Military shipbuilder Huntington Ingalls (NYSE:HII) beat its earnings estimates for the fourth quarter of 2018. In the report delivered earlier this month, it revealed that sales increased 10% year over year for both the quarter and the year as a whole. Profits more than tripled for the quarter, and were up a lower, but still staggering, 82.5% for the year -- to $19.09 per diluted share.
And yet Huntington stock is now actually trading a few pennies below what it cost on earnings day. After an initial rush of enthusiasm over the Q4 results, the market has dialed back its optimism, and so here the shipbuilder's stock sits, becalmed on the ocean's swells.
What will it take to get Huntington Ingalls stock moving higher again? Management dropped a few clues in its post-earnings conference call with analysts. Let's listen in.
Get ready to welcome your new aircraft carrier(s)
At Newport News, the team is focused on completing ship erection of CVN 79 Kennedy in the spring, and painting of the hull in late summer or early fall in the support of launch planned for the fourth quarter of this year. The ship is approximately 87% structurally complete, with 390 of 448 lifts joined together in the dry dock, and approximately 55% complete overall, [built with help from] lessons learned from CVN 78 USS Gerald R. Ford. -- Huntington Ingalls CEO Mike Petters
Let's start with the big news -- a big, new aircraft carrier. Actually the biggest ever built , by anyone, anywhere, the USS John F. Kennedy will be the second carrier of the Gerald R. Ford class. It probably won't be officially delivered to the Navy this year -- but five other warships will: the USS Delaware nuclear fast-attack submarine, two guided missile destroyers, an amphibious warfare vessel and a national security cutter for the Coast Guard.
And after Kennedy is delivered, Huntington will proceed with building two more aircraft carriers for the Navy. Contracts worth $15 billion to build USS Enterprise (CVN 80) and an as-yet-unnamed "CVN 81" were awarded to the company at the end of January.
Backlog is booming
We received approximately $3.3 billion in new contract awards during the quarter, including contracts for NSC 10 and 11, which is the continuation of the stable serial production program for the Coast Guard. As a result, our backlog was approximately $23 billion at the end of the quarter, of which approximately $17 billion is funded. The two-ship contract award for CVN 80 and 81 announced at the end of January is a significant step toward building these ships more efficiently and affordably. And this contract increases backlog by over $15 billion. -- Petters
Indeed, based on the backlog of work (and revenues booked, and profits earned), business seems to be booming at Huntington Ingalls these days. The $3.3 billion in new contract awards received in Q4 2018 exceeded the $2.2 billion in revenues it recorded during the quarter by 50% -- a 1.5 book-to-bill ratio -- and that doesn't even count the $15 billion award to build the next two Ford-class supercarriers, which came down after Q4 had already ended.
Huntington Ingalls even landed an order to build six new Arleigh Burke-class guided missile destroyers (DDG 51s). At a unit cost of $1.8 billion per ship , that's nearly $11 billion in revenues -- nearly as much as the price of an aircraft carrier.
Revenues and profits
During the Q1 call last May, I commented that we expected the return on sales for [Newport News] Shipbuilding to be in the 7% to 9% range for 2018 and 2019. Even with the step back in the Virginia-class program, the 2018 reported return on sales for shipbuilding was 8.6%. And we expect to remain in the 7% to 9% range for 2019 and do expect to return to the historical 9% range in 2020 ... At Ingalls ... The backlog is expanding pretty dramatically. We're in a place where we feel pretty comfortable that next year we're going to back into 9% to 10% range ... across the whole business. -- Petters
And so our view is that the healthy blended business of shipbuilding ought to be a mix of very mature product lines with the significant volume of new work, and that blended, puts you in a 9% to 10% range. We've been very consistent about that since we left Northrop Grumman. We still believe that to be the case. -- Huntington Ingalls CFO Christopher Kastner
So revenues are going great guns. What about profits earned on those revenues?
Huntington Ingalls is coming off of a fabulous fiscal 2018 during which operating profit margins hit an all-time high of 12.3%, and margins on "continuing operations" reached 10%. This was great news, but as Petters observed, management doesn't expect these conditions to last forever.
Judging from the comments of its two top executives, 2019 should be the year that things get back to more or less normal at Huntington Ingalls -- "normal" being an operating profit margin of somewhere between 9% and 10% across the company.
Revenues, profits ... and free cash flow
If the nation were to decide that they wanted to ... go to a three Virginia-class per year build rate, concurrent with the Columbia-class program, then that would probably require another thought on capital. But we are not seeing that being the discussion today, and so we feel pretty comfortable with the capital investments that we've made on the VCS program. And even if they add a ship here or a ship there, we think that that ... we're well positioned to support that. -- Kastner
Free cash flow at Huntington was similarly impressive -- not a record high, but still pretty impressive at $451 million in real cash profits, according to data from S&P Global Market Intelligence. Huntington calculates these things differently -- by its estimation, FCF was $512 million. But whichever number you use, the company did set a new record for capital investment, spending $463 million on it last year, which held down that FCF figure.
One piece of good news is that it looks like last year's investments may mean more modest capex spending in the years ahead. In the course of discussing its own Virginia-class program last month, General Dynamics -- which builds those submarines in tandem with Huntington Ingalls -- had a few things to say about capex. In particular, GD management noted that the Block V boat will be "a significant upgrade in size and performance" over Block IV Virginia-class subs, "requiring additional manufacturing capacity" to produce, which accordingly would eat into GD's capital budget.
This doesn't seem to be the case at Huntington Ingalls, however, where the CFO seems confident that simply building a bigger, better Block V boat won't require additional capital investment. Now, a 50% increase in the pace of building those subs might require it to spend more -- but then again, that would bring significant additional revenues to help pay for the capex.
Thinking long term
We are still confident with a [revenue] 3% CAGR '17 through '22. Obviously, we had a good 2018. But we don't really expect that to continue. -- Kastner
Yeah, and I would just go and point out that what's actually going to happen here beyond the persistent 3% growth in shipbuilding is that the backlog is going to put us in a place where we're going to be able to talk about not just five years but 10 years. -- Petters
So what does all of this tell us about Huntington Ingalls' long-term prospects as a stock? Here we have the company's two top execs promising a 3% long-term revenue growth rate. And earlier in the call, they reiterated a long-term target of perhaps 9% (or more optimistically, 10%) for the operating profit margin.
Analysts polled by S&P Global are currently predicting a 40% long-term annual earnings growth rate for Huntington Ingalls -- but judging from the executives' comments, this is definitely not in the cards. In fact, given a decline in operating profit margin from 12.3% last year to 9% (or even 10%) in future years, I'd think that even with 3% revenue growth, Huntington Ingalls may find itself challenged just to maintain its current level of GAAP profitability, much less growth it, and much, much less grow it at 40%.
To reiterate: That 40% growth projection is what the analysts are saying -- not what management is promising. As for me, I'd be looking more for a drop-off in profitability at Huntington Ingalls this year, and much slower earnings growth over the next five years, than the 26% (compounded ) rate of income growth that we've seen over the last five.
That won't be welcome news for Huntington Ingalls stockholders, I know, but I think it's better to know this beforehand than to risk disappointment later on.