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The Best Defense Stock You've Never Heard Of

Monday, March 3, 2014 - 10:00am

The defense industry may now seem like an area best avoided by investors, what with the sequester eroding the U.S. defense budget and imposing total projected defense cuts of about $1 trillion over a 10-year span.

I wouldn't categorically dismiss defense stocks, though. You could end up missing opportunities for some very nice investment returns.

There's one defense firm in particular that has held up quite well so far in spite of the sequester, with earnings per share (EPS) growing by 50% in the past 12 months. During that time, the company's stock has more than doubled, compared with a 23% return for the S&P 500.

The firm has remained strong in large part because it's so crucial to national defense, providing the bulk of the equipment and services necessary to keep the U.S. Navy operational. I wouldn't be surprised if most investors were unfamiliar with the company because it certainly isn't among the first names that typically come to mind when you think of firms involved in defense like Lockheed Martin (NYSE: LMT), Boeing (NYSE: BA) and General Dynamics (NYSE: GD).

However, the company was spun off a few years ago from another well-known defense firm, Northrop Grumman (NYSE: NOC), which wanted to focus on areas it perceived as more profitable like manned and unmanned aircraft, intelligence, communications, surveillance, and cybersecurity. As it turns out, the new entity -- Huntington Ingalls Industries (NYSE: HII) -- may very well be a much better investment.

Sequester or not, Huntington is the go-to shipbuilder for the Navy: 70% of the existing U.S. fleet was constructed in Huntington shipyards. What's more, Huntington is the only designer, builder, refurbisher and refueler of nuclear aircraft carriers, up to 110,000-ton behemoths that form the nucleus of virtually every naval task force. The latest, the USS Gerald R. Ford, cost $13 billion and took more than a decade to design and build.

Huntington manufactures a variety of warships in addition to carriers such as nuclear submarines (only one other company builds nuclear subs), guided missile destroyers and amphibious assault ships, to name a few. I think it's safe to say no other firm in the world approaches Huntington's importance in keeping the U.S. Navy equipped and up to date.

The company is also a key supplier to the Coast Guard, typically providing much smaller and more lightly armed cutters for patrolling domestic waters. And it provides crucial overhaul and repair services for all the ships it constructs.

Huntington Ingalls Industries
Huntington Ingalls is also a key supplier to the Coast Guard, typically providing much smaller and more lightly armed cutters for patrolling domestic waters.

Huntington has generated $6.7 billion of revenue during the past 12 months and boasts a backlog of nearly three times that amount ($19.3 billion). A significant portion of future sales should come from aircraft carriers, since the company is contracted to build 10 of the Gerald R. Ford type, with one to be delivered every five years starting in early 2016. At approximately $13 billion per ship, that's about $130 billion of projected revenue during the coming half-century, averaging out to $2.6 billion a year.

And that's just from aircraft carriers, let alone all the other types of ships Huntington builds.

Although it might not seem so, overhaul can be a major revenue source depending on the type of ship. Carriers, for example, are refurbished stem to stern after 25 years of service, at a cost of about $3 billion. And, once they've reached the end of their 50-year lifespan, Huntington charges as much as $1 billion to scrap them. Last year, for instance, the Navy awarded the company a $745 million contract to scrap the USS Enterprise, the world's first nuclear carrier, which was launched in 1961.

There's also potential for billions in future business from the so-called Ohio Replacement Program, the Navy's effort to design replacement nuclear ballistic-missile submarines for the older Ohio-class subs introduced in 1981. The program is currently planning for 12 new nuclear submarines during the next 15 years at a cost of $4 billion to $7 billion each. No decision has been made yet as to who will build them, but I'd be very surprised if Huntington wasn't contracted for at least half of them.

While the firm should be getting plenty more work from Uncle Sam, management knows deeper defense spending cuts are very possible and could result in reduced or canceled contracts. So, like the rest of the defense industry, it's looking for business internationally.

One potential customer could be the Philippines, which would like to establish some sort of naval presence in response to China's growing fleet. (China launched its first aircraft carrier in 2012 and is working on a second.) A number of other countries, including India, Japan and Brazil, are increasing defense spending as well and could also be future Huntington customers, providing a lucrative supplement to its U.S. operations.

Risks to Consider: Huntington depends heavily on the U.S. government for business. A substantial decrease in government orders could dampen profits and trigger large declines in the stock price. Severe cuts in spending on the Navy could threaten Huntington's very existence.

Action to Take --> Based on its dominance as a naval warship manufacturer, contract pipeline, and growing international focus, I like Huntington's chances of meeting consensus estimates for earnings per share (EPS) growth of 26.5% a year from the current $4.36 to $14.12 in 2019. Assuming the price-to-earnings (P/E) multiple remains in the current range of about 23, there's potential for stock price growth to $325 a share during that time, more than triple the current price of $101.

A word of caution: I consider Huntington pretty speculative at this point because of its heavy reliance on the government. So if you're interested in buying, I'd consider limiting the stock to a relatively small portion of your overall portfolio.

P.S. Investing doesn't have to be complicated. If you invest in simple businesses that dominate their industries, you stand to crush the market over time. It works. In fact, the stocks in our latest report, "The Top 10 Stocks For 2014," have delivered a total return of 237% over the past five years following this simple strategy. To learn more about our top picks for 2014 --including several names and ticker symbols -- click here.

Tim Begany does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.