Huntington Ingalls: Overhauling the Navy

07/07/2017 2:50 am EST

Focus: INDUSTRIALS

Peter Mantas

CIO, Logos LP

Huntington Ingalls Industries (HII) is a defense contractor for the U.S. Navy that has significant upside potential, explains Montreal-based money manager and value investor Peter Mantas in his Logos LP blog.

The company was spun-off from Northrop Grumman (NOC) in 2011. It is the largest military shipbuilder in the U.S., with over 70% market share in the construction and repair of nuclear-powered ships and ballistic missile submarines built at the Newport News and Ingalls port, the largest shipbuilding ports in the U.S.

HII 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.

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. 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.

However, HII faces considerable risks and volatility being tied to U.S. government budgets. However, we believe that the short-term risks do not outweigh these important tailwinds.

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. 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.

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.

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