An Undervalued Wide-Moat Stock to Buy With Momentum

Huntington Ingalls Industries is the largest military shipbuilder in the United States. Despite long planning horizons and budget visibility, tweaks to timing around big programs can lead to lumpy quarterly results, which had likely damped enthusiasm for these undervalued shares. But we think Huntington Ingalls stock looks attractive today, trading in 4-star territory. Given its ties to the Department of Defense as the sole provider of nuclear aircraft carriers and turbine-powered amphibious landing ships (and its position as one of two producers of nuclear submarines for the US Navy), the company is poised to generate recurring profits well into the future. Huntington Ingalls appears on Morningstar analysts’ list of 33 Undervalued Stocks for the third quarter. It’s also one of Morningstar chief US market strategist Dave Sekera’s 4 New Stocks to Buy With Catalysts for Future Gains.

Huntington Ingalls generates revenue on almost every significant military shipbuilding contract; in some cases, as with aircraft carriers, it’s the only supplier. The company derives four fifths of its revenue and practically all of its profits from building ships for the US Navy. Ships are the longest-cycle defense product, as vessels takes years to manufacture, remain in service for decades, and are typically purchased in blocks to reduce unit costs. These long lead times mean that funding for a project, once awarded, is difficult to cut, and block purchases give the builder visibility into long-term revenue. Huntington Ingalls’ top line is therefore less sensitive to changes in the defense budget than peers, making it a defensive play even among defense contractors. The major value drivers for Huntington Ingalls are nuclear-powered submarines and large surface warships.

Key Morningstar Metrics for Huntington Ingalls

• Fair Value Estimate: $317
• Star Rating: 4 Stars
• Economic Moat Rating: Wide
• Uncertainty Rating: Low

Economic Moat Rating

The durability of economic profits in the defense sector may seem paradoxical: Large defense contractors invest billions of dollars to generate cutting-edge products whose unit pricing tends to decline over time. What’s more, these companies primarily sell to a single buyer with rapidly evolving needs, a tendency to change product requirements, and occasional squabbles over paying the bill. Nonetheless, wide moats are prevalent at the large end of the defense contracting business. These durable competitive advantages exist because of significant intangible assets. First among these is the extreme product complexity that thwarts new entrants, bolstered by decades-long product cycles and contract structures that reduce risk for incumbents and lock out alternative suppliers. We also see the switching costs of a risk-averse customer facing significant time and risk to change products or suppliers as a competitive advantage.

Read more about Huntington Ingalls’ moat rating.

Fair Value Estimate for Huntington Ingalls Stock

Our $317 fair value estimate implies an enterprise value/2024 EBITDA multiple of 12.5 times. At the Ingalls shipyard, over the next five years we forecast revenue from amphibious warships will remain essentially flat, although we expect revenue from Arleigh Burke destroyers to grow 14% annualized. At the Newport News shipyard, we forecast revenue from building and refueling nuclear aircraft carriers will also remain essentially flat around $2.8 billion per year, but we see construction of Virginia and Columbia class submarines growing 8% and nearly 30%, respectively, annualized over the next five years. We forecast the technical solutions segment to grow about in line with the company and constitute 25% of revenue, albeit at a lower margin than shipbuilding. We’re normalizing our capital expenditure as a percentage of sales at about 2%, well below recent averages around 4%, but roughly in line with the trailing 10-year average. Our terminal operating margin forecast is approximately 7.5%. Our normalized tax rate is 21%, and our weighted average cost of capital is 7.1%, reflecting low uncertainty around cash flows and negligible exposure to macro and market volatility.

Read more about Huntington Ingalls’ fair value estimate.

Risk and Uncertainty

We think the biggest risk is that the Navy may deprioritize the procurement of one of Huntington Ingalls’ major programs. The company’s biggest revenue stream is its sole-source contract for nuclear-powered aircraft carriers, and we think there is a material chance that the Navy may reduce its long-term goal of maintaining 11 such craft, in order to free up budget dollars and allow more commitment to the distributed maritime operations model. However, the impact would be limited to a distant future order—the most likely outcome, in our view—and it would also result in increases in demand for other Huntington Ingalls products, such as amphibious assault ships or future versions of destroyers and unmanned watercraft. Although US defense spending has risen recently, the risk remains that defense budgets get caught up in political wrangling.

Read more about Huntington Ingalls’ risk and uncertainty.

Huntington Ingalls Bulls Say

• The National Defense Strategy prioritizes modernizing the military to counter potential great-power adversaries. We think this will increase the proportion of the defense budget available to contractors.
• Huntington Ingalls is one of two major shipbuilders for the US Navy, which is a difficult-to-replicate business. The US has a vested interest in maintaining the financial viability of the company.
• Defense prime contractors operate in an acyclical business, and shipbuilders are particularly acyclical, which could offer some protection from an eventual US recession.

Huntington Ingalls Bears Say

• Competing claims on future US budgets may depress defense spending.
• Huntington Ingalls used capital to acquire Alion, a defense services company, which is outside its core shipbuilding competence.
• Fincantieri Marinette Marine won the Constellation-class frigate contract. and we expect that this company may become a competitor for some future contracts.

This article was compiled by Susan Dziubinski and Sylvia Hauser.