In a cryptic note released last Friday, loaded with more acronyms than you can shake a stick at, investment banker Credit Suisse announced that it is upgrading the stock of Huntington Ingalls Industries (NYSE:HII), and raising its price target to boot.
Previously pessimistic on the builder of military warships, Credit Suisse removed its underperform rating from Huntington Ingalls stock on Friday, upgrading the shares to neutral. Simultaneously, it raised Huntington's price target from $115 to $130 per share -- but the reasoning behind both moves was pretty convoluted. As described on the pages of StreetInsider.com, Credit Suisse noted that Huntington "has been harvesting reserves from prior conservative margin bookings" for orders previously placed with it by the U.S. Navy. This helps the company to grow its profits a bit faster than might otherwise have been expected.
Giving with one hand, taking back with the other
On the other hand, despite upgrading the stock, Credit Suisse spent an inordinate amount of time talking about the risks in Huntington Ingalls' shares, rather than on the opportunities. According to Credit Suisse, high-margin work building aircraft carriers and "LHAs/LPDs/NSC" -- two variants of amphibious assault warships, and also the U.S. Coast Guard's National Security Cutter -- is expected to give way to lower-margin work in the future. Indeed, according to Credit Suisse, one of the big risks it's monitoring is the potential that Huntington Ingalls will win contracts to build a new San Antonio-class amphibious transport dock (LPD 28), and perhaps a series of contracts to build T-AO(X) oilers as well.
And that's bad news why?
Why does Credit Suisse consider the potential winning of contracts a possible downside for Huntington Ingalls investors? Because depending on how much the Navy promises to pay for them, and how much it costs to build the vessels, the new ship designs "can reintroduce some risk into sector margins."
Simply put, until we see what kinds of profit margins Huntington Ingalls is able to produce in the course of building these ships, Credit Suisse thinks we can't assume those margins will measure up well against what Huntington has produced in the past.
That's a curious -- and counterintuitive -- interpretation of a company winning contracts, to say the least. It's not one, however, that we should ignore. Over the past five years, Huntington Ingalls has consistently expanded its operating profit margins. S&P Capital IQ data show Huntington earning as low as 5% operating profit margins five years ago, rising to more than 11% today.
Now, that sounds like good news: 11% is significantly better profit than what rival General Dynamics (NYSE:GD), for example, earns on its Navy shipbuilding contracts, and one interpretation of the data is that Huntington is just plain doing a better job earning profit on its work than its rival is. On the other hand, General Dynamics has shown a lot of consistency in its profit margins over the past five years. General D's Marine Systems division pretty much always churns out steady 10% margins from shipbuilding.
If what General Dynamics has been earning is closer to the "right" profit margin for a military shipbuilder, then Huntington Ingalls' margin growth may turn out to be more of a pendulum movement, starting below the "right" level of profit, then swinging high above it, only to later revert back to the mean in future years. If that's what the future holds for Huntington, then it would obviously not be good news for its profits -- or for shareholders.
While I can't say for certain this is the right interpretation to make of the data, Credit Suisse certainly deserves credit for highlighting the possibility.
Fool contributor Rich Smith does not own shares of, nor is he short, any company named above. You can find him on Motley Fool CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 245 out of more than 75,000 rated members.
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