Huntington Ingalls Industries, Inc. — Q3 2012 Form 10-Q
Business context and reporting period. 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. This unaudited filing covers the three and nine months ended September 30, 2012, compared with the same periods in 2011. Approximately 99% of revenue came from flexibly priced contracts.
Financial performance
| Metric | Three months ended Sept. 30 | Nine months ended Sept. 30 |
|---|---|---|
| Sales and service revenue | $1.596 billion, versus $1.593 billion | $4.885 billion, versus $4.840 billion |
| Operating income (loss) | $66 million, versus $(190) million | $252 million, versus $(14) million |
| Net earnings (loss) | $13 million, versus $(248) million | $96 million, versus $(163) million |
| Diluted EPS | $0.26, versus $(5.07) | $1.92, versus $(3.34) |
| Operating margin, calculated | 4.1%, versus (11.9)% | 5.2%, versus (0.3)% |
Revenue and segments. Q3 revenue was essentially flat. Ingalls revenue fell 9% to $670 million, while Newport News rose 8% to $944 million. For the nine months, revenue increased 1%; Ingalls declined 4% and Newport News grew 5%. Newport News’ growth reflected carrier construction and related work, including CVN-78 and CVN-79 programs. Ingalls’ lower amphibious-ship sales were partly offset by surface combatant and cutter work.
Profitability and unusual comparison. The year-over-year earnings improvement primarily reflects the absence of a $300 million goodwill impairment recorded at Ingalls in Q3 2011; that charge was later finalized at $290 million for 2011. Excluding this comparison, current-period performance also reflected contract results and higher workers’ compensation expense. Q3 net cumulative contract estimate adjustments reduced operating income by $9 million; the nine-month net effect increased it by $39 million. The company recorded $24 million of workers’ compensation expense in Q3 following a change in the discount rate used for the liability.
Cash flow and capital spending. Operating cash flow was $(41) million for the first nine months, versus $54 million provided in 2011. Capital expenditures were $92 million, resulting in free cash flow of $(133) million, versus $(65) million. Higher pension funding and working-capital movements weighed on operating cash flow. Cash declined to $766 million from $915 million at year-end 2011.
Balance sheet and liquidity. At September 30, total assets were $5.863 billion, current assets $2.226 billion, and current liabilities $1.239 billion. Total debt was $1.837 billion, including $43 million current; cash less total debt was approximately $(1.071) billion. The $650 million revolver was undrawn, with $46 million of letters of credit issued and $604 million remaining available. HII reported compliance with debt covenants. Management said cash from operations and credit facilities should be sufficient for debt service, contractual obligations, and capital spending for at least 12 months.
Other financial measures. HII expected 2012 capital expenditures at the high end of its usual 2%–3% of annual revenue range. It expected 2012 qualified pension contributions of approximately $236 million; $230 million had been contributed through September, comprising $143 million minimum and $87 million discretionary. Nine-month interest expense was $88 million, up from $75 million. The reported effective tax rate was 64.9% for Q3 and 41.5% year to date, affected in part by $8 million of non-cash tax adjustments under the Tax Matters Agreement.
Outlook, risks, and contingencies
- Defense budgets: The Budget Control Act mandated $487 billion in DoD reductions over ten years beginning in 2013; possible sequestration could impose up to $600 billion in additional defense cuts through 2021. HII said impacts were uncertain and could materially affect operations, revenue, and asset values.
- Backlog: Total backlog was approximately $16.4 billion at September 30, versus $16.3 billion at year-end 2011. It included $12.9 billion funded and $3.5 billion unfunded; substantially all was U.S. Government business. New awards during the first nine months were approximately $5 billion. Backlog is not equivalent to guaranteed revenue.
- Avondale: HII’s current estimated restructuring cost for the planned facility wind-down is $265 million, treated as recoverable under contracts. DCAA audit reports questioned approximately $25 million and stated that the cost proposal lacked sufficient support for a conclusion. Recovery is not assured; HII was also assessing whether to keep the facility open for non-naval industrial work.
- False Claims Act complaint: A relator’s complaint alleges improper recovery of post-Katrina costs and seeks at least $835 million plus penalties and other costs; damages could be trebled. The Department of Justice declined to intervene. HII disputes the allegations and intends to defend the case, but cannot predict the outcome.
- Other exposures: HII continued litigation against FM Global over Hurricane Katrina insurance coverage; no related receivable was recognized. Trial was scheduled for October 2013. The filing also discusses asbestos claims, ship quality issues, and government investigations, which HII did not expect to have a material effect based on information then available.
- Operating execution: Lower performance on LPD-24 Arlington and unfavorable adjustments on the LPD-22 through LPD-25 contract affected Ingalls. Higher workers’ compensation expense affected both segments. HII stated that the Transition Services Agreement with Northrop Grumman ended October 9, 2012.
Most important facts for investors to verify
- Whether planned DoD budget cuts or sequestration alter ship-program funding, timing, or contract economics.
- Whether HII can convert its backlog—particularly unfunded backlog—into funded work and revenue on expected schedules.
- Whether cash generation improves after substantial pension contributions and working-capital use; verify full-year pension funding and capital spending.
- Whether Ingalls contract performance and the LPD-24-related cost outlook improve, and whether workers’ compensation assumptions remain appropriate.
- Whether the Navy accepts the Avondale restructuring-cost recovery proposal and how the facility’s future operating plan affects estimated costs.
- Developments in the $835 million-plus False Claims Act complaint and Katrina insurance litigation, including any change in estimated exposure or recoveries.
- How elevated tax expense and the company’s debt and interest burden affect future earnings and liquidity.