HUNTINGTON INGALLS INDUSTRIES, INC. annual report, FY2013

Huntington Ingalls Industries, Inc. — FY 2013 Form 10-K

Business context and reporting period. The filing covers the fiscal year ended December 31, 2013; the company also reports unaudited fourth-quarter results. HII designs, builds, overhauls, and repairs ships, principally for the U.S. Navy and Coast Guard. Its reportable segments are Ingalls and Newport News. The company depends overwhelmingly on U.S. Government customers; approximately 94% of 2013 revenue came from the Navy and 6% from the Coast Guard.

Financial performance

Metric	FY 2013	FY 2012	Change
Sales and service revenues	$6.820 billion	$6.708 billion	Up 2%
Operating income	$512 million	$358 million	Up 43%
Operating margin	7.5%	5.3%	Up 2.2 percentage points
Net earnings	$261 million	$146 million	Up 79%
Diluted EPS	$5.18	$2.91	Up 78%
Operating cash flow	$236 million	$332 million	Down $96 million
Capital expenditures	$139 million	$162 million	Down $23 million
Free cash flow (non-GAAP)	$97 million	$170 million	Down $73 million

Fourth-quarter 2013 revenue was $1.938 billion, operating income was $174 million, net earnings were $91 million, and diluted EPS was $1.82. For Q4 2012, the comparable figures were $1.823 billion, $106 million, $50 million, and $0.98, respectively.

Segment results: Ingalls revenue declined 3% to $2.757 billion, while segment operating income rose to $175 million from $97 million. Newport News revenue increased 5% to $4.139 billion and segment operating income increased 9% to $392 million.
Cash flow: The decline in operating cash flow primarily reflected higher income-tax payments and retirement-benefit funding. HII paid $154 million in net federal and state income taxes in 2013, versus $28 million in 2012.
Margins and earnings drivers: Higher operating income reflected a $64 million favorable net impact from hurricane-related insurance recoveries and customer direction, improved submarine contract performance and risk retirement, carrier RCOH progress, and the absence of a prior-year workers’ compensation adjustment. These benefits were partly offset by Gulfport closure costs and contract-specific delays and repair costs.

Financial position, debt, and liquidity

At year-end, cash and cash equivalents were $1.043 billion, current assets were $2.676 billion, and current liabilities were $1.392 billion.
Total debt was $1.779 billion, including $79 million classified as current; long-term debt net of current maturities was $1.700 billion. HII had $622 million of unused revolving capacity, plus $28 million of issued but undrawn letters of credit, and reported compliance with debt covenants.
HII reported total assets of $6.225 billion and stockholders’ equity of $1.521 billion. The company stated that cash from operations, cash on hand, and credit facilities were expected to be sufficient for debt service, contractual obligations, and capital expenditures for at least the next 12 months.
Contractual obligations totaled $4.542 billion, including $1.779 billion of debt, $624 million of estimated debt interest, and $1.334 billion of purchase obligations.
Qualified pension plans were 93% funded on a FAS basis at year-end, compared with 76% in 2012. HII made $301 million in discretionary qualified pension contributions in 2013 and expected $123 million in 2014, plus approximately $35 million of other postretirement-benefit contributions.

Material changes and business developments

Total backlog rose to approximately $18.0 billion from $15.5 billion. About 32% of year-end 2013 backlog was expected to convert to sales during 2014. New awards were approximately $9.4 billion in 2013, versus $6.0 billion in 2012.
Major 2013 awards included a $3.3 billion multi-year contract for five DDG-51 destroyers, the CVN-72 Abraham Lincoln carrier refueling and overhaul, the CVN-65 Enterprise inactivation contract, and construction of NSC-6 Munro.
HII planned to wind down military shipbuilding at Avondale in 2014 and consolidate Ingalls military shipbuilding in Pascagoula. Management estimated Avondale restructuring and asset-related costs at $256 million and expected recovery under government-contract rules, but had no agreement with the Navy on accounting and pricing treatment. DCAA had questioned the support for the recovery proposal.
HII announced closure of its Gulfport composite facility, expected by the end of Q2 2014. Estimated total closure costs were approximately $57 million; $16 million reduced 2013 operating income, net of contract recoveries. A contracting officer took exception to the timing of cost recognition.
On January 2, 2014, HII acquired The S.M. Stoller Corporation for an initial purchase price of $53.7 million, subject to a working-capital adjustment; the purchase-price allocation was not complete at filing.

Outlook, risks, contingencies, and unusual items

Outlook: HII forecast 2014 capital expenditures at approximately 3% of annual revenue. The filing did not provide a specific revenue or earnings forecast. Management cited the Bipartisan Budget Act’s sequestration relief for 2014–2015, while noting that sequestration remained scheduled for 2016–2021 and could affect future programs, awards, suppliers, and demand.
Customer and contract concentration: Substantially all revenue and backlog depended on the U.S. Government. Changes in appropriations, shipbuilding priorities, contract awards, funding schedules, or customer decisions to modify or terminate contracts could materially affect results. Contract-cost estimates are significant judgments; 2013 net cumulative catch-up adjustments increased operating income by $113 million.
Government investigation: HII disclosed an internal investigation into possible employee mischarging of time or misstating progress on Ingalls contracts. Customers initially withheld $24 million; the Navy reduced its portion to $9.4 million, while the Coast Guard maintained a $5.8 million withhold. HII estimated maximum potential mischarging of approximately $4 million. Penalties or suspension/debarment remained possible; the ultimate outcome was uncertain.
False Claims Act case: A relator complaint concerning alleged misuse of Hurricane Katrina-related federal funds sought at least $835 million plus penalties and costs, with potential treble damages. The Department of Justice declined to intervene. HII disputed the allegations and said it would defend the matter; the outcome could not be assured.
Hurricane recovery and related litigation: HII received a $180 million settlement payment from FM Global in 2013, bringing total insurance recoveries for its Hurricane Katrina claim to $677.5 million. The company recorded a net $64 million favorable 2013 operating-income impact from recoveries and customer direction on disallowances and allocation. HII also pursued a separate claim against its insurance broker seeking more than $200 million in damages; any recovery was uncertain.
Other exposures: The company cited asbestos-related litigation, possible environmental costs at Avondale that were not reasonably estimable, pension and workers’ compensation estimate sensitivity, supplier and skilled-labor availability, cyber and nuclear-operation risks, and the possibility of adverse government audits or contract-system payment withholds. Recorded probable environmental remediation costs were $2 million, excluding uncertain Avondale closure-related costs.
Capital returns: The quarterly dividend increased from $0.10 to $0.20 per share in October 2013. HII repurchased approximately 1.72 million shares for $119 million during 2013; debt agreements restricted dividends and repurchases.

Key investor verification points

Track contract execution, cost estimates, and delivery schedules on major programs, especially LHA-6 America, LPD ships, carrier programs, and Virginia-class submarines.
Verify conversion and funding of the $18.0 billion backlog, including the distinction between funded and unfunded backlog, and assess the impact of future defense appropriations.
Monitor cash generation, working capital, pension contributions, debt maturities, and compliance with debt covenants as HII maintains dividends and repurchases shares.
Follow resolution of the Avondale cost-recovery proposal, Gulfport closure-cost dispute, government payment withholds and investigation, and the Katrina-related False Claims Act and broker litigation.
Assess whether reported earnings gains are sustainable apart from insurance recoveries, cumulative contract-estimate adjustments, and other discrete items.