2023-10-09 07:00:00 ET
Summary
- Sleeping well at night in the next recession is a lot easier with safe dividends, a strong balance sheet, and a wide moat.
- Huntington Ingalls is the biggest navy shipbuilder in America, the king of nuclear subs, a completely recession-resistant industry.
- HII is finally undervalued after a post-Ukraine invasion rally and now offers a 17% annual return potential over the next two to 10 years.
- An attractive 2.5% safe yield pays you to wait for potentially 400% returns in the next decade, more than 2X the market's return potential.
- If you're looking for a solid dividend growth stock with a wide moat, consider buying some HII today.
This article was co-produced with Kody Kester of Kody's Dividends.
One stock I don't yet own but think could be a great pick in this environment is the military shipbuilder Huntington Ingalls Industries ( HII ).
After the fallout of Russia's invasion of Ukraine that sent defense contractors soaring, the stock rallied well beyond its fair value to a 52-week-high of $260 a share last year. But as always is eventually the case, the market realized its exuberance, with HII down around 20% since that time. Let's dig into what makes HII a buy for dividend growth investors seeking stability.
Huntington Ingalls Industries pays a safe dividend based on its EPS (35%) and free cash flow (46%) payout ratios. Rating agencies consider 60% safe for this industry.
The military shipbuilder is well-positioned for promising growth moving forward.
Huntington Ingalls Industries is financially solid, with an interest coverage ratio of around eight and an investment-grade credit rating of BBB - stable.
- 11% 30-year bankruptcy risk
The defense contractor appears to offer a sizable enough margin of safety to be a potentially reasonable buy for dividend growth investors.
- About 10% discount to fair value vs. 5% S&P overvaluation
Huntington Ingalls Industries offers a combination of yield, growth, and valuation multiple expansion that should beat the S&P 500 index in the next decade.
- 2.5% yield + 13.5% growth + 1.1% annual valuation boost = 17.1% CAGR annual 10-year consensus total return potential vs. 10.1% S&P 500
- 385% 10-year consensus total return potential vs. 163% S&P 500
It would be speculation on my part to offer an exact day, week, or month of when the next U.S. recession will occur. But various factors tell us that it is a matter of when and not whether there will be a recession.
For one, worker strike activity in the U.S. has reached its highest levels in about 25 years. The 4.1 million workdays lost to strikes this past August was more than double the highest mark of this century. The U.S. economy will increasingly feel the impact as these strikes drag on.
Student loan payments have resumed for tens of millions of borrowers at the start of this month. This could meaningfully weigh on consumer spending in the foreseeable future. WTI crude shows little sign of dipping below $75 a barrel, which could further crimp consumer spending.
If these elements weren't enough, the two-year and 10-year yields have been inverted for the last 18 months: The former is currently yielding 5.1% while the latter is yielding 4.8%. When the 2-10 yield curve inverts, there is a 98%-plus chance that a recession will crop up within two years.
"There has been a better than two-thirds chance of a recession at some point in the next year and a greater than 98% chance of a recession at some point in the next two years,” according to Bespoke. - CNBC
The bond market currently estimates a 93% chance of recession beginning in 2024.
This would indicate that a recession could arise between now and next summer.
The Most Dominant Player In Its Niche
Founded more than 135 years ago, the Virginia-based HII is the largest military shipbuilder in the country. The company generated $10.7 billion in total sales in 2022 and operates in the following three segments: Ingalls, Newport News, and Mission-Based Solutions.
HII 10-K
The Ingalls segment designs non-nuclear ships for the U.S. Navy and Coast Guard as the sole builder of amphibious assault ships and one of just two builders of surface combatants for the U.S. Navy (~24% of 2022 sales). The Newport News segment designs and builds nuclear-based aircraft carriers and subs for the U.S. Navy (~55% of 2022 sales). Finally, the Mission Based Solutions segment specializes in solving national security challenges for the U.S. Department of Defense (~22% of 2022 sales and details per pages 3-6 and 46 of 137 of HII 10-K filing ).
U.S. military spending has ebbed and flowed but gradually risen over time. In the last 20 fiscal years, U.S. military spending has roughly doubled from $440 billion in fiscal year 2003 to shy of $880 billion in 2022.
The mission-critical nature of HII's products and services means that demand likely isn't going anywhere but up throughout our lifetimes. The company's total backlog reflects that as of June 30, 2023, it was at a near-record of $46.9 billion. Backlog is important for defense contractors because it measures sales stability. HII's backlog is approximately four years of revenue, which builds great visibility into its sales in the years ahead. For context, this is better than the approximately two years of backlog that the more diversified competitor General Dynamics boasts.
HII's industry leadership in a steadily growing industry explains why FactSet Research anticipates the company's diluted EPS will compound by 14% annually over the long run. HII also is financially sturdy if these admirable growth prospects aren't enough to win you. The company's interest coverage ratio through the first six months of 2023 was just under 8 , which is why the company enjoys an investment-grade BBB- credit rating from S&P.
Dividend Growth Should Remain Robust
HII's 2.5% dividend yield won't amaze income investors in this high-rate environment. But dividend growth investors will appreciate that the company has grown its dividend by 14% annually in the last five years.
As HII continues to grow, the company should have plenty of room to keep growing its dividend at a healthy rate. This is because HII generated $14.44 in diluted EPS in 2022. Measured against the $4.78 in dividends per share paid during that time, this is a diluted EPS payout ratio of just 33.1%. This is well below the industry guideline of 60%, so HII enjoys a 4/5 dividend/balance sheet safety rating per our Research Terminal.
The company also has the free cash flow to easily pay its dividend: HII posted $482 million in free cash flow during 2022. Compared to the $192 million in dividends paid for the year, this is a payout ratio of 39.8% (per page 64 of 137 of HII’s 10-K filing).
Risks To Consider
HII is a tremendous business with a presumably bright future. But as a defense contractor, it does face risks that investors must be comfortable with before buying the stock.
HII derived 82% of its 2022 sales from the U.S. Navy (according to page 4 of 137 of HII 10-K filing). There are a variety of risks that stem from sales largely tied to the U.S. government.
As the government continues to run budget deficits, total federal debt is climbing. Higher borrowing costs with elevated rates and rising entitlement spending (e.g., Social Security, Medicare, and Medicaid) are eating into the discretionary spending power of the government. In a worst-case scenario, this could force the government to cut spending in other areas like defense. Such a move could weigh on HII's fundamentals if it happens.
A more company-specific risk to HII is that it could fail to deliver its projects to the government on time and within budget. If this were to occur consistently on major projects, it could hurt HII's profit margins and favor the government.
Summary: HII Is An Undervalued Company That Can Deliver Market-Beating Returns To Shareholders
Buying high-quality companies at or below fair value is paramount as an investor targeting above-average total returns. This is because, over the long run, a stock’s valuation always reverts to fair value. Scoring 11/13 in terms of quality rating, HII is a SWAN-quality stock trading at an intriguing valuation.
Based on the aggregate of various valuation metrics that we use to arrive at an average fair value, HII looks to be a decent, though not spectacular, buy right now. The current $202 share price is about 10% below its average fair value of $235. If the stock fell below $200, it could go from a potentially reasonable buy to a good one.
FAST Graphs, FactSet FAST Graphs, FactSet
HII’s 2.5% dividend yield and range of 8% to 15% annual consensus earnings growth alone could beat the 10% total yearly returns expected from the S&P 500 index from current levels. Adding in a 1.1% annual boost from valuation multiple expansion as HII reverts to fair value, this is the cherry on top that makes the stock an arguably better buy than the S&P 500.
For further details see:
Huntington Ingalls: A Great Long-Term Opportunity For The Next Recession