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Huntington Ingalls Industries (HII) Memo Huntington Ingalls Industries (HII) Memo Name: Ryan Rechkemmer College/School: College of Arts & Sciences Year: 2nd academic year Important Company Financial Data Market Capitalization: 1.89B Operating Margin: 3.69% Insider Ownership: 0.36% Price per Share: 38.68 Return on Equity: 9.46% Current Ratio: 0.59 Trailing Price/Earnings: 9.90 Sales Growth: 6.85% Quick Ratio: 0.33 Expected Long-Term Growth: 15.00% EBITDA: 431M Total Debt/Equity: 57.83% Revenue: 6.72B EV/EBITDA: 6.28 EBITDA-CapEx/Interest Exp: 6.00 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. 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
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