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Nathan Parsh
Nathan Parsh
Articles (119) 

Huntington Ingalls Offers a Deep-Value Opportunity

The stock has had a major selloff in 2020, but looks cheap compared to its historical average valuation

July 13, 2020 | About:

The defense sector has been a favorite industry of mine due to vast amount of spending done by governments around the world, particularly in the U.S. For example, the U.S. will spend nearly $740 billion on defense in 2020, and the proposed budget for next year calls for roughly the same amount.

While I tend to focus on the larger names in the space, there are smaller defense companies worth considering given their expertise in more niche areas. One such name is Huntington Ingalls Industries Inc (NYSE:HII).

The stock has suffered this year, losing 29% year-to-date while the Aerospace and Defense ETF has lost more than 33% and the S&P 500 is down just 2.4%. This decline in value for Huntington Ingalls could create an opportunity for investors to reap a high rate of return, in my opinion.

Company background and recent earnings results

Huntington Ingalls was part of Northrop Grumman (NYSE:NOC) until being spun off into an independent company in March 2011. Huntington Ingalls produces both nuclear and non-nuclear ships for the U.S. Navy and Coast Guard. The company has three divisions, including Ingalls Shipbuilding (which makes surface combat ships and Coast Guard cutters), Newport News Shipbuilding (which provides nuclear powered aircraft carriers and submarines) and technical Solutions (which offers fleet upkeep and modernization and nuclear management and operations). Huntington Ingalls has a market capitalization of $6.8 billion.

Huntington Ingalls last reported earnings results on May 7. The company’s revenue grew nearly 9% to $2.3 billion, topping market analysts’ estimates by nearly $150 million. Earnings-per-share increased 48% to $4.23, though this was 27 cents lower than expected. Excluding the benefit of a favorable pension benefit, adjusted EPS grew 14% to $2.43. Operating margin improved 176 basis points to 9.5%.

Total shipbuilding revenue increased 5.7% to just under $2 billion.

Revenues for the Ingalls Shipbuilding division improved 7.7% to $629 million. This business benefited from higher revenues for the company’s San Antonio-class of amphibious transport docks and its Arleigh Burke-class of guided missile destroyers. Lower volumes on Coast Guard Cutters partially offset these gains. Margins for Ingalls improved 290 basis points to 10.8%.

Newport News Shipbuilding generated revenue of $1.3 billion, a 4.8% increase from the same quarter a year ago. Increased volumes for submarine cconstruction led to higher revenues, mostly due to the Virginia-class submarine program Block V boats. Aircraft carriers decreased due to lower volumes on certain ships. Margins expanded 75 basis points to 7.1%.

Technical Solutions grew 32% to $317 million. Growth for the smallest business within Huntington Ingalls was primarily attributed to the company’s acquisition of Fulcrum IT Services in February of last year. Fulcrum offers advanced engineering, cyber security and software development products and services. Margins were a negative 2.2% compared to a positive 0.8% in Q1 of 2019 due to lower performance on fleet support and nuclear and environmental services.

Huntington Ingalls also completed its acquisition of Hydroid Inc, a leader in unmanned underwater vehicles. This deal combines Hydroid’s extra large UUV with Huntington Ingalls small and medium underwater vehicles. Hydroid will be included in the Technical Solutions business for reporting purposes.

COVID-19 did not have a material impact on first quarter results, but the company noted that worker absenteeism related to the pandemic will likely cause an impact on its ability to meet it prior guidance for shipbuilding revenue. Previously, Huntington Ingalls had expected shipbuilding revenue to grow 3% to 5% for 2020, but the company now guides toward the low end of that range.

Wall Street Analysts expect EPS of $18.83 for 2020.

Dividend and valuation analysis

Huntington Ingalls has paid a dividend every year since 2012. Dividend growth has been quite high in recent years.

The company has a compound annual growth rate of:

  • 12.7% over the past three years.
  • 16.3% over the past five years.

The company increased its dividend 20% to for the December 12, 2019 payment. To go along with a high dividend growth rate, Huntington Ingalls offers a market beating 2.5% dividend yield.

The reason Huntington Ingalls can raise its dividend at an aggressive rate is because it has very low payout ratios over the long-term.

Shareholders should expect $4.12 of dividend per share this year, which results in a payout ratio of 22% based on analysts’ estimates for 2020. This is just above the five-year average payout ratio of 21%.

Free cash flow is a bit murkier, but for a good reason.

The company distributed $42 million and had negative free cash flow of $3 million. Negative cash flow was caused by acquisitions and should return to growth in the coming quarters.

Looking back further, free cash flow more than covers dividend payments. Huntington Ingalls paid out $149 million of dividends last year while free cash flow totaled $366 million for a free cash flow payout ratio of 41%. The average free cash flow payout ratio for the period of 2016 through 2018 was even lower at 24%.

The EPS payout ratio looks extremely low while free cash flow was negative for Q1. The long-term free cash flow payout ratio means that the company has normally managed its dividend and cash flows extremely well. It will be interesting to see what future quarters look like in this area, but for now, I am willing to accept a reduction in free cash flow in order to grow the business.

Shares of Huntington Ingalls closed Friday’s trading session at $167.04 which gives the stock a forward price-earnings ratio of 8.9 using 2020 estimates for EPS. The stock has traded with an average price-earnings ratio of 14.4 since becoming a publicly traded company according to Value Line.

Huntington Ingalls is among the smaller defense sector names and has a particularly focused shipbuilding business. A delay or cancelation of contracts in this business, though unlikely due to the multi-year cycle nature of most contracts, would have a significant impact on results.

Therefore, I have a target price-earnings range of 11 to 13 for shares of the company. This gives the stock a price target range of $207 to $245. This means that investors could be in line for a 24% to 47% gain from the most recent closing price.

Final thoughts

Huntington Ingalls has not escaped the sell off in the Aerospace & Defense sector this year. That said, the company performed well in the most recent quarter. Despite lower employee attendance due to the COVID-19 pandemic, the company still expects ship building revenue, its largest business, to grow within its previous range.

The company saw revenue growth in all areas of its business and margins expanded in its two most important segments.

Huntington Ingalls is vastly undervalued based off of its historical average, giving investors a deep value opportunity in this defense company.

Author disclosure: the author has no position in any stocks mentioned in this article.

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About the author:

Nathan Parsh
I am originally from Detroit, Michigan, before moving to Maryland to begin a career as an educator. This is my 14th year teaching. My wife and I have two young children who keep us on our toes.

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