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A Spinoff from Northrop

A potential investor who has a long term focus (i.e. two to three years) and seeking capital appreciation might want to add Huntington Ingalls (NYSE:HII) to their portfolio. I believe that the company is in the early stages of seeing significant margin improvement which could lead to an increase in the price of the stock of more than 25% based on price to earnings valuation methodology. I expect better net margins will be a driver of earnings, dividends, and share buybacks. The company's seasoned management team and high visibility and stable revenues are unique along with their world class facilities and ships.

HII is the United States premier navel shipbuilder. They have a monopoly as a builder and servicer of the US Navy's aircraft carrier fleet. They also have an oligopoly on building and servicing the US Navy submarine fleet sharing this honor with Electric Boat, a business segment of General Dynamics (NYSE:GD). These businesses have a very high "moat", and therefore a competitive durable advantage. It is very doubtful that competitors could surface given the barriers to entry.

Since the US Navy operates what is the most sophisticated largest navy in the world, HII is an opportunity to invest the best navel manufacturer in the world, and a key link in the defense of this great country. The company employs nearly 38,000 people in Virginia, Mississippi, Louisiana and California. It has two major business segments Newport News and Ingalls. The three major shipyards are currently located in Newport News, Virginia, Pascagoula, Mississippi and Avondale, Louisiana.

Strategic Importance for the US Navy

HII is the sole source for U.S. Navy nuclear-powered aircraft carriers and their refueling services. It is also one of two builders constructing the Virginia Class nuclear-powered submarines, and one of two builders of the Arleigh Burke class of destroyer. It is also the "builder of record" for LPD, LHD and LHA class amphibious assault ships, and the builder of the largest multi-mission U.S.C.G. National Security Cutter. In addition, HII provides comprehensive life-cycle services to U.S. Navy for these product lines.

Background: The Spinoff from Northrop

HII was a spinoff from Northrop Grumman in March of 2011. Northrop distributed 100% of their ownership in HII making them a fully independent company and publicly traded on the New York Stock Exchange. The ratio was 6 shares of NOC equaled 1 share of HII. HII came public with $1.58 billion in net debt. Northrop issued 48.8 million shares with the new HII stock trading at $37.5 gave the company a market capitalization of $1.83 billion. This created a company with an enterprise value of $3.41 billion. With sales of approximately $6.5 billion and adjusted EBITDA for 2010 of $555 million the company had a valuation of 6.14 of EV to EBITDA at the time of the spinoff.

From the time of the road show presentation for the spinoff until now, management has made it their stated goal to improve margins from approximately 5% to 9% plus. While the company has the opportunity to capture new ship building contracts, HII is not a revenue growth story. It is about cost cutting and consolidation. This opportunity is coming from the wind down of the Avondale facility and operating improvements in Ingalls segment. The Newport News segment has shown long term profitability and operating performance. Alternatively, the Ingalls segment has been a struggle and a drag on performance. (Table Source: HII 10K 2012)

Fiscal Year201120102009
Operating Income (Loss) ($ in millions) 
Ingalls(220)(61)(29)
Newport News342355313
Total Segment Operating Income (Loss)122294284
Non-segment factors affecting operating income (loss) 
FAS/CAS Adjustment(13)(49)(88)
Deferred state income taxes1315
Total operating income (loss)110248211

Near Term Margin Catalyst

Management currently intends to wind down its construction activities at the Avondale shipyard in 2013 and consolidate Ingalls construction into the Mississippi facilities. This should help drive or improve margins and is a near term catalyst. The consolidation of Pascagoula will hopefully realize the benefits of serial production, reduce program costs on existing contracts, and make future vessels more affordable by reducing overhead rates, thereby making HII more competitive on future U.S. Navy and U.S. Coast Guard contracts. d

Creating Shareholder Value: Dividends and Buyback

This quarter the company announced its intention to pay a $0.40 dividend per year or $0.10 per quarter or approximately 1%, and they also announced a $150 million stock buyback over the next three years. It could not be more clear that management intends to be model steward of value creation for shareholders by returning cash to shareholders. While these steps may appear modest, it is the right direction.

In an interview with Bloomberg on November 16th and quoted by Bloomberg, the CEO, Peters, said, "We are planning to return cash to shareholders. We're actually doing that sooner than we thought we would." I don't think you can ask a CEO to be more explicit about how he wants to treat shareholders.

Valuation and Target Price

The company has a funded backlog of $12.9 billion. If we assume that the stock can trade 10x earnings (i.e. PE 10) and that management can realize their goal of 8% net margins on revenues of $6 billion (i.e. current run rate $6.5, assuming no growth), I arrive at $480 million in pretax operating income. If we assume 35% tax rate, we are left with $312 million in net income or a market capitalization of $3.12 billion or 10 times net income. If we assume 50 million shares outstanding, I arrive at a target price per share of $62.4 per share. This valuation including margin assumption is approximately equal to the aerospace industry, according to Capital IQ. Moreover, given that the Newport News business segment generated $342 million in operating income, the key will be to turn around the Ingalls operation.

Risks to Consider

Investing HII does have certain risks:

· The company is dependent on a single customer, the U.S. Government, for substantially all its business, and changes affecting this customer's ability to do business with HII could have a material adverse effect on its financial position, results of operations or cash flows.

· Contracts with the U.S. Government are subject to uncertain levels of funding, modification due to changes in customer priorities and potential termination. Such changes could have a material effect on future earnings.

· Contract cost growth on fixed price and other contracts that cannot be justified as an increase in contract value due from customers exposes HII to reduced profitability and to the potential loss of future business.

· HII earnings and margins depend, in part, on its ability to perform under contracts, subcontractor performance and raw materials and component availability and pricing. Its results of operations depend on the award of new contracts.

· The Department of Defense has announced plans for significant changes to its business practices that could have a material effect on its overall procurement process and adversely impact HII current programs and potential new awards.

Summary

Huntington Ingalls is an opportunity to invest in a recession resistant, undervalued defense company that is strategically important to the defense of this nation. They have no direct exposure to Europe's economic problems and are unlikely to be affected by a recession in the Untied States. Earnings are predictable due to the long tail on Navy capital expenditures. Defense spending cuts are unlikely to initially affect US aircraft carrier maintenance and submarines.

The stock price has largely traded sideways since the spinoff in March of 2011 from $37.50 to $40.5; however, management continued to make progress on margins. The re-election of Obama and the potential risk of the "Fiscal Cliff" may have spooked investors. The stock dropped from $44.96 on November 6th to $40.30 on November 16th or a decline of approximately 10%. This correction creates a buying opportunity.

Source: Huntington Ingalls Monopoly Offers 25% Upside