Lockheed Martin's Q1 2024 earnings call was a symphony of optimism, a testament to the robust demand for their 21st-century security solutions. Amidst the usual pronouncements of record backlogs and international contracts, a subtle undercurrent emerged, barely noticeable beneath the waves of positive news: a potential shift in Lockheed Martin's risk appetite.

This shift wasn't announced with fanfare, nor was it explicitly stated. It revealed itself in whispers, tucked away in the detailed discussions of contract structures and the lingering specter of the MFC classified program's losses. Could this signal a more cautious approach from the defense giant, a recalibration of their stance in the delicate dance with their monopsony customer, the US Department of Defense?

The first clue lies in Jim Taiclet's comments on the evolving nature of government contracting. He openly acknowledged the "monopsony environment" where the DoD holds the reins, leading to a history of industry players taking "tremendous risk on cost and pricing" in a desperate bid to secure "must-win" programs. This cutthroat competition has resulted in a familiar litany of cost overruns, schedule delays, and congressional scrutiny.

Taiclet's solution? A firm rejection of the "must-win" mentality. He declared that Lockheed Martin will no longer be lured by the siren song of high-risk contracts, even if it means letting competitors snatch away perceived victories. Instead, they will prioritize "balanced price risk profile" opportunities. This newfound pragmatism suggests a departure from the traditional defense industry playbook, potentially heralding a more disciplined and shareholder-centric approach.

Further evidence can be found in Jay Malave's remarks regarding the increasing prevalence of cost-plus contracts. He noted a rise from 38% in 2022 to 41% in 2023, attributing 20 basis points of margin pressure to this shift. While this might seem counterintuitive, Malave interpreted this as a "favorable trend," indicating a potential softening in the DoD's stance on risk allocation.

Perhaps the most compelling piece of the puzzle lies in the handling of the MFC classified program losses. While the specific nature of the program remains shrouded in secrecy, its financial impact is anything but subtle. Malave stated that the anticipated losses for 2024 amount to 50 basis points of consolidated margin headwind, stemming from the recognition of losses on two production lots.

Intriguingly, despite acknowledging the potential for additional losses exceeding $1 billion, Lockheed Martin refrained from adjusting their full-year guidance. This unwavering confidence could be construed as a deliberate signal of their commitment to absorbing short-term pain for long-term gain.

This long-term view was echoed by Taiclet, who emphasized the program's "long run franchise" potential, assuring investors of "many, many years of orders to follow." This strategic commitment to a program, despite its current financial burden, hints at a more sophisticated risk management approach, one that prioritizes long-term value creation over short-term profitability.

The company's deliberate shift towards a value pricing model further underscores this changing risk appetite. Taiclet envisions a future where Lockheed Martin transitions from merely selling products to delivering comprehensive capabilities, drawing parallels with the subscription-based models prevalent in the commercial tech world.

This transition, however, necessitates a fundamental shift in how the DoD engages with industry. Taiclet called for an "adjacent acquisition process" specifically designed for digital services, enabling value-based pricing and fostering collaboration with commercial tech giants, whose R&D investments dwarf those of traditional defense companies.

The potential implications of this subtle shift are significant. A more risk-averse Lockheed Martin could signal a broader industry trend, prompting a reevaluation of risk premiums and pricing strategies. This could lead to a more balanced and sustainable relationship with the DoD, characterized by realistic program expectations and a greater emphasis on long-term value creation.

It's too early to definitively declare a paradigm shift within the defense industry. However, the whispers emerging from Lockheed Martin's Q1 2024 earnings call suggest a potential sea change, a subtle but significant recalibration of risk appetite. As the defense landscape continues to evolve, these whispers may well turn into a resounding roar, reshaping the contours of government contracting and heralding a new era of collaboration between traditional defense giants and the titans of the commercial tech world.

Hypothesis:

Lockheed Martin is deliberately adopting a more risk-averse approach to government contracting, prioritizing long-term value creation over short-term profitability. This shift is evident in their rejection of the "must-win" mentality, their acceptance of the increasing prevalence of cost-plus contracts, and their unwavering commitment to the MFC classified program despite its current financial burden.

Numbers:

Increase in cost-plus contracts from 38% to 41% of sales in 2023.

Anticipated losses on MFC classified program amount to 50 basis points of consolidated margin headwind in 2024.

Potential for additional losses exceeding $1 billion on MFC classified program, not yet reflected in guidance.

Projected F-35 deliveries between 75 and 110 in 2024, significantly below the 156 production rate.

Projected inventory of 100 to 120 undelivered F-35s at the end of 2024.

F-35 Deliveries vs. Production Rate

The following chart illustrates the disparity between Lockheed Martin's projected F-35 deliveries and the program's production rate, suggesting a strategic decision to prioritize long-term program success over short-term delivery targets.

These numbers, when viewed alongside Taiclet's commentary, suggest a calculated shift in approach. The lower F-35 deliveries and the substantial classified program losses indicate a willingness to absorb short-term challenges to ensure long-term program success and ultimately, a more sustainable business model.

"Fun Fact: The F-35 Lightning II program is the most expensive weapons program in history, with an estimated lifecycle cost of over $1.7 trillion."