When’s the last time you went grocery shopping?
I can just about guarantee you that you perused a list of sales and/or coupons before buying anything.
Almost nobody goes to the grocery store “blind”, only buying what they want to buy.
You instead let the sales and promotions “guide” you a little bit.
Likewise, I recommend letting the sales in the stock market guide your investments.
Search out upon the sea of stocks and let the most attractive names come to you.
This is something I’ve repeatedly done as I built out my FIRE Fund.
That’s my real-money, six-figure dividend growth stock portfolio.
It generates the five-figure passive dividend income I live off of.
This passive income allows me to live a great life without a job.
In fact, I retired in my early 30s.
My Early Retirement Blueprint describes exactly how I did that.
A major part of the Blueprint is the investing strategy I’ve used.
It promotes buying and holding equity in world-class businesses that pay reliable, rising cash dividends.
The Dividend Champions, Contenders, and Challengers list contains invaluable data on hundreds of these stocks.
But this strategy involves a lot more than a list.
There’s picking the right business at the right valuation, which I hinted at earlier.
While price is what you pay, it’s value that you actually 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.
Letting the stock market guide you toward the sales can allow you to build wealth and passive income faster than if you were to blindly buy only what you feel like buying.
Fortunately, finding the “sales” is easier than you might think.
Fellow contributor Dave Van Knapp might not mail you coupons, but his Lesson 11: Valuation is almost as good.
It’s part of a series of “lessons” on dividend growth investing, and it provides a valuation process that can be easily used to estimate the intrinsic value of almost any dividend growth stock.
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) is a major American defense company, operating as the largest independent military shipbuilder.
Founded in 1886, Huntington Ingalls is now a $7.5 billion (by market cap) military powerhouse that employs almost 15,000 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 their largest customer, generating almost 90% of the company’s revenue.
The company operates across three segments: Newport News, 60% of FY 2020 revenue; Ingalls, 29%; and Technical Solutions, 14%.
In a world that’s constantly uncertain, demand for sovereign defense is certain.
It’s been certain since societies were using bows and arrows thousands of years ago. It’ll be certain thousands of years from now. It’s simply an unfortunate truth.
In fact, defense companies offer a countercyclical effect in this sense: The more uncertain the world gets, the more demand there is for sovereign defense.
Against that backdrop, you have an oligopoly with entrenched players that basically vacuum up all of the large contracts within their respective spaces.
For example, Huntington Ingalls has no competition when it comes to building nuclear-powered aircraft carriers for the United States. If the US military orders an aircraft carrier, Huntington Ingalls is the company that will build it.
Indeed, the technology and scale required to build modern-day defense products further entrenches established players. It’s very difficult for new competition to suddenly enter the picture.
Favorable industry dynamics layered on top of a basic level of certainty promotes fertile ground for growing profit and dividends.
Dividend Growth, Growth Rate, Payout Ratio and Yield
The company has already increased its dividend for nine consecutive years.
That might seem short at first glance, but that’s only because the company was spun off from former parent company Northrop Grumman Corporation (NOC) in 2011.
So Huntington Ingalls has been paying and increasing the dividend for as long as it possibly could do so.
The five-year dividend growth rate is 20.1%.
This growth comes on top of the stock’s yield of 2.42%.
That yield is quite a bit higher than what the broader market offers. It’s also more than 90 basis points higher than the stock’s own five-year average yield.
And with a payout ratio of only 26.6%, this is one of the more secure dividends you’ll find.
I love dividend growth stocks in what I refer to as the “sweet spot” – a yield of between 2.5% and 3.5%, paired with high-single-digit (or better) dividend growth.
This stock is squarely in that spot.
Revenue and Earnings Growth
As great as these dividend metrics are, though, they are looking backward.
But investors are ultimately risking today’s capital for tomorrow’s returns.
It’s those future dividend raises we care most about.
Thus, I’ll now build out a forward-looking growth trajectory for the business, which will later help us estimate the stock’s intrinsic value.
I’ll first show you what the company has done over the last decade in terms of top-line and bottom-line growth.
Then I’ll compare that to a near-term professional prognostication for profit growth.
Combining the proven past with this future forecast should give us a very good idea as to where the business is going.
Huntington Ingalls grew its revenue from $6.575 billion in FY 2011 to $9.361 billion in FY 2020.
That’s a compound annual growth rate of 4.0%.
Solid growth here. I like to see mid-single-digit top-line growth from a mature business like this. They delivered.
Meanwhile, earnings per share moved from $2.91 in FY 2012 to $17.14 in FY 2020 – a CAGR of 24.81%.
Notably, I moved the starting year for the EPS growth rate one year forward. This is because the company registered a GAAP loss for FY 2011.
A combination of buybacks and aggressive margin expansion definitely helped spur this excess bottom-line growth.
The outstanding share count is down by ~15% over the last decade, while net margin has more than doubled.
Looking forward, CFRA believes that Huntington Ingalls will grow its EPS at a compound annual rate of 9% over the next three years.
This would be a fairly significant drop from the kind of growth the company has proven out over the last 10 years.
While 9% growth is nothing to sneeze at, I think this might be underestimating the true potential of the business.
Keep in mind, Huntington Ingalls just reported Q4 and full-year FY 2020 results on February 11.
A highlight was the $6.15 in Q4 EPS – beating consensus by $1.62. Talk about underestimating this business.
Also, their backlog is $46 billion, as of year end 2020. That’s more than six times as much as the company’s entire market cap.
Even if they come in at only 9% near-term EPS growth, we’re looking at a setup where dividend growth can easily exceed that mark by virtue of the low payout ratio.
I would say that high-single-digit dividend growth should be a base near-term expectation. It wouldn’t be surprising at all to see something higher.
Moving over to the balance sheet, the company has a solid financial position.
The long-term debt/equity ratio is 0.89, while the interest coverage ratio is over 8.
Profitability is robust. As foreshadowed earlier, the expansion in net margin in recent years has been nothing short of spectacular.
Over the last five years, the firm has averaged annual net margin of 7.39% and annual return on equity of 35.85%.
For perspective, net margin for FY 2012 and FY 2013 came in at under 4%.
This is a high-quality business from every angle.
And with massive barriers to entry, scale, technological know-how, R&D, IP, long-term contracts, high switching costs, and a unique government relationship, there are durable competitive advantages in place. Of course, there are risks to consider.
Litigation, competition, and regulation are omnipresent risks in every industry.
While competition is limited, regulation is amplified by way of direct regulatory oversight.
The very business model comes with geopolitical risk here.
The current Democratic regime in the US government could aim to limit defense spending, which would impact this business.
There’s heavy reliance on only one customer.
There is also execution risk, especially with a large backlog. The company must continue to complete projects in a timely and cost-effective manner in order to avoid backlash, scrutiny, and possibly reduced order flow.
Overall, I see these risks as very manageable.
That’s especially true if the stock is bought at an attractive valuation.
With the stock still 20% off of its 52-week high, I’d argue the stock is attractively valued right now…
Stock Price Valuation
The stock trades hands for a P/E ratio of 10.97.
That’s less than half that of the broader market’s earnings multiple.
It’s also well off of the stock’s own five-year average P/E ratio of 16.1.
If we move past earnings, we can even see that the P/CF ratio of 7.0 is much lower than its own three-year average of 11.2.
And the yield, as noted earlier, is substantially higher than its own recent historical average.
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%.
This DGR is at the top end of what I allow for, but I think this business deserves it.
There is no element of the company’s growth profile that is below this mark.
Both the long-term EPS growth rate and long-term dividend growth rate are well in excess of this.
And with such a low payout ratio, the dividend is primed to grow at a high rate for years to come.
The DDM analysis gives me a fair value of $246.24.
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.
Even after bouncing nicely from its lows, the stock still looks undervalued from where I’m sitting.
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 4-star stock, with a fair value estimate of $191.00.
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 4-star “BUY”, with a 12-month target price of $215.00.
I came out somewhat high. Averaging the three numbers out gives us a final valuation of $217.41, which would indicate the stock is possibly 16% undervalued.
Bottom line: Huntington Ingalls Industries Inc. (HII) is a high-quality defense contractor with durable competitive advantages and a massive backlog. This business model offers certainty in an uncertain world. With a market-beating dividend, almost 10 straight years of dividend increases, double-digit dividend growth, a very low payout ratio, and the potential that shares are 16% undervalued, dividend growth investors would be wise to consider defending their portfolios with this stock.
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.
This article first appeared on Dividends & IncomeWe’re Putting $2,000 / Month into These Stocks
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