HUNTINGTON INGALLS INDUSTRIES, INC. quarterly report, Q3 FY2019

Huntington Ingalls Industries, Inc. — Q3 2019 Form 10-Q

Business context and reporting period. HII is a military shipbuilder and government-services provider, organized into Ingalls, Newport News, and Technical Solutions. Most business is with the U.S. Government, primarily the Department of Defense. This unaudited filing covers the quarter and nine months ended September 30, 2019; comparisons are with the corresponding 2018 periods.

Financial performance

Metric	Q3 2019	Q3 2018	Nine months 2019	Nine months 2018
Sales and service revenues	$2.219 billion	$2.083 billion	$6.487 billion	$5.977 billion
Operating income	$214 million	$290 million	$550 million	$738 million
Net earnings	$154 million	$229 million	$400 million	$624 million
Diluted EPS	$3.74	$5.29	$9.66	$14.15

Quarterly revenue rose 7%, while operating income fell 26% and net earnings fell 33%. For the nine months, revenue rose 9%, while operating income declined 25% and net earnings declined 36%.
Service revenue increased 26% in Q3 and 24% year to date, with growth in Technical Solutions, including the Fulcrum and G2 acquisitions, and higher Newport News activity. Product revenue was nearly flat in Q3 and up 3% year to date.
Segment operating income was $191 million in Q3, down 12%, and $458 million for nine months, down 11%. Ingalls earnings declined; Newport News was lower; Technical Solutions improved in Q3 but was flat year to date.
Margins were pressured by higher costs relative to product and service revenues and by a smaller pension accounting benefit. HII cited program performance and contract mix, lower risk retirement, a 2018 workers’ compensation benefit, and lower Virginia-class submarine performance among the factors.
Net cumulative contract estimate adjustments added $44 million to Q3 operating income and $57 million to nine-month operating income, versus $34 million and $99 million, respectively, in 2018.

Cash flow, debt, and liquidity

For the first nine months, operating cash flow was $330 million, compared with $266 million in 2018. Free cash flow, a non-GAAP measure defined as operating cash flow less capital expenditures net of grants, was $52 million versus $6 million.
Capital expenditure additions were $349 million, partly offset by $71 million of grant proceeds. Investing cash outflow was $470 million, including $195 million for the Fulcrum acquisition.
Cash and cash equivalents were $32 million at September 30, down from $240 million at December 31, 2018. Long-term debt was $1.549 billion, up from $1.283 billion; this included $264 million drawn on the revolving facility.
The $1.25 billion revolving facility had $964 million available and $22 million of issued but undrawn letters of credit. HII reported compliance with debt covenants and said cash generation, cash on hand, and credit facilities should be sufficient for obligations and operations over at least the next 12 months.
HII paid $107 million in dividends and repurchased $156 million of shares during the nine months. The board increased the repurchase authorization to $3.2 billion and extended it through October 31, 2024, on November 5, 2019, after quarter-end.

Backlog, outlook, and management commentary

Total backlog was approximately $39.2 billion at September 30, compared with $23.0 billion at December 31, 2018; the increase was concentrated in Newport News. New awards during the nine months were approximately $22.6 billion, including Enterprise (CVN 80), CVN 81, and Harrisburg (LPD 30).
Remaining performance obligations were $39.2 billion. HII expected approximately 20% to be recognized as revenue through 2020, a further 30% through 2022, and the balance thereafter. Backlog includes funded and unfunded firm orders and is not equivalent to guaranteed revenue.
HII gave no specific revenue or earnings forecast in the provided filing text. For 2019, it expected maintenance and sustainment capital spending of approximately 2%–2.5% of annual revenue and discretionary capital spending of approximately 3%–3.5%.
Management identified long-term U.S. defense budget uncertainty as a significant risk, notwithstanding 2019 budget legislation providing funding relief through fiscal 2021. Appropriations and program decisions remained uncertain and could delay, reduce, or cancel work.
HII acquired Fulcrum IT Services for approximately $195 million in February 2019 to expand Technical Solutions. It also adopted lease accounting in 2019, recording $208 million of operating lease assets and $208 million of lease liabilities at quarter-end; adoption had no material retained-earnings impact.

Risks, contingencies, and unusual items

Two unsealed False Claims Act cases in Florida concerned alleged non-conforming supplier parts and alleged material application on Virginia-class submarines. The Department of Justice declined to intervene in both; HII had not been served and could not estimate a possible loss. The filing warns that outcomes could include damages, penalties, or suspension or debarment from government contracts.
A March 2019 transportation incident damaged a Navy destroyer, an Ingalls work barge, and a dry dock. Repairs were underway; HII said it expected to recover sufficient costs from third parties or insurance but noted that failure or delay could have a material effect.
HII continued seeking enforcement of an approximately $151 million arbitration award against Venezuela, which was offset by an approximately $22 million counter-award to Venezuela. Collection and ultimate resolution were uncertain.
Nine-month net earnings included a higher effective tax rate than in 2018, largely because of prior-year research-credit items and tax-return true-ups. The 2018 comparison also included a claim for higher research and development credits and other items affecting comparability.
Qualified pension contributions were $21 million in the first nine months, versus $508 million in 2018; management anticipated no further significant qualified-plan contributions in 2019. HII also noted risks from government audits, contract cost estimates, supplier performance, and future defense spending.
Management reported effective disclosure controls and no material change in internal control during Q3. The Ingalls ERP system was implemented in Q1, with continued monitoring planned.

Important facts for investors to verify

Whether lower operating income reflects temporary contract timing and pension-accounting effects or sustained deterioration in program execution and margins, particularly at Ingalls and on Virginia-class submarines.
How the substantial increase in Newport News backlog converts into funded orders, production, revenue, and cash flow, and whether expected program schedules and costs hold.
Whether the Technical Solutions growth from acquisitions translates into improved segment profitability, given flat year-to-date segment operating income and the disclosed fleet-support contract loss.
Progress and potential exposure in the two False Claims Act cases, the destroyer damage recovery, and collection of the Venezuela arbitration award.
Cash conversion and liquidity trends, including working-capital needs, capital expenditures, borrowings, and the effect of continued dividends and share repurchases.