role in Ukraine.

Despite these positive trends, the stock prices of RTX and LMT haven't reflected these benefits. RTX has been impacted by product recalls. Specifically, hundreds of jet engines made by Pratt & Whitney were recalled due to metal contamination. This recall will cost RTX billions in the coming years as it compensates airlines for maintenance and engine replacements. Lockheed is grappling with supply chain disruptions. Last week, the company trimmed its revenue forecast, citing delays from its supplier, L3Harris. The F-35 is also facing software problems, which will decrease the number of deliveries this year.

Dividend and Valuation

Lockheed's challenges with the supply chain and concerns over its F-35 deliveries are shared industry concerns. This is not to downplay their importance, but while both RTX and Lockheed (and the entire Aerospace market) grapple with the supply chain issues, RTX faces an additional burden regarding the anticipated $7.5 billion expenses associated with its GTF engine malfunctions. One might ask, in a world where a client's annual budget is $850 billion, how impactful is the official $7.5 billion cost estimate on RTX? The answer is a lot. Specifically, it is 18 months of operating cash flows.

The more serious issue is that, given the three-year plan to address these GTF engine issues, there's considerable uncertainty regarding the final bill, and it's conceivable that RTX will ultimately bear costs exceeding the current $7.5 billion projection. If, say, inflation rates increase, spare parts become less available, or more issues are found in the engine or other engines using the same tech, then the price tag RTX will have to spend will increase. This leaves the share price vulnerable to preliminary estimates that can change.

Despite these risks, when comparing the valuation, RTX doesn't seem to offer a meaningful discount compared to Lockheed.

Overall, beyond the strategic wins of RTX over Lockheed, such as in the Hypersonic Cruise Missile and Naval Radar arenas, Lockheed enjoys a more favorable market position, as mirrored in its higher book-to-bill ratio of +1 compared to 0.85 for RTX, supported by the success of its F-35 program.

Summary

RTX secured pivotal wins in recent years, particularly in areas like Navy surveillance and Hypersonic Cruise Missile and Defense systems, often outpacing Lockheed in the race. Still, one should be careful when drawing broad conclusions. While RTX's contract wins mentioned in this article are impressive and important, they only represent a fraction of the vast strategic initiatives of the US military. Lockheed still plays a critical role with popular programs such as the F-35, Black Hawk, THAAD, and Patriot 3 missile systems. Moreover, RTX faces significant headwinds with the costly recall of its Pratt and Whitney engines. Investors tempted to buy the dip should tread with caution, given the uncertainty regarding the cost estimates related to the recall program, which is expected to extend through 2026. Factors such as inflation, parts shortages, or potential discovery of issues in engines using the same tech or materials can escalate the cost estimates. Such unexpected escalations could severely undermine the stock value.