Huntington Ingalls Industries, Inc. — FY 2015 Form 10-K
Reporting period: Fiscal year ended December 31, 2015. The filing also provides unaudited fourth-quarter results. Amounts are in U.S. dollars; financial amounts are in millions unless stated otherwise.
Business context
HII designs, builds, overhauls, and repairs ships, principally for the U.S. Navy and Coast Guard. Its segments are Ingalls, Newport News, and Other. The company is the sole U.S. designer, builder, and refueler of nuclear-powered aircraft carriers, and one of two builders of nuclear submarines and DDG-51 destroyers. U.S. Navy revenue represented approximately 89% of 2015 revenue; Coast Guard revenue was approximately 7%.
Financial performance and liquidity
| Metric | FY 2015 | FY 2014 | Change |
|---|---|---|---|
| Sales and service revenues | $7,020 | $6,957 | +1% |
| Operating income | $769 | $655 | +17% |
| Net earnings | $404 | $338 | +20% |
| Diluted EPS | $8.36 | $6.86 | +22% |
| Operating cash flow | $828 | $716 | +16% |
| Free cash flow | $640 | $551 | +16% |
Operating margin was approximately 11.0%, versus 9.4% in 2014; net margin was approximately 5.8%, versus 4.9%. Free cash flow is a non-GAAP measure defined as operating cash flow less capital expenditures.
At December 31, 2015, cash and cash equivalents were $894, total assets were $6,024, and stockholders’ equity was $1,490. Long-term debt was $1,273, with no current portion reported. The company had $1,223 of undrawn revolving-credit capacity, in addition to cash, and reported compliance with debt covenants. The current ratio was approximately 1.8, based on current assets of $2,284 and current liabilities of $1,274.
Capital returns increased: 2015 dividends declared were $1.70 per share, compared with $1.00 in 2014; the board raised the quarterly dividend to $0.50 in October. HII repurchased approximately $234 of shares during 2015 and increased its authorized repurchase program to $1.2 billion.
Material changes and unusual items
- Ingalls revenue declined 4% to $2,188, while segment operating income rose to $379 from $229. The increase was principally attributed to the Aon insurance-broker settlement, contract-change resolutions, and improved performance on certain ship programs.
- Newport News revenue increased 4% to $4,700; segment operating income was $422 versus $415. Higher submarine and fleet-support activity was partly offset by lower aircraft-carrier performance.
- Other reported an operating loss of $134, compared with $59, including $75 of goodwill impairment and $27 of intangible-asset impairment. The impairments reflected deteriorating oil-and-gas market conditions and reduced expectations.
- Aon paid HII $150 in May 2015 in settlement of litigation related to Hurricane Katrina insurance claims. After a $14 credit to the U.S. Government, HII reported a net favorable operating-income impact of $136.
- Cash generated from operations increased to $828, partly reflecting the settlement proceeds and changes in retiree-benefit funding; higher income-tax payments and working-capital timing partly offset the increase. Capital expenditures were $188.
- HII refinanced $600 of 7.125% notes with $600 of 5.000% notes due 2025 and repaid term loans. Interest expense decreased to $137 from $149, although the company recorded a $44 loss on early extinguishment of debt.
Fourth quarter: Revenue was $1,905, compared with $1,927 in Q4 2014; operating income was $144 in both quarters; net earnings were $50 versus $52; diluted EPS was $1.06 versus $1.05. Q4 2015 included $16 of goodwill impairment and $27 of intangible-asset impairment.
Backlog, outlook, and management commentary
- Year-end backlog was approximately $22.1 billion, up from $21.4 billion. Approximately 29% was expected to convert to sales in 2016. Backlog included $11.3 billion funded and $10.8 billion unfunded; substantially all was U.S.-government related.
- Management expected 2016 operating cash generation, existing cash, and credit facilities to be sufficient to service debt, meet contractual obligations, and fund capital expenditures for at least the next 12 months. Maintenance and sustainment capital expenditures, excluding discretionary projects, were expected to be 2%–3% of annual revenue.
- HII expected 2016 qualified defined-benefit pension contributions of $167, all discretionary, and other postretirement contributions of approximately $37. It expected a 2016 FAS/CAS pension adjustment benefit of approximately $137, subject to change as estimates are updated.
- The 2015 Bipartisan Budget Act provided sequestration relief for fiscal years 2016 and 2017; sequestration remained scheduled for 2018–2021. Management cited ongoing uncertainty around future defense budgets and the potential for program delays, reductions, or cancellations.
Risks, contingencies, and controls
- Government concentration and funding: The business depends heavily on U.S. government appropriations and procurement priorities. Contract termination, delayed funding, or reduced ship procurement could materially affect results and cash flows.
- Contract execution and estimates: Most revenue is generated from long-term flexibly priced contracts. Cost overruns, schedule delays, supplier constraints, technical issues, and changes in estimated costs to complete can affect margins. Net cumulative catch-up adjustments increased 2015 operating income by $239, or diluted EPS by $3.21.
- Avondale recovery: HII estimated Avondale restructuring and shutdown costs at $287 and expected substantial recovery under government contracts, but had no agreement with the Navy on accounting and pricing treatment. A preliminary government determination questioned allocation of up to $57 of employee retention and incentive costs. Potential Avondale environmental costs were not estimable and were not included in the financial statements.
- Investigations and litigation: The Department of Justice was investigating disclosed allegations of employee time mischarging or progress misstatements at Ingalls; HII said it was cooperating and could not estimate a loss range. Approximately $8.3 of customer payments remained withheld, and HII estimated maximum potential Navy and Coast Guard mischarging of approximately $4. A separate False Claims Act case seeking at least $835 plus potential penalties was dismissed in HII’s favor as to the remaining relator; an appeal was pending. HII also disclosed a Venezuela arbitration involving its $173 claim and a $61 counterclaim.
- Pensions and workforce: Qualified pension plans were 84% funded on a FAS basis, versus 86% in 2014. Actual pension-asset returns in 2015 were approximately negative 1%, versus a 7.5% expected-return assumption. Roughly half of employees were covered by collective bargaining agreements; labor availability and negotiations are operational considerations.
- Other exposures: HII cited government audits and potential payment withholds, nuclear and environmental liabilities, cyber and security threats, supplier concentration, and possible additional impairment in the oil-and-gas-related Other segment. Probable environmental remediation costs accrued were $2; the filing noted some potential environmental obligations could not be estimated.
The financial statements received an unqualified audit opinion, and the auditor and management concluded internal control over financial reporting was effective as of December 31, 2015.
Most important facts for investors to verify
- Whether 2015 earnings and margin improvement are sustainable apart from the $136 net Aon settlement benefit and other contract-estimate adjustments.
- Progress and final recoverability of the $287 Avondale restructuring estimate, including the disputed allocation of up to $57 and any unestimated environmental costs.
- Developments in the DOJ investigation, remaining payment withholds, the False Claims Act appeal, and the Venezuela arbitration.
- Funding and conversion of the $22.1 billion backlog, including the funded/unfunded mix and the expected 2016 conversion.
- Defense appropriations and ship-program schedules, as well as further oil-and-gas deterioration and resulting impairment risk.
- Pension funding needs, asset performance, and the assumptions underlying the expected 2016 contribution and FAS/CAS adjustment.