Huntington Ingalls: Not A "BUY" Now Either
Summary
- Since I wrote my last neutral article on the company, Huntington Ingalls has outperformed the market and appreciated significantly.
- However, while this outperformance may be justified in the longer term, the short- and medium-term look much more uncertain.
- I believe it is best to be cautious about this stock at this particular time, and continue to wait for a better entry prior to purchasing.
- Huntington Ingalls, despite excellent results, is a "HOLD" here.
I first wrote about Huntington Ingalls Industries (NYSE:HII) back in February, and the company has since that article actually outperformed the market by a bit of a margin. I have a sizeable portfolio slice in HII, but I'm not looking to buy more at this particular time. I'm all about the valuation of the things I invest in, and when looking at this particular company, I don't see a valuation that I particularly like.
However, we need to look at the company's results in context, of course. In this article, that's what we'll do. Give an overview of the latest results, put them in context with valuation and expectations, and construct a continued thesis for the company using this as a base. Let's get going.
(Source: Huntington Ingalls)
Huntington Ingalls - How has the company been doing?
Since my last article, we have FY20 numbers. I expected the company to provide excellent results, and I also pointed to the company's now-massive backlog as a reason for potentially investing in the business, but the results really go to show how good this actually was and is going to be going forward.
(Source: Huntington Ingalls Industries)
With a backlog nearly twice the size of 3 years ago, and a continued revenue growth, it's no wonder from some respects that the company keeps delivering and growing. HII was also awarded a $2.2B construction contract during 2020 for six module sections for the first two Columbia-Class submarines. The John F Kennedy - known as CVN 79 - is around 78% complete during the year, and the company also delivered underwater unmanned vehicles to the German navy, showcasing some of its international profile.
On a quarterly basis, despite the pandemic, margins, revenues, and incomes were up YoY. The same is true on a full-year YoY basis, meaning as far as HII is concerned, you really can't tell that there was a pandemic based strictly from looking at their result numbers.
The revenue improvements came from growth from all the company's divisions, as well as favorable adjustments, and the company continued to deploy capital in share repurchases and dividends, coming from the nearly $757M FCF for the full year. Over $252M was distributed during the year, with no repurchases during 4Q20, but beginning them again in 1Q20.
On a segment-by-segment basis, results were especially impressive in the company's shipbuilding segment (Newport), which had growth in the carrier, submarine, and fleet support divisions, but no portion of the company really performed poorly in any way.
The company's financial outlook is positive. HII expects an FY20-24 cumulative FCF of $3B, delivering consistent top-line growth combined with margin expansion in core areas. Shipbuilding is set to deliver a 3% revenue CAGR, and CapEx is forecast to decline to 3.5% of sales in FY21, with 2.5% of sales in FY22 and beyond. The company's pension impacts will be insignificant during 2022-2024 without much impact on the company.
The company has multiple milestones upcoming...
(Source: Huntington Ingalls Industries)
... which should continue to deliver impressive company results over the next few years.
The company delivered a fantastic 2020, and from that view, it's not a surprise that valuation is moving in a direction we're seeing here. However, the scope of this improvement caught me by surprise - as the call I gave in February for this company has clearly been the wrong one in terms of market outperformance. The right call in February would have been to "BUY" Huntington Ingalls, with a Bullish stance on the company.
So, the question that we need to ask ourselves becomes - has this changed in any way? Is the company now worth buying? To really find that out, we need to look at the company valuation and expectations/forecasts.
Huntington Ingalls - What is the valuation?
Unfortunately, clarity and valuation for the company haven't really improved all that much since my last article. Despite top-line growth and impressive results, the 2-3 year upside at this valuation is barely above 10% annually. You may invest in this, and returns are certainly acceptable, but I still argue that some of the fundamentals and the potential downside, especially during 2021, where the company is expecting EPS to drop, could deliver returns that you're not looking for.
(Source: Huntington Ingalls)
At current valuations, HII trades at around 13.7 average weighted P/E - which sounds low, but the thing to take into consideration is that this includes the incredibly impressive 2020 results, which aren't necessarily representative for 2021. On a 2021E P/E basis, HII trades at valuations of nearly 17.5 based on 13 analyst forecasts from FactSet (Source: FactSet).
The company continues to carry its sub-par BBB- credit rating. While I agree that the likelihood of a downgrade is practically zero here, it's something to take into consideration. The company also has a nearly 25% 10%-MoE adjusted forecast ratio, meaning the rate of uncertainty for the analysts isn't exactly "low" here.
So, based on these things we have a split picture.
The company could deliver acceptable and even impressive overall returns until 2023...
(Source: F.A.S.T. Graphs)
30% in 3 years isn't bad at all, and it could be enough for you when delivered from this company. However, the flip side is the 2021-2022 risk, which at the company's historical P/E carries a risk of either zero growth rate until 2022 or negative 20% growth at 2021E numbers. I'm not saying that the company will revert to such valuations, I'm saying that it's a risk.
Given the company's proclivity for share repurchases, it's not unlikely that this will serve to support the valuation. The company may also be on the lookout to scoop up their own shares on the cheap if they should fall.
In the end, you can't ever call a company like HII, one of the world's foremost shipbuilders, a "bad" company or investment. We're talking about a business with governments as its customers and a backlog of over $60B, which is essentially "guaranteed" income. It's not a bad business, and anyone calling it this should take a second look.
What we can do is try to put ourselves in positions for outperformance both over the short and medium timeframe, with as little risk as humanly possible. I favored peers to the company such as Lockheed Martin (LMT), General Dynamics (GD), Northrop-Grumman (NOC), and others above this company. All of these investments, which are sizeable stakes of around 8% of my portfolio altogether, have outperformed the market significantly. So, however, has Huntington Ingalls, in a timeframe where I did not necessarily expect it to do so.
So as to the question if there is upside to the company, there most certainly is upside to this company. However, this upside is based on the very long-term timeframe, looking to the future. If you're okay with this, and you're okay with investing in a company at what is essentially overvaluation to 2021-2022 results (though more fair value to 2022), then you could buy Huntington Ingalls.
However, if you're more risk-conservative, such as myself, you want to take a second look at the company. Because despite being a solid business, Huntington Ingalls has a history of volatile pricing not entirely shared by its peers - at least not to the same degree.
(Source: F.A.S.T. Graphs)
I believe that the company's results will continue to trend up and down as they have historically done, as its valuation. The company may climb to current averages in terms of P/E of up to 19.5X, which would deliver a massive upside from today's valuation, but we've also seen in the past that the company could just as well drop back down when the earnings hits for 2021 are delivered in the quarterlies.
The opportunity in defense majors has thinned considerably over the past few months. I have been banging on about most of them for near-on a year at this point. Frankly, if you're just warming up to them now, you're a bit late to the party, because most of the better and bigger ones have lost the best portions of their opportunities at this point. LMT is now fairly valued, GD is actually well above fair value, NOC is touching fair valuations, and Raytheon (RTX) has even more intra-year uncertainty than does Huntington Ingalls.
There is still safety here, I will argue - but the opportunity has thinned out.
Analyst targets are as follows:
(Source: S&P Global, Google Sheets)
You should be careful when normally exuberant analysts are telling you that a company is overvalued even to their targets - but my articles have been an establishment of the trend that analysts either tend to overshoot or undershoot actual valuations in the short or medium term. However, in this particular case, I believe the analysts to be correct in terms of overall valuations.
At this point, I would argue that Huntington Ingalls is little more than fairly valued for a 3-year average forecast, and I wouldn't necessarily fill up at this valuation. The upside is there, but you could also end up with poor returns over the next 2 years, and at a relatively meager yield of 2.15% (my YoC is closer to 2.7%), you might be doing yourself a disservice.
I also don't consider any other form of investing in HII here to be practical. I don't want to sell my HII shares on the basis of current trends, but I also wouldn't write any sort of puts here, nor would I invest in the common shares at this particular valuation, unless I'm strictly looking at the longer term.
Thesis
The reason I'm not only looking at the longer term is that there are investments available that offer not only long-term upsides, but short-to medium-term upsides as well. Companies that, despite market exuberance, still have an appealing overall undervaluation available to them. These are of course superior to any investment, risks being equal or close, that lacks such an upside.
Because of this, I don't view Huntington Ingalls as a comparably appealing investment at this point.
My five points for investing are:
- This company is overall qualitative.
- This company is fundamentally safe/conservative & well-run.
- This company pays a well-covered dividend.
- This company is currently cheap.
- This company has realistic upside based on earnings growth or multiple expansion/reversion.
Huntington Ingalls checks all boxes, and you could argue that from a long-term earnings point of view, the company isn't actually expensive - nor is it from the perspective of 2020 earnings. You wouldn't be wrong, and the upside, as I've pointed out, is actually within the realm of what I would consider appealing.
However, you need to understand the risks you're taking when investing in a company that has a projected EPS drop-off for the next 2 years. Whenever I have done so, those two years have resulted in sub-par returns.
Because of this, I don't consider HII fulfilling #4 at this point, and while you could invest here, I consider HII to be a "HOLD" here. Targeting a price here is hard given the company's ups and downs, but I would buy HII at around $210/share or below. It's not that it's grossly overvalued here, it's that there are risks to the investment.
Let me know if you have questions or comments on this, and I'll be happy to field them.
Thank you for reading.
This article was written by
Wolf Report is a senior analyst and private portfolio manager with over 10 years generating value ideas in European and North American markets.
He is a contributing author for the investing group iREIT on Alpha where in addition to the U.S. market, he covers the markets of Scandinavia, Germany, France, UK, Italy, Spain, Portugal and Eastern Europe in search of reasonably valued stock ideas. Learn more.Analyst’s Disclosure: I am/we are long HII, NOC, RTX, GD, LMT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
While this article may sound like financial advice, please observe that the author is not a CFA or in any way licensed to give financial advice. It may be structured as such, but it is not financial advice. Investors are required and expected to do their own due diligence and research prior to any investment. Short-term trading, options trading/investment and futures trading are potentially extremely risky investment styles. They generally are not appropriate for someone with limited capital, limited investment experience, or a lack of understanding for the necessary risk tolerance involved.
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Comments (15)
Your analysis would be appreciated.
Regards, Simon
It really is depressing,even more so with people actually happy about these silly valuations "yay line go up" ... sigh. Literally the only place in the world where people are happy about things getting more expensive.
