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Huntington Ingalls Industries NYSE: HII Recommendation: BUY Samuel Chen and Brian Kelley. Executive Summary. While defense spending has been limited since 2011 due to the Budget Control Act, sequestration relief provided by the BBA for 2018 and 2019 indicate increased DoD expenditures
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Huntington Ingalls Industries NYSE: HII Recommendation: BUY Samuel Chen and Brian Kelley
Executive Summary • While defense spending has been limited since 2011 due to the Budget Control Act, sequestration relief provided by the BBA for 2018 and 2019 indicate increased DoD expenditures • The shipbuilding subsector is dominated by two main players, and will be driven by the DoD’s increased focus on maritime operations Industry Overview • Huntington Ingalls dominates 29.2% of the domestic shipbuilding market, and is the largest military shipbuilding company • Huntington, originally spun off from Northrop Grumman in 2011, now has has 3 reporting segments – Newport News, Ingalls, and Technical Solutions Company Overview • Recent market-wide sell offs have depressed trading price, creating an opportunity to invest in HII • Variant View: Market has not fully taken into account the impact of escalating tensions with China that will drive defense spending, especially for the US Navy • HII is in the best position to be awarded contracts for completing the Force Structure Assessment desired fleet Investment Thesis • Base case valuation, with a price target of $268.24, represents a 20.9% upside to current trading price of $221.79(1). • Upside case – price target of $327.34 – 47.6% upside • Downside case – price target of $216.71 – 2.3% downside Valuation Risks • 97% of Huntington's revenue in 2017 was derived from the US government • The main manufacturing input is steel and margins may be compressed due to rising prices • Midterm elections for Congress may pose a threat to increased military spending approval and appropriation (1) Closing price of 10/24/2018
Industry Overview Trends Global Market Share Domestic Revenue ($bn) United States Defense Spending ($bn) Since 2011 the industry as a whole has seen decreased spending as part of the Budget Control Act of 2011 - $487bn in cuts Midterm elections create an uncertain situation Chinese and Russian surges in spending putting pressure on the US Conflict in the South China Sea in addition to a Pivot to Asia provide a clear driver for US naval expansion • Spratly Islands see 3x more shipping traffic than Suez Canal Newly unveiled DoD plans call for 46 new ships over the next 5 years, followed by 30 more over the 25 following years New DoD requested budget is a 14.0% increase over 2018; most of the spending will go towards the Navy and the Air Force CAGR: 2.83%
Company Overview Business Profile Competitive Advantage Revenue by Type ($mm) Revenue by Segment ($mm) Huntington Ingalls Industries is the largest military shipbuilding company, maintaining nuclear and non-nuclear ships for the United States Navy and Coast Guard Business Segments: • Ingalls – construction of non-nuclear ships • Newport News – design and construct nuclear-powered ships • Technical Solutions – provider of life-cycle sustainment services (fleet support, nuclear, oil and gas) 97% of revenue in 2017 was derived from US government Huntington is the only company capable of building, refueling, and inactivating nuclear-powered aircraft carriers Sole builders of security cutters for coast guard 1 of 2 companies that design and build nuclear-powered submarines, the Arleigh Burke class of destroyers, and large deck amphibious assault and expeditionary warfare ships for the U.S. Navy Huntington is well positioned to be awarded future contracts for all of these ships
Annotated Stock Chart Hawkish Pence speech on China policy Index Constituent Add/ Drops USTR is authorized to investigate whether steel / aluminum imports pose a threat to national security Industry-wide EPS miss Tariff fears and Trump criticism of the Fed cause major selloff HII awarded $1.43 bn contract Exceeded EPS expectations by $1.75 Exceeded EPS expectations by $1.31 Yahoo Finance, Company Filings, Bloomberg
Investment Thesis While tensions between the U.S. and China began over an economic battleground, the possibility of armed confrontation over the South China Sea have led the DoD to strengthen resolve in cementing naval dominance. The market has failed to account for this favorable tailwind due to recent market turmoil. This is reflected in this year’s National Defense Strategy as well as Washington rhetoric. 1 The Force Structure Assessment, completed in December 2016, calls for an increase of ships to 355, up 26.7% from the 280 in service by 12/31/2017. Newly unveiled plans call for 46 new ships over the course of the next 5 years – and being the dominant shipbuilder for the USN, HII is well-positioned to land many of these new contracts. 2 Opportunity for portfolio exposure to Aerospace & Defense Industry, less volatility compared to tech dominated holdings. As a contractor for the US government and backlog based business model, companies in the defense industry are uniquely positioned to obtain steady revenues. 3
1. Rising Global Tensions National Defense Strategy, 2018 Spratly Islands Geopolitical Developments South China Sea The DoD’s latest summary on defense strategy marks a tremendous shift from the military downsizing seen over the past decade Focus now lies on inter-state strategic competition rather than terrorism The economic, political, and military strategies of China and Russia are all highlighted as a significant threat to global sovereignty and exchange As a result the DoD recommends higher spending to replace aging systems and platforms in order to maintain an operational advantage in all theaters Also an intention to ramp up spending on R&D to gain a competitive advantage in cyber defense, AI / ML, rapid application of commercial breakthroughs The US is beginning to fund programs designed to combat China’s Belt and Road Initiative as well as the Made in China 2025 plan After pulling out of a 2015 nuclear deal with Iran, the Trump administration has reimposed sanctions on Iran Murder of Jamal Khashoggi puts a $110bn arms deal with Saudi Arabia at risk in addition to putting sanctions on the table Russia’s annexation of Crimea, financial and military backing of the Donetsk People’s Republic, and meddling with democratic elections poses a significant threat to international order 4th largest oil reserves in the world, ahead of Kuwait High commercial shipping traffic – 25% of the world’s crude oil and liquefied natural gas passes through, and in total the area sees 3x more traffic than the Suez canal China utilizes the “cabbage strategy” to forcefully take islands from other nations with legitimate claims, in addition to dredging sand to create new islands US now regularly sails destroyers through the islands as part of Freedom of Navigation Operations, and is often trailed closely by Chinese vessels Sources: Department of Defense, Wall Street Journal, New York Times, Washington Post
2. Force Structure Assessment 2016 Relevant Shipbuilding to Huntington Ingalls Implications • Huntington Ingalls is the sole company that provides design, construction, and refueling and complex overhaul (RCOH) services of nuclear aircraft carriers. • Responsible for construction of 2 more Gerald R. Ford class carriers • 7 more ships – contracts likely awarded to HII • Huntington is 1 of 2 companies that constructs the surface combatants (destroyers) and nuclear powered submarines • Force Structure Assessment 2019 to be conducted in response to the new National Defense Strategy likely to provide upside to USN objectives • 46 ships out of all USN objectives expected to be launched within next five years • Uncertainty regarding sequestration relief after 2019 indicates much of Huntington’s new contracts will be awarded within the next few years and a steady backlog of a revenues
3. Portfolio Exposure S&P 500 vs Defense Spending, 1947-Present Diversification Insulation from Recessions As it currently stands, 26% of the Investment Club portfolio is in Tech, Media, and Telecom None of the Club’s holdings are in the Aerospace & Defense Sector Resultantly, adding HII to the portfolio could add a bonus in terms of diversification Historically, defense spending hasn’t been constrained by stock market recessions – if anything, the opposite is true The rollback in spending following the Great Recession was the result of a militarily complacent administration running $1T budget deficits and wasn’t in response to the markets per se Since being spun off of Northrup Grumman, HII has had backlogs in excess of $15bn – currently $21.2bn in orders, which could take 3 years to fill in the absence of new contracts Resultantly, naval contracts position HII very well for recessions Source: NDIC
Final Recommendation Downside Price Target - $216.71 Downside – 2.3% Base Case Price Target - $268.24 Upside – 20.9% Upside Case Price Target - $327.34 Upside – 47.6% Huntington Ingalls Industries, Inc. (NYSE: HII) is undervalued in the market. The market fails to capture the unique position Huntington is in during these next couple years as the leading military shipbuilder. We recommend a buy.
Appendix Q & A
Products and Services Source: Company Filings
Backlog Analysis – America Class Amphibious Assault Ships ($mm)
Virginia Class (SSN 774) Fast Attack Submarines Blocks 3, 4, 5
