“U.S. Navy Supplier—a Company with NO Competitors—Could Bring You Another 77% Profits in the Next 10 Months”

Sniffing out the monopolist teased by Charles Mizrahi's Hidden Values Alert

By Travis Johnson, Stock Gumshoe, October 17, 2012

I hope the folks at the Federal Trade Commission aren’t reading today, because I have to make a confession: I start to feel all squishy inside when I think of monopolies.

After all, what could be better as an investor? A company that is the only supplier of its product, with plenty of demand and the ability to set their own price? Mmmm, just gives you shivers. Unless you’re the customer, of course.

And if that particular product happens to be one where the customer is extremely price-insensitive, too, well, it’s all I can do stay sitting upright.

So you can see why the recent teaser for Charles Mizrahi’s Hidden Values Alert caught our eye — it wasn’t just that a bunch of eager readers asked your friendly neighborhood Gumshoe to review it (though that always helps), it was that it’s a monopoly company and their customer is the U.S. Military, the folks who are so price-insensitive that they famously shelled out hundreds of dollars for toilet seats (I know that story’s partly apocryphal, but there’s some underlying truth) … which makes us dream that if this story pans out we ought to be able to refill our toilet paper dispenser here at Gumshoe HQ with $100 bills (the $20 bills we use now are just too scratchy, I’m afraid).

And yes, I know, the story never pans out quite like we dream … but still, let’s figure out who he’s teasing us about, shall we? Here’s a taste of the ad that got our attention:

“This U.S. Navy Supplier—a Company with NO Competitors— Could Bring You Another 77% Profits in the Next 10 Months

“This company’s shares have risen steadily over the last 10 months. But, as you’ll see, its share price could quickly double or triple in the months ahead!”

Doubling and tripling are both lovely, of course. So what’s the story? Well, the basic pitch is that the world is dangerous and growing more unstable (North Korea, Iran, embassy attacks, Israel, Syria, etc.), and that the first line of defense for the US is our distributed and flexible military presence in the world that’s made possible, in large part, by our aircraft carriers.

“So what is the United States military doing to protect U.S. citizens from the many threats all over the globe?

“Here’s our first line of defense.

“The United States Navy has ships strategically positioned all over the globe.

“In particular, the Navy’s nuclear-powered aircraft carriers… are this nation’s first line of defense….

“… we all hope for peace across the globe – the simple fact of the matter is that our need for vigilance is not going away.

“And the aircraft carriers currently deployed by the U.S. Navy actually have one thing in common…

“They’re all built – and maintained – by a single company.

“Today I’m writing you about this unique company – the only one of its kind on the planet – to show how its ‘monopoly’ status actually presents an enormous profit opportunity for those investors who act quickly.

“This single stock is virtually certain to provide investors with a steady stream of double- or triple-digit profits in the months and years ahead.”

Need a break to do your little monopoly dance? It’s OK, we’ll wait.

Ready? OK, here are some more specific clues from the ad:

  • “Sole Supplier — This one-of-a-kind company is the sole supplier to the U.S. Navy for its most important products. And for 70% of the company’s $6.6 billion annual revenue stream…they have NO competitors!
  • Future Earnings are Virtually Guaranteed — The company—at this very minute—has a backlog of $16.3 billion. That’s three years’ worth of sales…guaranteed!
  • Improved Profitability—The company is about to shed a number of low-margin contracts and has replacement work—at double the profit margin—already on the books.

“Simply put—the floodgates are about to open for this company when it comes to profitability.

“It’s virtually guaranteed—the company simply just has to exist over the next five years…and its bottom line will change dramatically.”

The argument from Mizrahi is that the company was spun off from some other firm, and that in the spinoff they were saddled with unprofitable contracts — contracts that are rolling off over the next three years and will provide “supercharged” returns when new contracts take their place.

Are you getting our free Daily Update
"reveal" emails? If not,
just click here...

Which is part of a trend that frequently profits individual investors and value investors: spinoffs are often undervalued by the marketplace, and they often outperform the market over time. There are any number of reasons for that, but the basic spiel you’ll hear from folks is that spinoffs are almost always sold right away by big investors, since they’re interested in the larger company that they bought in the first place, and the spun-off company is usually small and misunderstood and underfollowed, with no analysts or big investors interested so the price dips after the shares are spun … but it also often has the opportunity to turn things around with a renewed focus on operations that were ignored when it was hiding in a parent’s petticoat.

Of course, we all leave our children with baggage — and corporations are no different, so they often saddle spinoffs with too much debt, or with bad contracts, or whatever else they’re trying to get rid of, so the “on average, spinoffs are good” bit certainly doesn’t mean it works out every time.

Back on point though — which stock is this? A few more clues:

“In fact, one highly respected analyst recently upgraded this stock—and forecast ‘double-digit earnings growth for the next three years’—meaning that it’s only a matter of time before others on Wall Street begin to take notice and drive this stock higher….

“At this very moment, the United States Navy has eleven aircraft carriers in active service all over the globe.

“The company I’m writing you about today is the sole builder of U. S. Navy aircraft carriers….

“This company is also the exclusive provider of refueling services for nuclear-powered aircraft carriers….

“We’re talking about a company with a history that dates back more than 125 years…

“And a company that gets more than 70% of its $6.6 billion annual revenue stream from business where they literally have no competition….

“When you invest in this company, you’re buying into a backlog of $16.3 billion…and that’s roughly equivalent of three years’ worth of sales.”

And apparently they build more than just aircraft carriers …

“not only the sole supplier of U.S. Navy aircraft carriers…but they’re also the largest supplier of U.S. Navy surface combatants.

“They’ve built 70 percent of the U.S. Navy’s entire fleet of warships.

“Missile destroyers…amphibious ships…aircraft carriers…nuclear-powered carriers…nuclear attack submarines…guided missile destroyers…assault ships…Coast Guard National Security Cutters…and fleet support services…this company does it all….”

Finally, we get a bit more info on those “bad contracts” that are rolling off, providing a catalyst for increasing margins and a stronger share price:

“One analyst recently declared that the ‘low margin days are over’ for this company.

“And that same analyst went on to write, ‘We are raising our rating…as we believe earnings risk from low-margin ‘problem programs’ is rapidly declining. (This) should drive double-digit earnings growth for the company overall for the next three years, we believe.’

“These ‘problem programs’ are estimated to represent roughly 16% of the company’s sales in 2012…and this is projected to decline to 8% in 2013…and 0% in 2015.

“The analyst went on to project an increase in margins of more than 50% for this company over the next three years!”

OK, so … improving margins, continued demand, a strong partner in the US military (assuming, of course, that the threatened defense cuts don’t go through … or that they don’t impact big-ticket Navy items particularly hard if they do go through) … what company is this?

Well, we toss all that into the ol’ Thinkolator and learn that this is … Huntington Ingalls Industries (HII)

Which was spun off from Northrop Grumman (NOC) about a year and a half ago, and which does indeed build many of the surface ships and maintain and refuel all the aircraft carriers for the U.S. Navy. It’s a “big small company” with a market cap of about $2 billion, and they’re expected to grow earnings quite abruptly next year and then settle in for low-double-digit growth over the coming several years, which seems reasonable for a company that, if you believe the analyst estimates, trades at a forward PE of about 10. They’re expected to earn about $3.30 this year, and hit about half that number in the first two quarters, so the current valuation is more like 12 times earnings. The average analyst rating is slightly better than “hold”, they’ve got quite a bit of debt but it’s easily manageable at their current earnings rate, and they don’t pay a dividend.

This is an intriguing one, I’d say, though I hadn’t ever heard of the company before today. I’m not an expert on the Navy’s procurement practices, (that’s an understatement), but I do like that they have a substantial revenue base built in thanks to long-term projects — and that they have the contract to refuel aircraft carriers, which should provide a baseline of work over time if they keep that contract (refueling aircraft carriers is usually done during a lengthy overhaul process that might take up to three years — they don’t have to do it often, these massive floating cities might go 10-25 years between scheduled overhaul/refuelings).

And I do like the low forward valuation, which indicates that there might be some unrecognized value in these shares even after a nice run-up — but clearly, major long-term growth would depend on increasing investment by the Navy and Coast Guard into renewing and expanding the US fleet, which I guess is the larger “big picture” question, one that is inextricably tied both to the rise of China (which is building its first aircraft carrier now) and to both long-term and short-term US budget considerations. We still spend multiples of any other country, which has been true since before the Soviet Union fell, and will do so even if sequestration stays in place in its current form — but big ticket items like new ships can easily become political and budgetary footballs, even if, thanks to long term deals, cuts don’t hit the bottom lines of the suppliers right away.

Right now the big picture drivers for the next several years for HII are aircraft carriers (two new Ford class carriers built over next eight years, first in that new class, and two refueled/overhauled over the next four years, along with a big wave of decommissioning/deactivation of the aging fleet of carriers that will retire) and nuclear submarines (they’re building half of the latest Virginia class subs), so Huntington Ingalls Industries will absolutely be impacted if there are major changes, delays, new orders, or cancellations in those areas, though they also can and do build and design several other major vessels.

There’s a good article on the arguments about future defense spending here, particularly as it pertains to the big ticket items that would significantly impact the business of HII’s shipyards over the coming decades, like aircraft carriers and destroyers. There’s also political posturing over big-ticket items like these, with Romney recently even promising specific increases in the number of major ships the Navy will order (a promise he made while fishing for votes in Virginia Beach, home turf of some of the Navy’s major shipyards … naturally). At the moment, the budget for the Department of Defense for the next five years is generally expected to waver between $650-700 billion a year, and HII is essentially a one-customer company with annual revenues in the neighborhood of $6.5 billion, so you can shorthand that to say that they’re currently getting about 1% of the defense budget. You can see their latest investor presentation here from last month, it includes the major programs and their projections.

HII expects to be able to improve margins and to generate more than 10% in annual revenue growth, based on their new contracts and their large programs (including next-generation amphibious assault ships for the Marines, in addition to those large carrier and sub projects), and they are the sole supplier for many of these programs (particularly the carriers), so there’s a lot to like in the numbers and forecasts for Huntington Ingalls — but the overhang of military sequestration is likely to hit the shares if people think the massive defense cuts scheduled for January 1 will really happen (I’d argue that investors expect those cuts not to happen right now), so if you’re a gambler and like the long-term prospects for HII you might want to consider looking for a more opportunistic buy point if you agree that there’s a likelihood that fear of massive defense cuts will hit HII investors over the next two months — my guess is that these cuts wouldn’t have a huge impact on HII given the big lead time on their projects, and the commitment to the new carrier class, but that’s a guess and it would certainly hit them to at least some degree … with the chance that it hits the stock price much harder than it hits the income statement. Of course, if for some reason Romney wins in a landslide and manages to wrest Congress to his will and come up with some more money and fix the budget immediately next year, perhaps he really will almost double the order book for Navy contractors right away and make HII investors even more flush, though I wouldn’t necessarily hold my breath on that.

So what do you think? Clearly a strong company in the midst of a nice turnaround in the profitability of their programs, with a monopoly position and a strong customer, but they have also already risen quite a bit on that success and I think there are substantial risks that there will be either real or perceived pressure as defense budget debates call attention to major programs in the short term, and long-term defense pending priorities in the longer term. That’s my two cents … but it’s your money, so what do you think? Am I just being greedy hoping for a better price when investors panic about the budget, or are the risks too high for the stock at this price? Or are you just not interested in investing in the builders of war machines? Let us know if HII is right for you by sharing your thoughts in a comment below.