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Here's What Wall Street Got Wrong About This Defense Stock

By Lou Whiteman - Nov 18, 2018 at 9:33AM

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Free cash flow marred an otherwise solid quarter. There's a lot to like about the stock despite a 6% price drop.

Shipbuilder Huntington Ingalls Industries (HII -0.59%) recently reported third-quarter results that topped estimates for both earnings and revenue, and increased its dividend by nearly 20%, yet the shares fell 6% after the results on fears of weaker-than-expected cash flow in the quarters to come.

Huntington Ingalls is in the early stages of a push to expand the Navy, and its outlook is a lot brighter than the post-earnings stock reaction would suggest. The company owns shipyards throughout the Gulf Coast and the massive Newport News facility in Virginia, across the James River from the U.S. Navy's Fleet Forces Command. It has a backlog of more than $22 billion, including steady work building the nuclear-powered carriers that are the centerpiece of Navy strategy.

USS Gerald R. Ford at sea

The USS Gerald R. Ford, the lead ship of the current carrier class, at sea. Image source: Huntington Ingalls.

Here's a look at where Huntington Ingalls stands following third-quarter results, with an eye toward determining whether investors should expect smooth sailing in the quarters to come.

About that cash...

Huntington Ingalls in the third quarter updated some of the assumptions surrounding its pension projections, and in turn analysts reduced their expectations for 2019 free cash flow from $750 million to less than $700 million. The company won't officially offer 2019 cash guidance until its next quarterly review, but the markets appear to be concerned that the pension-related cash recoveries that have helped to boost free cash flow are running out.

Company CEO Mike Petters on a call with investors said Huntington Ingalls believes its pension strategy will help it to be more competitive in the years to come. The company's pension plans are near fully funded, which should mean reasonably sized contributions in the future and no pension-related price shocks for customers.

As we work our way through how we describe impact of pension for next year and cash recoveries for next year and the year after, I'm pretty happy with where we are because I think we are in a much more competitive position, and I think our products are going to be more affordable. And in an environment where every dollar in the budget is a knife fight, that's not a bad place for us to be. 

Investors should note that expected decreases to future capital expenditures should help to offset falling pension-related cash recoveries. Huntington Ingalls has been involved in some early-stage development work of late, which tends to be more expensive, but expects total 2019 capex to be flat compared to this year, and to fall by as much as $200 million in 2020.

Meanwhile, there is no sign that the company is cutting corners. In November 2015, Huntington Ingalls committed to returning "substantially" all free cash to shareholder in the form of repurchases and dividends, with a plan to increase the dividend by at least 10% annually. Since that time, the company has invested more than $900 million to modernize its facilities, but has kept up with the dividend plan and has spent about $1 billion to repurchase 4.9 million shares.

A healthy and growing order book

Huntington Ingalls was awarded $2.8 billion in new orders in the third quarter, including $1.8 billion for two new Arleigh Burke-class destroyers, and said work on the John F. Kennedy, the Navy's next carrier, is ahead of schedule and 84% structurally complete. Its Ingalls shipyard in Pascagoula, Mississippi, maker of a range of destroyers and other surface ships, should see an increase in deliveries early in 2019 versus full-year 2018. That's good news for margins as early-stage work in ship construction tends to be less profitable.

The biggest catalyst for Huntington Ingalls heading into 2019 is a prospective order for a new multi-ship carrier. The Pentagon has warmed to the company's suggestion that carriers, despite their $10 billion-plus price tag, should be ordered in bulk to allow the company to save on component sourcing prices and by keeping specialized workers year-round instead of going through the expense of staffing up and retraining for every ship.

Petters on the call said that Huntington Ingalls continues to have talks with the Pentagon and legislators about the next carrier order, calling the talks "very substantive and constructive dialogue." Although the company is not ready to predict an outcome or a timeline for when a decision could be made, it appears likely that Congress could move forward with a two-ship carrier buy in the first half of 2019. That would provide a boost to Huntington Ingalls' backlog and give investors added clarity into revenue projections well into the mid-2020s.

Other potential awards in the quarters to come include a new block of Virginia-class submarines to be split with General Dynamics, and the introduction of a new amphibious warship with a dock landing platform for use by the Navy and the Marine Corps. The Navy is also considering a $20 billion-plus order of about 20 frigates in what is expected to be a winner-take-all competition that could be decided before 2020.

Full steam ahead

Shares of Huntington Ingalls have been stuck in dry dock all year, down 8.9% over the past 12 months and underperforming all the major defense contractors. The company is relatively affordable as well, last among its peers with a 16.14 price-to-earnings ratio.

HII Chart

HII data by YCharts.

There are reasons for that discount: Huntington Ingalls' reliance on the U.S. Navy makes it the least diversified company in the industry, and the nature of shipbuilding means Huntington Ingalls is tied to multiyear projects that have substantial ramp-up costs and are at risk for delays and unexpected expenses.

But investors should take note of Huntington Ingalls' standing with the U.S. Navy, as evidenced by the Pentagon even considering taking on the risk of a multi-carrier buy. Huntington Ingalls has a solid book of business, which will take it well into the next decade, and potential additional wins on the horizon.

Huntington Ingalls offers predictability, slow but steady growth, and a forward dividend yield of 1.3% with the potential to grow. This stock isn't for everyone, but it's a great option for a conservative portfolio in search of some upside without taking on too much risk.

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