– By Nathan Parsh
Shares of Huntington Ingalls Industries Inc. (NYSE:HII) are down slightly since I last looked at the company, but I feel this has given investors looking for exposure to the defense sector another opportunity to purchase the stock.
Huntington Ingalls may not be as well known as its larger counterparts in the defense sector, but the company has produced strong results recently. The stock also offers an above-average dividend yield and shares look significantly undervalued today.
Huntington Ingalls reported third-quarter results on Nov. 5. Revenue grew 4.3% to $2.31 billion, topping Wall Street analysts’ estimates by $111 million. The company’s GAAP earnings of $5.45 per share was a 46% improvement from the previous year and $1.33 above expectations. Contributing to results was a lower tax rate due to a claim for higher research and development tax credits in the preceding years. Operating margins dipped just five basis points to 9.6%.
The Ingalls Shipbuilding segment grew 4.3% to $657 million. This segment benefited from higher revenues for surface combat ships, especially in the destroyer program. The Legend-class National Security Cutter program, which supplies the U.S. Coast Guard with its flagships, all had increased volumes. Partially offsetting this was lower volumes for amphibious assault ships. Operating margins were down 20 basis points to 9.2%.
Newport News Shipbuilding was higher by 6.6% to $1.4 billion. Higher volumes for the Block V Virginia-class nuclear submarine program was the primary contributor. Volumes were also up for the improved Columbia-class ballistic missile submarine program, which has been identified as the Navy’s top priority program. Aircraft carrier revenues improved due to higher volumes on certain ships as well as an advanced planning contract award. Operating income decreased almost 35% due to lower risk retirement of the Virginia-class submarine program and lower profit booking rates. Operating margins decreased 368 basis points to 5.8% as a result.
Technical Solutions revenue fell 1.8% to $320 million. This decline was mostly due to the conclusion of several repair contracts at the San Diego Shipyard. This decrease was partially offset by Huntington Ingalls completed its acquisition of Hydroid Inc., a leading provider of advanced marine robotics in late March of this year. The integration of acquisitions and the related cost synergies helped drive a 380 basis point improvement in operating margins to 6.6%.
Huntington Ingalls received awards of approximately $1.6 billion during the quarter, which brings the backlog to $45.3 billion or 15.6% higher year over year. This gives company more than five years of business based on last year’s revenue results.
Most of Huntington Ingalls’ contracts are very long. For example, the Block V Virginia-class contract is a $22.2 billion fixed-price, multiyear agreement that will run from fiscal year 2019 through fiscal year 2023. Given the size of these contracts, it is extremely likely that these contracts will not be canceled regardless of which party controls government. This provides many years of reliable revenue for the company.
The company ended the quarter with $744 million of cash and equivalents on its balance sheet with access to another $1.75 billion of credit. The company has a total debt of $1.45 billion, but plans to prepay $600 million worth of debt that is due in 2025.
Huntington Ingalls also gave update guidance for 2020. The company expects shipbuilding revenue to be at the high end of its previous guidance of $7.6 billion to $7.9 billion, with margins of 5.5% to 6.5%. Technical solutions revenue is also projected to be at the upper end of prior guidance of $1.2 billion to $1.25 billion. The company expects margins of 2.6%, higher than its prior guidance. Free cash flow should be in excess of $500 million this year.
Analysts expect Huntington Ingalls to earn $15.56 in 2020 according to Yahoo Finance. With shares trading for $161 currently, Huntington Ingalls has a forward price-earnings ratio of 10.3.
Huntington Ingalls has traded with an average price-earnings ratio of 14.4 since being spun off from Northrop Grumman (NYSE:NOC) in 2011. Compared to its own historical average, Huntington Ingalls’ stock is 40% undervalued.
GuruFocus is in agreement with the assessment that Huntington Ingalls is trading below its intrinsic valuation.
According to GuruFocus, Huntington Ingalls has a GF Value of $255.40. Using the most recent price, the stock has a price-to-GF Value ratio of 0.63, which earns Huntington Ingalls a rating of significantly undervalued.
Reaching the GF Value would result in a price gain of 59% from current levels.
Huntington Ingalls easily topped analysts’ estimates for the company’s third quarter, with an especially strong performance on the bottom line. The company’s two largest segments showed growth year over year. I consider operating margins coming in flat compared to the prior year a win considering margins for the largest segment, Newport News Shipbuilding, were down almost 4%.
The stock also offers a dividend yield of 2.9%, which is more than a full percentage point above the average yield of the S&P 500 and almost three times the stock’s average yield since Huntington Ingalls began paying a dividend in 2012. The company has raised its dividend at an annual rate of 16.3% over the last five years, with an 11% increase announced earlier this year.
Huntington Ingalls’ stock is well off its average price-earnings ratio. The stock looks even cheaper when using GuruFocus’ intrinsic value. Including dividends, total return for Huntington Ingalls could be in a range of 40% to 60%. All it would take to achieve high double-digit gains would be for the stock to trade with at least its average historical valuation. Given the company’s recent performance, its long-dated contracts and massive backlog, I continue to feel that Huntington Ingalls is vastly undervalued.
For these reasons, Huntington Ingalls looks to be an extremely deep-value opportunity.
Disclosure: The author has no position in any stock mentioned in this article.
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This article first appeared on GuruFocus.