Huntington Ingalls Industries, Inc. — FY 2016 Form 10-K
Reporting period: Fiscal year ended December 31, 2016. This is an annual filing; unaudited fourth-quarter results are also reported. Amounts are in U.S. dollars unless stated otherwise.
Business context
HII designs, builds, overhauls, and supports U.S. Navy and Coast Guard vessels, and provides government, nuclear, environmental, IT, and oil-and-gas services. Its segments are Ingalls, Newport News, and Technical Solutions, established in Q4 2016 following a business realignment and the acquisition of Camber. More than 95% of revenue was derived from the U.S. Government; the Navy accounted for approximately 89% and the Coast Guard approximately 6%.
Key financial results
| Metric | FY 2016 | FY 2015 | Change |
|---|---|---|---|
| Sales and service revenue | $7.068 billion | $7.020 billion | +1% |
| Operating income | $858 million | $769 million | +12% |
| Net earnings | $573 million | $404 million | +42% |
| Diluted EPS | $12.14 | $8.36 | +45% |
| Operating cash flow | $822 million | $861 million | −5% |
| Free cash flow | $537 million | $673 million | −20% |
Operating margin was approximately 12.1%, versus 11.0% in 2015; net margin was approximately 8.1%, versus 5.8%. These percentages are calculated from reported revenue and income. Lower interest expense ($74 million versus $137 million) and a lower effective tax rate (26.9% versus 36.1%) contributed to earnings growth. The tax-rate decline primarily reflected stock-award tax benefits and changes in uncertain tax positions.
Revenue mix shifted toward services: product sales declined 1% to $5.631 billion, while service revenue increased 6% to $1.437 billion. Segment revenue and operating income were: Ingalls, $2.389 billion and $321 million; Newport News, $4.089 billion and $386 million; Technical Solutions, $691 million and $8 million. Technical Solutions improved from a $113 million loss in 2015, chiefly because 2015 included goodwill and intangible-asset impairments.
Fourth-quarter 2016 revenue was $1.922 billion, operating income $268 million, net earnings $197 million, and diluted EPS $4.20. Fourth-quarter 2015 comparatives were $1.905 billion, $144 million, $50 million, and $1.06, respectively.
Liquidity, debt, and capital allocation
- Cash and cash equivalents were $720 million at year-end, down from $894 million. Current assets were $2.142 billion and current liabilities $1.343 billion.
- Long-term debt was $1.278 billion. HII had $1.225 billion of unused revolving-credit capacity, plus $25 million of undrawn letters of credit, and reported compliance with debt covenants.
- Capital expenditures were $285 million, up from $188 million; operating cash flow less capital expenditures produced $537 million of free cash flow.
- HII paid $98 million in dividends ($2.10 per share), repurchased $192 million of stock, and raised its quarterly dividend to $0.60 per share in November 2016.
- Qualified pension plans were 83% funded on a GAAP basis. HII expected $290 million of qualified pension contributions and approximately $37 million of other postretirement contributions in 2017.
Material changes and outlook
Total backlog was $21.024 billion at year-end, down from $22.062 billion. Approximately 30% of the 2016 year-end backlog was expected to convert to sales in 2017. New awards were approximately $5.2 billion in 2016, compared with $7.6 billion in 2015. Management said 2017 operating cash generation, existing cash, and credit facilities were expected to cover debt service, retiree benefits, contractual obligations, and capital expenditures for at least 12 months.
For 2017, HII expected maintenance and sustainment capital spending of 2.0%–2.5% of annual revenue and discretionary capital spending of 2.5%–3.0%. Management estimated a 2017 FAS/CAS pension adjustment benefit of approximately $198 million, subject to revision. The filing does not provide a specific 2017 revenue or earnings forecast.
Management cited continuing uncertainty over U.S. defense budgets and sequestration beginning again in 2018, as well as affordability initiatives and changing Navy priorities. The Navy’s 2017 shipbuilding plan targeted a 308-ship fleet, while its 2016 force assessment described a 355-ship objective; funding and implementation remained uncertain. Aircraft-carrier programs represented approximately 31% of 2016 revenue.
Risks, contingencies, and unusual items
- Customer and contract exposure: Dependence on U.S. Government appropriations, program timing, contract awards, and customer priorities. Fixed-price incentive work and long-duration shipbuilding also expose HII to cost-estimate, schedule, labor, supplier, and performance risks.
- Avondale claim: HII estimates net restructuring and shutdown costs of $276 million and expects substantial recovery under government contracts. The Navy contracting officer denied HII’s claim in December 2016; HII intends to pursue it under the Contract Disputes Act. Potential Avondale environmental costs are not estimable and are excluded from the estimate.
- Government matters: A Department of Justice investigation continues regarding alleged mischarging or progress-reporting issues at Ingalls; the company could not estimate the outcome. A separate sealed False Claims Act case concerns allegedly non-conforming supplier parts; loss exposure was not estimable. The filing also describes remaining customer payment withholds related to the Ingalls matter.
- Other claims: HII asserts a $173 million claim in arbitration with Venezuela, which has counterclaimed for $61 million plus interest. HII also faces asbestos-related claims; management did not expect current matters to have a material effect but cannot assure outcomes.
- Contract accounting and pensions: Net favorable cumulative catch-up adjustments increased 2016 operating income by $224 million and diluted EPS by $3.08; these estimates may change. Lower pension discount rates contributed to increased benefit obligations and actuarial losses. Expected 2016 pension-asset return was 7.5%, versus an actual return of approximately 6.9%.
- Other exposures: Potential risks include cyber incidents, nuclear operations, environmental remediation, labor negotiations, supplier concentration, and limits on insurance. Probable environmental remediation costs accrued at year-end were approximately $1 million; additional Avondale costs were not estimable.
HII acquired Camber for approximately $372 million net of cash acquired on December 1, 2016, recording $278 million of goodwill and preliminarily recording $76 million of intangible assets. The 2016 results also included $15 million of state and local government grant income and grant-related depreciable assets. By contrast, 2015 included a net $136 million favorable Aon settlement impact and $102 million of goodwill and intangible-asset impairment charges.
The independent auditor issued an unqualified opinion on the financial statements and internal control over financial reporting; management and the auditor concluded controls were effective as of year-end.
Most important facts for investors to verify
- Backlog funding, conversion timing, and new awards—particularly the split between funded and unfunded backlog.
- Progress and cost performance on major carrier, submarine, and amphibious-ship programs, and the sustainability of 2016 contract-estimate benefits.
- Outcome and potential financial impact of the Avondale recovery claim and the ongoing Department of Justice and supplier-parts matters.
- Actual 2017 capital spending, pension contributions, cash generation, and dividend capacity relative to management’s expectations.
- Defense appropriations and Navy procurement plans, given customer concentration and the significant share of revenue from aircraft carriers.