Huntington Ingalls: Defense Stock For Moat Seekers

seekingalpha04-18

Huntington Ingalls Industries is the only company in the US that builds and maintains aircraft carriers, and one of two companies that design and build nuclear-powered submarines.The blue-water navy ...

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Aircraft carriers and nuclear-powered submarines are its core.HII keeps solid financials, with 66% total debt to equity and 63.5% total liabilities/total assets. In FY23, the company delivered 7.3% revenue YoY growth and 17.6% net income YoY growth.The company's backlog, net of total liabilities, is $41 billion, or about x4 of its market cap of $10.9 billion. I give HII stock a buy rating.   Stocktrek/DigitalVision via Getty Images Thesis The Navy is the cornerstone of US foreign policy. Its ability to project power across the globe ensures the US's position as a leading world power. The aircraft carriers and nuclear-powered submarines make the US domination over the oceans possible. Only one company in the US builds and maintains aircraft carriers, and only two companies design and build nuclear-powered submarines. Huntington Ingalls (NYSE:HII) and General Dynamics (GD) are the enterprises in question. Today’s article is dedicated to HII. The company has a $48.1 billion backlog, 66% total debt/equity, and pays secure dividends. In 2023, HII delivered strong results: 7.3% revenue growth and 38.2% operating income growth. Compared to its rival GD, it trades at lower multiples. I review HII operations and finances in today's article and discuss its valuation and risks. Operations HII operates three divisions: Ingalls Shipbuilding, Newport News Shipbuilding, and Mission Technologies. Newport accounts for 53% of the company's revenue and 56% of the backlog. Newport designs, builds and maintains US Navy aircraft carriers. In a partnership with Electric Boat (General Dynamic's Marine Systems subsidiary), HII designs, builds, and maintains nuclear-powered submarines. Ingalls builds surface combatants and amphibious assault ships. It contributes 24% of the company's revenue and 33% of the backlog. The third division, Mission Technologies, brings 23% of the revenue and 11% of the backlog. The trilateral security alliance AUKUS (Australia, United Kingdom, and the US) is a strong driver behind the growing demand for submarines. Its two pillars are nuclear-powered submarines (pillar 1) and cyber technology (pillar 2). Pillar 1 brings a $250 billion opportunity for Navy shipbuilders. HII and GD are perfectly positioned to benefit from that. The table below from the last HII presentation shows the projected submarine production. HII presentation It is 5x growth in 30 years period. In my opinion, this projection is realistic. The US government will keep increasing its defense spending as a percentage of GDP. Part of the funds are dedicated to updating its fleet of nuclear-powered submarines. The Columbia class will replace the Ohio class. To give a context, let’s share some data from the US Navy Institute: The Navy’s FY2025 budget submission estimates the total procurement cost of the first boat at $15,179.1 million (i.e., about $15.2 billion) and the procurement cost of the second Columbia-class boat at $9,283.1 million (i.e., about $9.3 billion). The first boat’s procurement cost is much higher than that of subsequent boats in the class because the first boat includes most of the detail design/nonrecurring engineering (DD/NRE) costs for the class. Virginia submarines cost about $4.3 billion. The major difference in the price tag comes from their purpose. Columbia is a Ballistic Missile Submarine. As the name suggests, it can carry and deploy SLBMs (submarine-launched ballistic missiles), while Virginia submarines cannot. Virginia is designed to carry out various missions, such as anti-submarine warfare and intelligence gathering. Simply put, a lot of CAPEX has yet to be done. The beneficiaries will be GD and HII. Newport is the only facility to commence RCOH (refueling and complex overhaul) of the US Navy’s aircraft carriers. The facility is also involved in constructing Virginia and Columbia class submarines. As stated, in the last Investor Day presentation and transcript, HII has an agreement with Electric Boat to build 50% of every Virginia submarine and about one-quarter of the Columbia submarines. Financials The table below presents HII performance FY23 by segments. HII presentation Ingalls Shipping is the best performer in terms of operating income growth. On the other hand, Mission Technologies delivered the highest revenue growth Year over Year, 13.1%. Looking at the operating margins, Ingalls Shipping and Mission Technologies scored considerable OPEX margin growth, 180 bps and 110 bps, respectively. HII released its 2023 report on February 1, 2024. FY2023 HII delivered robust results: $11.4 billion in revenue, $781 million in operating income, and $681 million in net income. Most importantly, the company realized a 6.8% OPEX margin, 153 bps higher than in 2022. Rising net income resulted in $17.07 EPS in 2023, 18.2% higher than 2022. It is worth meeting the consistent revenue growth of 6.6% CAGR realized by HII over the last four years. The following table discusses HII 2024 guidelines. HII presentation HII expects $11.5 - $11.8 billion in total revenues for 2024, which aligns with 2023 figures. Its Shipbuilding division (Ingalls + Newport) is projected to deliver about $9.0 billion in revenue in 2024. Profit margins are expected to improve. HII projects a Shipbuilding segment OPEX margin above 7.5%,40 bps higher than the 2023 figure. Shipbuilding is a capital-intensive endeavor, heavily dependent on the inflation rate. Considering the inflation comeback, I hesitate to say HII will deliver the stated margins. Rising inflation means higher input costs (labor, capital, and steel), leading to CAPEX and OPEX growth. Of course, this impacts, also, the cost of new ships and submarines, resulting in higher revenues for HII. The point is which one will grow faster, the revenues or the costs. The inflation pressure first impacts input costs. So, I expect costs growth rate to exceed revenues growth rate. On the positive side, I expect HII to deliver the projected revenues in 2024. The Columbia program and AUKUS Pillar 1 and Pillar 2 will act as tailwinds for HII revenues in the coming years. Shipbuilding has lower profit margins than the other defense industry segments. Combat Systems and Aerospace can deliver operating margins in the low teens. HII 2023 operating margin is 6.8% or 153 bps higher than 2022. For comparison, GD Marine Systems delivered a 7.0% operating margin in 2023. The table below compares gross and EBITDA margins on HII, GD, NOC, and LMT. Koyfin LMT scores the highest EBITDA margin, 15.13%, while NOC has the best gross margin at 16.67%. NOC and LMT are among the leaders in the aerospace industry. HII realized 9.77% EBITDA margin and 14.37% Gross margin. However, we must consider that HII is concentrated on shipbuilding. I do not ignore its Mission Technology division, but it delivers about one-quarter of the revenues and accounts for 11% of the company's backlog. GD is a diversified company. Its tech division brings in about 30% of the company’s revenue, closely followed by the Marine segment. Aerospace and Combat Systems delivered approximately 20% of the annual revenue each. Let’s see what returns HII delivers. Koyfin LMT leads with 85.9% ROE, but we must consider its capital composition. LMR has 272% total debt/equity. This means the ROE equation's denominator is relatively smaller, resulting in an excessively high ROE. HII realized 17.9% ROE and 9.07% ROIC, similar to GD returns. HII will release its 1Q24 report on May 02, 2024. I will look at profit margin changes and backlog developments. Balance sheet HII keeps a solid balance sheet with $430 million cash, $2,204 million long-term debt, and $2,724 total debt (including $238 million lease agreements). The company scores 66% total debt/equity and 63.5% total liabilities/total assets. For 2023, HII delivered $970 million operating cash flow and $781 million operating income. Over the same year, the company incurred a net interest expense of $58 million. In 2023, HII repaid $480 million in debt. The table below from the 2023 annual report shows the HII debt composition. HII 2023 report The company must repay $229 million debts FY24. In January, HII already prepaid a $145 million Term Loan originally due on August 19, 2024. The next debt maturity is in 2025, a $500 million bond issue with a 3.84% interest rate. Its repayment will further improve the company’s liquidity by reducing its interest expenses. Dividends HII does not impress with its dividend yield at 1.89% TTM, although the company offers safe and consistent dividends. Seeking Alpha In 2023, HII distributed $200 million as dividends. Moreover, the company repurchased shares for $75 million, resulting in a 0.81% buyback yield. HII dividend yield is comparable to GD and NOC. However, the company keeps a lower payout ratio at 29.4%. In the long term, it is safer, providing less volatility in dividend yields. In FY23, HII plans to return $500 million to its shareholders. The share repurchase program has been extended to 2028 and increased to $1.5 billion. Valuation HII trades at 1.15 TTM EV/Sales and 11.81 TTM EV/EBITDA. It is cheaper than GD. Seeking Alpha GD is a diversified company, plus the ownership of Gulfstream makes it attractive to a broader investing audience. Its strong annual and YTD performance has been a sign of that. Nevertheless, HII outperformed GD on a 12M basis, scoring 34% vs GD's 29%. HII is neither cheap nor expensive compared to its 10Y averages, North American Industrials and Global Equity. Koyfin EV/Sales multiples fall in the middle. Looking at Price to Book, however, the company trades at the bottom percentile compared to its 10Y average. What I like about HII is its large backlog compared to its market cap. The company ended 2023 with a $48.1 billion backlog, while its capitalization as of April 15, 2024, is $10.92 billion. If I subtract the company’s total liabilities of $7.12 billion from the backlog, I get $41.0 billion, about 4x the HII market cap. GD has a $93.6 billion backlog, $33.5 billion total liabilities, and a $78 billion market cap. Thus, GD’s market cap exceeds its backlog net of total liabilities. Simply put, HII comes at an attractive price considering its backlog. Valuing a company based solely on backlog is imperfect; however, it gives an idea of how expensive or cheap the business is compared to its expected future revenues. 89% of the HII backlog is related to its shipbuilding divisions. As mentioned, HII and GD are the only two players in that sandbox. Planned updates of the US submarine fleet add certainty that a significant percentage of that backlog will be converted into cash flows. However, I do not expect higher profit margins due to the inflationary pressures in the long term. Investor Takeaway HII fully embodies the meaning of a moat in investing. It is the only company building aircraft carriers and the second to GD building nuclear-powered submarines. The barriers to entry into such a business are impossible to overcome. The new entrants must have highly qualified personnel, ample funding, and the know-how. The hurdles are unbearable. This leads to long-term consolidation in the defense industry. A few companies dominate every niche, as shown in the graph below.   Bloomberg The table is from 2022. However, the data is still valid. Shipbuilding is shared between GD and HII. The demand for blue-water navy vessels (aircraft carriers, destroyers, and nuclear-powered submarines) will grow. As pointed out, AUKUS is among the prime drivers. The world has been unipolar for longer than usual, leading to low single-digit defense budgets as a percentage of GDP. However, the tide has turned. China and Russia are pushing their agendas in the South China Sea and Ukraine. Recent events reminded us that the Middle East remains the global power keg. HII thesis comes with a few risks: financial, maker, and operational. Financially, HII is sound, considering its ample liquidity and capital composition. The operating cash flows provide sufficient funds for CAPEX and dividends. Defense stocks are relatively indifferent to the broad indexes, especially when rising geopolitical volatility occurs. Defense stocks do not tightly correlate with the market except in a profound market crash. Under operational risk, I consider the potential issue of converting the backlog into profits. Two constraints may act as limitations: supply chain disruptions and a shortage of skilled personnel. Below is a quote from the HII Investors Day transcript about the company’s supply chain: And our work teams cannot build the ship on time if they don't have the material on time. And you can imagine that our supply chain management team stays pretty busy with 80,000 purchase orders open on almost every given day, across 2,500 suppliers, mainly in the U.S. with a handful abroad, managing over $4 billion of orders, which really means that our suppliers, many of our suppliers, are providing material that is critical to a planned sequence build, which means their on-time delivery is critical to our on-time performance. The HII supply network is complex, so it depends on multiple suppliers. They are primarily located in the US, which mitigates the supply risk from foreign vendors. HII proactively engages with the Navy and local communities to attract its workforce. As a token of the successful workforce policy, in April 2024, the HII was awarded one of the best employers for excellence in health and well-being.  HII is an excellent proposition for investors seeking exposure to growing geopolitical volatility who love a company with formidable moats. 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