Huntington Ingalls Industries, Inc. — Q2 2019 Form 10-Q
Business context and period: The filing covers the three and six months ended June 30, 2019. HII builds and supports naval ships and provides government, energy, and oil-and-gas services through Ingalls, Newport News, and Technical Solutions. Most business is with the U.S. Government, primarily the Department of Defense.
Financial performance
| Metric | Q2 2019 | Q2 2018 | First half 2019 | First half 2018 |
|---|---|---|---|---|
| Sales and service revenues | $2,188 million | $2,020 million | $4,268 million | $3,894 million |
| Operating income | $175 million | $257 million | $336 million | $448 million |
| Net earnings | $128 million | $239 million | $246 million | $395 million |
| Diluted EPS | $3.07 | $5.40 | $5.91 | $8.86 |
| Operating cash flow | Not separately stated | Not separately stated | $(33) million | $359 million |
| Free cash flow | Not separately stated | Not separately stated | $(198) million | $201 million |
- Q2 revenue grew 8%, but operating income fell 32% and net earnings fell 46%. Approximate operating margin declined to 8.0% from 12.7%; net margin declined to 5.9% from 11.8%.
- First-half revenue rose 10%, while operating income declined 25% and net earnings declined 38%. Approximate operating margin was 7.9% versus 11.5% and net margin was 5.8% versus 10.1%.
- Q2 service revenue increased 28%, while product sales increased 1%. First-half service revenue increased 23% and product sales increased 5%. Cost of product sales and services increased faster than revenue; management cited weaker submarine performance, lower risk retirement on the San Antonio-class program, a fleet-support contract loss, and an unfavorable pension-accounting adjustment.
- At June 30, cash was $29 million, current assets $2,123 million, and current liabilities $1,902 million. Contract assets were $1,259 million, up from $1,003 million at year-end, and accounts receivable were $564 million, up from $252 million.
- Long-term debt was $1,698 million, compared with $1,283 million at December 31, 2018. This included $414 million drawn on a $1.25 billion revolving facility; $814 million remained unused. HII reported compliance with debt covenants. The filing states available cash, expected operating cash generation, and credit facilities should be sufficient for at least the next 12 months.
- First-half operating cash flow deteriorated primarily because of working-capital timing and higher income-tax payments, partly offset by lower retiree-plan contributions. Capital expenditures were $234 million and grant proceeds were $69 million. Free cash flow was negative $198 million.
- Dividends declared were $0.86 per share in Q2, versus $0.72 a year earlier. First-half dividends paid were $72 million; HII repurchased 429,940 shares for $88 million during the half, with an additional $48 million of prior-year repurchases settled in cash.
Material changes and business developments
- Revenue growth was led by Newport News, up 7% in Q2 and 12% for the first half, and Technical Solutions, up 38% and 25%, respectively. Ingalls revenue declined 1% in both periods.
- Segment operating income in Q2 declined at Ingalls ($69 million versus $83 million), Newport News ($70 million versus $91 million), and Technical Solutions (loss of $1 million versus income of $7 million). First-half Newport News income increased to $148 million from $142 million; Ingalls and Technical Solutions declined.
- HII acquired Fulcrum IT Services in February for approximately $195 million net of acquired cash. The acquisition added $133 million of goodwill and $49 million of intangible assets, allocated to Technical Solutions. HII also recorded a $7 million goodwill adjustment related to the prior G2 acquisition.
- Backlog rose to approximately $39.4 billion from $23.0 billion at year-end, including $18.9 billion funded and $20.5 billion unfunded. New awards in the first half totaled approximately $20.5 billion, including aircraft-carrier and amphibious-ship contracts.
- HII adopted the new lease standard on January 1, 2019, recording $215 million of operating lease assets and $215 million of lease liabilities, with no material retained-earnings impact.
Outlook, risks, and unusual items
- No specific earnings or revenue guidance is provided. HII expects to convert approximately 25% of remaining performance obligations to revenue through 2020, a further 30% through 2022, and the balance thereafter. Management estimated 2019 maintenance and sustainment capital expenditures at 2%–2.5% of annual revenue and discretionary capital expenditures at 3%–3.5%.
- Management highlighted uncertainty around federal defense budgets and sequestration for fiscal years 2020 and 2021; reduced or delayed Navy ship funding could materially affect results. HII noted the Administration’s proposal to cancel the USS Harry S. Truman refueling was subsequently reversed, with refueling announced in April 2019.
- Contract estimates and cumulative catch-up adjustments remain important sources of earnings variability. Net catch-up adjustments increased Q2 operating income by $19 million and first-half operating income by $13 million; first-half 2018 adjustments had increased operating income by $65 million. A fleet-support contract loss was among the unfavorable adjustments.
- A False Claims Act matter concerning allegedly non-conforming supplier parts remains sealed; HII cannot estimate a possible loss. The filing also discusses a March dry-dock transport incident that damaged a Navy destroyer, a work barge, and the dry dock. HII said it expected third parties or insurance to cover sufficient costs, but collection uncertainty could have a material effect.
- HII is pursuing enforcement of a 2018 arbitration award of approximately $151 million against Venezuela, which awarded Venezuela approximately $22 million on counterclaims; no assurance is given on collection. Asbestos litigation costs in the first half were immaterial, and estimated environmental remediation costs were immaterial.
- The higher 2019 effective tax rate reflected, in part, the absence of higher research-and-development tax-credit benefits recorded in 2018 and an unfavorable adjustment to prior-year credit claims. HII also attributed reduced pension-related non-operating benefit income to lower 2018 plan-asset returns.
Key facts for investors to verify
- Whether contract performance, especially Virginia-class submarines and the fleet-support contract, improves and limits further margin pressure.
- Whether working-capital movements reverse and operating cash flow and free cash flow recover from first-half negative levels.
- How much of the $39.4 billion backlog is funded, and whether expected conversion timing and major ship-program awards hold.
- Debt and liquidity trajectory, including revolving-credit usage, cash balances, and planned capital spending, dividends, and repurchases.
- Potential financial exposure and recoveries associated with the False Claims Act case, destroyer damage incident, and Venezuela arbitration award.
- Federal budget and appropriations decisions, including sequestration risk and funding for HII’s major shipbuilding programs.