Huntington Ingalls Industries (NYSE: HII) is a defense contractor for the U.S. Navy, and spun-off from Northrop Grumman in 2011. The company is the largest military shipbuilder in the U.S., with over 70% market share in the construction, repair and maintenance of nuclear-powered ships, amphibious assault ships, ballistic missile submarines and other high-grade ships built at the Newport News and Ingalls port, the largest shipbuilding ports in the U.S. It also provides ancillary products and services to the U.S. Navy, including information technology solutions, professional services and business support services for U.S. Navy missions. The U.S. government makes up roughly make roughly 97% of the company’s revenues while 3% is focused on commercial clients in the oil & gas and nuclear markets.
HII has seen moderate sales growth since being public but has a strong operating profile over the past 7 years: gross margins have grown roughly 53%, free cash flow has nearly quadrupled, book value per share has grown over 50%, and return on invested capital has grown from 8.30% in 2012 to 21.35% in 2017, with the last 4 year average being in the mid-to-high double digits. The company also has tailwinds that we believe are quite significant going into 2030: HII has a backlog of over $20 billion (and growing – they recently won another $3 billion contract from the Navy) of which 50% has already been committed. The Navy is in desperate need of an overhaul, with new ships and vessels required sooner rather than later and government budgets dedicated to fulfill their cause. Moreover, given this pent up demand, a number of legacy ships are under a replacement cycle and current competitors Lockheed Martin and General Dynamics (who they have a partnership with HII for specific services) have cost the U.S. Navy far too much under the troubled Littoral Combat Ship program, creating new shipbuilding demand for HII. Further, with President Trump’s renewed focus and vow to build 350 ships for the U.S. Navy in addition to the Navy’s request for 12 new vessels in fiscal 2018 and depot maintenance funds beyond that, there is little doubt that HII will be the sole beneficiary presenting the company with very predictable revenue streams.
Without question HII has proven that it can be a successful operator under the right conditions and upper management is very homegrown (their new strategic sourcing VP spent years building ships for the company). Further, there has been considerable insider buying over the most recent quarter, with a senior VP purchasing over 4100 shares in the company in May. The company has a payout ratio of 19% (considerable room to increase dividends) and has a stated policy to return a substantial amount of cash to shareholders by 2020 via buybacks and dividends from the significant free cash flow it generates. Despite creating a perfect storm for shareholders, HII faces considerable risks and volatility being tied to U.S. government budgets. A gridlocked Congress (likely under the Trump administration), reduction in committed vessels, waning demand from the U.S. Navy, reduction in maintenance funds, and an overall reduction in government spending will all create a significant reduction in the short-term price of the stock (which has already happened). However, we believe that the short-term risks do not outweigh these important tailwinds. The company is always on the lookout for strategic acquisitions to bolster their add-on services (their recent acquisition of Camber Corporation allows HII to enter into mission based software, systems engineering, data analytics and simulations for the Navy and other federal government agencies) which will support strategic growth initiatives and free-cash flow goals for shareholders.
HII has remarkable free-cash flow generating capabilities, which is due to the company’s superior economic and pricing power that it faces as a market leader. As new ships get built and maintained, the company will realize significant depreciation in the early years (before the ships are delivered), with depreciation coming down in future years despite growth in revenue due to maintenance and add-ons. This means that the company has very sticky (and growing revenue) on fleets that are worth less tomorrow than they are today, increasing the rate of change of free cash flow every year. In 2012, the company faced a depreciation expense of $206 million with net income at $261 million. As of last year, depreciation was $163 million with net income at $573 million. Free cash flow grew from $168 million in 2010 to $560 million in 2017, while free cash flow per share grew from $0.98/share in 2011 to $13.29/share as of 2016. Not only does this reflect a favorable economic environment for the company, but in comparison to its peers, it is a better operator of capital with a much cheaper valuation. The company has a free cash flow yield that is 40% greater than General Dynamics, while the company’s price to sales ratio is 1.2x, which is on the low-end of defense contractors: General Dynamics, Lockheed Martin and Northrop Grumman have price to sales ratios of 1.7x, 1.8x and 2.0x, respectively. HII is significantly smaller than the other defense contractors (GD = ~$51bn market cap; LMT = ~$81bn market cap; NOC = ~$44bn market cap) and if it were to reach a similar valuation to its peers (i.e. 1.8x sales, which we deem fair value) this would value the company at $12.652bn in market cap, giving the company 47% upside. We believe that, despite the volatile nature of defense stocks, this company should be worth at least 1x its backlog in the next 10 years, giving us a roughly $20 billion valuation and a price target of $434.70/share.
LOGOS LP is LONG: HII