Huntington Ingalls Industries, Inc. — 2017 Form 10-K
Reporting period: Fiscal year ended December 31, 2017. The filing also reports fourth-quarter results. Amounts are in U.S. dollars; financial figures are generally in millions unless stated otherwise.
Business context
HII designs, builds, overhauls, and supports military ships, and provides government, nuclear and environmental, IT, and oil-and-gas services. Its three segments are Ingalls, Newport News, and Technical Solutions. The U.S. Government accounted for more than 95% of revenue; the Navy alone generated approximately 87%, and the Coast Guard approximately 6%. The company reported approximately 38,000 employees.
Backlog at year-end was $21.367 billion, versus $20.735 billion a year earlier; $13.374 billion was funded and $7.993 billion unfunded. Management expected approximately 31% of year-end backlog to convert to sales in 2018. New awards were approximately $8.1 billion in 2017, compared with $5.2 billion in 2016.
Financial performance and liquidity
| Metric | 2017 | 2016 | Change |
|---|---|---|---|
| Sales and service revenue | $7,441 | $7,068 | +5% |
| Operating income | $865 | $858 | +1% |
| Net earnings | $479 | $573 | -16% |
| Diluted EPS | $10.46 | $12.14 | -14% |
| Operating cash flow | $814 | $822 | -1% |
| Free cash flow* | $453 | $537 | -16% |
Calculated operating margin was approximately 11.6% (12.1% in 2016); calculated net margin was approximately 6.4% (8.1% in 2016). Product cost was 79.7% of product sales, up from 77.8%; service cost was 84.3% of service revenue, down from 85.5%.
Revenue growth reflected a 30% increase in service revenue, notably in Technical Solutions after the Camber acquisition, while product sales declined 1%. Segment revenue and operating income were: Ingalls $2.420 billion and $313 million; Newport News $4.164 billion and $354 million; Technical Solutions $952 million and $21 million. Segment operating income decreased 4% overall, primarily due to lower risk retirement and volume in several ship programs, partly offset by improved oil-and-gas services performance.
Cash and cash equivalents were $701 million, total current assets $2.195 billion, and current liabilities $1.391 billion at year-end. The resulting current ratio was approximately 1.58. Long-term debt carrying value was $1.279 billion; contractual debt principal was $1.305 billion. The $1.25 billion revolving credit facility was undrawn, with $1.235 billion available after letters of credit. HII reported compliance with debt covenants.
Capital expenditures were $382 million. HII paid $115 million in dividends and repurchased shares for $288 million during 2017. The annual declared dividend was $2.52 per share. *Free cash flow is a company-defined non-GAAP measure: operating cash flow less capital expenditures, net of grant proceeds.
Material changes, outlook, and commentary
- Net earnings declined despite higher revenue and slightly higher operating income. The effective tax rate rose to 38.0% from 26.9%, including a $56 million provisional tax expense to remeasure deferred tax assets following the Tax Act’s reduction in the federal corporate rate to 21%.
- Fourth-quarter revenue was $1.996 billion versus $1.922 billion a year earlier; operating income was $227 million versus $268 million, and net earnings were $64 million versus $197 million. The filing attributes the 2017 tax expense increase to the Tax Act.
- HII issued $600 million of 3.483% senior notes due 2027 and redeemed $600 million of 5.000% notes due 2021. Early debt extinguishment charges contributed $22 million to 2017 interest expense, which rose to $94 million from $74 million.
- Operating cash flow was nearly flat, but free cash flow fell, reflecting higher capital spending and retiree-benefit funding. Qualified pension plans were 89% funded on a FAS basis at year-end; 2018 pension contributions were expected to be $508 million, all discretionary, with about $35 million expected for other postretirement plans.
- Management expected 2018 maintenance and sustainment capital expenditures of 2.0%–2.5% of revenue and discretionary capital expenditures of 3.0%–3.5%. It stated that cash, operating cash generation, and credit facilities were expected to cover debt service, benefit plans, contractual obligations, and capital expenditures for at least 12 months. The filing does not provide a specific 2018 revenue or earnings forecast.
- Management cited continued uncertainty over defense budgets: sequestration relief covered fiscal years 2018 and 2019, but sequestration remained in effect for 2020 and 2021. Customer funding, contract awards, cost estimates, schedule execution, supplier availability, skilled labor, cyber threats, and pension assumptions are key risks.
- Net favorable cumulative catch-up contract adjustments increased 2017 operating income by $204 million and diluted EPS by $2.90. A $10 million doubtful-account provision was recorded in 2017 following a commercial customer’s bankruptcy; certain $28 million of payments received may be subject to recovery by the bankruptcy trustee.
- HII settled a Department of Justice investigation concerning previously disclosed Ingalls time-charging and progress-reporting matters in August 2017; the settlement was not material, and the Navy and Coast Guard released remaining withheld payments. A separate sealed False Claims Act matter involving allegedly non-conforming supplier parts remained unresolved, with loss not estimable. HII’s Venezuela arbitration claim sought $173 million plus interest and costs; Venezuela counterclaimed for $61 million plus interest.
- The U.S. Government agreed that $251 million of Avondale shutdown costs were allowable; HII expected most to be billed and collected by the end of 2018. Sale of the facility remained subject to the potential buyer’s decision after due diligence. The filing reported $1 million of accrued environmental remediation costs, but potential additional Avondale remediation costs were not estimable.
The independent auditor gave an unqualified opinion on the financial statements and internal controls; management also concluded internal control over financial reporting was effective at December 31, 2017.
Important facts for investors to verify
- Whether the $21.367 billion backlog converts on schedule, and how much unfunded backlog receives appropriations.
- Contract margin sustainability: quantify the contribution of cumulative catch-up adjustments and monitor ship-program cost, schedule, and delivery performance.
- 2018 cash demands, especially the expected $508 million pension contribution, capital spending, and shareholder distributions.
- Final accounting for the Tax Act and its effect on future cash taxes and earnings; the 2017 deferred-tax remeasurement was provisional.
- Developments in the sealed supplier-parts lawsuit, the Venezuela arbitration, the commercial-customer bankruptcy, and any Avondale sale or remediation costs.
- Defense budget and procurement decisions, including funding for major carrier, submarine, surface-combatant, and amphibious-ship programs.