Huntington Ingalls (HII): Hold For Fundamental Upside, Buy And Hold For Dividends

In December 2023, I initiated coverage for Huntington Ingalls Industries (NYSE:HII) stock with a buy rating. Since then, the stock has gained nearly 7% compared to the 5.7% return for the broader markets. On the 1^st of February, Huntington Ingalls Industries reported fourth quarter earnings, and in this report, I will analyze the earnings and update my assessment of the prospects of HII stock.

My Thesis For Huntington Ingalls Industries

As I previously discussed, Huntington Ingalls Industries in my view is not a stock that has a huge upside from a fundamental perspective even when we take future earnings into account. However, the company can lean on long-term shipbuilding plans and a strong $48 billion backlog and it provides growing free cash flow prospects and shareholder returns in the form of dividends and share repurchases. That is the investment thesis that we will put to the test by looking at fundamentally driven upside in the coming years.

Huntington Ingalls Industries Results Driven By Higher Revenues and Favorable Cost Amortization

In the fourth quarter, we saw 13% growth in revenues as well as 13% sequential growth with operating income up 197.1% and 81.4% sequential growth. So, there was significant growth on the operating level. Huntington Ingalls Industries reports in three segments, namely Ingalls Shipbuilding, Newport News Shipbuilding, and Mission Technologies. So, we will be discussing the results by segment to get a clearer view of how the revenue and income growth was realized.

Ingalls Shipbuilding revenues grew $142 million or 21.6% to $800 million, driven by higher surface combatants and amphibious assault ships, partially offset by Legend class volumes. Operating income grew $119 million or 238%. Although this is extremely strong growth, it was driven by Huntington Ingalls Industries selling a court judgement against Venezuela. So, that is really a non-recurring jump in earnings that we should not expect to occur again in the future.

Newport News Shipbuilding saw its fourth quarter revenue growth of $81 million or 5.1% to $1.665 billion, driven by higher aircraft carrier and submarine sales offset by lower refueling volumes for ship reactors. The operating earnings increased by $30 million or 37.5%, driven by higher volumes and a positive cost adjustment on the refueling and complex overhaul for the CVN 73 aircraft carrier.

Mission Technologies revenues grew 23.8% to $745 million, driven by C5ISR (Command, Control, Computers, Communications, Cyber, Intelligence, Surveillance, and Reconnaissance) services. Operating income grew by 240% to $51 million, driven by a combination of higher volumes and primarily by the settlement of representation and warranties insurance claim related to the acquisition of Hydroid while modelling and simulation and fleet sustainment performance were weaker.

Overall, I believe that while the year-over-year growth in operating income was strong, it was driven by selling a court judgement and settlement income.

For the full year, Huntington Ingalls Industries reported a 7.3% increase in sales to $11.45 billion with operating income up 38.2% to $781 million. At Ingalls Shipbuilding, revenues increased 7.1% to $2.75 billion, driven by the drivers that also drove Q4 revenues higher. Segment earnings were up 24% to $362 million, driven by the same drivers observed in Q4 and a positive contract incentive for the DDG destroyer, partially offset by lower-risk retirement on the LPD (Lower platform, dock) ships.

Newport News Shipbuilding revenues were up 4.8% to $6.1 billion, with 6.2% growth to $379 million in operating earnings. Revenues were driven by higher volumes for aircraft carrier construction and engineering as well as higher revenues on the submarine programs offset by lower aircraft carrier refuelling and overhaul and naval nuclear support services. The improvement of the submarine contributions to the revenues year-over-year points to the supply chain health for submarines improving. Operating income grew year-over-year by the same drivers as well as positive revenue positive adjustment for the refuelling and complex overhaul for the CVN 73, partially offset by a contract incentive recognized in 2022 earnings for the Columbia class submarine.

Mission Technologies revenues grew 13.1% to $2.7 billion due to higher C5ISR volumes and cyber, electronic warfare & space contracts. Earnings grew 60.3% to $101 million, driven by the settlement related to the Hydroid acquisition, offset by lower equity income from divestitures.

Overall, 2023 showed strong growth, which was driven by higher revenues, positive development of product sales as a percent of revenues, favorable amortization of general expenses, and an increase in non-recurring income.

Huntington Ingalls Industries Targets Sustained Growth

For the first quarter of 2024, Huntington Ingalls Industries expects revenues of $2.85 billion, indicating 6.5% growth in revenues year-over-year and a potential to grow operating income at a rate of 20%. For the full year, the company targets sales of $8.8 billion to $9.1 billion in revenues, indicating that revenues are expected to be flat at the low end and provide 3.5% growth at the high end. Combined with the operating margins, this would put the operating income estimate at $745 million to $750 million, which is lower than the $781 million seen in 2023. This is driven by HII guiding conservatively as it previously has seen some naval deliveries slip and 2023 saw a positive impact of the sale of claims. Furthermore, it expects $600 million to $700 million in free cash flow, which would be more or less stable year-over-year if the cash flow is met at the higher end of the range. This is due to an increase in CapEx as a percentage of sales from 2.4% in 2023 to 5.3% in 2024. The higher CapEx is projected to not be a one-off but run through 2026 to meet higher-quality standards with the possibility of reducing delivery delays and meeting higher capacity requirements.

So, the initial guidance for 2024 is most certainly not impressive but there could be an upside to the 2024 earnings if the company manages to reduce delays in deliveries at the end of the year. The company also provided mid-to-long revenue growth targets with >4% revenue growth targeted. So, the increase in CapEx supports the revenue growth. 4% is not huge, but over the mid- to longer-term, it still provides 20 to 50 percent revenue growth from current levels over a 5- to 10-year period. This fits my view from my current report that Huntington Ingalls Industries is not a high-growth company, but it can lead to a solid long-term shipbuilding plan.

For the coming five years, Huntington Ingalls Industries expects free cash flow generation of $3.6 billion, which points to a growth of 20%, in line with its revenue growth expectations for the coming five years. For the previous five years, the company had guided for $2.9 billion and ended up generating $3 billion, so the company seemingly has good insights into its ability to generate free cash flow.

Huntington Ingalls Industries Is No Longer A Top Aerospace and Defense Company

When I covered Huntington Ingalls Industries in December 2023, it was ranked #4 of the Top Aerospace and Defense stocks on Seeking Alpha. Since the 9^th of February, the Quant Rating for Huntington Ingalls Industries has flipped from Buy to Hold while Wall Street and Seeking Alpha analysts have maintained a Buy rating, resulting in the stock now ranking #29 in the list of top aerospace and defense list.

Huntington Ingalls Industries Lacks Upside For Years To Come

I previously had a Buy rating on HII stock and that has flipped to a Hold rating. There are various reasons for that. First of all, some companies tend to not trade in line with peer groups and our stock screener now takes that into consideration. Furthermore, in the years to come, the CapEx will be elevated. In 2023, Huntington Ingalls Industries prioritized debt reduction to maintain an investment grade rating as discussed during the HII Q4 2023 earnings call. My previous assumption was that with that out of the way, the company would direct its cash towards shareholder returns and that is still the case but to a lesser extent as the elevated CapEx levels will be elevated at least until 2026. Combining these changes, Huntington Ingalls Industries stock is fairly valued towards 2026. I feel quite comfortable with the valuation so far as the company has a lot of visibility in its revenue growth. I wouldn’t say that the stock is not attractive at all, but at current standing, it is a Hold. I believe this could be a more rewarding investment opportunity deeper into the second half of the decade but that does not warrant a present buy rating.

Does Huntington Ingalls Industries Pay A Dividend?

Huntington Ingalls Industries’ dividend currently stands at $5.20 annualized or $1.30 quarterly, giving it a 1.9% forward yield. The yield is definitely something that I would be buying the stock for. However, its yield on cost for the longer term is attractive. As a result, I believe that this could be an appealing name for investors with a long-term focus.

Conclusion: Huntington Ingalls Industries Lacks Fundamental Upside Due To Elevated CapEx

Huntington Ingalls Industries saw nice growth numbers in its results, but from what I could see, most of its growth was driven by one-off items. Furthermore, the company will be seeing elevated capital expenditures in the current and upcoming years, which significantly reduces the ability to return capital to shareholders compared to what I had previously expected and its shipbuilding margins guide was a bit on the soft side.

That, however, does not mean that there is no value at all. I still believe the yield on cost development over the longer term goes well with the long-term shipbuilding plans that support the business. So, I would mark this as a hold for people looking for close-in value, but given the longer-term yield on cost development, this could be a nice name to hold in a defensive portfolio.