Human nature is fascinating.
It can be wonderful and awful, simultaneously.
Another thing about human nature?
Elements of it are fairly predictable.
And investing in those predictable elements of human nature can be terrifically profitable.
When you take a look around and study the world, especially as an investor, you notice certain themes repeating themselves.
Predictability in human nature can lead to predictable business results.
And that’s precisely what you want as an investor.
The dividend growth investing strategy epitomizes this.
You can see what I mean by perusing the Dividend Champions, Contenders, and Challengers list.
This list contains invaluable information on hundreds of US-listed stocks that have raised dividends each year for at least the last five consecutive years.
The consistently increasing dividends are a result of consistently increasing profits.
And that all leads back to predictability.
That’s because these companies sell the products and/or services that consumers predictably demand.
That demand has been present for a long time.
And that demand will likely persist for a long time to come.
I’ve personally been using the dividend growth investing strategy for more than a decade, building up the FIRE Fund during that time.
This real-money portfolio produces enough five-figure passive dividend income for me to live off of.
Indeed, following this strategy allowed me to retire in my early 30s.
I lay out in my Early Retirement Blueprint exactly how I accomplished that feat.
Much of dividend growth investing’s effectiveness hinges around the idea of investing in business models with high degrees of predictability.
However, valuation at the time of investment is also very important.
It’s price that you pay. But it’s value that you get.
An undervalued dividend growth stock should provide a higher yield, greater long-term total return potential, and reduced risk.
This is relative to what the same stock might otherwise provide if it were fairly valued or overvalued.
Price and yield are inversely correlated. All else equal, a lower price will result in a higher yield.
That higher yield correlates to greater long-term total return potential.
This is because total return is simply the total income earned from an investment – capital gain plus investment income – over a period of time.
Prospective investment income is boosted by the higher yield.
But capital gain is also given a possible boost via the “upside” between a lower price paid and higher estimated intrinsic value.
And that’s on top of whatever capital gain would ordinarily come about as a quality company naturally becomes worth more over time.
These dynamics should reduce risk.
Undervaluation introduces a margin of safety.
This is a “buffer” that protects the investor against unforeseen issues that could detrimentally lessen a company’s fair value.
It’s protection against the possible downside.
Investing in predictable business models can favorably lead to predictable growth in profits and dividends, and investing when undervaluation is present makes this even more favorable over the long term.
That said, taking advantage of undervaluation would first require one to have an understanding of valuation.
But this isn’t as difficult as you might think.
Fellow contributor Dave Van Knapp put together Lesson 11: Valuation in order to demystify the valuation process.
As part of a comprehensive series of “lessons” on dividend growth investing, it provides an easy-to-follow valuation template that can be quickly applied toward almost any dividend growth stock out there.
With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to be undervalued right now…
Huntington Ingalls Industries Inc. (HII)
Huntington Ingalls Industries Inc. (HII) is a major American defense company, operating as the largest independent military shipbuilder.
Founded in 1886, Huntington Ingalls is now a $9 billion (by market cap) military mammoth that employs over 40,000 people.
Huntington Ingalls primarily designs, constructs, maintains, and repairs a range of nuclear and non-nuclear ships. These ships include aircraft carriers, submarines, and amphibious assault ships.
The United States Navy is by far their largest customer, comprising approximately 90% of the company’s total annual revenue.
The company operates across three segments: Newport News, 59% of FY 2021 revenue; Ingalls, 27%; and Technical Solutions, 15%.
Huntington Ingalls benefits and profits from human nature.
Conflict is an element of human nature; it’s part of our reality.
And so sovereign defense will be necessary for as long as sovereign entities exist – humans have demonstrated that we can’t have one without the other.
What makes Huntington Ingalls special as it relates to defense is that they’re the only company that manufactures certain products for the US military.
Nuclear-powered aircraft carriers are the primary example.
If the US military orders a nuclear-powered aircraft carrier, Huntington Ingalls will be the company to build it.
Adding yet another advantageous layer on top of all of this is the fact that defense products are steadily becoming more complex and expensive as time goes on.
Projectiles, for instance, have gone from arrows to missiles.
This technological evolution in defense provides a built-in escalator in terms of growth.
And it further entrenches the established companies that command the scale and know-how necessary to manufacture the appropriate products for modern warfare.
This positions the likes of Huntington Ingalls very well for continued growth in their revenue, profit, and dividend.
Dividend Growth, Growth Rate, Payout Ratio and Yield
To date, the company has increased its dividend for 10 consecutive years.
That might seem like a short track record.
However, it’s actually as long as it possibly could be, as Huntington Ingalls was spun off from former parent company Northrop Grumman Corporation (NOC) in 2011.
So they’ve basically been increasing the dividend right from the outset.
And the five-year dividend growth rate of 17% shows what a fast start they’re off to.
Now, it wouldn’t be realistic to expect that kind of growth to persist forever.
Some of this initial explosive growth was possible, even inevitable, because the payout ratio started out at 0% upon the spin-off, giving the company the ability to quickly expand that number.
That said, the payout ratio is still only 35.4% – even after aggressive dividend growth.
This gives the company plenty of room for more dividend increases.
You also get the stock’s market-beating yield of 2.3% to start off with.
That yield, by the way, is 50 basis points higher than its own five-year average.
Solid dividend numbers here right across the board.
Revenue and Earnings Growth
As solid as these numbers may be, they’re largely looking backward.
However, investors are risking their capital today for the assumed rewards of tomorrow.
As such, I’ll now build out a forward-looking growth trajectory for the business, which will later be used to estimate the stock’s intrinsic value.
I’ll first show you what this company has done over the last decade in terms of top-line and bottom-line growth.
After that, I’ll unveil a professional prognostication for near-term profit growth.
Blending the proven past with a future forecast in this manner should give us the ability to form a reasonable picture of what the growth path might look like from here.
Huntington Ingalls advanced its revenue from $6.7 billion in FY 2012 to $9.5 billion in FY 2021.
That’s a compound annual growth rate of 4%.
This is solid.
I usually expect a mid-single-digit top-line growth rate from a fairly mature company like this – and despite being spun out into an independent entity only recently, it is mature.
Meanwhile, earnings per share increased from $2.91 to $13.50 over this period, which is a CAGR of 18.6%.
We can now see that the high dividend growth rate has been supported by like earnings growth, which is why the payout ratio remains somewhat low.
The wide spread here between top-line growth and bottom-line growth can be largely explained by a combination of margin expansion and share buybacks.
Net margin has more than doubled over the last 10 years.
And the outstanding share count is down by approximately 20% over this period.
Looking forward, CFRA believes that Huntington Ingalls will compound its EPS at an annual rate of 7% over the next three years.
This would clearly be quite the growth slowdown relative to what the company generated over the last decade.
This is less than half that of the company’s proven EPS growth rate over the last decade.
Is it totally unreasonable?
Not necessarily.
I say that because the company already expanded its margins considerably, giving them one less arrow in the quiver in terms of their ability to improve the business.
To the contrary, CFRA notes the possibility of margin compression, due to fixed-price contracts in an inflationary environment.
Also, the company engages in very large-scale projects. Results can fluctuate over short periods of time, depending on completion dates.
On the other hand, we have to guard against underestimating this business.
Keep in mind, Huntington Ingalls has a backlog of nearly $50 billion.
That’s more than five times the size of the company’s entire market cap.
Put another way, it’s about five years’ worth of revenue.
This company is not short on work.
Moreover, the geopolitical conditions, including open war in Eastern Europe, are such that US defense spending will likely be even more prioritized than before.
And it’s not like defense spending is ever really a low priority. CFRA puts it like this: “CFRA has found that US defense spending typically grows regardless of recessions, deficits, or political parties in power.”
In the end, I’d say that a high-single-digit bottom-line growth rate, especially in this uncertain environment, would be nothing to scoff at.
With the payout ratio still being low, this kind of EPS growth would easily give the company the capacity to grow the dividend at a high-single-digit rate over the next few years.
Pairing that with the 2.3% yield sets us up for a very nice combination of yield and growth.
Financial Position
Moving over to the balance sheet, the company has a good financial position.
The long-term debt/equity ratio is 1.2, while the interest coverage ratio is 8.
These numbers are not bad at all on their own, but the long-term revenue visibility (via the large backlog) makes them even better to my eye.
Said another way, I don’t think a balance sheet needs to be pristine when you have multiple years of revenue already locked in.
Profitability is strong, and it’s only been getting stronger.
Over the last five years, the firm has averaged annual net margin of 7.3% and annual return on equity of 35.7%.
The margin expansion story has been remarkable.
A decade ago, net margin was routinely running below 4% annually.
This well-run defense company benefits from the current geopolitical climate, with increasing complexity and costs across defense products only serving the business.
And the company is protected by durable competitive advantages, including high barriers to entry, large economies of scale, technological know-how, R&D, IP, long-term contracts, switching costs, and a unique government relationship.
Of course, there are risks to consider.
Litigation, regulation, and competition are omnipresent risks in every industry.
An oligopoly among major US defense companies limits competition; on the other hand, regulation is amplified through direct government oversight.
The very business model has geopolitical risk, which can cut both ways.
The current Democratic regime in the US government could aim to limit defense spending, which would impact defense companies. The company does have a sizable backlog to mitigate against this risk. And this spending tends to only grow over the long run.
Customer concentration is a risk. The company is almost completely reliant on only the US Navy.
Highlighting this risk, CFRA states this: “This concentration on Navy contracting subjects HII to the risk of government funding cuts for major ship programs. The Navy has proven a reliable long-term growth customer, though, and we see increasing bipartisan support for Navy superiority over non-Democratic nations mitigating funding risk.”
The large backlog introduces execution risk. The company must complete large, complex projects in a timely and cost-effective manner.
These risks are worth reviewing and considering.
But I do see the stock’s reasonable valuation as overcoming these risks…
Stock Price Valuation
The P/E ratio is sitting at 15.6.
That is not high by any measure.
Many major defense contractors are commanding earnings multiples of at least 18 right now.
There’s also the P/S ratio of 0.9, which is slightly off of its own five-year average of 1.1.
And the yield, as noted earlier, is significantly higher than its own recent historical average.
So the stock looks cheap when looking at basic valuation metrics. But how cheap might it be? What would a rational estimate of intrinsic value look like?
I valued shares using a dividend discount model analysis.
I factored in a 10% discount rate and a long-term dividend growth rate of 8%.
Now, this is as high as I’ll go with a long-term dividend growth rate expectation.
But I don’t see this as too much of a stretch for the business.
It’s well below their demonstrated growth across both EPS and the dividend over the last decade.
The near-term EPS growth forecast is already nearly this high, and the low payout ratio would easily allow for the dividend to grow faster than earnings for the foreseeable future.
Furthermore, their massive backlog practically guarantees prosperous years ahead.
I view the 8% dividend growth rate as a very realistic target for the business.
The DDM analysis gives me a fair value of $254.88.
The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.
The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.
It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.
I find it to be a fairly accurate way to value dividend growth stocks.
I’d argue my valuation model was sound, yet the stock comes out looking at least slightly cheap.
But we’ll now compare that valuation with where two professional stock analysis firms have come out at.
This adds balance, depth, and perspective to our conclusion.
Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system.
1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.
Morningstar rates HII as a 3-star stock, with a fair value estimate of $223.00.
CFRA is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line.
They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.
CFRA rates HII as a 3-star “HOLD”, with a 12-month target price of $241.00.
I came out the highest, but the range here is fairly narrow. Averaging the three numbers out gives us a final valuation of $239.63, which would indicate the stock is possibly 15% undervalued.
Bottom line: Huntington Ingalls Industries Inc. (HII) is a high-quality business operating within an oligopoly benefiting from a favorable environment. Human nature gives them a nearly unlimited demand runway for products that keep getting more complex and expensive, and their main customer has extremely deep pockets. With a market-beating yield, double-digit long-term dividend growth, a low payout ratio, 10 consecutive years of dividend increases, and the potential that shares are 15% undervalued, this is a timely idea for long-term dividend growth investors looking to take advantage of the world’s current affairs.
— Jason Fieber
P.S. If you’d like access to my entire six-figure dividend growth stock portfolio, as well as stock trades I make with my own money, I’ve made all of that available exclusively through Patreon.
Note from DTA: How safe is HII’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 68. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, HII’s dividend appears Safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.
The goal? To build a reliable, growing income stream by making regular investments in high-quality dividend-paying companies. Click here to access our Income Builder Portfolio and see what we’re buying this month.
Source: DividendsAndIncome.com