Huntington Ingalls Industries, Inc. — Q1 2013 Form 10-Q
Reporting period: Three months ended March 31, 2013; unaudited. HII designs, builds, overhauls, and repairs ships, primarily for the U.S. Navy and Coast Guard. Its reportable segments are Ingalls and Newport News, and substantially all business is with the U.S. Government.
Financial performance
| Metric | Q1 2013 | Q1 2012 | Change |
|---|---|---|---|
| Sales and service revenues | $1.562 billion | $1.568 billion | Down $6 million; essentially flat |
| Operating income | $95 million | $80 million | Up 19% |
| Net earnings | $44 million | $33 million | Up 33% |
| Diluted EPS | $0.87 | $0.67 | Up $0.20 |
| Operating margin | 6.1% | 5.1% | Up about 1.0 percentage point |
| Operating cash flow | $(362) million | $(329) million | Greater cash use |
| Free cash flow | $(392) million | $(356) million | Greater cash use |
Product sales fell 2% to $1.321 billion, while service revenues rose 12% to $241 million. Cost of product sales decreased 6%; G&A expense increased 13% to $170 million, primarily reflecting higher FAS/CAS pension adjustment expense and bid and proposal activity. The effective tax rate declined to 32.3% from 34.0%, in part because the research and development tax credit was retroactively extended.
Segment results: Ingalls revenue was $631 million, down 9%, and operating income was $26 million, up 30%. Newport News revenue was $950 million, up 6%, and operating income was $94 million, up 16%. Consolidated segment operating income rose 19% to $120 million.
Financial position and liquidity
- At March 31, 2013, cash was $652 million, down from $1.057 billion at year-end 2012. Current assets were $2.391 billion and current liabilities were $1.177 billion.
- Total debt was $1.817 billion, including $38 million current; long-term debt net of current portion was $1.779 billion. Cash less total debt was approximately $1.165 billion net debt. The $650 million revolving facility was undrawn, apart from $46 million of issued but undrawn letters of credit; $604 million remained available. HII reported compliance with debt covenants.
- Operating cash use of $362 million principally reflected working-capital outflows, including receivables and payables timing. Capital expenditures were $30 million. Cash declined by $405 million during the quarter.
- HII expected 2013 capital expenditures of 2%–3% of annual revenue and qualified pension contributions of $301 million, all discretionary. Management said operating cash generation plus existing credit facilities should be sufficient for debt service, contractual obligations, and capital spending for at least 12 months.
Material changes and operating developments
- Net favorable cumulative contract estimate adjustments were $30 million, versus $14 million in Q1 2012; the 2013 adjustments increased diluted EPS by $0.39. Favorable adjustments chiefly reflected risk retirement and contract-change resolutions on the Virginia-class submarine program and work on the USS Theodore Roosevelt refueling and overhaul.
- Backlog increased to approximately $17.2 billion from $15.5 billion at year-end. Funded backlog was $11.6 billion and unfunded backlog $5.6 billion. Newport News total backlog rose to $10.5 billion, including a substantial increase in unfunded backlog; Ingalls backlog declined to $6.7 billion. New awards were approximately $3.2 billion.
- Avondale wind-down and restructuring costs were estimated at $256 million. HII was discussing cost recovery with the Navy and had included the costs as allowable in contract earnings; the DCAA had questioned costs and had not reached a conclusion on the proposal.
- A collective bargaining agreement amendment led to a pension plan remeasurement that increased the pension liability and pretax accumulated other comprehensive loss by approximately $30 million.
Outlook, risks, and contingencies
- Management highlighted uncertainty from the Budget Control Act and sequestration, which could reduce defense and Coast Guard spending and affect contract funding, revenue, facilities, suppliers, goodwill, and long-lived assets. Fiscal 2013 appropriations funded several named ship programs; the fiscal 2014 President’s Budget Request included funding for specified carrier, submarine, destroyer, and Coast Guard programs, but congressional outcomes remained uncertain. No specific company revenue or earnings guidance was provided.
- Approximately 99% of quarterly revenue came from flexibly priced contracts, making results dependent on allowable costs, contract performance, estimates at completion, and customer decisions on changes and fees.
- HII disclosed a False Claims Act complaint alleging misuse of Hurricane Katrina-related funds and seeking at least $835 million plus penalties; damages could be trebled. The company said it believed the claims lacked merit and did not expect a material effect, while noting it could not predict the outcome.
- HII reported an internal investigation into whether some Ingalls employees mischarged time or misstated contract progress. The company agreed initially to withhold $24 million in customer payments; it estimated the potential customer financial impact at approximately $4 million and intended to discuss releasing some or all withheld funds. Government actions could include penalties or suspension or debarment from contracting.
- Other uncertainties include Avondale cost recovery, asbestos-related claims, environmental remediation, Hurricane Katrina insurance litigation, and potential challenges to post-Katrina depreciation costs. The company reported $2 million accrued for probable environmental remediation and stated that it had not recognized an insurance receivable from FM Global.
- Interest-rate sensitivity: a 1% increase in rates would raise annual interest expense by approximately $5 million on the $512 million floating-rate term loan outstanding. Foreign-currency forward contracts were not significant.
Key facts for investors to verify
- Whether contract estimate benefits—especially the $30 million favorable catch-up adjustment—are repeatable and how they affect later-period earnings.
- Sequestration and appropriations outcomes, and the conversion and funding profile of the $17.2 billion backlog, particularly Newport News unfunded backlog.
- Working-capital collections and payments, cash generation, and the planned $301 million pension contribution against the cash balance and debt obligations.
- Resolution of the Ingalls time-charging investigation and release or continued withholding of the $24 million in customer payments.
- Navy recovery of Avondale restructuring costs and the ultimate outcomes of the False Claims Act and Hurricane Katrina-related matters.