Huntington Ingalls Industries, Inc. — Q3 2018 Form 10-Q
Reporting period: Three and nine months ended September 30, 2018; unaudited. HII builds and supports military ships and provides technical services, with most business tied to the U.S. Government. Reportable segments are Ingalls, Newport News, and Technical Solutions. Unless noted otherwise, amounts are in millions of dollars.
Financial performance
| Metric | Q3 2018 | Q3 2017 | Nine months 2018 | Nine months 2017 |
|---|---|---|---|---|
| Sales and service revenue | $2,083 | $1,863 | $5,977 | $5,445 |
| Operating income | $290 | $241 | $738 | $650 |
| Net earnings | $229 | $149 | $624 | $415 |
| Diluted EPS | $5.29 | $3.27 | $14.15 | $9.04 |
| Operating margin, approximately | 13.9% | 12.9% | 12.3% | 11.9% |
Revenue rose 12% in Q3 and 10% year to date; operating income increased 20% and 14%, respectively. Net earnings increased 54% and 50%. Q3 revenue growth was concentrated in shipbuilding: Ingalls revenue rose 17% and Newport News 12%, while Technical Solutions grew 2%. Year-to-date segment operating income was $229 at Ingalls (down 4%), $261 at Newport News (up 5%), and $25 at Technical Solutions (up from $13).
For the nine months, operating cash flow was $266, down from $380. Capital expenditure additions were $293, offset by $33 in grant proceeds; free cash flow, as defined by HII, was $6 versus $152. Cash and cash equivalents were $68 at September 30, 2018, compared with $701 at year-end 2017. Long-term debt was $1,282, leaving approximately $1,214 of net debt. The $1,250 revolving facility was undrawn, apart from $16 of letters of credit; $1,234 remained available. HII reported covenant compliance.
Current assets were $1,859 and current liabilities $1,631. Total liabilities were $4,374 and stockholders’ equity $1,825. The company repurchased $512 of shares and paid $95 in dividends during the first nine months; dividends declared were $2.16 per share.
Material changes and notable items
- Lower effective tax rates supported earnings: 22.4% for Q3 and 17.0% year to date, versus 32.3% and 29.1% in 2017. HII cited the lower federal corporate tax rate and research-credit claims, partly offset by other tax changes.
- Non-operating retirement income was $19 in Q3 and $56 year to date, compared with expenses of $4 and $12 in the 2017 periods. This materially benefited pretax comparisons. Operating FAS/CAS pension adjustments also benefited operating income by $73 in Q3 and $218 year to date.
- Net cumulative contract estimate catch-ups added $34 to Q3 operating income and $99 year to date, below $56 and $142 in the respective 2017 periods. HII reported that no individual adjustment was material.
- Operating cash flow was pressured by $537 of pension and other postretirement contributions, including $508 of discretionary qualified pension contributions, compared with $326 total contributions in the prior-year period. HII anticipated no further significant qualified-plan contributions in 2018.
- HII adopted revenue standard ASC 606 in 2018 using the modified retrospective method; prior-year periods were not restated. Adoption reduced Q3 operating income by $5 and diluted EPS by $0.08, and reduced year-to-date operating income by $4 and diluted EPS by $0.07.
Outlook, risks, and contingencies
HII gave no specific earnings or revenue guidance in the provided filing text. Backlog was $21.9 billion at September 30, including $16.6 billion funded; remaining performance obligations were also $21.9 billion. The company expects to recognize approximately 40% of remaining performance obligations through 2019 and another 40% through 2021. New contract awards totaled approximately $6.5 billion year to date, including two DDG 51 destroyers and LPD 29. For 2018, HII expected maintenance and sustainment capital expenditures of 2%–2.5% of annual revenue and discretionary capital expenditures of 3%–3.5%. Management said cash, expected operating cash generation, and credit facilities should be sufficient for at least the next 12 months.
- Defense budget uncertainty remains a long-term risk. Sequestration relief applied for fiscal 2018 and 2019, but sequestration remained in effect for 2020 and 2021; continuing appropriations for portions of the federal government ran through December 7, 2018. Funding changes could delay or reduce programs, orders, revenue, profits, and cash flow.
- A DCAA audit identified significant deficiencies in Newport News’ material-management business system. If unresolved, the government could withhold up to 5% of certain interim billings, potentially affecting cash receipts.
- A sealed False Claims Act case involving alleged non-conforming supplier parts remained unresolved; HII said it could not estimate a reasonably possible loss or outcome. The government also continued discussions with HII concerning Gulfport closure-cost allocation; failure to recover costs as expected could materially affect results or cash flows.
- HII was seeking court confirmation or enforcement of a 2018 arbitration award in its Venezuela dispute: approximately $151 awarded to HII and $22 to Venezuela. Resolution remained uncertain.
- HII completed the sale of the Avondale facility in October 2018. It expected to recognize a $7 gain in Q4; $41 of related assets had been classified as held for sale at September 30.
- Other exposures include government investigations and contract-cost disputes, asbestos claims, pension assumptions, labor negotiations, and defense-program execution. HII reported no material changes to the risk factors in its 2017 Form 10-K.
Important facts for investors to verify
- Whether improved earnings persist after considering the lower tax rate, retirement-related income, pension accounting adjustments, and contract estimate catch-ups.
- Whether cash conversion improves after unusually large pension contributions and elevated capital expenditures; free cash flow was only $6 year to date.
- Resolution and potential cash-flow effects of the Newport News DCAA findings, Gulfport cost-recovery discussions, and other government claims.
- Backlog funding and conversion assumptions, given that $5.3 billion of backlog was unfunded and most revenue depends on U.S. Government customers.
- Execution of shipbuilding programs and contract cost estimates, which can change reported profits through cumulative catch-up adjustments.
- Whether the Avondale sale proceeds and expected Q4 gain are realized as anticipated.