Huntington Ingalls Industries, Inc. — Q1 2014 Form 10-Q
Business context and reporting period. The filing covers the three months ended March 31, 2014. HII designs, builds, overhauls, and repairs ships, primarily for the U.S. Navy and Coast Guard. Its reportable segments are Ingalls and Newport News; substantially all business is with the U.S. Government. Prior-period segment information was reclassified to reflect the 2014 realignment, without changing consolidated results.
Financial performance
| Metric | Q1 2014 | Q1 2013 |
|---|---|---|
| Sales and service revenues | $1.594 billion | $1.562 billion |
| Operating income | $159 million | $95 million |
| Net earnings | $90 million | $44 million |
| Diluted EPS | $1.81 | $0.87 |
| Operating cash flow | $(214) million | $(362) million |
| Free cash flow | $(238) million | $(392) million |
- Revenue increased 2%; operating income rose 67% and net earnings more than doubled. Approximate operating margin increased to 10.0% from 6.1%; net margin to 5.6% from 2.8%.
- Product sales were $1.332 billion, up 1%; service revenue was $262 million, up 9%. Lower product costs and G&A supported earnings; G&A fell 12% to $150 million.
- Segment results: Ingalls revenue was $547 million and operating income $43 million, versus $550 million and $24 million. Newport News revenue was $1.047 billion and operating income $94 million, versus $1.012 billion and $96 million.
- Q1 net favorable cumulative contract estimate adjustments added $44 million to operating income and $0.58 to diluted EPS, compared with $30 million and $0.39 in Q1 2013.
- Cash declined to $742 million from $1.043 billion at year-end. Current assets were $2.544 billion and current liabilities $1.240 billion.
- Total debt was $1.779 billion, including $79 million current; cash less total debt implies net debt of about $1.037 billion. The $650 million revolving facility was undrawn, with $28 million of letters of credit issued; HII reported covenant compliance.
Changes, outlook, and management commentary
- Operating cash use improved year over year but remained substantial, chiefly reflecting working-capital movements, including the timing of receivable collections and payments. Free cash flow remained negative.
- HII expected 2014 capital expenditures of 2%–3% of annual revenue and $123 million of qualified pension-plan contributions, all discretionary. Management said cash, operating cash generation, and available credit were expected to cover debt service, contractual obligations, and capital spending for at least 12 months.
- Backlog was approximately $18.743 billion at March 31, up from $18.038 billion at year-end; $13.019 billion was funded and $5.724 billion unfunded. New awards were approximately $2.2 billion in the quarter. The company reported that about 32% of year-end 2013 backlog was expected to convert to sales in 2014.
- Revenue and profit improvement reflected risk retirement and favorable contract estimate revisions, particularly on LPD-17, National Security Cutter, Virginia-class submarine, and CVN-78 programs. Segment operating income increased 14%; consolidated operating income also benefited from a $45 million year-over-year favorable change in the FAS/CAS pension adjustment.
- Stoller was acquired on January 2 for a preliminary $52 million net of cash received, funded with cash on hand. Its results are included in Newport News; the company said the acquisition was not significant to consolidated results.
- Key demand risk remains U.S. defense and Coast Guard funding. The 2014–2015 budget provided some sequestration relief, but sequestration remained in effect for 2016–2021, with potential adverse effects on programs, revenue, and asset values.
Risks, contingencies, and unusual items
- Avondale: Estimated wind-down costs were $284 million, which HII treated as recoverable under existing or future Navy contracts while discussions continued. DCAA had previously questioned about $25 million of a $310 million proposal; a revised $284 million proposal was submitted in March 2014. Failure to recover costs could materially affect results. HII was also studying alternative uses for the facility.
- Government investigation: HII disclosed an internal investigation into possible employee mischarging or misstatement of progress on Navy and Coast Guard contracts. The Navy reduced its withholding to $9.4 million; the Coast Guard continued to withhold $5.8 million. HII estimated maximum mischarging at about $4 million, but warned of possible penalties or suspension/debarment.
- False Claims Act case: A complaint alleges improper use of post-Katrina federal funds and seeks at least $835 million plus penalties and other costs; damages may be trebled. The government declined to intervene. HII said it believed the claims lacked merit but could not predict the outcome.
- Gulfport closure: HII expected about $57 million in total costs, mostly accelerated depreciation. A contracting officer disputed the timing of cost recognition; HII did not expect a material consolidated impact.
- Contract estimates and tax: Earnings include significant cumulative catch-up contract adjustments. The 2014 tax rate of 31.8% benefited from a non-recurring release of uncertain tax positions as well as the domestic manufacturing deduction.
- Environmental remediation accruals were $2 million. HII also reported asbestos-related litigation, other government claims, and the appeal/options relating to a 2013 contracting officer decision that reduced operating income by $116 million for Katrina-related matters.
- HII noted potential effects of defense-budget reductions, contract execution and cost-estimate risks, leverage, government investigations, and possible contractor-system payment withholds. No material risk-factor changes from the 2013 Form 10-K were reported.
Important facts for investors to verify
- Whether negative operating and free cash flow reverse as working capital normalizes, and how much of the earnings increase converts to cash.
- How much of the $44 million contract-estimate benefit is repeatable, and whether subsequent program performance supports the assumptions.
- Progress toward recovering Avondale restructuring costs and resolution of the Gulfport cost-recognition dispute.
- Developments in the Ingalls investigation, government withholds, and the False Claims Act litigation, including possible financial or contracting consequences.
- Backlog funding and conversion, future defense appropriations, and execution of major shipbuilding programs.
- Debt repayment, pension contributions, capital spending, and liquidity relative to the company’s stated 12-month sufficiency outlook.