Huntington Ingalls Industries, Inc. — Q3 2015 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2015. HII designs, builds, overhauls, and repairs ships, principally for the U.S. Navy and Coast Guard. Its segments are Ingalls, Newport News, and Other.
Financial performance
| Metric | Q3 2015 | Q3 2014 | Nine months 2015 | Nine months 2014 |
|---|---|---|---|---|
| Sales and service revenues | $1.800 billion | $1.717 billion | $5.115 billion | $5.030 billion |
| Operating income | $200 million | $171 million | $625 million | $511 million |
| Net earnings | $111 million | $96 million | $354 million | $286 million |
| Diluted EPS | $2.29 | $1.96 | $7.28 | $5.80 |
| Operating margin | 11.1% | 10.0% | 12.2% | 10.2% |
Quarterly revenue rose 5%, operating income 17%, and net earnings 16% year over year. Nine-month revenue increased 2%, operating income 22%, and net earnings 24%. Nine-month diluted EPS included $2.51 from cumulative contract estimate adjustments, compared with $2.03 in the prior-year period.
- Revenue and segment trends: Q3 Ingalls revenue was $593 million, up 6%, and Newport News revenue was $1.177 billion, up 7%. Other revenue fell 51% to $30 million, principally on weaker oil and gas services. For nine months, Other reported a $79 million operating loss, including a $59 million goodwill impairment.
- Margins and costs: Q3 product cost was 79.7% of product sales, versus 78.4%; service cost was 86.1% of service revenue, versus 83.7%. Nine-month product cost improved to 75.4% from 79.0%, while service cost worsened to 86.5% from 84.4%. HII attributed variations chiefly to contract mix and program performance.
- Cash flow: Nine-month operating cash flow was $417 million, up from $314 million; capital expenditures were $86 million, producing reported free cash flow of $331 million versus $223 million. Management cited the Aon settlement and retiree-benefit funding changes as favorable, partly offset by higher taxes and working-capital movements.
- Debt and liquidity: Debt was $1.305 billion at September 30, versus $1.700 billion at year-end 2014, after repayment of the prior facility’s term loans. Cash was $671 million, down from $990 million. A $1.25 billion revolving facility was undrawn except for $29 million of letters of credit, leaving $1.221 billion unused. HII reported compliance with debt covenants and said available cash, operations, and credit facilities should cover obligations and capital expenditures for at least 12 months.
- Other measures: Total backlog was $23.265 billion, compared with $21.430 billion at year-end; $12.498 billion was funded. HII repurchased $196 million of shares and paid $58 million in dividends in the nine-month period. Dividends declared were $1.20 per share, versus $0.60.
Material changes and unusual items
- A settlement with Aon generated a $150 million gain in Q2 2015; a $14 million credit to the U.S. Government reduced the net nine-month operating-income benefit to $136 million. This was a significant contributor to the year-over-year improvement.
- Net cumulative catch-up contract adjustments increased operating income by $62 million in Q3 and $188 million for nine months. Favorable items included risk retirement on several ship programs and contract-change resolutions; unfavorable adjustments included lower performance on the CVN-78 Gerald R. Ford program.
- The $59 million goodwill impairment followed deterioration in oil-and-gas market conditions, including lower price expectations, customer spending cuts, and project delays.
- On November 2, 2015, HII announced a planned $600 million issue of 5.000% notes due 2025 and a tender offer or redemption for its 7.125% notes due 2021. The board also increased the share repurchase authorization to $1.2 billion on October 29.
Outlook, risks, and contingencies
- Outlook: The filing gives no specific earnings or revenue guidance. HII expected 2015 maintenance and sustainment capital expenditures, excluding discretionary projects, to be approximately 2% of annual revenue, and anticipated no further significant qualified pension contributions in 2015.
- Government funding: At filing, the government was operating under a continuing resolution expiring December 11, 2015. Sequestration and uncertainty over fiscal 2016 and later defense and Coast Guard budgets could delay, reduce, or cancel programs, affecting revenue, suppliers, and asset values.
- Cost recovery matters: HII was seeking recovery of Avondale restructuring costs; the government had raised concerns about its allocation method. The company recognized those costs in contract earnings based on expected recovery, but a materially adverse determination could affect results. Gulfport closure-cost recovery was also under government review; $35 million of receivables related to those costs remained outstanding.
- Government investigation: The Department of Justice was investigating disclosed potential employee time-charging or progress-reporting issues at Ingalls. HII was cooperating but could not estimate potential loss; penalties, damages, suspension, or debarment could be material. Customer payment withholds remained under discussion.
- Other legal matters: A False Claims Act case was dismissed in HII’s favor, but the relator appealed. HII also faced asbestos claims and a Venezuela arbitration involving its $173 million claim and a $61 million counterclaim; outcomes were uncertain.
Most important facts for investors to verify
- How much reported earnings and cash flow depended on the Aon settlement and contract estimate adjustments, and whether these benefits recur.
- Progress and profitability on the CVN-78 program and performance of the Other segment amid continuing oil-and-gas weakness.
- Resolution of Avondale and Gulfport cost-recovery issues, the DOJ investigation, and outstanding customer withholds.
- Funding and timing for major Navy and Coast Guard programs, and the proportion of backlog that is funded and converts to revenue.
- Terms and completion of the planned 2025 notes issuance and 2021 notes tender or redemption, together with future capital returns and liquidity needs.