Huntington Ingalls Industries, Inc. — Q2 2012 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2012; unaudited results compared with the corresponding 2011 periods. Balance-sheet figures are compared with December 31, 2011. Amounts are in millions of dollars except per-share data and percentages.
Business context
HII designs, builds, overhauls and repairs ships, principally for the U.S. Navy and Coast Guard. Its two reportable segments are Ingalls and Newport News. Substantially all business is with the U.S. Government, principally the Department of Defense. HII completed its spin-off from Northrop Grumman in March 2011.
Financial performance
| Metric | Q2 2012 | Q2 2011 | Six months 2012 | Six months 2011 |
|---|---|---|---|---|
| Sales and service revenues | $1,721 | $1,563 | $3,289 | $3,247 |
| Operating income | $106 | $91 | $186 | $176 |
| Net earnings | $50 | $40 | $83 | $85 |
| Diluted EPS | $1.00 | $0.80 | $1.67 | $1.72 |
| Operating cash flow | Not presented quarterly | $(178) | $(178) | |
| Capital expenditures | Not presented quarterly | $57 | $83 | |
| Free cash flow | Not presented quarterly | $(235) | $(261) |
Q2 revenue rose 10% and operating income rose 16%; six-month revenue increased 1% and operating income increased 6%, while net earnings declined 2%. Approximate consolidated operating margin was 6.2% in Q2 2012 versus 5.8% in Q2 2011, and 5.7% for the first half versus 5.4%.
Q2 diluted EPS benefited by $0.44 from net favorable cumulative contract estimate adjustments; the six-month benefit was $0.63. These adjustments increased operating income by $34 and $48, respectively. Segment operating income increased 30% in Q2 and 25% in the first half, reflecting improved submarine and LPD-17 program performance and a $7 contract dispute resolution. The larger FAS/CAS pension expense partly offset segment gains.
- Segments: Q2 revenue/operating income: Ingalls $756/$38, Newport News $979/$89. First-half revenue/operating income: Ingalls $1,448/$58, Newport News $1,874/$170.
- Cash and liquidity: Cash was $669 at June 30, down from $915 at year-end. Current assets were $2,167 and current liabilities $1,217. Operating cash use reflected working-capital movements and increased retirement-benefit funding.
- Debt: Long-term debt, including current portion, was $1,844, versus $1,859 at year-end. The $650 revolving facility had $520 unused; $130 of letters of credit were issued but undrawn. HII reported compliance with debt covenants.
- Retirement funding: HII contributed $202 to pension and other benefit plans in the first half and expected approximately $236 in full-year 2012 qualified pension contributions.
Material changes, outlook and risks
- Newport News growth reflected higher carrier and submarine production, including the Virginia-class program’s transition toward two boats annually. Ingalls Q2 sales increased, while its first-half sales declined 1%, mainly due to lower National Security Cutter program revenue.
- Backlog was approximately $16.2 billion at June 30, including $12.6 billion funded and $3.6 billion unfunded. New awards in the first half totaled approximately $3.3 billion. Backlog was nearly unchanged from year-end.
- Management stated that operating cash and existing credit facilities should be sufficient for debt service, contractual obligations and capital expenditures for at least the next 12 months. It expected 2012 capital expenditures at the high end of its usual 2%–3% of annual revenue range. The filing provides no quantified earnings or revenue guidance.
- The Budget Control Act reduced planned DoD spending by $487 billion over ten years from 2013; possible sequestration could impose up to a further $600 billion in defense cuts through 2021. HII said the resulting impact was uncertain and could affect operations, workforce, suppliers, revenue and asset recoverability.
- Avondale wind-down: Management estimated total restructuring costs of $265. DCAA reports questioned approximately $25 of an earlier $310 proposal and said the submission lacked sufficient support for a conclusion. HII expected substantial recovery from the Navy, but stated that unrecovered or higher costs could materially affect results.
- Legal and insurance matters: A False Claims Act complaint seeks at least $835 plus penalties, potentially including treble damages; the Department of Justice declined to intervene, and HII disputes the allegations. HII’s Hurricane Katrina insurance dispute with FM Global remained unresolved, no recovery receivable was recorded, and trial was scheduled for October 2013.
- HII continued to address Ingalls pipe-weld and other ship-quality matters with the Navy; management did not expect the identified matters to have a material financial effect. Other risks include contract cost-estimate changes, government investigations, pension obligations and dependence on federal defense spending.
Investor verification priorities
- Assess how much Q2 and first-half earnings growth depended on favorable contract estimate adjustments and whether those gains recur.
- Track operating cash conversion, working capital, pension contributions and the remaining 2012 funding requirement.
- Verify funded versus unfunded backlog, timing of awards and exposure to potential defense-budget reductions.
- Monitor the Navy’s resolution of Avondale cost recovery and the status and potential exposure of the False Claims Act and Katrina insurance cases.
- Review debt-service capacity, floating-rate exposure and continued compliance with credit-facility covenants.