(NYSE: HII): Defense Contractor With Significant Upside

Huntington Ingalls Industries (NYSE: HII) is a defense contractor for the U.S. Navy, and spun-off from Northrop Grumman in 2011. The company is the largest military shipbuilder in the U.S., with over 70% market share in the construction, repair and maintenance of nuclear-powered ships, amphibious assault ships, ballistic missile submarines and other high-grade ships built at the Newport News and Ingalls port, the largest shipbuilding ports in the U.S. It also provides ancillary products and services to the U.S. Navy, including information technology solutions, professional services and business support services for U.S. Navy missions. The U.S. government makes up roughly make roughly 97% of the company’s revenues while 3% is focused on commercial clients in the oil & gas and nuclear markets. 

HII has seen moderate sales growth since being public but has a strong operating profile over the past 7 years: gross margins have grown roughly 53%, free cash flow has nearly quadrupled, book value per share has grown over 50%, and return on invested capital has grown from 8.30% in 2012 to 21.35% in 2017, with the last 4 year average being in the mid-to-high double digits. The company also has tailwinds that we believe are quite significant going into 2030: HII has a backlog of over $20 billion (and growing – they recently won another $3 billion contract from the Navy) of which 50% has already been committed. The Navy is in desperate need of an overhaul, with new ships and vessels required sooner rather than later and government budgets dedicated to fulfill their cause. Moreover, given this pent up demand, a number of legacy ships are under a replacement cycle and current competitors Lockheed Martin and General Dynamics (who they have a partnership with HII for specific services) have cost the U.S. Navy far too much under the troubled Littoral Combat Ship program, creating new shipbuilding demand for HII. Further, with President Trump’s renewed focus and vow to build 350 ships for the U.S. Navy in addition to the Navy’s request for 12 new vessels in fiscal 2018 and depot maintenance funds beyond that, there is little doubt that HII will be the sole beneficiary presenting the company with very predictable revenue streams. 

Without question HII has proven that it can be a successful operator under the right conditions and upper management is very homegrown (their new strategic sourcing VP spent years building ships for the company). Further, there has been considerable insider buying over the most recent quarter, with a senior VP purchasing over 4100 shares in the company in May. The company has a payout ratio of 19% (considerable room to increase dividends) and has a stated policy to return a substantial amount of cash to shareholders by 2020 via buybacks and dividends from the significant free cash flow it generates. Despite creating a perfect storm for shareholders, HII faces considerable risks and volatility being tied to U.S. government budgets. A gridlocked Congress (likely under the Trump administration), reduction in committed vessels, waning demand from the U.S. Navy, reduction in maintenance funds, and an overall reduction in government spending will all create a significant reduction in the short-term price of the stock (which has already happened). However, we believe that the short-term risks do not outweigh these important tailwinds. The company is always on the lookout for strategic acquisitions to bolster their add-on services (their recent acquisition of Camber Corporation allows HII to enter into mission based software, systems engineering, data analytics and simulations for the Navy and other federal government agencies) which will support strategic growth initiatives and free-cash flow goals for shareholders.

HII has remarkable free-cash flow generating capabilities, which is due to the company’s superior economic and pricing power that it faces as a market leader. As new ships get built and maintained, the company will realize significant depreciation in the early years (before the ships are delivered), with depreciation coming down in future years despite growth in revenue due to maintenance and add-ons. This means that the company has very sticky (and growing revenue) on fleets that are worth less tomorrow than they are today, increasing the rate of change of free cash flow every year. In 2012, the company faced a depreciation expense of $206 million with net income at $261 million. As of last year, depreciation was $163 million with net income at $573 million. Free cash flow grew from $168 million in 2010 to $560 million in 2017, while free cash flow per share grew from $0.98/share in 2011 to $13.29/share as of 2016. Not only does this reflect a favorable economic environment for the company, but in comparison to its peers, it is a better operator of capital with a much cheaper valuation. The company has a free cash flow yield that is 40% greater than General Dynamics, while the company’s price to sales ratio is 1.2x, which is on the low-end of defense contractors: General Dynamics, Lockheed Martin and Northrop Grumman have price to sales ratios of 1.7x, 1.8x and 2.0x, respectively. HII is significantly smaller than the other defense contractors (GD = ~$51bn market cap; LMT = ~$81bn market cap; NOC = ~$44bn market cap) and if it were to reach a similar valuation to its peers (i.e. 1.8x sales, which we deem fair value) this would value the company at $12.652bn in market cap, giving the company 47% upside. We believe that, despite the volatile nature of defense stocks, this company should be worth at least 1x its backlog in the next 10 years, giving us a roughly $20 billion valuation and a price target of $434.70/share.

LOGOS LP is LONG: HII

Cal-Maine Foods: A Tale of Two Egg Shells?

Cal-Maine Foods (NASDAQ: CALM) is the largest shell egg producer in the United States and has been a short-sellers dream lately: the stock is down nearly 26% over the past year and short interest is at an all-time high. The catalyst for this decline, in a nutshell, is the expected price decline of eggs going into late 2016 as egg prices peaked earlier in the year due to the Avian flu creating a supply shortage. The market is expecting LOSSES due these price declines, as CALM is at the mercy of a fairly volatile commodity. Is this the beginning of the end for CALM, or is this an excellent opportunity for buyers? We believe it is the latter.

It is no secret that the egg market is an extremely cyclical business and is heavily tied to the forces of supply and demand, which are outside the control of any one producer. Although this would certainly hit CALM in the short-term, the company has had a history of creating value over very long periods of time despite volatility. History provides good insight into CALM’s operations: According to the company the: “demand trend related to the popular diets faded dramatically and (egg) prices fell” in late 2004, dropping the stock nearly 25% in 6 months. However, if one were to have bought CALM stock during this time and held until today, that particular investor would have made a return of over 520% (nearly 4x in less than 12 years) excluding the dividend (which currently yields over 6% per year). This is not to say that egg prices may not be perpetually depressed over the coming months or that CALM could be in for very long periods of egg deflation, but historically speaking, and this was recently seen with the price of oil, the harder a particular commodity falls, the more vicious it will rise especially if that commodity has favorable economic tail winds like the consumption of eggs.

Despite these macroeconomic variables, CALM is a solid operator of capital and has a history of creating value: the company has very little debt (has more cash than LTD) while providing investors with an ROE north of 28%. Operating margins are at a healthy 14% and the company has a FCF/Sales of over 15%. Despite the volatility of egg prices, CALM has an acquisition based strategy (it is a purely market share play) and revenue has increased nearly five fold over the past ten years with book value increasing nearly 6x over that same time span. Over its latest quarter, the company grew operating income by over 19%, revenue by nearly 3% while maintaining a P/E ratio of under 6 (which, quite frankly, does not make much sense). FCF over the trailing twelve months is at an all-time high, price to sales is at a paltry 1.0, and it has an extremely healthy payout ratio of 32%. Over 1/3 of the company’s market cap is in working capital, which is means that if this price decline continues, the company is looking at a Graham-esque valuation unseen by a consumer non-cyclical company.

Do we expect CALM to recover and the price of eggs to rebound?

Although we do not play in the futures markets, we do believe that CALM provides attractive value as the owner and operator of the largest egg brand in the U.S. (Egg Land’s Best) and history suggests that egg fundamentals will eventually stabilize given long-term demand trends for eggs. For investors who are patient and can stomach the wild swings, there are very few names that offer this level of value run by quality management. We’re expecting CALM price to fall near the $35, which would be an extremely attractive opportunity for the long-term investor.

DISCLAIMER: Logos LP is long CALM.

Renasant Corp.: An Upcoming Regional Powerhouse

Renasant Corp. (NASDAQ: RNST) is a regional bank operating in Mississippi that is successfully taking advantage of both a unique resurgence in the state as well as in the American South. The bank holding company provides traditional banking services to the southeast, including industrial and commercial loans, residential mortgages, consumer deposits and wealth management services. The company recently closed the acquisition of KeyWorth Bank to expand its presence in Georgia and is looking to drastically enhance its wealth management footprint within the southern U.S. The real story, however, is two fold; the possibility that RNST is a proxy for an improving southern U.S. as well as RNST's ability to capture market share within its core divisions.

Mississippi has become a 'new economy' as traditional industries have given way to new markets within the state, creating a plethora of opportunity for business expansion (see Figure 1). Gone are the days of natural resource and government as the major drivers of employment and in are the days of new professional services, business services, health care and information. Moreover, unemployment in certain regions within the state are dropping to record lows while the annual percent change of incomes within the state is growing faster than the national level (see Figure 2). 

Figure 1

Figure 2

Despite these macroeconomic catalysts, Renasant has been a prudent allocator of capital within the financial markets within which it operates as it has been able to appropriately capture revenue growth within its home state (see Figure 3). The company has a very healthy ROE near 8% while increasing book value per share by 25% over the last three years. Unlike other major diversified banks like GS, WFC, C or BAC, Renasant is trading at a slight premium (1.3 times book) which reflects the positive catalysts within the state in addition to southeast service expansion. Over the past 5 years, operating cash flow has more than doubled while operating income year-over-year has increased by 36.58%, which is very strong for a regional bank. Revenue growth over the last quarter has increased by over 47% and the 10 year average of revenue growth has surpassed 11%, which reflects the quality and prudence of management as it has been able to weather the financial crisis in a sustainable fashion. The more impressive metric, however, has been the bank's cash flow from sales which is at a remarkable 65.06%, which is almost double from last year. The reason why this is important is because this level of conversion allows the financial institution to have an abundant purse to continue its expansion within the southeastern U.S. while being able to take advantage of the economic turnaround happening within the state of Mississippi. In light of the bearish sentiment still present both with the U.S. and globally, it is impressive to see a financial institution with this kind of cash flow generation avoiding the typical excuses of a low interest rate environment we keep hearing from the bigger banks. 

Figure 3

Figure 4

Source: finbox.io

There are certainly some headwinds facing the company, especially since RNST has performed so well and the market is starting to price in the southern U.S. region's improving economic picture. At 27.6x EV/LTM EBITDA, the company is not exorbitantly expensive (unlike peers HOMB and PNFP at 87.3x and 43.1x, respectively) but the company has compounded at over 20% per year for last 5 years and begging the question whether the ship has sailed. Moreover, just like any financial institution, the macroeconomic picture is a major variable bearing on future revenue and ROE growth and some are wondering whether we are starting to enter into peak unemployment and economic growth. However, there are reasons to believe this is not the case as U.S. GDP is expected to outpace Mississippi's growth.

Figure 5

Overall, we believe RNST below $30 creates a unique opportunity to participate in a growing regional bank in a very unique economic situation. Prudent and competent management, strong economic growth, low loan loss provisions, increasing cash flows and operating income combined with growing ROE (grew 6% from last quarter) should propel RNST towards becoming a financial institution worth north of $2 billion in market capitalization. 

Teledyne Technologies: Recent Weakness Creates Entry Opportunity

Teledyne Technologies (NYSE: TDY) is an industrial technology company producing niche technology products for a variety of industries including healthcare, aerospace, energy and natural resources. Over the past year, the company's shares are down over 14% but I believe this creates an interesting opportunity to get into a quality small-cap name. 

The company has a very stable portfolio of diverse clients, as over a quarter of the company's revenue comes from the U.S. Federal Gov't. Moreover, the company operates in industrial technology markets going through complete refresh cycles, as instrumentation and emission monitoring systems markets are expected to compound at 10.4% CAGR over the next 5 years, while the portable analytic instrumentation market is expected to grow by over 17% through 2020. On current conservative estimates, the company is expected to grow at high single digits and has an excellent track record of providing significant returns on invested capital: over the past decade, gross margins have grown from 28% to over 37%, book value per share has tripled, while free cash flow has more than tripled. ROE and ROIC are at a healthy 14.13% and 9.02% respectively while cash flow as a percentage of sales is over 7%. What is interesting though is that the company is going through a transformation as it has seen an increase in its retained earnings over the last 5 quarters by 12.8% while cash and equivalents have been increasing over the last 3 quarters by 50%.

There are some headwinds for the company including the drag on energy and oil and gas markets which have destabilized energy spending. Energy infrastructure has typically accounted for a quarter of TDY's revenues and the company understands it is a key vertical in its instrumentation segment. It is unclear when the price of oil will continue to rally or drop below $40 a barrel, but uncertainty in the energy markets may distort short term earnings for the company leading to further downside. However, for the patient and long-term investor, TDY's long-term stewardship and timely acquisitions will allow it to hit double digit CAGR for years to come. 

DISCLOSURE: Logos LP is LONG TDY

Rocky Mountain Dealerships: Opportunity In Farming

Rocky Mountain Dealerships (TSE: RME) is a small-cap Canadian company operating in Western Canada within the used agricultural equipment market. The company is trading below 2009 levels and has been in a depressed state given the collapse of energy hurting agricultural spending across Western Canada. However, I believe there is an interesting opportunity in this name considering the long-term fundamentals. By any measure, the company is very cheap: 0.7 price to book ratio, 0.1 price to sales ratio, 3.3 price to free cash flow and forward price to earnings at 7.7. On other valuation metrics, the company seems even more undervalued: the company has a projected FCF-based value of $8.65, enterprise value of $147M (vs. $122 market cap) and pays over 7% yield despite only having a 78% payout ratio.

What is interesting about this company is that they are growing in many key segments despite seeing slight declines in their overall business. Total revenues increased 1.0% last year with used equipment sales up 24% to $377 million despite weaker overall demand and earnings and gross margin declines. Although the market has slightly rebounded, the company is allocating capital in a difficult agricultural environment by building new facilities, making acquisitions (Chabot Implements enhanced their sales footprint in Manitoba) and investing in new markets such as geomatics and agrimatics technologies which aim to make farmers more productive and efficient (through their acquisition of NGF Geomatics)

Will Rocky Mountain Dealerships turn the corner?

Although the company has been through a rough patch and is making the right moves, a lot more work needs to be done in order to enhance performance. Although the company has a decent return on invested capital (~11%), the company needs to enhance its gross and operating margins in order to increase cash flows while continuing to diversify its portfolio in new innovations within the agricultural space. This certainly requires a (very) long-term mindset but management will have to execute, be creative and contrarian while navigating a cyclical environment. The company has very little debt (debt to assets is 0.08), and with retained earnings growing every quarter, the company should be in a position to outperform over the long-term. 

DISCLOSURE: Logos LP is long RME