Huntington Ingalls: an Undervalued "Defensive" Proposition by Rutvij Thakkar

Tl;dr their valuation is incredibly low and growth should see a significant increase from here

Huntington Ingalls is one of the largest defense contractors for aquatic/nautical vessels for the United States military, and the largest defensive shipbuilding company in America. It was formed as a spin-off of Northrop Grumman in 2011 due to Northrop previously being a very bloated organization, which is a good sign in and of itself. Now Huntington Ingalls’ management team will operate with the sole intention of shipbuilding in mind rather than carrying out the hundreds of other complex products that Northrop used to be responsible for. In an industry as fixed as defense, the more the amount of divisions, the better due to the lack of synergy and a presence of bureaucracy in defense conglomerates. This company now almost exclusively operates for the Navy and the Coast guard, making its competitive advantage solidified. The defense industry as a whole has a relatively fixed growth strategy, and is usually a safe bet for most investors who just want solid dividends and growth, but due to the pandemic, there has been a lot of mis-pricing of defense companies even though the Federal budget’s defense policy remains. Outside of just military ships, Huntington Ingalls also works on technical solutions for defense, nuclear innovation, and oil and gas field services.

HII’s revenues primarily come from the US Navy, approximately 87% according to the most recent annual SEC filing. A great amount of HII’s unrealized potential is in its $40B+ backlog of orders, of which 17% are planned to be filled this year but obviously that’ll see a delay. But a good thing about this backlog is that there are very few contenders ready to take it other than HII. Their primary competition would be from General Dynamics, but they have a full plate for when it comes to aviation already. Huntington’s main revenue stream, which is “designing, building, overhauling, and repairing military ships”, they believe there are no niche competitors which a clear sign of something known as competitive advantage, and in their most recent 10K, they state:

“We believe we are well-positioned in our markets. Because we are the only company currently capable of building, refueling, and inactivating the U.S. Navy's nuclear-powered aircraft carriers, we believe we are in a strong competitive position to be awarded each contract to perform such activities”.

Huntington Ingalls also tends to outperform its relative index due to its size, and it has historically beaten the returns of the S&P 500 and its Aerospace and Defense counterparts:

Shareholder returns, 2015-2019

This stable growth along with 45 billion in unrealized revenue that has to be filled and will be with re-openings and vaccines reportedly being deployed in 2 months (https://www.bloomberg.com/news/articles/2020-09-02/cdc-tells-states-to-get-ready-for-nov-1-vaccine-distribution) along with HII’s vast network economics via supporting their large manufactured fleets and generating revenue in this fashion as well (basically customers become a part of a network that generates consistent revenues once they purchase the product, which is their naval support products), and it’s clear that Huntington Ingalls’ logistic support is preferred by the Navy as they were recently awarded another contract for logistics support (https://finance.yahoo.com/news/huntington-ingalls-industries-selected-support-180000552.html). Huntington is what one would call “too big to fail” as it’s the largest industrial employer in the state of Virginia and provides a network system so unique for its line of products that the government is almost forced to use them. At a time where the government is buying out company debt via bonds to float them, they have literally been (no pun intended) floating on government money since day one:

$HII Revenues for the past 3 years

As a percentage of revenue streams, approximately 30% of their revenues come from technical service support, which should see continued funding from the defense budget despite COVID-19 because as we previously mentioned, there’s nobody better to support Huntington Ingalls' very complex and expensive ships than their own technical support team. Ingalls’ operating income had decreased between 2018 and 2019 due to lower support required and slightly lower volumes on Legend class ships (this didn’t affect the stock price at this time because the price doesn’t frequently reflect immediately for a decrease in production for one year since revenues are almost fixed for defense contracts, and between 2018 and 2019, the stock price of HII actually increased significantly) and lower risk retirement on the San Antonio class landing platforms (more reliability). Huntington says that operating cash flows were lower in 2019 from 2018 basically because of change in trade working capital which was driven by accounts payable timing. In terms of liabilities, long term debt didn’t increase in between the two most recent financial reports, so that’s always a good sign. Here’s the most condensed statement that identifies the various revenue streams between 2018 & 2019 with the most detail:

As for the most recent 10Q filing:

You will see that revenues were almost unaffected from the same time last year which means the huge backlogs are on the way to being met and it should hopefully be smoother sailing once COVID passes.

Net cash by operating activities actually increased from a loss to significant surplus in one year:

For the six months ended period, earnings also saw virtually no hit, but the three months ended period did. This is likely because of a difference in accounts receivable planning plus to some effect the shutdowns:

For the three months ended period recording sales and revenues were down by 7% but for the six months ended period, sales and revenues were up slightly:

Now obviously, operations involving shipbuilding will be significantly damaged by a pandemic, but the defense industry is one best equipped to last through it, especially in such a unique field. Free cash flow actually increased, due to net increase in cash from operations:

So far, Newport News shipbuilding has taken proactive measures to ensure employees with COVID do not come to work, which will affect productivity, but the curve for COVID in the area has began to flatten out, which will undoubtedly be good news for HII.

And now for some time-bound visuals:

Mostly declining SG&A per $ of Gross Profit

Mostly consistent rises in Gross Profits YoY

Relatively low Debt/Equity

Consistent EBITDA

But the main reason you should be buying is because of the great value it possesses. Huntington Ingalls is down by over 45% from it’s pre-covid prices, and the valuation multiples for them fare a lot better than competitors, especially considering that Huntington Ingalls mostly is specialized with aquatic activity. First valuation: a Price/Earnings ratio of 11, which is a decent amount below their nearest competitor who really isn’t as focused on shipbuilding as much as they are on well, everything else: General Dynamics who has a P/E of 14. But P/E doesn’t even begin to give the full picture, it focuses far less on the most important part of valuation: cash.

HII has a Price/Cash per share ratio of 9.69 whereas GD has a P/Cash of 19, which means HII is trading at ½ the multiple of GD, which is already pretty undervalued. HII has a price to free cash flow of just 9.85 while General Dynamics has a P/FCF of 31, which means HII is trading at ⅓ of the multiple of GD based on that metric. And finally, HII has a Price/Sales ratio of only 0.69 versus GD’s 1.13 (for all of these, HII is trading at a much lower “discounted price”). HII also has a higher quick ratio, which means it’s more liquid than GD. HII also has a Debt/Equity ratio of 0, against GD’s 1.05. HII also has a Return on Equity of 31.9%, against GD’s 24.1% without having nearly as much leverage. HII also has a trailing twelve month Return on Investment of 20.9% against GD’s 15.2%. HII also has a short ratio of 1.59 which is lower than GD’s 2.15 meaning that investors are signaling this is the bottom in terms of pricing, and while GD is up 51% from its 52wk low, HII is right next to it, only up 2% from the 52wk low. Of course, both of these companies are massively different. General Dynamics is very general for the most part making all sorts of military equipment from missiles to airplanes and to some extent boats as well, but HII is focused mainly on one type of product, which will reduce complications for them in the future as they continue to chip away at the backlog half the size of General Dynamics’. If there’s anything to be concluded from the information we know, it’s that this ship isn’t sinking any time soon, and the average analyst price target (on the low end) of $220 is far from met. Margins do have far more room for improvement, and slowdowns are a concern, but this is so undervalued that it’s bound to revert sooner more than later. The 2.74% dividend is also a nice cherry on top, but the intrinsic value is far from met, and this is one of the most extreme cases of it. I’d set the intrinsic value at about $200 per share based on their cash flows, and usually stocks trade at a higher market valuation to that of the intrinsic value.

Due to the strong financials, HII's price was rising for a while, but now that one ER messed up, it makes it a perfect time to add this to your portfolio. The industry advantage HII has is irreplaceable, and that makes it a strong buy at any level, but especially now if you're still out looking for recession bargains.

Credit:Finviz

Now is the best possible buy opportunity, so jump in quick before the recovery for this one begins.