The bull case for shipbuilder Huntington Ingalls (NYSE:HII) is centered in no small part on the company's place as the sole builder and maintainer of the nation's fleet of nuclear-powered aircraft carriers. A reported shift in Navy thinking over the need for a massive carrier fleet could challenge Huntington's growth expectations, though it's too soon for investors to react to the speculation.
The Navy is considering not requesting funding in its fiscal 2020 budget to begin prep work to refuel and upgrade the USS Harry S. Truman, a Nimitz-class supercarrier launched in 1996 and due to remain in the fleet well into the 2030s, according to a report on BreakingDefense.com.
The move would save the Pentagon upward of $30 billion over 25 years in refueling costs, personnel costs, and operating expenses. But it would also face severe opposition from Congress and is far from certain to occur even if naval leaders believe it is the best path forward.
A big-ticket budget casualty?
The Truman overhaul, scheduled to begin in 2024 at Huntington Ingalls' Newport News shipyard, would generate about $6.5 billion in revenue for the company over a four-year period. Truman was built and launched from Newport News with an expected 50-year service life, but that was assuming periodic maintenance, upgrades, and a mandatory midlife restocking of the reactor's core.
The push to skip the overhaul was reportedly part of a deal inside the Pentagon that includes the Navy ordering its next two carriers simultaneously, a big win for Huntington Ingalls and the result of a long-term lobbying push by the company. But given the long lead time required to build a carrier, retiring the Truman early would shrink the Navy's carrier fleet from 11 to 10 in the mid-2020s.
There's more at stake for Huntington Ingalls and fellow shipbuilder General Dynamics (NYSE:GD) beyond the $6.5 billion in lost refueling revenue. A modern aircraft carrier does not sail alone but rather relies on a large number of escorts and affiliated ships that also need to be acquired and staffed. There is also the expense of finding pilots for the large number of planes that are housed on a carrier.
In 1991, when the Navy sailed 15 carriers, it had a fleet of 529 ships, according to data compiled by the Center for a New American Security. By comparison, in 2002, with 12 carriers, the fleet was 313 ships.
Investors have been enthusiastic about the prospects of the Navy growing its fleet to 355 ships in the years to come. But it is possible that given the procurement, personnel, and maintenance costs associated with more warships, coupled with advances in lower-cost autonomous ship and submarine technologies, the Navy is rethinking its strategy.
Opposition will be intense
If the Navy wishes to retire the Truman early, it's in for a fight. By law, the Pentagon is required to have at least 11 operational carriers, and the White House has publicly pushed for that number to increase instead of shrink. The last proposal to retire a carrier early -- in 2014, the USS George Washington was earmarked to skip an overhaul -- was blocked by Congress.
Indeed, the talk of retiring the Truman is likely at least partially motivated by budget negotiations, with the Navy using a ship that is popular with Congressional leaders as a bargaining chip to win a greater share of military funding in the upcoming fiscal 2020 budget.
But the economics behind the move do point to the challenges to the long-term plan to grow the fleet. In addition to carriers, the Navy has priorities including the Columbia-class ballistic submarine to pay for before any additional smaller surface ships are considered.
Factor in growing concerns by some military experts -- including former Secretary of Defense James Mattis -- that new advanced missile technology being developed by potential adversaries Russia and China could make carriers vulnerable to attacks, and there is some logic to allocating resources elsewhere instead of going full throttle into expanding the carrier fleet.
Keep expectations realistic
It's hard to imagine lawmakers letting the Truman die, but given the planned refueling isn't to begin until 2024 and can be delayed by a few years, it is possible that the issue will be left unresolved in the current year's budget negotiations. Whatever happens, the threat is a shot across the bow at Navy expansion plans and should be taken seriously by investors in shipbuilders.
There is no risk that business will dry up on Huntington Ingalls. In the fourth quarter, the company received $3.3 billion in new contracts, ending the year with a total backlog of $23 billion. The two-ship carrier award came after the quarter ended, giving Huntington Ingalls visibility into future revenue streams nearly a decade out.
But the best-case scenario for the shares, a surge in orders by the Navy to try to hit the 355-ship fleet objective, appears to be crashing into harsh economic realities. The Congressional Budget Office last October estimated it would cost $28.9 billion annually over the next 30 years to implement that expansion plan, nearly 80% more per year than the funding for shipbuilding that the Navy has received in recent decades.
There's still a case to buy Huntington Ingalls. But that case is based on the slow but predictable revenue growth well into the middle of the next decade from the orders already in place and not based on the potential for much faster growth from a supercharged Pentagon budget.
The Navy fleet will grow, and Huntington Ingalls will benefit from it. But as the battle over the Truman illustrates, there will be trade-offs along the way.