Shares of Huntington Ingalls Industries (HII +0.82%) plunged more than 8% on May 3 after the company reported first quarter earnings that came in well below analyst estimates. The shipbuilder had been climbing steadily higher leading up to earnings season, propelled by increased Pentagon spending and calls from the Trump Administration to dramatically expand the U.S. Navy.
Was Huntington's miss a one-time stumble, or a realization by the markets that investor enthusiasm had outpaced financials? Here is a look at the company's recent results, its updated outlook, and whether the company is a buy after this recent drop.
The USS George Washington navigates Huntington Ingalls' Newport News shipyard. Image source: Huntington Ingalls.
Margin mishap
You'd never know it from the stock reaction, but much of the earnings miss is attributable to a one-time retirement benefit expense triggered by changes in the tax law. Even with the one-time item, net income came in at $156 million, a 31% improvement over the same three months of 2017. Revenue, at $1.87 billion for the quarter, was up 8.7% from a year prior.
Still, there were reasons for concern with the company's quarterly results. Huntington Ingalls said to expect shipbuilding margins in the 7% to 9% range for 2018 and 2019, below the 9% to 10% range CEO Mike Petters said should be expected if the company has a "healthy blend" of older, more lucrative orders and newer, less profitable orders and "executing well." Petters on the call with analysts said the margins are tied to the significant number of recent orders the company has received, noting that it does not fully recognize income until it retires risk by delivering a completed ship.
"We look out over the next couple years and we see the major amount of shipbuilding coming down the pipeline, so that's going to put us even more out of balance," Petters said. Huntington Ingalls expects to deliver four ships in 2018, down from six in 2017.
Of course, over time having an increase in orders is good news for Huntington Ingalls and its shareholders. The company believes that while the next few quarters could be uneven, the long-term outlook is strong.
"I wouldn't trade this position for anything," Petters said. "Frankly, this is the most exciting shipbuilding environment in over 30 years."
Benefits of a bigger Navy
Indeed, the long-term outlook for Huntington Ingalls provides plenty of reason for optimism. The Pentagon is planning to order guided-missile destroyers and submarines in bulk, with a new Coast Guard cutter and amphibious ship on deck. More importantly for Huntington Ingalls, as the nation's sole builder of aircraft carriers, the Navy is inching toward ordering its next two carriers at once.
The House Armed Services Committee included authorization of a two-carrier contract in its version of the fiscal 2019 authorization bill released last month, a clear indication that momentum is headed in that direction.
Petters has been a vocal advocate for multi-ship orders, arguing that the labor and procurement savings that can be generated from building two ships at once would benefit both the company and the government. It would also help stabilize the ebb and flow nature of Huntington's labor force, helping to keep expert workers on the payroll year-round and reduce training costs.
At quarter's end, Huntington Ingalls had about 25 ships under contract. The company sees the potential to add 20 to 30 additional ships by the end of 2020.
A patient buy
Huntington Ingalls, despite the potential for new orders, remains a relative bargain among government contractors. The company trades at 20.14 times trailing earnings, a 20% discount or more to the valuations of Northrop Grumman, Raytheon, or Lockheed Martin.
Granted, Huntington is only one-third of the size of the smallest of those companies, and while the others are diversified, HII is reliant on the U.S. Navy. But for the next few years at least, strong ties to the U.S. Navy is a positive for the company. Huntington is also traditionally the least-profitable of the major defense contractors, with a 12% trailing-twelve-month Ebit margin compared to 12.17% for Lockheed, 13.15% for Raytheon, and 13.61% for Northrop. Even if those margins prevent Huntington from closing the valuation gap completely, that 20% difference seems unwarranted.
Huntington Ingalls is a well-run company positioned to soak up more than its fair share of the growing U.S. defense budget. The recent quarter was a reminder that this voyage will not be without some choppy seas. But for long-term holders, Huntington Ingalls is a definite buy.
