Huntington Ingalls Industries, Inc. — Q2 2016 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2016; comparisons are with the corresponding 2015 periods. HII builds, overhauls, and repairs ships primarily for the U.S. Navy and Coast Guard. Its segments are Ingalls, Newport News, and Other. Amounts below are in millions, except per-share data.
Financial performance
| Metric | Q2 2016 | Q2 2015 | Six months 2016 | Six months 2015 |
|---|---|---|---|---|
| Revenue | $1,700 | $1,745 | $3,463 | $3,315 |
| Operating income | $217 | $269 | $415 | $425 |
| Net earnings | $133 | $156 | $269 | $243 |
| Diluted EPS | $2.80 | $3.20 | $5.68 | $4.99 |
| Operating cash flow | — | $223 | $176 | |
| Free cash flow | — | $138 | $127 |
- Q2 revenue fell 3% and operating income fell 19%; six-month revenue rose 4%, while operating income declined 2%. Net earnings rose 11% for the first half despite lower operating income, aided in part by lower interest and income tax expense.
- Calculated operating margins were approximately 12.8% in Q2 2016 versus 15.4% in Q2 2015, and 12.0% for the first half of 2016 versus 12.8% in 2015.
- Net cumulative contract estimate adjustments added $74 to Q2 2016 operating income and $143 for the first half; the filing reports diluted EPS benefit of $1.02 and $1.97, respectively.
- At June 30, cash was $852; long-term debt was $1,276. The company had $1,225 of unused revolving credit capacity, with $25 of letters of credit issued but undrawn. Current assets were $2,197 and current liabilities $1,141. HII reported compliance with debt covenants.
- First-half capital expenditures were $85, up from $49. Dividends paid were $48; share repurchases were $86. Dividends declared were $1.00 per share for the first half, compared with $0.80 in 2015.
Material changes and segment results
- Ingalls: First-half revenue increased 15% to $1,171, while segment operating income fell 30% to $170. Q2 operating income fell to $88 from $198, mainly reflecting the prior-year Aon insurance settlement benefit and weaker volume/risk retirement in the National Security Cutter program; higher risk retirement on amphibious ship work partly offset the decline.
- Newport News: First-half revenue increased 1% to $2,243 and operating income decreased 5% to $191. Q2 revenue declined 7% to $1,090 and operating income fell 6% to $102, reflecting lower aircraft-carrier and submarine volumes and lower submarine risk retirement.
- Other: First-half revenue decreased 32% to $51; operating loss improved to $11 from $74, principally because 2015 included a $59 goodwill impairment. Lower oil and gas activity continued to weigh on revenue.
- The year-over-year comparison is affected by 2015 unusual items: the Aon settlement generated a net favorable operating-income impact of $136 in Q2 2015, while the Other segment recorded a $59 goodwill impairment. The filing also states that 2015 Aon proceeds affected contract costs and segment results.
Liquidity, outlook, risks, and contingencies
- Operating cash flow improved by $47 year over year in the first half, principally due to trade working-capital timing and pension funding effects. HII said cash, expected operating cash generation, and credit facilities should be sufficient for debt service, contractual obligations, and capital spending for at least 12 months.
- Management estimated 2016 maintenance and sustainment capital expenditures at 2%–2.5% of annual revenue and discretionary capital expenditures at 1.5%–2%. It anticipated no further significant qualified pension contributions in 2016. The filing provides no specific revenue or earnings guidance.
- Backlog was approximately $20.5 billion at June 30, down from $22.1 billion at year-end 2015; $12.6 billion was funded and $7.9 billion unfunded. First-half new awards were approximately $1.9 billion. Substantially all backlog was from U.S. Government orders.
- Management cited ongoing uncertainty about defense budgets and sequestration for 2018–2021, which could reduce, delay, or cancel programs and pressure revenue, profit, cash flow, suppliers, and the industrial base. The 2016 federal appropriation funded several ship programs and procurement priorities, but later funding remained uncertain.
- Avondale recovery: Estimated net shutdown and restructuring costs were $276. HII sought a contracting officer’s final decision in June 2016 and treated the costs as allowable in contract earnings. The government could reject some recovery; HII warned that a shortfall could materially affect results or cash flows.
- Investigations and litigation: The Department of Justice is investigating previously disclosed potential employee mischarging on Navy and Coast Guard contracts; some payments remain withheld, and the ultimate outcome is not estimable. HII also disclosed a sealed False Claims Act suit involving allegedly non-conforming supplier parts, with loss not estimable. Other matters include the Venezuela arbitration and asbestos claims. The company said it could not assure outcomes in these matters.
- HII had $356 of surety bonds outstanding. It reported no material changes to the risk factors in its 2015 Form 10-K and said disclosure controls were effective.
Important facts for investors to verify
- How much of the reported contract-estimate benefit—$143 in first-half operating income—is repeatable, and what underlying programs drove it?
- Whether and when the U.S. Government will approve recovery of Avondale costs, and the potential impact if recovery is below management’s expectations.
- Progress and financial exposure from the DOJ investigations and the sealed supplier-parts lawsuit, including any change to payment withholds or contract eligibility.
- Backlog conversion and funding: the mix shifted toward funded backlog year over year, but total backlog declined; verify award pace and future appropriations for major ship programs.
- Whether operating cash flow and capital spending remain consistent with management’s stated liquidity expectations, particularly given pension contributions and contract working-capital timing.