Huntington Ingalls Industries, Inc. — Q3 2014 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2014; comparisons are with the same 2013 periods unless noted. HII builds, overhauls, and repairs ships primarily for the U.S. Navy and Coast Guard. Its segments are Ingalls, Newport News, and Other. Results include Stoller from January 2014 and UPI from May 30, 2014.
Financial performance and liquidity
| Metric | Q3 2014 | Q3 2013 | Nine months 2014 | Nine months 2013 |
|---|---|---|---|---|
| Sales and service revenues | $1.717B | $1.637B | $5.030B | $4.882B |
| Operating income | $171M | $127M | $511M | $338M |
| Net earnings | $96M | $69M | $286M | $170M |
| Diluted EPS | $1.96 | $1.36 | $5.80 | $3.37 |
| Operating margin | 10.0% | 7.8% | 10.2% | 6.9% |
Quarterly revenue increased 5%; nine-month revenue increased 3%. Service revenue grew 37% in the quarter and 18% year to date, while product sales were nearly flat. Nine-month operating cash flow was $314M, versus cash use of $56M; capital expenditures were $91M, producing reported free cash flow of $223M, versus negative $141M. Management attributed the cash improvement principally to lower pension contributions, working-capital changes, and higher earnings; cash taxes paid rose to $132M from $54M.
Cash was $769M at September 30, down from $1.043B at year-end 2013. Total debt, including current maturities, was $1.743B, down from $1.779B; net debt was approximately $974M. The $650M revolving facility was undrawn, with $31M of letters of credit issued; the company reported compliance with debt covenants. Current assets were $2.380B and current liabilities $1.234B.
Material changes and operating drivers
- Segment operating income rose 6% in Q3 and 13% for nine months. Ingalls improved on ship-program performance and risk retirement; Newport News results were broadly stable year to date. The new Other segment recorded $81M of nine-month revenue and a $5M operating loss.
- Net cumulative contract-estimate adjustments increased operating income by $46M in Q3 and $154M year to date, versus $2M and $67M in 2013. These adjustments added $0.61 and $2.03 to diluted EPS, respectively. Favorable changes chiefly reflected risk retirement on submarine, National Security Cutter, LPD, and CVN-78 programs.
- HII acquired Stoller for approximately $47M and UPI for approximately $225M, both funded with cash on hand. Goodwill increased by $205M, including $163M related to UPI and $42M to Stoller.
- Backlog was approximately $22.8B at September 30, versus $18.0B at year-end 2013; $13.1B was funded and $9.7B unfunded. Nine-month contract awards were approximately $9.6B.
Outlook, risks, and unusual items
- Management expected operating cash, existing cash, and credit facilities to be sufficient for debt service, contractual obligations, and capital expenditures for at least 12 months. 2014 capital expenditures were expected at 2%–3% of annual revenue; no earnings or revenue guidance was provided in the filing.
- Federal fiscal 2015 appropriations had not passed by the fiscal year-end; the government was operating under a continuing resolution scheduled to expire December 11, 2014. Sequestration remained a risk for 2016–2021 and could reduce defense spending and affect HII’s revenue and asset values.
- Avondale restructuring costs were estimated at $284M; recovery remained under discussion with the Navy. HII treated the costs as allowable in contract earnings, but warned that unrecovered costs or higher actual costs could materially affect results. Gulfport closure costs were estimated at $57M, and the company disputed the government’s position on their treatment.
- Contingencies include a False Claims Act complaint seeking at least $835M plus penalties (which may be trebled); a government inquiry into alleged employee mischarging, with approximately $8.3M in Navy and Coast Guard withholds then outstanding; and a Venezuela arbitration involving HII’s $173M claim and a $61M counterclaim. HII described defenses in these matters but could not assure outcomes.
- Quarterly and year-to-date earnings benefited from contract estimate revisions. The prior-year comparison also included hurricane insurance and related contract-accounting effects. In October 2014, HII signed an MOU with the Navy and Coast Guard on hurricane-related requirements, with no material accounting impact. On October 30, after quarter-end, the board expanded the share-repurchase authorization to $600M and extended it through October 2019.
Important facts for investors to verify
- Whether the large favorable cumulative contract adjustments are sustained by subsequent program cost and schedule performance.
- Resolution and recoverability of Avondale and Gulfport costs, including any required accounting changes.
- Funding and timing of major Navy and Coast Guard programs amid continuing-resolution and sequestration uncertainty; also the funded portion and conversion timing of backlog.
- Developments in the False Claims Act, government mischarging, and Venezuela matters, including potential payment withholds or penalties.
- Post-acquisition performance and cash returns from UPI and Stoller, and cash deployment under the expanded repurchase program.