Huntington Ingalls Industries, Inc. — Q2 2014 Form 10-Q
Reporting period: Three and six months ended June 30, 2014; comparisons are with the corresponding 2013 periods. HII builds, overhauls, and repairs ships primarily for the U.S. Navy and Coast Guard. Its reportable segments are Ingalls, Newport News, and Other; Other was established in Q2 2014 for non-shipbuilding commercial activities.
Financial performance
| Metric | Q2 2014 | Q2 2013 | Six months 2014 | Six months 2013 |
|---|---|---|---|---|
| Revenue | $1.719bn | $1.683bn | $3.313bn | $3.245bn |
| Operating income | $181m | $116m | $340m | $211m |
| Net earnings | $100m | $57m | $190m | $101m |
| Diluted EPS | $2.04 | $1.12 | $3.84 | $2.00 |
| Operating margin | 10.5% | 6.9% | 10.3% | 6.5% |
| Net margin | 5.8% | 3.4% | 5.7% | 3.1% |
- Revenue grew 2% in both the quarter and first half. Product sales rose 1%; service revenues rose 10% in Q2 and 9% year to date.
- Operating income increased 56% in Q2 and 61% year to date. Management attributed improvement to contract risk retirement and performance, lower product-cost ratios, and a favorable pension accounting (FAS/CAS) adjustment. Segment operating income grew 20% in Q2 and 17% year to date; Ingalls improved materially while Newport News was broadly flat.
- Net cumulative contract estimate adjustments increased operating income by $64m in Q2 and $108m in the first half, adding $0.84 and $1.42, respectively, to diluted EPS. These adjustments are a significant contributor to reported earnings growth.
- Effective tax rates were 34.2% for Q2 and 33.1% for the first half, modestly below prior-year rates; the 2014 rates benefited from a larger domestic manufacturing deduction and a non-recurring release of uncertain tax positions.
Cash flow, balance sheet, and capital allocation
- First-half operating cash flow was $58m, versus cash used of $337m in 2013. The improvement reflected working-capital movements and lower pension contributions; the company contributed $123m to qualified pension plans versus $301m a year earlier.
- Capital expenditures were $51m; free cash flow, defined by HII as operating cash flow less capital expenditures, was $7m versus negative $392m. Investing cash outflow was $324m, including $273m for acquisitions. Financing cash outflow was $185m, including $104m of share repurchases and $20m of dividends.
- Cash was $592m at June 30, down from $1.043bn at year-end 2013. Total debt, including current maturities, was $1.765bn, implying net debt of about $1.173bn. Debt declined from $1.779bn at year-end. The company reported compliance with debt covenants.
- The $650m revolving credit facility had $622m available, net of $28m of undrawn letters of credit. Current assets were $2.327bn and current liabilities $1.267bn.
- HII repurchased approximately 1.065m shares for $105m in the first half and declared dividends of $0.40 per share, double the prior-year first-half amount.
Backlog, outlook, and management commentary
- Total backlog was $24.157bn at June 30, versus $18.038bn at December 31, 2013; $14.412bn was funded and $9.745bn unfunded. First-half contract awards were approximately $9.2bn. Substantially all backlog was U.S. Government business.
- Management said cash from operations, existing cash, and credit facilities should be sufficient for debt service, contractual obligations, and capital expenditures for at least the next 12 months. Expected 2014 capital expenditures were 2%–3% of annual revenue. The filing provides no specific earnings or revenue guidance.
- Defense budget uncertainty remains a key risk: sequestration relief covered 2014–2015, but sequestration remained in place for 2016–2021. Management noted that future funding reductions could affect programs, revenue, workforce, suppliers, and asset values.
- HII acquired Stoller, a technical and environmental services provider, for approximately $47m in January, and UPI, an oil-and-gas engineering and project-management provider, for approximately $226m in May. Both acquisitions were funded with cash; reported operating contributions were not material in the period.
Risks, contingencies, and unusual items
- Avondale: Estimated restructuring costs were $284m. Recovery depends on U.S. Navy agreement; the Navy requested further documentation after DCAA questioned support for costs. HII continued to treat costs as allowable, but inability to recover them could materially affect results. The company was also exploring alternative use of the facility.
- Gulfport closure: Estimated costs were approximately $57m. In July 2014, the Supervisor of Shipbuilding objected to HII’s treatment of these costs; HII disagreed and was evaluating next steps. Non-recovery could be material.
- Government investigation: An internal investigation concerned alleged employee mischarging or misstated progress on Navy and Coast Guard contracts. The company estimated potential mischarging at approximately $4m. Government payment withholds had been reduced, but further release and ultimate resolution remained uncertain; penalties or suspension/debarment were possible.
- False Claims Act: A relator complaint seeks at least $835m plus penalties and fees, with potential treble damages. The Department of Justice declined to intervene; HII said it believed the claims lacked merit and intended to defend them.
- Other litigation: In an arbitration involving Venezuela, HII sought $173m plus interest and expenses; Venezuela counterclaimed for $61m plus interest. A final hearing was scheduled for January 2015.
- HII’s contract accounting uses estimated costs and percentage-of-completion methods; revisions produce cumulative catch-up adjustments. Pension assumptions, contract performance, federal procurement and funding, and claims recovery remain material sources of estimation and business risk.
Most important facts for investors to verify
- Whether contract estimate gains and risk-retirement benefits continue, given their substantial contribution to first-half operating income and EPS.
- Whether the Navy accepts Avondale restructuring costs and how the Gulfport cost dispute is resolved.
- Whether operating cash flow remains positive after the unusually large 2013 pension contributions and working-capital fluctuations.
- How much of the $24.157bn backlog is funded, and whether budget decisions support scheduled naval and Coast Guard programs.
- Developments in the government investigation, False Claims Act case, and Venezuela arbitration, including any effect on payments or contracting eligibility.