Huntington Ingalls Industries

Moat: 2/5

Understandability: 3/5

Balance Sheet Health: 3/5

Huntington Ingalls Industries is a global all-domain defense partner, primarily designing, building, and delivering the world’s most powerful, survivable naval ships and technology for maritime security and other applications.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Business Overview:

Huntington Ingalls Industries (HII), is primarily a defense contractor, with the U.S. government, particularly the U.S. Navy, serving as a major customer. HII operates through two segments:

  • Ingalls: Designing and building non-nuclear surface combatants, such as destroyers and amphibious assault ships, and providing fleet maintenance and modernization services, primarily for the US Navy.
  • Newport News: Designing, building, and refueling nuclear-powered aircraft carriers and submarines, notably the Virginia and Columbia classes, for the US Navy.
  • Mission Technologies : It provides a range of services including advanced analytics, intelligence, training, and cybersecurity solutions to defense and federal organizations across the United States and globally.

HII’s operations are complex and technology-intensive, requiring specialized facilities and a skilled workforce.

  • Revenue Distribution: In Q3 2024, the Ingalls segment accounted for approximately 60% of the total revenues, while the Newport News segment contributed approximately 30%, and the Mission Technologies roughly 10%. The distribution may vary by period, with Ingalls, typically contributing the most. Contracts are largely cost-plus, time and material, or fixed price.
  • Industry Trends: The defense industry continues to evolve with geopolitical tensions and technological advancements driving demand for more sophisticated and advanced systems. There is increased focus on cybersecurity, artificial intelligence, and autonomous capabilities in defense platforms. The industry is also seeing increased budgetary pressure, which can lead to a shift in priorities in spending. The U.S. government remains the largest customer and has been focusing on technological advantages and improving capabilities for its military. In the medium term we are seeing a focus on defense and naval capabilities. The defense industry is highly regulated, capital intensive with long term programs and long-term contracts.
  • Margins: HII operates in a cost-plus environment which reduces exposure to risks. However its also limits potential for exponential margin growth compared to a commercial organization. Operating margins average around 13%
  • Competitive Landscape: HII faces competition primarily from other major defense contractors, like General Dynamics, Lockheed Martin, and BAE Systems. These competitors are also primarily U.S. Government contractors with a specialization in aerospace. There are limited number of peers that can do what HII does, especially in naval ship building.
  • What Makes HII Different: HII’s core advantage lies in its highly specialized expertise and infrastructure for building aircraft carriers and submarines, as well as its strong track record with complex naval programs. The company is the sole designer and builder of aircraft carriers for the U.S. Navy and one of two builders of nuclear-powered submarines. Their expertise and relationships with US government are very strong. Furthermore, HII’s mission technologies division has a strong reputation in the digital, data, and security space and can leverage this to provide support and security services to their ship building division.

Financials In-depth:

  • Revenues: Revenue is primarily from the U.S. government, making the company heavily dependent on government spending and contracting. For the nine months ended September 30, 2024, HII reported revenues of $8.277 billion, a slight increase compared to $8.27 billion in the same period of 2023. The modest rise suggests the company is slowly growing revenues. The increase in Ingalls revenues was driven by higher volumes for Amphibious Assault Ships and Surface Combatants, partially offset by lower volumes in the Virginia Class Submarine Program.
  • Profitability: For the nine months ending Sept 30, 2024, HII’s net earnings were $427 million, slightly lower than the $437 million reported for the same period in 2023. This suggests while they’re growing in revenue, they are facing pressure on the bottom line. Their operating profit was $425 million as compared to $463 million in the same period last year. This means they are having issues with operating efficiency. Operating margins are typically in the mid to low teens.
  • Cash Flow: The Company has generated cash flow from operations this year. The cash generated from operations has decreased from $456 million in 2023 to $407 million in 2024. In addition, they spent approximately $253 million in 2024 on Capex, primarily for facilities development. They used this free cash to do buybacks, and paydown debts in 2024. The company generates relatively stable cash flow, but some volatility is expected in the future given the long contracts and large projects that the company undertakes. The decrease in operational cash flow for 2024 is a result of increased spending. They have not generated positive free cash flow, so future capex might be needed for future projects. This reliance on debt and equity to fund future capex projects could make the company more risky in the future.
  • Balance Sheet: HII has total assets worth approximately $11.3 billion and $6.9 billion in total liabilities, with $4.2 billion in equity. Their total debt is roughly $3 billion. Their current assets are a bit low compared to their current liabilities, so they may have a bit of issues with liquidity if some issues arise. In general, their balance sheet is okay and is trending slightly positively.
  • Recent Issues: HII recently had a cyber security incident in October 2023 which was detected and investigated. While it did not lead to a material financial impact, such issues should still be considered a risk for the company. There has been some concerns about labor relations, as some of the employees are unionized. Supply chain issues also remain a persistent risk for defense contractors.

Moat Assessment: 2/5

HII possesses some characteristics that provide a narrow moat, particularly the barriers to entry in the naval ship building industry. The construction of nuclear-powered ships requires specialized skills, heavy capital investment, long lead times, and stringent regulatory compliance. However, the reliance on government contracts and the limited number of customers, creates issues regarding pricing power and growth.

  • Strengths (Narrow Moat):

    • High Barriers to Entry: The substantial capital, expertise, and regulatory requirements make it extremely difficult for new competitors to emerge in the naval shipbuilding space.
    • Intangible assets and know how: They have an incredible track record and history with the US Navy, making this a very valuable partnership and moat.
    • Specialized Skills and Workforce: HII’s employees have very specialized skills needed to build such complex ships which may be hard to replicate.

  • Weaknesses (Moat Erosion):

    • Dependence on Government Spending: HII is highly reliant on government spending and contracts and budget volatility and changes can impact demand and profitability.
    • Limited Customer Base: The limited number of customers for their business puts them in a precarious situation, if one client (US Navy) decides to decrease spending.
    • Pricing pressure: With limited number of clients, there can be pricing pressure as well.
    • Potential for Technological Disruption: Despite the focus on highly specialized processes, advancements in technology can quickly make certain operations or equipment obsolete.
    • Lack of Brand Power: HII primarily does b2b contracting and has no real brand with end consumers

Risks to the Moat:

  • Technological Changes: Rapid tech advancements could erode the value of the company’s capabilities.
  • Changes in Government Spending/Budget: Reduced government spending, including contract terminations, could lead to a decrease in revenue.
  • Increased competition: New players with newer technologies, or large companies starting to consolidate in the sector can lead to increase competition
  • Contract Issues: Contract delays, disputes, and cancellations can lead to financial risks and loss of revenue. They have had past issues with contract delays.

Business Resilience:

HII’s resilience stems from the nature of its core business, which is directly tied to government defense spending and is less susceptible to market volatility. They have government contracts for multi-year programs with long lead times, making their revenue streams somewhat protected. But still there are risk of cancellations and delays. That said, they still have high exposure to government spending.

Understandability: 3/5

While HII’s core shipbuilding business is easily understandable, its size and complexity including a variety of specialized contracts and technologies, makes analyzing their financial statements more complex, leading to a moderately understandable score.

Balance Sheet Health: 3/5

HII’s balance sheet is moderately healthy. While they have a lot of assets, a considerable portion of them is in goodwill, intangibles, and investments. Cash on hand and current assets is slightly low compared to current liabilities, which needs to be worked on. High debt and liabilities also make their balance sheet somewhat unstable. They’re paying down debt and improving things, but more focus needs to be put on that. It is not weak or unhealthy, but could definitely be improved.

Concluding Remarks

HII is a key player in the defense industry and a leader in its niche, which should provide a decent level of protection. While HII’s balance sheet does not look too risky, but could be improved. They need to prioritize generating positive free cash flows. The biggest risks to the business are all around contract and government spending volatility and the technology risk. Their value is primarily tied to their relationships with the US government and their specialized skills which make it somewhat resilient and stable but not a highly durable moat, therefore they achieve a moat score of 2 out of 5. Overall, they’re a solid business with a good track record and future, but with some potential risks that need monitoring. The understandability of this business is moderate.