Huntington Ingalls Industries, Inc. — Q2 2018 Form 10-Q
Reporting period: Three and six months ended June 30, 2018; unaudited. Comparisons are with the corresponding 2017 periods. HII builds military ships and provides government, energy, and other services through Ingalls, Newport News, and Technical Solutions. Most business is with the U.S. Government, principally the Department of Defense.
Financial performance
| Metric | Q2 2018 | Q2 2017 | Six months 2018 | Six months 2017 |
|---|---|---|---|---|
| Revenue | $2.020 billion | $1.858 billion | $3.894 billion | $3.582 billion |
| Operating income | $257 million | $241 million | $448 million | $409 million |
| Net earnings | $239 million | $147 million | $395 million | $266 million |
| Diluted EPS | $5.40 | $3.21 | $8.86 | $5.77 |
| Operating margin | 12.7% | 13.0% | 11.5% | 11.4% |
Revenue rose 9% in both comparison periods. Product sales increased 7% in Q2 and 6% year to date; service revenue increased 13% and 16%, respectively. Newport News led growth, particularly through higher aircraft-carrier activity, naval nuclear support, and submarine work. Q2 operating income rose 7%, while six-month operating income rose 10%. Net earnings grew faster, helped by lower income taxes and favorable non-operating retirement results.
Segment operating income, HII’s non-GAAP operating measure, declined 3% in both periods: Q2 was $181 million versus $187 million, and six-month results were $298 million versus $307 million. Ingalls’ six-month segment income fell to $147 million from $164 million; Newport News’ fell to $142 million from $152 million despite higher revenue; Technical Solutions improved to $9 million from a $9 million loss.
Cash flow, liquidity, and capital
- Six-month operating cash flow was $359 million, up from $284 million. Free cash flow, as defined by HII, was $201 million versus $147 million, after $177 million of capital expenditures and $19 million of grant proceeds.
- Cash was $398 million at June 30, 2018, down from $701 million at year-end 2017. Current assets were $2.152 billion and current liabilities $1.509 billion; contract assets increased to $1.078 billion from $759 million.
- Long-term debt was $1.281 billion, compared with $1.279 billion at year-end. The $1.25 billion revolving facility was undrawn, with $17 million of letters of credit issued and $1.233 billion available. HII reported compliance with debt covenants and no principal payments due within five years.
- HII repurchased 1.81 million shares for $413 million in the first half and paid $64 million in dividends. Dividends declared were $1.44 per share, versus $1.20 a year earlier.
Material changes, outlook, and notable items
- HII reported a $21.2 billion backlog, approximately unchanged from year-end; $15.0 billion was funded. It also disclosed $21.2 billion of remaining performance obligations, expecting about 50% to be recognized through 2019 and a further 35% through 2021. New awards in the first half were approximately $3.7 billion, including the LPD 29 detailed design and construction contract.
- Management expects 2018 cash from operations, existing cash, and credit facilities to be sufficient for at least the next 12 months. It projected maintenance and sustainment capital expenditures of approximately 2%–2.5% of annual revenue and discretionary capital expenditures of approximately 3%–3.5%. No specific revenue or earnings guidance is provided in the supplied filing text.
- Six-month net cumulative contract estimate catch-up adjustments increased operating income by $65 million and diluted EPS by $1.15, compared with $86 million and $1.21 in 2017. The filing says no individual 2018 adjustment was material; favorable adjustments were primarily tied to risk retirement on the San Antonio-class program.
- Q2 included $12 million of other income and gains, primarily recoveries related to an Ingalls settlement. The Q2 effective tax rate was 8.8% versus 32.6%, and the six-month rate was 13.6% versus 27.1%, primarily reflecting research and development tax credits and the lower federal tax rate, partly offset by other tax items. Tax accounting remained incomplete for certain Tax Act provisions.
- HII expects $508 million of 2018 cash contributions to qualified pension plans, all discretionary; $84 million had been contributed in the first half. The company cited long-term U.S. defense-budget and sequestration uncertainty: relief applied for 2018–2019, but sequestration remained scheduled for 2020–2021.
- A Defense Contract Audit Agency review identified significant deficiencies in Newport News’ material-management business system. If unresolved, the Government could withhold up to 5% of interim billings on certain contracts, potentially affecting cash-receipt timing.
- Other matters to monitor include a sealed False Claims Act case involving allegedly non-conforming supplier parts, the unresolved government discussion over Gulfport closure-cost allocation, and enforcement of a roughly $151 million arbitration award against Venezuela, which also received a roughly $22 million counter-award. HII could not estimate a reasonably possible loss for the sealed case.
- HII adopted revenue-recognition Topic 606 in 2018; the filing says the impact on results was not significant. Prior-year results were not restated. The company anticipated that the 2019 lease standard would increase reported lease assets and liabilities without materially changing operating results.
Important facts for investors to verify
- Whether contract execution, cost estimates, and risk retirement sustain operating performance, particularly as segment income declined despite higher revenue.
- Cash conversion and working-capital trends, including the increase in contract assets, planned pension contributions, and the pace of capital spending and share repurchases.
- Whether the Newport News material-management deficiencies are remediated and whether any payment withholdings occur.
- Defense appropriations, program funding, and the effect of future budget changes on the substantial but partly unfunded backlog.
- Developments in the supplier-parts investigation, Gulfport cost recovery, and collection or enforcement of the Venezuela arbitration award.
- Completion of Tax Act accounting and the sustainability of the unusually low 2018 effective tax rates.