Rich Smith, The Motley Fool
26 April 2015
Depending on whom you ask (and how you count), the United States Navy boasts a war fleet of as many as 430 ships (in active service and the reserve fleet). Or perhaps only 273 (deployable "battle force ships"). Or maybe something in between.
Whichever number you prefer, one thing's certain: The Navy's about to get a lot more ships.
Specifically, 10 new Flight III Arleigh Burke-class destroyers, and nine Virginia-class attack submarines. This is according to USNI.org, one of the premier sites for all things Naval news.
As USNI reports, the U.S. Navy is putting the final touches on its fiscal-year 2018 long-range shipbuilding plan. In it are details for the purchase of the Navy's 19 newest warships, which, when combined with other acquisitions, will swell the Navy to 308 warships by about 2031.
Cost containment is key to reaching this goal. And in the interests of keeping costs as low as possible, the Navy is structuring its ship acquisitions in the form of "block buys" -- awarding the contractors who give it the best prices contracts for multiple warships.
Why? According to the Congressional Research Service, the average cost of an Arleigh Burke-class destroyer historically has been about $1.8 billion. CRS pegs the cost of the latest batch of Burkes, however, at closer to $2 billion apiece, incorporating the higher cost of upgraded Air and Missile Defense S-Band Radar systems from Raytheon.
In offering multiple-ship contracts, the Navy hopes to incentivize its two primary shipbuilders, Huntington Ingalls (NYSE: HII ) and General Dynamics (NYSE: GD ) , to put their very best bids forward -- and then do the same with the Virginia subs contract as well. And once the companies know they've got multiple contracts in the bag, the winning defense contractors can better predict their costs years into the future, and not have to make last-minute changes to production capacity. (Change being the bane of cost control in the defense contracting sphere).
Who gets the contracts?
Whatever the precise bids, history suggests that both the destroyer and the submarine contracts will split down the middle between Huntington Ingalls and General Dynamics. And while this may smack of collusion within the "military-industrial complex," it's actually a good thing.
By giving roughly equal amounts of work to each contractor, the Navy is able to maintain a larger industrial base, capable of building more ships in future years. And by maintaining two viable shipbuilders to bid on its contracts, the Navy also avoids a situation in which one "sole source" shipbuilder can basically dictate prices to the Pentagon. With two rivals in the mix, each must constantly look over its shoulder to ensure it's not getting underpriced by its rival. (Case in point: The most recent destroyer contracts awarded to General Dynamics and Huntington Ingalls saw bids within 1% of each other.) That's good news for taxpayers.
What it means to investors
This situation is also good news for investors in the defense industry. We can be reasonably certain, for example, that both these companies will win about half the work on offer. And absent worries about revenues, we can focus on buying whichever company earns the most profit on these revenues.
To wit: General Dynamics does about $7.3 billion in business at its Marine Systems division, which is its second smallest business unit. S&P Capital IQ puts General Dynamics' operating profit margin on ships at just 9.6%, making the division also General Dynamics' second least profitable per dollar of revenue -- a double whammy.
Huntington Ingalls, in contrast, specializes in ships, and reports annual revenue of $7 billion. Huntington Ingalls earns a 10.8% operating margin.
At 20 times earnings, a share of Huntington Ingalls costs a bit more than a share of General Dynamics (which sells for 18 times earnings). However, analysts who track the two companies expect Huntington Ingalls to grow its earnings at 15% annually over the next five years -- significantly faster than the 9% growth rate posited for General Dynamics.
Seems to me, if investors want to own one of these companies, the right call is to make a "block buy" of their own -- of Huntington Ingalls stock.
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