Business Context and Reporting Period
This Form 10-Q covers the quarterly period ended March 31, 2011, for Huntington Ingalls Industries, Inc. (HII). The reporting period is defined by a material corporate event: the spin-off of HII from its former parent, Northrop Grumman Corporation, which was completed on March 31, 2011. Following the distribution, HII became an independent, publicly traded company on the New York Stock Exchange under the ticker symbol "HII." The company operates two reportable segments: Ingalls (amphibious assault ships, destroyers, and Coast Guard cutters) and Newport News (nuclear-powered aircraft carriers and submarines).
Key Financial Metrics
| Metric ($ in millions) | Q1 2011 | Q1 2010 |
|---|---|---|
| Total Sales and Service Revenues | 1,684 | 1,712 |
| Operating Income | 85 | 87 |
| Net Earnings | 45 | 41 |
| Diluted Earnings Per Share | $0.92 | $0.85 |
| Net Cash Used in Operating Activities | (364) | (117) |
| Free Cash Flow | (427) | (149) |
| Total Long-Term Debt | 1,880 | 105 |
| Cash and Cash Equivalents | 225 | — |
Note: Q1 2010 figures reflect HII as a subsidiary of Northrop Grumman. Q1 2011 figures reflect the standalone entity post-spin-off.
Material Changes vs. Prior Period
- Revenue Decline: Total revenues decreased 1.6% to $1,684 million. This was driven by a 16% drop in service revenues (due to the completion of the USS Enterprise EDSRA in 2010) and lower volume in the DDG-51 and LPD programs, partially offset by higher product sales in aircraft carrier and submarine programs.
- Profitability: Operating income decreased slightly to $85 million. Segment operating income fell 15% to $84 million, primarily due to lower margins on the CVN-78 Gerald R. Ford program and unfavorable performance in the LPD program. However, net earnings increased to $45 million due to a lower effective tax rate (35.7% vs. 46.8% in 2010) and a reduced net pension adjustment expense.
- Debt Structure: In connection with the spin-off, HII incurred significant new debt. Long-term debt increased from $105 million to $1,880 million, consisting of $1,200 million in senior notes and a $1,225 million credit facility (including a $575 million term loan and $650 million revolver).
- Cash Flow: Net cash used in operating activities increased significantly to $364 million (from $117 million), primarily due to a $235 million increase in trade working capital related to the timing of customer collections.
Outlook, Risks, and Management Commentary
- Backlog: Total backlog stands at approximately $17.4 billion ($10.4 billion funded, $7.0 billion unfunded). Approximately 31% of the backlog is expected to convert to sales in 2011.
- Avondale Wind Down: HII is winding down operations at its Avondale, Louisiana facility by 2013 to consolidate Gulf Coast operations in Mississippi. This is expected to incur approximately $310 million in restructuring costs, which the company anticipates recovering through government contracts, though this is subject to DCAA and Navy review.
- Legal and Contingencies:
- False Claims Act: A complaint alleges improper use of Hurricane Katrina funds, seeking damages of at least $835 million. HII believes it has substantive defenses.
- Insurance Disputes: Ongoing litigation with FM Global regarding Hurricane Katrina coverage and arbitration with Munich Re regarding reinsurance claims.
- Quality Issues: Ongoing resolution of pipe weld issues on LPD-17 class ships and bearing wear on main propulsion diesel engines.
- Liquidity: Management expects cash generated from operations and existing credit facilities to be sufficient to service debt and meet obligations for the next 12 months.
Investor Verification Checklist
- Verify the status of the Avondale facility wind-down and the progress of cost recovery discussions with the U.S. Navy and DCAA.
- Monitor the False Claims Act complaint regarding Hurricane Katrina funds and the outcome of insurance litigation with FM Global and Munich Re.
- Assess the impact of the new debt load ($1.88 billion) on interest expense and future liquidity, particularly given the variable rate components of the credit facility.
- Review the working capital trends, as the significant cash outflow in Q1 2011 was driven by timing differences in collections.
- Track the margin performance on the CVN-78 Gerald R. Ford program, which contributed to the decline in segment operating income.