Description
Thesis:
- Secular tailwinds from structural underinvestment in the US naval shipbuilding industry and growing geopolitical tensions.
- Margin expansion.
- Mission Technologies business—a hidden gem.
HII is the largest military shipbuilder in the US and a key player in the rapidly growing defense technology area. The company was formed in 2011 as a spinoff from Northrop Grumman.
HII operates three business segments: Ingalls, Newport News (“Shipyards”), and Mission Technologies. HII is one of two military shipbuilding companies in the United States (alongside the Electric Boat division of General Dynamics). HII's shipyards build a wide range of navy ships, from nuclear-powered aircraft carriers and submarines to Flight III destroyers and amphibious warships.
HII’s stock took a hit during the pandemic and has been recovering since then, along with the broader defense sector.
Secular tailwinds from structural underinvestment in the US naval shipbuilding industry amid growing geopolitical threats are evident. Below are several articles on the problem of underinvestment in the US military shipbuilding/submarine industry:
Following the end of the Cold War, incentives to maintain the US Navy at prior scales declined, leading to decades of underinvestment in military shipbuilding. Yet, as China has emerged as a new world power, the era of the peace dividend seems to be coming to an end. In the last two decades, China has tripled the size of its Navy and is on pace to surpass 400 ships by 2030. While the US Navy still dominates in terms of scale and capabilities, the gap is rapidly closing. This dynamic makes HII an increasingly strategic and valuable asset.
In April 2024, Secretary of the Navy Carlos Del Toro highlighted current navy problems: "Over the past 40 years, America's shipbuilding capabilities have atrophied. The consequences for naval shipbuilding have been manifesting for years and will grow ever more acute unless we reverse the underinvestment," he said. "Right now, we build the most capable warships in the world, in shipyards that are sometimes decades behind the global technological standard." He warned that the current level of shipyard capability is "wholly inadequate to pace our 21st-century competitors."
Rebuilding military shipbuilding capacity will take many years and billions of dollars of investment, even with government support. During the last Investor Day, HII management described the current environment as “a military shipbuilding supercycle.” There are signs that Western governments are becoming increasingly involved. In 2021, the US, UK, and Australia formed the AUKUS alliance with the goal of building out Australia’s capabilities in nuclear-powered submarines. The program, which will last over three decades, is currently estimated at $250 billion, with HII as one of the key beneficiaries.
Margin Expansion: The biggest issue HII currently faces is not the lack of demand, but the lack of labor. This problem is not new, but COVID-19 dramatically elevated industry attrition rates, and companies like HII have struggled with the labor deficit. Among the key reasons for such elevated turnover rates are COVID-driven layoffs, accelerated retirements, and improved job opportunities elsewhere.
Commercial shipyards and naval shipbuilders alike have faced endemic workforce shortages. These shortages are driven by several factors, such as uncompetitive wages, too few young workers willing to work in the challenging conditions of America’s antiquated waterfronts, and too few Americans with the requisite technical skills (including those of naval architects, welders, and pipe fitters).
The company has been addressing these issues by investing in its own training and apprenticeship programs, and introducing workforce development and retention programs. During their recent Investor Day held in March 2024, management discussed labor issues: "For the Shipyards, the four key drivers that will improve cost performance and drive margin expansion are well understood—it's labor: hiring, training, and retention rates. Improving retention rates will result in more experienced craft personnel in the yard, increasing productivity, lowering our rework, and improving operational efficiency."
The company does not provide guidance on how quickly they will solve labor issues. Yet, there are early signs they are making progress. 2023 was the first year when net hiring turned positive after the turbulent 2020-2022 period, although employee churn remains elevated.
How big is the opportunity for margin expansion? While the Ingalls Shipbuilding margin is currently near its historical levels, Newport News returning to margins seen prior to 2018 would lift HII’s segment operating profit by 20%.
Mission Technologies (MT): The MT segment is the fastest growing part of HII. Between 2015 and 2023, revenue from this segment increased from $0.6 billion to $2.7 billion, accounting for half of HII’s total revenue growth over that period. MT is expected to continue growing faster than the Shipyards business for the foreseeable future, which will reduce capital intensity of the company and will further improve its growth profile. Growth at MT has been both organic and through M&A, with the largest recent acquisitions being Alion (AI and simulation development, 2021) and Hydroid (autonomous underwater systems, 2020).
MT capabilities include C5ISR systems and operations; the application of AI and machine learning to battlefield decisions (at HII, AI was “cool” even before the current market frenzy); defensive and offensive cyberspace strategies and electronic warfare; unmanned, autonomous systems; LVC solutions; platform modernization; and critical nuclear operations.
To give a sense of the opportunity ahead of MT: in Q1 2024, Mission Tech had a business pipeline of $80 billion (includes potential projects at Evaluation; Qualification, Capture & Proposal and Exploratory stages), an increase from $60 billion in 2022.
Capital Allocation: Historically, HII has been a disciplined acquirer, with the primary focus of growing the MT segment. Over the past eight years, the company recorded only one minor goodwill impairment: in 2019, HII wrote down the value of a legacy oil and gas business by $29 million, which was subsequently disposed of in 2021.
Over the next three years, HII will increase capex to 5% of revenue to support higher expected volumes of shipbuilding work. Starting from 2027, capex will return to historical levels of low-to-mid 2% range, which will boost free cash flow generation. Management guides for $3.6 billion of FCF during 2024-2028, which will be back-loaded towards 2027-2028 given the cadence of the capex program.
Valuation: We expect $28 EPS in 2028, at a 15x multiple this should result in a mid-teens IRR from the current stock price level (including dividends and share buybacks).
I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.
Catalyst
improving hiring trends
growing geopolitical threats