Summary:

Huntington Ingalls is a recent spinoff. I believe the company is significantly undervalued at current price of $30.62 mainly due to temporarily depressed operating margin and selling pressure generated by the spinoff. Both David Einhorn's Greenlight Capital and Rich Pzena's Pzena Investment Management acquired HII shares after the spin at prices higher than today's (around $36).

Background:

Huntington Ingalls is the Nation's premier naval shipbuilder. It is the sole source for U.S. Navy nuclear-powered aircraft carriers and their refueling services, one of the two builders constructing the Virginia-class nuclear powered submarines, one of two builders of Arleigh Burke-class destroyer, builder of other mission critical ships for the Navy and Coast Guard, and provider of Navy fleet maintenance and overhaul services.

HII currently has two operation segments: Newport News Virginia and Ingalls in Pascagoula Mississippi (Avondale, LA is being shut down, more on this later). Newport News focuses on nuclear ships while Ingalls focuses on other types of ships.

The Spinoff:

HII was part of Northrop Grumman (NOC) and NOC decided to spin HII off earlier this year. HII shares started trading on Mar 22, 2011 and closed that day at $37.49

Here is NOC's official explanation for the spinoff: "Northrop Grumman's board of directors has determined that the spin-off is in the best interests of Northrop Grumman and its stockholders because the spin-off will provide the following key benefits: (i) greater strategic focus of investment resources and each management's efforts, (ii) enhanced customer focus, (iii) direct and differentiated access to capital markets and (iv) enhanced investor choices by offering investment opportunities in separate entities."

I think the above explanation is not too far from the real motivations of the spinoff. Shipbuilding is quite different from NOC's other businesses: aerospace, electronic systems, and information systems, shipbuilding also has lower profit margin than the other segments, and shipbuilding business has had a tough decade after NOC acquired Newport News and Ingalls in 2001. So leverage up the shipbuilding business and spin it off seems to be a good option for NOC.

As professor Greenblatt likes to say, it is critical to watch the insiders in a spinoff situation. In this case, the management team of NOC's shipbuilding business will continue to run HII. The management team does not own a lot of stocks yet (less than 2%) but I don't see any obvious flags in the compensation packages either.

What about outsiders? HII has a market cap of $1.5B compare to NOC's $15B. It is somewhat leveraged, does not belong to any index, is in a totally different business, and for every six shares of NOC you get one share of HII. All good reasons for people who received HII shares in the spinoff to sell regardless of merits. No wonder HII share has declined about 26% since begin trading. (the recent market sell off certainly did its part)

From a very high level, the essence of the deal is this: HII issued $1.7B new debt, kept $300m and contributed $1.4B to NOC. NOC gives up HII's earning power. The operating incomes for first and second quarter are $85M and $91M, the interest expense reflecting HII's new capital structure is about $30M per quarter. Not a bad deal for HII overall.

Also, the Navy was involved in this deal. I guess they have to make sure their sole source for nuclear aircraft carriers will not go bankrupt anytime soon. Here is what Sean Stackley, the Navy's top acquisition official, said about the deal: "NOC has cooperated with the Navy in working through the complex issues related to its potential spin-off of its shipbuilding business to HII. Our support of the spin-off is based on a critical review of HII's proposed capital structure, current contract financials, required capital investment and proprietary forward-looking projections." "The Navy's concern with HII's credit rating, driven by its initial debt, has been offset by NOC's agreement to relieve HII of first quarter 2011 debts, to provide a starting cash balance of $300 million, and not to recoup retentions, performance incentives, and economic price adjustment payments that the Navy might owe under current shipbuilding contracts with Northrop Grumman Ship Building from HII"

So HII seems to be a promising spinoff opportunity, now we need to decide its value.

I believe HII is in the middle of turnaround that will help the company to go back to its normalized performance. This assessment is based on two assumptions: revenue stays relatively flat, operating margin improves significantly from the current, depressed level (5% to management stated goal of 9%+).

On the revenue side, since HII align its operation to Navy's 30-year shipbuilding plan, there is very good revenue stability and visibility. For example, you can see exactly which aircraft carrier will be under construction and which will be coming back for refueling in 2013. At the end of March 2011, the company has a backlog of $17.3B, approximately three year worth of sales. The main risk here is defense budget cut, which the CEO does not believe will impact shipbuilding significantly. I will discuss the budget issue in the risk section below.

Assuming revenue stays flat, margin improvement becomes key. Essentially I am betting on revert to mean here.

Before getting into details of HII's margin performance, let's step back and look at the naval shipbuilding business for a second. This is really a unique business. Take aircraft carrier construction for example, there is only one buyer, the US Navy, and one seller, HII. There is no competition to press the margin at all (ye, there is Congress to watch our money for us). Even in the situation where HII is not the only capable builder, there are usually only one or two others. Of course they compete for contracts, but more often than not they also share the contract and build ships together, so I think the pricing environment is benign compare to a lot of other industries. There is pretty much a decent margin built into these contracts and the contractor will make that money as long as it does not screw things up badly. Look at it from a different angle, HII, the sole builder of aircraft carrier, cannot not build those ships if it cannot cover its cost of capital and delivers a reasonable returns for its shareholders. The Navy understands this. That is why most of the contracts are flexibly priced contracts which provide for reimbursement of the contractor's allowable costs incurred plus a fee that represents profit. There is one more point to keep in mind, the more complicated the ship is, the higher the margin will be and HII builds some of the Navy's most complicated ships. (unfortunately, this is also why it screw up sometimes)

Enough theory, let's look at historically what kind of margins the naval shipbuilders were getting:

Note Northrop Grumman's shipbuilding Division, the former HII, was made up of three major shipyards: Ingalls, Avondale, and Newport News. Avondale is being shut down by HII. All three shipyards were acquired by Northrop Grumman in 2001 and they were under different management till 2008.

First, historical margins for Newport News (1985 - 2000)

15.8%, 15.0%, 10.5%, 10.5%, 10.3%, 10.6%, 10.2%, 11.0%, 12.1%, 11.4%, 9.1%, 7.5%, (1.1%), 9.4%, 11.7%, 9.9%

Average: 10.24%

Historical margins for Ingalls (1985 - 1999)

9.6%, 9.9%, 10.7%, 12.4%, 12.1%, 12.4%, 10.5%, 9.3%, 9.3%, 9.5%, 9.4%, 11.0%, 12.1%, 13.0%, 14.8%

Average: 11.1%

Historical margins for Avondale (1985 - 1998)

1.2%, 4.6%, 7.0%, 7.0%, 4.5%, (0.5%), (7.5%), 1.3%, 0.7%, 3.6%, 4.6%, 5.9%, 7.1%, 4.9%

Average: 3.2%

As you can see, both Newport News and Ingalls have been earning above 10% margin from 1985 to 2000. Avondale has been weak historically.

Here is what happened between 2001 and 2010, when all three shipyards were under Northrop Grumman's shipbuilding Division:

Historical margins for Northrop Grumman's shipbuilding Division (2001 - 2010)

1.0%, 6.5%, 5.4%, 6.2%, 4.2%, 7.4%, 9.3%, (37.5%), 4.8%, 4.8%

Average: 6.1%

Note when calculating the average I did not include data for 2001 (1.0%) since that was the year NOC acquired all three shipyards so the number is misleading. I did not include 2008 (-37.5%) either since there was a one-time goodwill impairment related to stock valuation.

As you can see, margins in the last decade were lower than before. The trend accelerated toward the end of the decade.

Note also these are combined results for all shipyards. I believe Newport News was doing fine while Ingalls and Avondale suffered.

So what happened at Ingalls and Avondale?

Before diving into details, let me make one point. A decade seems a long time for underperformance, you might be wondering whether there is something permanently wrong about the business. Keep in mind those shipbuilding contracts are long-term, multi-year contracts, so once got off on the wrong foot, you pretty much have to suffer through it and it takes long time to correct the underlying problems.

Now back to troubles at Ingalls and Avondale. As we discussed earlier, usually there is a decent profit margin built into these contracts. The shipbuilder can screw up on quality, cost, or schedule. That is exactly what went wrong at the Gulf operation (Ingalls and Avondale).

For the Navy, the last decade was a decade building "lead" ships. A lead ship is the first ship in its class. These ships have lots of new technologies, new materials, and new designs so they present a much bigger challenge for the builder, especially when the builder gets aggressive and underestimates the complexity and risk.

According to a research conducted by the US Government Accountability Office in 2005, "Shipbuilders cited a number of direct causes for the labor hour, material, and overhead cost growth. The most common causes were related to design modifications, the need for additional and more costly materials, and changes in employee pay and benefits. For example, the lack of design maturity when introducing new technologies led to rework, increasing growth in labor hours for most of the ships. The design of ship systems for LPD 17 continued to evolve even as construction proceeded. As a result, workers were required to rebuild completed areas of the ship to accommodate design changes. Growth in materials costs was due, in part, to the Navy's and shipbuilders' underbudgeting of these costs. For example, the materials' budget for the first four Virginia class submarines was $132 million less than quotes received from vendors and subcontractors at contract award. Price increases also contributed to the growth in materials costs." (underbudgeting will cause delay, which is very inefficient for shipbuilding)

Internally, I believe then Northrop Grumman's shipbuilding division made several major mistakes too. First of all, they signed some very aggressive contracts without fully understand the cost and risk. Those contracts priced lead ship building as serial production shipbuilding. Some of those contracts were signed in the aftermath of Katrina with the intention to mobilize the workforce as fast as possible. Second, they did not capture any benefit of serial production. Take the LPD program for example, they were building two ships at Ingalls, two ships at Avondale, and had four different outsourcing plants. I suspect they were doing this just to keep both yards happy. Those mistakes could have been avoided if then management acted more prudently.

The current management team took over the Gulf operation (Ingalls and Avondale) in 2008, they were only responsible for Newport News before. Once in charge, they did three things to improve the Gulf operations. First, they implemented a new operating system to capture benefits of serial production and currently conduct weekly, monthly, and quarterly performance reviews to monitor contract progress. Second, they tried to renegotiate or swap unpromising contracts as much as they can with the Navy. Third, they've decided to consolidate facilities and shutdown Avondale operation by 2013.

Also, after a decade of building lead ships, the Navy is switching into serial production mode.

During the newest quarter (Q2, 2011), Newport News operating margin was 9.1%, consistent with last year. Ingalls operating margin improved to 2.7%, up year-over-year from 2.3%. The total operating margin improved to 5.8% from 5.4% last year.

For the next few years, HII has to complete the legacy under-performing LPD and LHA6 contracts. Those contracts currently have operating margins of zero. As those old contracts roll-off, mostly by end of 2012, the margin will improve since the new contracts will reflect the recent experience and hopefully the management will get execution right this time.

So assuming margin goes back to 9%, which is what Newport News delivers right now, how much money will HII make given flat revenue?

For Q2 2011, total sales was $1,563M, 9% of $1,563 is $141M. Adjust for net pension and deferred state income taxes of $7M we get $134M, adjust for $30M of interest expense we get $104M, apply 35% tax rate we get net income of $67.6M, divide by 49M shares outstanding we get quarterly EPS of $1.38 per share, which is $5.5 per share annually.

Assuming PE of 10, $55 per share is 83% above the current price of $30

Even if you assume no further margin improvement from Q2 level, which is highly unlikely since they are not making any money on those LPD22-25 and LHA6 contracts, the share should still be trading around $32 since Q2 EPS was $0.8 per share. This provides a strong margin of safety at current price level.

Risks:

Significant defense budget cuts will certainty hurt HII. No one will deny the importance of Navy's ability to project power around the world and protect US interests. But in the current political environment crazy stuff can happen. The solid backlog, approximately three year worth of sales, does provide some comfort and the CEO maintains projection for flat revenue.  

The execution certainly could get screwed up again. Although one would expect they've learned their lessons after paying such high price. The current management did a great job when managing Newport News alone, so it is reasonable to expect they will do the same at Ingalls. Also, the Navy is getting into serial production mode after a decade of building lead ships. 

Total debt was $1.87B at end of second quarter. Interest expense was $30M. Cash on hand was $381M, plus $529M available under revolving credit facility, for $910M total liquidity. 2011 capital expenditures expected to be slightly over 3% of sales. As mentioned earlier, the Navy did a critical review on HII's capital structure before the spin to make sure it is sustainable.

Then there is risk of natural disasters. The shipyards in Louisiana and Mississippi were hit by Katrina in 2005. As a result, the company invested significant capital to harden, protect and modernize its Ingalls facilities and to ensure the shipyard's robustness.  

LEAPS:

I haven't really checked, but it might be interesting to look into LEAPS for HII as well

Usually it is quite difficult to estimate future earnings, even for only a few years out. You will have to consider both external factors such as demand, competition and internal factors such as operating efficiency. The more guesses you make, the less accurate the estimate becomes. In the case of HII however, the situation is simplified. The external factors such as demand and competition are relatively stable so you can focus on whether the internal operating efficiency will improve. I believe it will since it was dragged down by mistakes that should have been avoided in the first place. The current management team knows exactly what went wrong and is doing a good job addreesing those issues. It is a matter of time before HII returns to its normalized margin and profit.