Cost-Plus Capitalism: Lessons from HII and the Future of Naval Shipbuilding (Part 5)
This is Part 5 of my client letter, sharing insights from my visit to Huntington Ingalls Industries’ Newport News shipyard, an overview of the current state of US shipbuilding, and the reasons behind our investment in HII. You can read the previous parts here.
My investment friends, IMA colleagues Cyrus and Robert, and I visited HII’s shipyard in Newport News in April. This trip gave me an unexpected insight into the industry. As a reminder, HII is one of only two companies in the US that builds nuclear submarines (the other is Electric Boat, owned by General Dynamics). It is also the sole supplier of nuclear aircraft carriers to the US Navy.
Today, it takes both companies a little over a year working together to produce one submarine. It takes HII about 10 years to build an aircraft carrier (you read that correctly). Korean shipyards can build a cruise ship with 2–3 times the displacement in just 18–24 months.
The visit to HII’s shipyard crystallized why. It felt like we were transported back to the 1970s. The process by which HII builds submarines has changed little since then. I expected to see a high degree of automation; we saw almost none.
While Korean shipbuilders rely heavily on automation, HII is heavily dependent on labor that, in the post-pandemic world, would rather work at 7-Eleven selling Slurpees than do physical outdoor work for $23 an hour. This is HII’s biggest problem today – finding people to staff its shipyards.
I can’t really blame HII or GD – they’ve responded to the customer’s demand. It would have been irresponsible from a shareholder perspective to make large investments in automation and equipment with little to no return. There was no need. HII could produce an aircraft carrier every few years, but why? These floating cities last 50 years. The US has 11 of them (more than the rest of the world combined).
Let’s say HII made a huge investment in equipment and automation so it could build an aircraft carrier in three years. This equipment would then collect dust for years till the next one was ordered.
Another explanation for why there’s been no change is the consolidation of our defense industry. On July 21st, 1993, then-Defense Secretary Les Aspin held an infamous dinner with defense industry executives, during which he informed them that the Cold War was over, government defense spending would decline, and the industry needed to consolidate. This dinner went into the history books as the “Last Supper.” Since then, the US Navy has shrunk by a third.
The US has had a peacetime navy – a navy that doesn’t lose ships in war. The US hasn’t lost a ship in combat since WWII. There was no need to produce ships fast and in high quantities.
This industry also has an inherently flawed incentive system, called “cost plus” – they get paid for incurring higher costs. The more money they spend (the cost), the more money they’ll make (the plus). This makes them good businesses to own – cash flows are highly recurring, stable, and predictable. But as a taxpayer, I realize that my tax dollars could be getting a much higher return (I’m oversimplifying a bit but directionally I’m right). Since the industry has consolidated, there’s little competition. We went from having 51 “prime” (top-tier) defense contractors to just five.
I’ve learned that when a shipbuilder builds a brand-new ship, they really don’t know how much it will cost – they’re still fiddling with process improvements. It takes about three or four ships to iron out all the construction kinks. I’m sure this isn’t much different from General Motors making cars – the cost of the first few hundred new (differently designed) cars rolling off the assembly line is higher than the next 300,000. Manufacturing is a process that improves with the quantity produced.
In fact, there are good reasons why commercial shipbuilders can stamp out ships much faster and cheaper – they produce at consumer scale, while HII and GD produce at government scale. It’s a numbers game.
We don’t have a civilian shipbuilding industry. During WWII, we had a large manufacturing base that switched from civilian to military products – but not today. This is where China has a significant advantage over the US. China can increase its production of destroyers almost overnight by converting its civilian shipbuilding industry. Its shipbuilding capacity is hundreds of times greater than ours.
China already has a larger navy than the US by size. Their average ship is still smaller than ours – they can’t travel as far and carry fewer missiles. But they’re increasing production of larger ships that match ours. In the not-so-distant future, their navy could become larger than ours in both quantity and quality. In all honesty, we don’t know how good their ships are, but we’re not going to wait to find out.
Under both the Biden and Trump administrations, the US has started to increase investment in our navy. The bill just passed by the Trump administration will directly invest in equipment to help HII automate its production (this equipment will be owned by the US government but used by HII).
The government is also making “an investment” in HII’s labor force – it’s essentially giving HII money to raise wages for its employees. This will enable HII to attract more workers and build ships and submarines faster. The US plans to increase submarine production from 1.1 to 2 per year by 2028. This may seem optimistic, but submarine construction is on the rise. The number of vessels the US government plans to buy in 2026 is increasing to 19 from the current 10–12 per year.
HII’s backlog is $48 billion and growing. Its revenue and earnings will continue to increase with the size of the US Navy. The pandemic’s effects still impact its profitability. The infusion of capital and increase in wages will allow HII to produce more ships and submarines annually. Our fairly conservative earnings estimates for 2030 are $30 a share. At 15–17 times earnings, we arrive at a $450–510 stock price. It currently stands at around $250.
You just read my write-up on a stock. I may have sounded very convincing, and you are thinking “I should buy this stock.” Before you do, read this.
Vitaliy Katsenelson is the CEO at IMA, a value investing firm in Denver. He has written two books on investing, which were published by John Wiley & Sons and have been translated into eight languages. Soul in the Game: The Art of a Meaningful Life (Harriman House, 2022) is his first non-investing book. You can get unpublished bonus chapters by forwarding your purchase receipt to bonus@soulinthegame.net.
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