2023-12-06 04:37:26 ET
Summary
- Huntington Ingalls Industries is an undervalued dividend stock with the potential for a 15% annual total return.
- HII is a global defense contractor specializing in naval ship construction and technologies.
- The company reported a robust Q3 with record revenues, improved segment performance, and a significant increase in free cash flow.
Introduction
I found a reason to talk about the aerospace & defense industry again. In this case, we'll discuss a company I haven't covered since May 21.
Back then, I wrote an article titled Huntington Ingalls: A Deep-Value Defense Stock . Since then, the stock has returned 22.3%, beating the S&P 500 by 13.5 points.
Having that said, this article isn't supposed to be a victory lap. No, I still believe that Huntington Ingalls Industries ( HII ) is a significantly undervalued dividend stock with roughly 15% annual total return potential.
Although the company may be seen as a CapEx-intensive producer of defense ships that come with significant operational risks, I believe the company is in a great spot to reward investors with steadily rising dividends, massive buybacks, and improving operations backed by the need to modernize America's naval capabilities.
So, without further ado, let's get to it!
What's HII?
As some of my readers may recall, I used to own Huntington Ingalls. The only reason why I sold it is because, at one point, I owned five different defense contractors. That's a bit much for a portfolio that usually holds fewer than 25 individual companies (it's currently at 20).
Furthermore, the decision to sell Huntington Ingalls was to focus on more advanced industry segments like space, hypersonics, next-gen Air Force fighters, bombers, and more.
I now have more than a quarter of my portfolio invested in Lockheed Martin ( LMT ), Northrop Grumman ( NOC ), RTX Corporation ( RTX ), and L3Harris Technologies ( LHX ).
Huntington Ingalls is different, but not worse!
The company behind the HII ticker is a global defense contractor specializing in the construction of naval ships and technologies.
With over a century of experience, the former Northrop Grumman spin-off includes the Ingalls Shipbuilding segment in Mississippi, the Newport News Shipbuilding segment in Virginia, and the Mission Technologies segment.
Huntington Ingalls Industries
Essentially, the company has a duopoly with its peer, General Dynamics ( GD ), when it comes to providing the Navy with floating hardware.
In its Ingalls segment, the company produces Amphibious Assault Ships and Surface Combatants. In its Newport News segment, the company builds aircraft carriers and nuclear-powered submarines.
The aforementioned Mission Technologies segment is the result of a number of acquisitions in the past few years, as the company knows that the future of defense relies on technology.
While ships will remain the backbone of the U.S.' defense capabilities, the company knows that expanding its own "tech" segment allows it to compete for a bigger chunk of Navy-related contracts that would otherwise go to its peers.
In 2021, the company bought Alion , which, I believe, was one of the biggest game changers of the past few years:
Alion provides advanced engineering and R&D services in the areas of ISR, military training and simulation, cyber and data analytics and other next-generation technology based solutions to the global defense marketplace. Alion has more than 3,200 employees with over 80% of employees maintaining security clearances.
Consisting of four business groups, this segment specializes in delivering advanced solutions to address national security challenges.
From intelligence, surveillance, and reconnaissance to cyber operations and advanced modeling and simulation, the Mission-Based Solutions group provides expertise that accelerates decision-making and exploits vulnerabilities in foreign threats.
There's Deep Value In HII
There are a few reasons why Huntington Ingalls has performed poorly since 2018.
Essentially, it is a mix of headwinds related to post-pandemic supply chain problems, inflation, and related labor issues. Building massive ships is very capital and labor-intensive.
On top of that, it also didn't help that there was (and still is) a lot of uncertainty regarding the defense budget.
Due to ongoing fights between the GOP and the Democrats in Washington, the market isn't betting on a long-term uptrend in funding - at least not without the ever-present risk of continuing resolutions, where spending levels are frozen until an agreement is reached.
On top of that, it didn't help the company that its CapEx plans are very inconsistent. For example, if it plans to build a large ship, it needs a lot of capital upfront. Once the ship is close to being completed, capital spending falls, and income projections rise. At that point, free cash flow starts to accelerate.
Producers of smaller "products" do not have these issues and much less cash flow volatility.
With that in mind, the third quarter was a very important quarter for the company and its shareholders.
In the third quarter, HII achieved a record revenue of $2.8 billion, a 7.2% increase from the previous year.
Operating income saw a significant rise of 31% to $172 million, with an operating margin of 6.1%. Net earnings were $148 million, leading to a diluted earnings per share of $3.70.
When taking a closer look at its segments, we see favorable developments.
- Ingalls Shipbuilding experienced a notable revenue increase of 14%, reaching $711 million, driven by higher volumes in specific shipbuilding projects.
- Newport News, with revenues of $1.45 billion, saw a slight increase of 1%, attributing a decrease in operating income to the Columbia-class program incentives earned in the previous year, which shows how volatile its segment margins are.
- Mission Technologies showed a strong performance, recording revenues of $685 million, a 15% increase. Operating income for this segment was $24 million, driven by higher volumes in mission-based solutions, particularly in C5ISR, Cyber, Electronic Warfare, and Space Programs.
Cash from operations in the quarter was $335 million, with net capital expenditures at $42 million.
Free cash flow was $293 million, a substantial improvement from the negative free cash flow in the same quarter of the previous year, which is the most important takeaway here, as it allowed the company to boost shareholder distributions.
Speaking of shareholder distributions, the company currently pays a 2.1% dividend yield. That's nothing to write home about.
However, this dividend comes with a sub-40% payout ratio and a five-year CAGR of 10.7%!
On November 1, the company hiked its dividend by 4.8%. Last year, it hiked by 5.1%.
Although dividend growth has come down in recent years, this was mainly due to subdued free cash flow growth.
The good news is that the company is now entering a period of very favorable free cash flow developments.
For example, after reporting stellar 3Q23 earnings, HII increased the revenue guidance for shipbuilding and Mission Technologies. Shipbuilding revenue guidance was adjusted to a range of $8.5 billion to $8.6 billion, and Mission Technologies' revenue guidance increased to approximately $2.55 billion.
The 2023 free cash flow guidance was raised to $500 million, reflecting strong third-quarter performance.
Next year, the company expects to see the steepest increase in free cash flow since pre-pandemic years, as it targets $700 million in free cash flow!
That's big news, as the company is not only showing favorable growth developments but also committed to returning all free cash flow to shareholders once it hits a sub-2x leverage ratio!
To give you an idea of how much $700 million in free cash flow is, it would be roughly 7.3% of its market cap!
Analysts expect the company to lower its net leverage ratio to less than 1.7x EBITDA in 2024, which bodes well for accelerated buybacks and consistent dividend growth.
It also helps that the company sees favorable demand developments.
In the third quarter, the company secured new contract awards totaling $5.4 billion.
As of the end of the quarter, HII's backlog stands at approximately $49 billion, with $27 billion currently funded.
This is its biggest backlog ever!
The shipbuilding division achieved a 2.4 book-to-bill ratio. Mission Technologies achieved a year-to-date backlog book-to-bill of 1.2.
This means that the shipbuilding division is getting $2.40 in new orders for every $1.00 of finished work. That's an impressive number.
To give you more details, the shipbuilding division, the biggest contributor to HII's backlog, achieved notable milestones during the quarter.
Contract awards at Ingalls, including the $155 million contract for USS Zumwalt DDG 1000 modernization and the substantial award for seven of the ten Flight III Arleigh Burke-class destroyers, contribute significantly to the backlog.
These awards not only represent immediate revenue but also contribute to the long-term backlog.
Valuation
Even after rallying almost 30% from its lows, Huntington Ingalls presents tremendous value.
Using the data in the chart below:
- HII is currently trading at a blended P/E ratio of 16.6x.
- This year, EPS is expected to grow by 1%, followed by accelerating growth of 14% in 2024 and 11% in 2025. I expect EPS growth to remain elevated in the future, backed by high demand and buybacks.
- Since its spin-off, the company has traded at a normalized P/E ratio of 14.6x.
- Unfortunately, a prolonged period of slow growth had a major impact on this valuation.
- Hence, I am using a fair multiple of 17x earnings, which I believe is fair for the company's better growth outlook.
- Based on these numbers, the company has the potential to return more than 15% per year through 2025, including dividends.
While these numbers are obviously theoretical, I believe they confirm my thesis of HII being a highly attractive dividend growth stock with new momentum after years without gains.
Takeaway
In the dynamic world of aerospace and defense, Huntington Ingalls Industries emerges as a beacon of value and resilience.
Despite challenges, the company reported a robust third quarter, marked by record revenues, improved segment performance, and a noteworthy leap in free cash flow.
Meanwhile, HII's commitment to shareholder value is evident through consistent dividend hikes and a promising projection of $700 million in free cash flow for 2023.
With a substantial backlog, favorable demand trends, and an attractive valuation, HII stands as a compelling choice for investors seeking steady growth in the defense sector.
For further details see:
Huntington Ingalls Is One Of The Most Underappreciated Dividend Stocks On The Market