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Huntington Ingalls Industries (HII) Memo
Important Company Financial Data
Thesis / Key Points Ø Huntington Ingalls Industries is entirely dependent on the highly volatile shipbuilding industry. Shipbuilding, even for the U.S. Navy,
has historically been burdened with extreme risks and variability in business dynamics. HII is not unique to its industry, as it has encountered its own travesties and continues to face growing risks to its ongoing operations. For instance, HII is highly dependent on flawless execution of its complex supply chain, with a strong reliance on the performance of subcontractors and the availability of affordable raw materials and technologically advanced long-‐lead components. Furthermore, the U.S. Government can withhold payments to HII when it deems systems to be inadequate, which would also result in serious reputational harm for HII, as has occurred from multiple quality issues on all classes of ships. Additionally, natural disasters have a profound impact on HII’s operations. Combined, $431 million in charges have been realized since 2008 for delays, poor-‐quality work, and damages from Hurricane Katrina. HII has also incurred costs related to the consolidation of all Gulf Coast construction into HII’s Pascagoula, Mississippi, facilities from the wind down of the Avondale, Louisiana, shipyard. HII could also suffer if it is unsuccessful in negotiating new collective bargaining agreements with HII’s 20,000 unionized employees as the agreements approach expiration between 2012 and 2014, with such failure in the past having resulted in work stoppages, strikes, and other labor disruptions. Other company-‐specific risks include unfunded pension liabilities and medical expenses associated with retirement benefit plans, unforeseen environmental costs, mounting financial concerns, nuclear regulatory issues, and lawsuits from asbestos-‐related working conditions.
Ø Increased competition threatens the predictability of the construction and maintenance backlog for Huntington Ingalls Industries. HII competes for new construction contracts on a national scale with the well-‐financed and horizontally integrated shipbuilding components of Lockheed Martin and General Dynamics, including Bath Iron Works, Electric Boat Corporation, and National Steel and Shipbuilding Company. Furthermore, for certain contracts to repair and overhaul the ships that it builds, HII must also compete with these same firms in addition to smaller companies, including 6 shipyards all less than 3 miles by waterways from Naval Station Norfolk adjacent to HII’s headquarters and main base of operations in Newport News. Although HII is the only company currently capable of refueling nuclear-‐powered carriers, there are two existing government-‐owned shipyards, one in the U.S. Pacific Northwest and the other in the U.S. Mid-‐Atlantic, which could refuel nuclear-‐powered carriers after making substantial investments in facilities, personnel, and training. Additionally, U.S. Government-‐owned shipyards are presently involved in refueling, overhaul and inactivation of SSN-‐688 Los Angeles-‐class submarines and are capable of repairing and overhauling non-‐nuclear ships.
Ø Huntington Ingalls Industries will suffer from relying on the U.S. Government as its sole customer. HII is highly dependent on the allocation of new contracts that are subject to uncertain levels of funding, which is also threatened by the ability of the U.S. Government to terminate or modify contracts with HII, in whole or in part, with little to no prior notice, for convenience or for default based on performance. As an example, the U.S. Navy has decided to delay procurement of CVN-‐79 from fiscal year 2012 to 2013, cancel the new-‐design CG(X) 24 procurement program, and truncate the DDG-‐1000 Zumwalt-‐class destroyers program to three ships. Furthermore, in response to the need for cheaper alternatives and the proliferation of “smart weapons,” it is possible that future DoD strategy reassessments, called Quadrennial Defense Reviews, may result in a decreased need for aircraft carriers. The reduced level of shipbuilding activity by the U.S. Navy, as demonstrated by the reduction in fleet size from 1122 ships in 1953 to 286 ships as of January 25, 2011, has resulted in workforce reductions in the industry but little infrastructure consolidation, with the consequence being intensified competition for the decreased number of contracts awarded to the same fixed number of shipyards.
Ø Political sentiment is beginning to shift determinably to cut military funding. President Obama recently backtracked on his earlier budget and outlined a new plan that would slash security spending by $400 billion by 2023, just as several other fiscal plans have called for reducing Pentagon spending by $1 trillion over the next 10 years. Currently, the federal government is being funded by short-‐term continuing resolutions which prevent new-‐start contracts like the construction of a second Virginia-‐class submarine from starting. This is threatened by the indefinite Congressional budget showdown and ensuing lack of funding for a final defense spending bill. HII President and CEO Mike Petters said that “this is the year the team (MII and GD) was going to ramp up the build to two submarines a year, and getting to two submarines a year was an important part of the pricing for those programs”.
Ø Huntington Ingalls Industries will be unable to support its failing financial position. HII is burdened by a strong lack of financial stability, as highlighted by HII’s junk debt rating. Standard & Poor's credit analyst Christopher DeNicolo assessed HII's financial risk profile as aggressive, saying that "the ratings on Huntington Ingalls reflect the high leverage which will follow the planned spin-‐off from Northrop Grumman Corp., as well as its weak profitability, limited product and customer diversity, and the possible long-‐term budget pressures facing military shipbuilders". HII has approximately $1.9 billion of outstanding debt in the form of senior secured and unsecured bank debt and public notes all maturing by 2021. HII's free cash flow in 2009 was negative $269M and only $168M in 2010, with credit analysts at Fitch expecting free cash flow to also be weak in 2011. HII faces further uncertainties from an extensive reorganization at least through 2012 to address performance issues at its Gulf Coast operations, includes the closing of its Avondale shipyard. HII also lacks the financing assistance and in-‐house IT support functions provided by its former parent company.
Name: Ryan Rechkemmer College/School: College of Arts & Sciences Year: 2nd academic year
Market Capitalization: 1.89B Price per Share: 38.68 Trailing Price/Earnings: 9.90 Expected Long-‐Term Growth: 15.00% Revenue: 6.72B
Operating Margin: 3.69% Return on Equity: 9.46% Sales Growth: 6.85% EBITDA: 431M EV/EBITDA: 6.28
Insider Ownership: 0.36% Current Ratio: 0.59 Quick Ratio: 0.33 Total Debt/Equity: 57.83% EBITDA-‐CapEx/Interest Exp: 6.00
Huntington Ingalls Industries (HII) Memo Misperception Ø Equity analysts wrongly believe that HII has an impenetrable competitive moat, yet HII, now without the capabilities previously supplied by
Northrop Grumman, must compete with such firms as Lockheed Martin and General Dynamics for new contracts. HII’s market dominance is also grossly exaggerated. In fact, one research analyst was quoted by Bloomberg as saying that HII is the "sole supplier of nuclear-‐powered carriers and submarines for the Navy". While HII is indeed the only capable builder and complex servicer of nuclear-‐powered carriers, General Dynamics has also been constructing submarines for the Navy for over a century. Even so, the U.S. Government could potentially retrofit existing infrastructure at either of two government-‐owned shipyards in order to refuel nuclear-‐powered carriers.
Ø Market participants assert that HII is “too big to fail” and can survive financially as an independent company because of its perceived competitive advantages. Howard Rubel, an analyst for Jeffries & Co., said that HII is “not going to collapse”, arguing that HII can now better focus on aligning itself with the needs of the U.S. Navy as outlined by HII President and CEO, Mike Petters. Furthermore Michael Broudo, an analyst for Miller Tabak & Co. who has a “buy” rating on HII, wrote in a March 25 note to clients that “Huntington’s potential for improved profit margins over the next five years will generate investor interest in the company”, with margin expansion also cited by Credit Suisse. However, while HII is currently profitable both on a cash profits basis and as measured by GAAP, HII has averaged just less than $7 million in annual free cash flow, which will make it extremely problematic for HII to consistently service a $1.9 billion debt load.
Value-‐Added Research Ø Rear Admiral (Retired) Jeff Brooks has over 25 years of senior executive and hands-‐on experience in ship maintenance, modernization,
marine engineering, and acquisition. During his 38 year career with the U.S. Navy, Admiral Brooks specialized in Navy ship construction along with maintenance and modernization, including 5 years as commanding officer at Newport News Shipbuilding, now HII, culminating in assignment to the Navy’s top maintenance position: Fleet Maintenance Officer, US Fleet Forces Command. In 2008, he joined the Executive Team at Earl Industries to lead operations at Earl Ship Repair, which is expert and fully certified at all types of complex, restricted, and technical availabilities on U.S. Navy ships and craft of all classes, including aircraft carriers and submarines. Quotes from my interview with Rear Admiral Jeff Brooks, now Earl Industries COO, follow:
Ø “The Navy’s not really good at articulating what that 30 year shipbuilding plan is.… Sometimes, based on the reduced Shipbuilding Plan for the Navy, some of those [shipbuilders] become almost casualties of war, so to speak.”
Ø “Do DoD and Congressional unallocated funding and budgeting problems threaten the survivability [of shipbuilding projects]? Most definitely. Invariably, if they’ve got to get the budget down, they cut one of those, and when the shipyard is projecting everything from those supply chains to their workforce and all those sort of things, it usually has a significant impact. If you get extra money at the end of the year, you can’t just start up that whole supply chain and production line again. The ability to forecast that funding and budgeting is very important to the new construction shipyards.”
Ø “The Navy has four public shipyards.… They don’t build stuff but they maintain and overhaul nuclear-‐powered carriers and submarines.” Ø “The biggest thing from the Navy’s perspective is the amount of debt that [HII] took on, and they are very concerned because… the Navy
subsidizes near everything that they’ve got going on over there, and they want to make sure that the debt is not just passed on to the Navy and they have to fork out more money on the next carrier cost, so they’re watching that very closely.”
How It Plays Out Ø Huntington Ingalls Industries is plagued by endemic problems arising from lack of funding for its contracts, diminishing quantities of new
contracts awarded, operational issues, and finally an inability to maintain its credit facilities, ending in default and government takeover. Risks / What Signs Would Indicate We Are Wrong? Ø Withstanding the potential for catastrophic fallout from any number of possible sources, HII would benefit from otherwise stable operating
conditions as the sole source manufacturer on about 66% of its revenues. HII also has a large and highly visible backlog totalling $17B, including both funded and unfunded contracts, as of Sept. 30, 2010. HII is somewhat well-‐positioned in the current defense spending environment, with roles on 4 of the DoD’s top 12 programs in the fiscal 2011 budget.
Ø HII has a high percentage of cost-‐plus and fixed-‐price incentive contracts, which have less risky terms than firm fixed-‐price contracts, although margins are generally lower. Decreased competition for new contracts from the U.S. Navy might also favor HII.
Ø While mergers and acquisitions have historically been plentiful among shipbuilders, HII would provide little synergy to potential acquirers, as evidenced by its large size and the absence of sufficient offers from bidders for HII before Northrop Grumman decided to spinoff HII.
Signposts / Follow-‐Up Ø HII’s recent growth rate of sales and earnings is still
reasonably steady and intact, with sales growth of 3.1% and operating income expanding 8.5% over the past year. Changes here would indicate a potential shift in HII’s ability to successfully compete with GD and LMT.
Ø HII carries a debt load of $1.9B, which is only sustainable with stability in higher future earnings. HII’s long-‐term goal is a profit margin exceeding 9 percent, compared with 5.5 percent in 2010. Rubel, an equity research analyst following HII, said that success depends on “how good the management team” led by CEO Michael Petters will be at “wringing cost out of the business”.
Ø It will be imperative to track political developments on Congressional funding of HII’s key shipbuilding projects and to observe implementation of the 30 year shipbuilding plan.
Company Description Huntington Ingalls Industries Inc. (HII), America's largest military shipbuilder, was spun-‐off from Northrop Grumman on March 31, 2011. Work today at Huntington Ingalls includes the construction of the Gerald R. Ford-‐class aircraft carriers, the refueling and complex overhaul of Nimitz-‐class aircraft carriers, construction of Virginia-‐class submarines, submarine design and life-‐cycle management, as well as fleet services for naval ships all over the world. The company is also constructing San Antonio-‐class amphibious transport dock ships and an America-‐class multipurpose amphibious assault ship and has built 28 of 62 Arleigh Burke-‐class destroyers. These activities are managed through three shipyards located in Newport News, VA, Pascagoula, MS, and Avondale, LA. The company plans to close Avondale yard by 2013 and move work to Mississippi. For over a century, HII has built more ships in more ship classes than any other U.S. naval shipbuilder. Employing nearly 38,000 in four states, its primary business divisions are Newport News Shipbuilding and Ingalls Shipbuilding.
Huntington Ingalls Industries (HII) Memo
Huntington Ingalls Industries (HII) Memo
Huntington Ingalls Industries (HII) Memo
Huntington Ingalls Industries (HII) Memo Ideas for the Club In order to foster more casual social interaction among members, and to encourage more dynamic group discussions on investing topics, MII should establish a “meal with a manager” program whereby members can sign up for a specific time once or twice each week to have a meal at a University dining hall, preferably lunch for everyone’s scheduling convenience and most likely at Newcomb for its proximity to most academic buildings. This will allow members to interact on a more regular basis with managers and actively accommodate learning of personal investment knowledge and experiences from their respective manager, potentially on a rotating basis every few months or semester. It is my perception that once the management team selects a stock to go on the “watch list”, no one ever watches the stock or offers reports to update the managers on evolving conditions that would provide an opportune entry point. I propose that members be encouraged to track specific stocks from the watch list and provide commentary on their company to the management team as necessary. This will allow members to gain the experience and practice the skills necessary to be an associate, and will therefore provide an adequate training ground for members interested in becoming more involved in leading MII later. Furthermore, it will prevent MII from missing great opportunities to enter positions on well-‐researched stocks at optimal price levels, thus boosting our performance. I believe that there exists an unacceptably large dichotomy in the size of our long positions, ranging from 1.7% to 6.4%. No degree of difference in our conviction for the stocks that we own can justify the fact that our biggest holding is 276% larger than our smallest. Therefore, we should consider a systematic plan to rebalance the size of our smallest holding. On a regular basis, such as every two months, the management team should have to choose either to “double down or ditch” the stock. By having the management team commit to routinely closing or doubling the size of MII’s smallest position, we will be forced either to cut our losses on stocks for which we might otherwise fail to address growing concerns, or we will be able to lower our average cost basis in high-‐quality stocks that are temporarily underperforming. This promotes discipline and responsibility for the managers, further holding the team accountable for every position, regardless of size, while also creating the chance for further future gains in the portfolio.
Finally, after seeing the extent of correlation in stock price performance between TIF and COH, and realizing that owning both of these stocks in MII's portfolio would likely fail to delivery diversified returns, caused me to wonder what “trading correlations” might already exist among MII's current positions. My research led to the formation of the accompanying charts. The chart below is more general, simply showing the aggregate cluster of 5-‐year returns on all of MII's present holdings, both long and short, between -‐50% and +100% for the period, with the highest performer being CALM and then DIN having the lowest dip during the recession. The four charts on the left are the result of finding 5 pairs of stocks in MII's portfolio that have exhibited relatively high correlations over the past 5 years, with some of these correlations being particularly dramatic in the past 1-‐2 years. My objective here is that MII consider the true extent of diversification provided by certain positions, both current and prospective, to ensure that the stocks owned by MII do not merely replicate each other in performance.
