Huntington Ingalls Industries (HII 1.37%) has stepped up its effort to diversify past its core shipbuilding business. It's a move the company needs to make, but investors should prepare for some potentially rough waters ahead.
On July 6, Huntington announced plans to acquire Alion Science and Technology from private equity firm Veritas Capital. The deal, priced at $1.65 billion in cash, would greatly expand Huntington Ingalls' technical services division.
Northrop Grumman spun Huntington Ingalls out as an independent back in 2011 in part because the defense titan worried the shipbuilding business was a potential anchor on long-term earnings growth. Huntington Ingalls is now charting a course to expand beyond its core, but the transition will not be an easy one.
Building a smarter shipbuilder
Alion provides advanced engineering and research focused on intelligence, surveillance, military training, cyber solutions, and simulations. The U.S. Navy, a customer Huntington Ingalls knows well, accounts for about one-third of the company's revenue, with the Air Force and classified work each accounting for about 25%.
Specifically, Alion does jobs including airborne sensor integration, big data analytics and cyber support, and Navy training. About 80% of Alion's employees maintain security clearances.
The deal adds about $3 billion in future business to Huntington Ingalls' backlog, and with Alion boasting a 90%-plus rate of winning recompetes, the business should be steady. That's different from shipbuilding, which tends to center on big-ticket, multiyear contracts that can mean choppy revenue results.
Although shipbuilding remains an important Pentagon priority, as boats get increasingly advanced and in some cases autonomous, some of the value proposition is moving from the metal benders who build the ships to the engineers who wire and program them. Huntington Ingalls has been attempting to capture more of that business, in recent years acquiring Hydroid and Spatial Integrated Systems as part of a campaign to build its tech credentials.
"We established the Technical Solutions division in 2016 with a vision and strategy focused on partnering with our customers to solve their most pressing challenges," CEO Mike Petters said in a statement. "Today's announcement, coupled with our previous investments in leading edge technologies, such as cybersecurity and autonomous systems, reflects our commitment to stay on the cutting edge of critical, high-growth national security solutions and generate significant long-term value for our shareholders."
No smooth sailing
Alion is a step in the right direction in terms of diversification, but there are some potential issues investors should be aware of. Unlike Huntington Ingalls' previous M&A efforts, Alion does not do much to address what is perceived by the market as the company's primary vulnerability: the rise of uncrewed ships.
For all the promise of Huntington Ingalls' moves to broaden its scope, there has been little payoff to date. The technical services division generated subpar 2.7% operating margin in the first quarter of 2021 and a 3.2% margin for all of 2020.
Alion is not coming cheap, priced at 12.2 times expected 2022 earnings before interest, taxes, depreciation, and amortization (EBITDA) and at a premium to the $1.6 billion in expected 2022 revenue. The alternative, leaning in on shipbuilding and using the cash to reduce the share count, is not nearly as glamorous as M&A but carries a lot less execution risk.
Don't board yet
In one sense, Huntington Ingalls arguably needs to do something. The company trades at a substantial discount to other big-platform defense contractors because markets are worried the shipbuilding business is at risk of falling behind due to the technology revolution infusing Pentagon platforms.
General Dynamics has a similarly large shipbuilding business supplemented by technology, aerospace, and land equipment, and is afforded a premium to Huntington Ingalls.
But given Huntington Ingalls' questionable merger track record, the high price paid for this acquisition, and the suggestion that it might be part of a larger M&A buildout into a new area, there is reason for pause. This isn't a company that has shown enough to earn the benefit of the doubt in recent years, and investors should take a wait-and-see approach as Alion is integrated.
The good news for Huntington Ingalls is the company has charted a course toward a higher multiple. But there remains a long, perilous journey up ahead.