What About Huntington Ingalls Industries?

| About: Huntington Ingalls (HII)

Summary

A safe stock with potential to grow and few downside risks.

Huge improvement on capital structure and profitability.

Exceptional market condition.

Recent acquisitions will help revenue to grow in the long run.

Strong cash generation that initiated a large stock repurchase program and a noticeable increase in dividends.

Huntington Ingalls Industries (NYSE:HII) became an independent and publicly-owned company on March 25, 2011, after its spin-off from Northrop Grumman (NYSE:NOC). It benefits from 130 years of experience and is America's largest military shipbuilding company, which has built more than 70% of the world's largest Navy fleet.

Since its IPO, the stock went from $39.25 to $136.94 (or +249%) as of 03/31/2016 and easily outperformed both the market and the Aerospace & Defense industry. The stock is showing a very strong resistance to economic downturn and the market selloff. Indeed, during the huge market selloff of January and February 2016, HII turned positive yoy on 02/10/16 (while it went down by only 4%), while the S&P 500 was down up to 10.5% on the exact same day and turned positive yoy only recently on 03/08/2016.

HII vs Industry vs S&P500 since the IPO (Source: Bloomberg)

HII vs Industry vs S&P500 Yoy as of 03/31/2016 (Source: Bloomberg)

In 2011, Northrop Grumman decided to spin-off its shipbuilding unit. The activity was struggling due to a slowdown in shipbuilding contracts, low margins (compared to the other activities of Northrop like aerospace and electronics), and huge debt. Taking into account that HII started with relatively high debt, weak revenue growth and low earnings, the stock was not attractive at the time.

But the situation has changed since 2011. The company succeeded to improve its margins and reduce its debt. HII will continue to increase its stock repurchase program and its dividends thanks to a strong and improving cash generation. It made some key acquisitions that will help the company to improve its growth in the long run. Its market position within the military shipbuilding market grants the company with very low risks and guaranteed revenues.

INDUSTRY OUTLOOK

Two of the specificities of the Aerospace & Defense industry is the relatively high unit price of completed products that can range from several millions to several billions of USD, and the fact that the most important customers are nothing less than the world's governments willing to expand their military expenditures, and so are not only able but also willing to pay very high amounts to maintain their armed forces. The U.S., with a 2016 $585 billion defense budget, has the world's biggest purchasing power and is the main customer of HII. The other unique advantage is that maturity does not actually exist. Knowing the current geopolitical situation, and history, armed forces are always trying to expand. Even without will to expand, states around the world will constantly need to equip, maintain, modernize, resupply, and inactivate military assets, which corresponds to the biggest proportion of military expenditures. In our current situation, the resurgence of global security threats, and growth in defense budgets of countries like Russia and China will push the U.S. defense budget to increase over the next years even if the next president of the United States of America is from the Democratic party. According to Deloitte, the industry growth is expected to return to 3% for the fiscal year 2016.

Focusing on the warships market, the 2015 U.S. Navy Shipbuilding Plan anticipates a fleet of 306 ships until 2044, comprised of 12 ballistic missile submarines, 11 nuclear-powered aircraft carriers, 48 nuclear-powered attack submarines, 88 large multi-mission surface combatants, 52 small multi-role surface combatants, 33 amphibious landing ships, 29 combat logistics force ships, and 33 support vessels.

DEFENSE BUDGET

A very important driver of the sales of the company is the U.S. defense budget, which is decided by the president and passed by the Congress. Since 2010, the military budget went from $691 billion to $560 billion in 2015, that represents a 19% drop. It is important to notice that even with such a decline, the Aerospace & Defense companies succeeded to maintain steady or slow growth in their activity.

U.S. Defense Budget (Source: Department of Defense)

Given the recent increase in global threat, the defense budget is expected to return to expansion, with a $585 billion budget for fiscal 2016. During the latest earnings call of the company, CEO C. Michael Petters highlighted that the president's fiscal year 2017 budget request marks the beginning of the process for Congress to consider shipbuilding priorities and investment for the next fiscal year, giving de facto a competitive advantage to HII.

According to the 2015 annual report, the latest contracts made with the government include the construction of two nuclear submarines, seven destroyers, two next-generation large-deck amphibious warships, three amphibious transport dock ships, one next generation fleet oiler, three National Security cutters and one new Coast Guard ice breaker over the next five years. Moreover, as HII is America's only aircraft carrier provider, it benefits from a large, complex and very expansive market. In addition to having the exclusivity of the most expansive ship ever, the Congress passed a law in 2012 requiring that there be eleven active aircraft carriers at all times. HII has just delivered the first next-generation Ford-class super-aircraft carriers to the U.S. Navy, and has started the construction of the next one. Huntington Ingalls Industries will build one aircraft carrier every five years until all of the eleven aircraft carriers have been completed. The unit cost is estimated to be around $13 billion guaranteeing at least $130 billion in product sales over the next fifty years, which would represent around $2.6 billion per year or 45% of the current product sales. In addition to being in charge of the complete renewal of the U.S. Navy aircraft carriers fleet, HII is in charge of the refueling of seven aircraft carriers between 2014 and 2042. The company will also inactivate four fifty-year-old aircraft carriers starting in 2020 and ending in 2042.

PRODUCT PORTFOLIO

Huntington Ingalls Industries is divided into two divisions that represent its core activity of designing, manufacturing, repairing, overhauling, refueling, and inactivating Navy ships, and into several subsidiaries specialized in different key areas.

Ingalls Shipbuilding, located in Pascagoula, Mississippi, is engaged in the development and production of technologically advanced and highly capable warships for the Navy, the U.S. Marine Corps, the U.S. Coast Guard, and foreign and commercial customers. It is the largest employer in Mississippi with 11,000 employees and is a major driver to the economic growth of the state.

Newport News Shipbuilding, located in Newport News, Virginia, is the sole designer, builder, and refueler of the U.S. Navy nuclear aircraft carriers and one of the two providers of U.S. Navy submarines. It is the largest employer in Virginia with 20,000 employees and the largest shipyards of the United States.

HII is currently operating six subsidiaries. AMSEC is a full-service supplier to the Navy and commercial maritime industry, providing naval architecture, engineering, ship systems assessments, maintenance engineering, waterfront support and acquisition program support. Continental Maritime of San Diego is a certified Master Ship Repair Contractor for the U.S. Navy. Undersea Solutions Group develops and manufactures specialized manned and unmanned undersea vehicles for military customers. Newport News Industrial provides construction, equipment repair, technical services and innovative products to the energy and petrochemical industries, the U.S. Department of Defense and Energy clients, and NASA. Stoller Newport News Nuclear is a full-service nuclear operations and environmental services company with the U.S. Department of Defense and Energy as principal customers. UniversalPegasus International provides world class expertise, efficiency and value in project management, engineering and construction management for the oil & gas industry.

FINANCIALS

Since the spin-off, the financial condition of HII remarkably improved thanks to efficient managers who put the priority of the company on improving the capital structure, operating margin, and cash generation. Between 2011 and 2015, the D/E ratio went from 0.72 to 0.11, which is well below the 0.22 industry average. The profit margin of the shipbuilding unit of NOC was within the 3% to 5% range. In 2014, after only three years, HII achieved the minimum 9% operating margin and reached 11% in 2015 (versus 11.4% for the industry) and the profit margin reached 6.1%. The gross profit went from 15% in 2011 to 21.41% in 2015 with a 20.60% industry average. Given the fact that HII's activity is supposed to be less profitable than other activities within the industry, it is quite exceptional it succeeded in only four years to reach a better gross margin and a slightly lower operating margin than the industry. Furthermore, 90% of the negotiated contracts with the U.S. government are Fixed Price Incentive or FPI that give the obligation to the Department of Defense to cover any excess incurred costs up to a ceiling price typically 125-135% of the target price.

The ROIC soared to 15.1% in 2015, so slightly better than the industry, even if its 7.5% NOPAT margin is slightly lower than the industry, and a higher cost of capital. This confirms a better revenue-to-invested capital (2.01 vs. industry of 1.83). Plus, as the capital structure greatly improved with relatively low debt, the cost on new debt is likely to decrease, which will reduce the cost of capital to further improve its ROIC. In other words, HII will be able to widen the positive gap of value creation over competitors the company initiated in recent years.

Gross Profit, Operating Income and Net Income since 2011 (Source: Bloomberg)

During Q4 2015, the company was able to pay off $40 million of ten-year notes, which is going to significantly reduce interest expense and hence increase the profit margin. Even with $1.8 billion in debt when the company went public, thanks to strong cash inflows and no capital expansion, the company was able to reduce its debt by more than 30% over only four years. The equity portion of the balance sheet is getting more and more weight even if the treasury stocks keep growing thanks to the $600 million stock repurchase program (or 10% of the market capitalization).

Total Assets, NPPE, LT Debt, Retained Earnings, and Treasury Stock since 2011 (Source: Bloomberg)

The company is committed to performance improvement. As HII is gaining experience on every brand new ship completion, the company is able to reduce costs and labor, improve workers' and engineers' efficiency, with substantially fewer man-hours required to complete warships. Furthermore, the company has closed one of its shipyards that is being consolidated to Ingalls Shipbuilding. This operation reduced overall costs by increasing efficiency at Ingalls Shipbuilding and addressed the overcapacity issue. The company is currently in talks for the sale of the now closed shipyard.

COMPETITORS

When compared to the main competitor, General Dynamics (NYSE:GD), and its former parent company, Northrop Grumman, we can see HII is doing pretty well, especially when taking into account the fact that both companies are very well diversified.

On the profitability aspect over four years, the gross profit and the EBIT margin improved much better than both competitors, even reaching a better gross profit than General Dynamics. The EBIT margin went from 1.5% in 2011 to 11.1% in 2015, which is quite close to the two more profitable companies whose EBIT increased at a very slow pace. The operating margin of General Dynamics, which is the most comparable competitor, is 2.0% higher, which gives HII some potential to continue its profitability improvement, especially on the Selling, General & Administrative expenses. We can notice that HII had to record a $75 million impairment on goodwill loss in 2015. This loss was the result of the recent drop in oil prices that negatively impacted the fair value of the recent oil & gas company acquisition in the beginning of 2014. The profit margin without the loss would have been 6.8%, which will be one of the items where the company will improve its profit margin.

Gross margin and Profit margin vs competitors (GD and NOC) (Source: Bloomberg)

On the financial leverage aspect, it is the same story. While HII managed to decrease its debt by 30% over four years, the long-term debt of General Dynamics decreased by 13.5%, and Northrop Grumman's increased by 62.5% given that fact that the total assets of General Dynamics decreased by 8%, and Northrop Grumman's decreased by 4% since 2011.

Competitors Comparison

RECENT ACQUISITIONS

In 2014, HII acquired UniversalPegasus International and Stoller Newport News Nuclear to expand in the nuclear energy and oil & gas markets. Those acquisitions were the result of the company's strategy to use its engineering and energy related expertise to expand its position in the energy marketplace. Even if currently the oil & gas industry is in crisis and companies cannot afford to lose money on engineering, project, or construction management services, these acquisitions can create a great opportunity of growth to a company that is facing limited growth potential. Since 2011, the service revenue grew each year, which is not the case for the product revenue. Service revenue went up by 22% the year of the acquisitions and grew by 9% between 2014 and 2015, representing more and more weight of the total revenue. With an oil & gas industry that is globally expanding, especially with new technologies and new fracking methods, and with current extremely low prices, the future can only be brighter.

Revenue Growth since 2011 (Source: Bloomberg)

Service and Product Revenue since 2011 (Source: Bloomberg)

RECOMMENDATION

Given its exceptional market position, HII will have large and guaranteed revenues for several tens of years by the world's safest and largest customer. The company already achieved considerable improvement in profitability and leverage, which made its margins in line with the industry even if its activity is supposed to be less profitable than the other Aerospace & Defense activities. The company will continue its strategy of performance improvement, cost reduction, consolidation of operations and disposal of overcapacity. The strong and sustainable cash generation incited the company to continue its constant dividend increase. Since 2012, the company is constantly increasing its stock repurchase program, giving investors strong confidence in the future of the company. In order to address the slow revenue growth, the company is using its expertise in the energy sector to expand into the nuclear energy and oil & gas markets. Such acquisitions and expansion can bring more growth to the company in the long run and can also increase its profitability. The stock is one of the least risky currently available on the market, but is still able to bring capital gain in line or superior to the market and the industry. That is making the stock a perfect fit to any portfolio looking for stocks that are able to decrease risks. Indeed, even if HII's stock may not be able to bring huge returns, it will bring a relatively good amount of safe returns. Given its activity, the company will not be impacted by economic downturn or even recession. Of course, it will still be impacted by change in fiscal and monetary policies, as well as the stock market. The only firm-specific event able to turn the price down (most contracts are granted to HII by default) are bad earnings, which will only have a temporary effect and may create buying opportunities.

Given all of these reasons, I reckon HII is the perfect addition to very efficient Aerospace & Defense stocks with huge potential like Lockheed Martin (NYSE:LMT), Boeing (NYSE:BA), Honeywell (NYSE:HON), General Dynamics, Raytheon, (NYSE:RTN), Northrop Grumman, and Orbital ATK (NYSE:OA).

HII Proforma

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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