You might have seen Huntington Ingalls' (NYSE:HII) earnings report last week, and you might have read what I had to say about the company's most important numbers. But unless you've also listened to management's post-earnings conference call with analysts, you still don't have the complete story on Huntington's penultimate quarter of the year.
So let's fix that. Here are five things you need to know about Huntington Ingalls and its business.
1. Huntington's (literal) flagship product
CVN 79 Kennedy is approximately 60 percent structurally complete and 35 percent complete overall. Construction is progressing very well as the team focuses on unit outfitting and assembly in the dry dock. In addition, the teams achieved a significant milestone with the first cut of steel for CVN 80 Enterprise. This is the third Ford-class Aircraft carrier, and it has the distinction of being the ninth U.S. Navy vessel to bear that great name.
-- Huntington Ingalls CEO Mike Petters
As one of America's two foremost military shipbuilders, Huntington Ingalls builds a lot of ships -- Arleigh Burke-class guided missile destroyers, America-class amphibious assault ships, nuclear submarines. But its flagship product is the nuclear-powered aircraft carrier. Currently, Huntington's Newport News shipyard is engaged in building a series of new Ford-class supercarriers to replace the existing Nimitz-class ships.
The Navy commissioned the first ship of this new class of carrier, the USS Gerald R. Ford (CVN 78), in July, and Huntington is already hard at work building the second ship of the class (the USS John F. Kennedy), and begun work on the third (the USS Enterprise) as well. The fourth ship of this line, which will be designated CVN 81, has yet to be named. At an estimated $13.3 billion per ship, the Ford class is the most expensive warship in the Navy -- each carrier "carries" a price tag worth nearly two years' worth of Huntington Ingalls' annual revenues.
2. Profit margins
[W]e're kind of moving toward the back end of the NSC program ... [and the] LPD program ... we're on the back end of that ... We're heading into a new round of competition on the Destroyer program. We're heading into a new round of -- or a new competition on a Frigate program. The LHA 7 is building off lessons learned from LHA 6 ... So we kind of look at each of those programs in terms of the relative maturity ... When you're on the back end of one of the block buys ... your opportunity register should look pretty good. When you're on the front end of the one of the block buys, there's a lot of risk in that. And that's kind of the way we look at every one of our programs.
It's important for investors in Huntington Ingalls stock to understand these dynamics. Basically, what Petters is saying here is that whenever Huntington Ingalls takes on the construction of a new class of warship, it expects to earn lower-than-normal profit margins initially. As the company gains experience in building a ship class, though, its profit margins expand over time -- reaching their zenith toward the "back end" of the program.
Now, in the context of Huntington's supercarriers, the first ship of the Nimitz class was commissioned in 1975. Huntington (or rather its predecessor companies) had more than 30 years to develop expertise and grow profit margins as it built 10 Nimitz-class vessels, one after the other.
Contrast that with the Ford-class program, where the Navy is buying only four ships -- three of which are being built simultaneously. Petters says that "when we came off of 78 ... we captured a lot of lessons learned like you do from a lead ship" and the savings are materializing as work begins on the later vessels. Still, this isn't going to be a long tail for Huntington. It's going to be a docked tail (if you'll forgive the nautical pun), and Huntington Ingalls isn't going to have as much time in which to gain expertise and grow profit margins before production winds down on the Ford family of carriers, as it already has with the Nimitz class.
3. What that means for Newport News
So at Newport News ... [w]e're on the first half of the CVN 79 ... we're at the beginning of an RCOH, and we're kind of even ahead of the beginning of Columbia class. And so ... at the beginning of all these programs, the risk registers are really, really high. And so we're very, very conservative [on profit margins predictions].
Partially acknowledging this, Petters isn't promising investors any immediate improvement in the 9.1% profit margins that Newport News turned in last quarter. Not only is its Ford-class work in early days, but the company is also taking on the task of helping to build the Navy's new class of Columbia nuclear ballistic missile submarines, and preparing to start up the refueling and complex overhaul (RCOH) needed to extend the life of the aircraft carrier USS George Washington (CVN 73).
All these projects are at the "front end" of their lifespans, and accordingly, margins can be expected to be tight.
4. What can investors expect margin-wise?
As I've said many, many times ... [operating margins] between 9% and 10% [are] healthy. If you're executing and you're below 9%, it means you probably have a majority of new programs. If you are executing and you are above 10%, it probably means you have a majority of very mature programs. What you're seeing in our shipbuilding business right now is exactly that. We have a lot of new programs at Newport News, we have a lot of mature programs at Ingalls, both yards are executing exceptionally well.
In a nutshell, this is why you are seeing Huntington's Ingalls Shipbuilding unit putting up 12.5% operating profit margins right now, while Newport News is eking out a 9.1% margin. In contrast to Newport News' several start-up projects, Ingalls' LPD, LHA, and DDG programs are in full swing and approaching their "back end," with correspondingly superb profit margins.
Long term, though, the pendulum will swing, and investors should still count on 9% to 10% operating profit margins as the norm for Huntington Ingalls as a whole.
5. The big reveal
We are heading into a new round of -- or a new competition on a Frigate program.
And one of the early requirements on this Frigate is that you have to have a parent design ... we're not going to start with a blank sheet of paper. You guys come to us with a parent design that we can then see if we can make it meet the requirements that we have for that kind of ship.
One final note, and this is something of a revelation. We've been talking for some years now about the Navy's plan to switch out production of Littoral Combat Ships (LCS) for something similar in size but more robust in stopping power -- a "frigate" class of warship. To date, I personally have assumed that this is a contract that would go to one of the incumbent LCS contractors -- Lockheed Martin, General Dynamics, or Austal.
Petters mentioned the frigate competition in last quarter's conference call, but only to the extent that he wanted to see "how the requirements shape out and if that even make sense" for Huntington to try to compete for the contract. Now that the Navy has confirmed that it wants a frigate based on an established ship design (which Huntington happens to have in hand, in the form of the National Security Cutter it builds for the Coast Guard), it sounds like the CEO's interest is well and truly piqued.
Now, if Huntington does get the contract, this is something that would be built by Ingalls rather than Newport News, and it would be a "front end" program that would probably depress margins for the division. But with tens of billions of dollars in new frigate revenues to be won, I suspect that's a sacrifice Huntington Ingalls would be willing to make.