Huntington Ingalls Industries: Certainly Worth A Look At Current Levels

Sep.11.11 | About: Huntington Ingalls (HII)

In March 2011, Northrop Grumman Corporation (NYSE:NOC) completed the spinoff of its shipbuilding business as a new publicly traded company, Huntington Ingalls Industries Inc. (NYSE:HII). Having done all my work on the stock prior to the spinoff date, I was disappointed when HII popped out around the relatively high price of $40. However, recent market declines have not spared HII, which closed on 9/9/11 at $26.73.

In my view, the fundamentals of the business could support a valuation of $50/share, perhaps higher, making HII certainly worth a look at current levels.

Investment Case

There are essentially two things going on that set up HII for significant upward revaluation.

1) A large operational restructuring that the casual observer might not fully appreciate. This restructuring, if successful, could increase HII's operating income by as much as 70% (by increasing operating margins from around 5% to around 9%, on flat revenue, by 2015). (See the recent earnings call for discussion of these performance goals.)

2) Budgetary concerns toward defense stocks in general that will likely turn out to be overblown, especially with respect to shipbuilding in particular. If actual budgetary developments cause those concerns to eventually recede, the stock will respond accordingly.

Basic Stock Characteristics

Just to provide some useful figures, the stock is at $26.73/share, with 49.5 million shares outstanding, for a market cap of $1.3 billion. In addition, the company has about $1.5 billion in net debt, for an enterprise value of $2.8 billion. Their normalized levered free cash flow run rate is currently around $200 million, a number that would go to about $320 million if they succeed in increasing their margins by closing their underperforming shipyard in Louisiana.

Say the stock is worth 8x - 10x free cash flow, if the restructuring succeeds (I'm betting it does), then it should be worth $50 - $65/share. Supposing the status quo doesn't improve ($200mm run rate), the stock should be worth $32 - $40/share.

Not Just Any Old Shipbuilder

Naval shipbuilding in the United States was historically a fairly fragmented industry, but now comes down to six major shipyards owned by two companies: General Dynamics Corporation (NYSE:GD) and Huntington Ingalls Industries.

Between these two companies, HII is distinguished as the owner of the Newport News shipyard, which is the only builder of nuclear-powered aircraft carriers in the country. Are those carriers a low-priority, dispensable, easily substituted component of the U.S. military power? Far from it. The U.S. Navy's 30-Year Plan, released in February 2010, has this to say about these ships (page 13):

Aircraft carriers provide forward presence to protect U.S. vital interests, assure friends and allies, as well as deter and dissuade potential adversaries. These ships are the centerpiece of the Navy’s combat striking power. This plan maintains the required [carrier] force structure to sustain the Navy’s required forward posture and meet surge requirements for war-fighting. To support these operational requirements, a minimum of 10–11 nuclear-powered aircraft carriers are required today. As was the case in the FY 2009 report, the Navy remains committed to supporting this requirement through FY 2040.

These are the sorts of considerations that support statements such as that made by Loren Thompson, a defense analyst at the Lexington Institute, when he calls HII's shipyard at Newport News "the most important naval construction facility in the Western Hemisphere."

These aircraft carriers have a useful life of about 50 years. Their construction cost currently runs around $12 billion a piece. The average age of the fleet is about 25 years. The Navy plans to construct six new carriers over the next 30 years, spending an average of at least $2.5 billion/year (cost increases have always far outpaced inflation). Meanwhile, when these carriers get halfway through their useful life, they are typically "refueled," a process that turns out to cost around $1.5 billion per ship. At the end of their lives, are these nuclear behemoths simply cast out to sea or dispatched with a well-aimed torpedo? The thought of it! Rather, they are decommissioned at a cost of about $650 million.

Besides building aircraft carriers, HII shares the market for nuclear submarines with General Dynamics about 50/50. They also build various amphibious assault ships, Coast Guard cutters, and other vessels.

Revenue Expectations

HII benefits from having essentially a single customer (the U.S. Navy) that happens to plan its purchases long in advance. The result is a high degree of predictability on the revenue line. Based on contracts already in place or contracts that HII is likely to receive based on shipbuilding goals described in the Navy's 30-Year Plan and further analysis by the Congressional Budget Office, HII can be expected to earn $7 billion in annual revenues between now and 2017. This is consistent with company guidance, too. (I'm happy to share the details of my analysis with anyone who requests it.)

The obvious question to ask relates to budget cuts: if the Navy drastically cuts back on its shipbuilding budget, doesn't all of this go out the window? Indeed, perhaps it may. However, I wouldn't count on it without bearing these considerations in mind:

1. Even if it were permissible from a military strength perspective, cutting spending on shipbuilding will turn out to be politically difficult. Shipyards are typically among the largest, if not the largest, industrial employers in the regions in which they operate. HII employs 39,000 people, and is (for example) the third-largest employer in Virginia.

2. The order of magnitude of budget cuts is likely to be small. As we have seen in recent fiscal wrangling in Washington, what counts as "deep" budget cuts these days is to slice $500 billion out of the defense budget over the next ten years, or $50 billion/year. That's approximately a 7% cut. Let's say that that happens. If you're trying to cut $50 billion out of $700 billion, is adequately maintaining our fleet of aircraft carriers likely to be the first thing to go? Or even the second thing? Indeed, when the total shipbuilding budget represents under 3% of total defense spending (i.e. about $20 billion/year), yet contributes significantly to our overall military power, are those line items at any appreciable risk of being cut?

Of course they are. But perhaps a better question is this: At $27/share, are we adequately compensated for assuming that risk? I believe that we are. And, by the way, the moment some new threat emerges (one hopes it doesn't happen), every discussion of cutting defense budgets goes out the window and defense stocks become the thing everyone wants to own.

Operational Restructuring

As mentioned earlier, HII is undergoing an operational restructuring. The change involves closing its underperforming Avondale shipyard (in Louisiana) and consolidating its operations into the Ingalls shipyard in Mississippi. What will this mean? It should not result in a loss of revenues, because orders that would otherwise go to Avondale will be completed in Ingalls. (Low margins in the industry relative to the historical average of ~8%, despite greater consolidation, are evidence that there does remain excess capacity.) The company has indicated that as many as 5,000 Avondale employees will likely be laid off. One hardly wishes to rejoice in such a potential economic calamity for so many working-class families; nevertheless, at an average rate of $24/hour, that amounts to annual savings of about $250 million for the company, or after-tax savings accruing to the bottom line of about $150 million. A $250 million improvement on a $366 million EBIT run-rate is about 70%, corresponding to the company's goal of increasing margins from 5.3% to 9.0%.

I am glad to answer any questions in the comments section. As always, thanks for reading!

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (I'd own it if it weren't for a personal liquidity crisis.)