Huntington Ingalls Industries (NYSE: HII) is the largest military shipbuilder in the United States. Despite long planning horizons and budget visibility, tweaks to timing around big programs can lead to lumpy quarterly results, which had likely damped enthusiasm for these undervalued shares. But we think Huntington Ingalls stock looks attractive today, trading in 4-star territory.

Given its ties to the Department of Defense as the sole provider of nuclear aircraft carriers and turbine-powered amphibious landing ships (and its position as one of two producers of nuclear submarines for the US Navy), the company is poised to generate recurring profits well into the future. Huntington Ingalls is one of Morningstar chief US market strategist Dave Sekera’s 4 new stocks to buy with catalysts for future gains.

Huntington Ingalls generates revenue on almost every significant military shipbuilding contract; in some cases, as with aircraft carriers, it’s the only supplier. The company derives four fifths of its revenue and practically all of its profits from building ships for the US Navy.

Ships are the longest-cycle defense product, as vessels takes years to manufacture, remain in service for decades, and are typically purchased in blocks to reduce unit costs. These long lead times mean that funding for a project, once awarded, is difficult to cut, and block purchases give the builder visibility into long-term revenue. Huntington Ingalls’ top line is therefore less sensitive to changes in the defense budget than peers, making it a defensive play even among defense contractors. The major value drivers for Huntington Ingalls are nuclear-powered submarines and large surface warships.

Key Morningstar metrics for Huntington Ingalls

  • Fair Value Estimate: $317
  • Star Rating: 4 Stars
  • Economic Moat Rating: Wide
  • Uncertainty Rating: Low

Economic Moat Rating

The durability of economic profits in the defense sector may seem paradoxical: Large defense contractors invest billions of dollars to generate cutting-edge products whose unit pricing tends to decline over time. What’s more, these companies primarily sell to a single buyer with rapidly evolving needs, a tendency to change product requirements, and occasional squabbles over paying the bill.

Nonetheless, wide moats are prevalent at the large end of the defense contracting business. These durable competitive advantages exist because of significant intangible assets. First among these is the extreme product complexity that thwarts new entrants, bolstered by decades-long product cycles and contract structures that reduce risk for incumbents and lock out alternative suppliers. We also see the switching costs of a risk-averse customer facing significant time and risk to change products or suppliers as a competitive advantage.

Fair Value estimate for Huntington Ingalls shares

Our $317 fair value estimate implies an enterprise value/2024 EBITDA multiple of 12.5 times. At the Ingalls shipyard, over the next five years we forecast revenue from amphibious warships will remain essentially flat, although we expect revenue from Arleigh Burke destroyers to grow 14% annualized.

At the Newport News shipyard, we forecast revenue from building and refueling nuclear aircraft carriers will also remain essentially flat around $2.8 billion per year, but we see construction of Virginia and Columbia class submarines growing 8% and nearly 30%, respectively, annualized over the next five years.

We forecast the technical solutions segment to grow about in line with the company and constitute 25% of revenue, albeit at a lower margin than shipbuilding. We’re normalizing our capital expenditure as a percentage of sales at about 2%, well below recent averages around 4%, but roughly in line with the trailing 10-year average. Our terminal operating margin forecast is approximately 7.5%. Our normalized tax rate is 21%, and our weighted average cost of capital is 7.1%, reflecting low uncertainty around cash flows and negligible exposure to macro and market volatility.

Risk and Uncertainty

We think the biggest risk is that the Navy may deprioritize the procurement of one of Huntington Ingalls’ major programs. The company’s biggest revenue stream is its sole-source contract for nuclear-powered aircraft carriers, and we think there is a material chance that the Navy may reduce its long-term goal of maintaining 11 such craft, in order to free up budget dollars and allow more commitment to the distributed maritime operations model. However, the impact would be limited to a distant future order—the most likely outcome, in our view—and it would also result in increases in demand for other Huntington Ingalls products, such as amphibious assault ships or future versions of destroyers and unmanned watercraft. Although US defense spending has risen recently, the risk remains that defense budgets get caught up in political wrangling.

Huntington Ingalls bulls say

  • The National Defense Strategy prioritizes modernizing the military to counter potential great-power adversaries. We think this will increase the proportion of the defense budget available to contractors.
  • Huntington Ingalls is one of two major shipbuilders for the US Navy, which is a difficult-to-replicate business. The US has a vested interest in maintaining the financial viability of the company.
  • Defense prime contractors operate in an acyclical business, and shipbuilders are particularly acyclical, which could offer some protection from an eventual US recession.

Huntington Ingalls bears say

  • Competing claims on future US budgets may depress defense spending.
  • Huntington Ingalls used capital to acquire Alion, a defense services company, which is outside its core shipbuilding competence.
  • Fincantieri Marinette Marine won the Constellation-class frigate contract. and we expect that this company may become a competitor for some future contracts.

Terms used in this article

Star Rating: Our one- to five-star ratings are guideposts to a broad audience and individuals must consider their own specific investment goals, risk tolerance, and several other factors. A five-star rating means our analysts think the current market price likely represents an excessively pessimistic outlook and that beyond fair risk-adjusted returns are likely over a long timeframe. A one-star rating means our analysts think the market is pricing in an excessively optimistic outlook, limiting upside potential and leaving the investor exposed to capital loss.

Fair Value: Morningstar’s Fair Value estimate results from a detailed projection of a company's future cash flows, resulting from our analysts' independent primary research. Price To Fair Value measures the current market price against estimated Fair Value. If a company’s stock trades at $100 and our analysts believe it is worth $200, the price to fair value ratio would be 0.5. A Price to Fair Value over 1 suggests the share is overvalued.

Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. To learn about finding different sources of moat, read this article by Mark LaMonica.

Uncertainty Rating: Morningstar’s Uncertainty Rating is designed to capture the range of potential outcomes for a company. An investor can think of this as the underlying risk of the business. For higher risk businesses with wider ranges of potential outcomes an investor should consider a larger margin of safety or difference between the estimate of what a share is worth and how much an investor pays. This rating is used to assign the margin of safety required before investing, which in turn explicitly drives our stock star rating system. The Uncertainty Rating is aimed at identifying the confidence we should have in assigning a fair value estimate for a stock. Read more about business risk and margin of safety here.

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