Huntington Ingalls Industries, Inc. — Q1 2019 Form 10-Q
Reporting period: Three months ended March 31, 2019; compared with the three months ended March 31, 2018. Amounts are in millions of dollars unless stated otherwise. HII builds ships for the U.S. Navy and Coast Guard and provides government, energy, and oil and gas services through Ingalls, Newport News, and Technical Solutions.
Financial results
| Metric | Q1 2019 | Q1 2018 | Change |
|---|---|---|---|
| Sales and service revenues | $2,080 | $1,874 | +11% |
| Operating income | $161 | $191 | -16% |
| Net earnings | $118 | $156 | -24% |
| Diluted EPS | $2.85 | $3.48 | -18% |
| Operating margin | 7.7% | 10.2% | Lower |
| Operating cash flow | $11 | $120 | -$109 |
| Free cash flow | -$63 | $47 | -$110 |
Revenue growth was led by Newport News (+17%), including aircraft carriers, naval nuclear support, and submarines; Technical Solutions grew 10%, partly reflecting the Fulcrum and G2 acquisitions. Ingalls revenue was essentially flat. Segment operating income rose 10% to $129 million, but GAAP operating income fell as the Operating FAS/CAS pension adjustment declined to a $34 million benefit from $72 million and non-current state taxes shifted from a $2 million benefit to a $2 million expense. Net cumulative contract estimate catch-ups reduced operating income by $6 million in Q1 2019, versus a $28 million benefit in Q1 2018.
Cost of product sales rose 18%, faster than product revenue, and product cost as a share of product sales increased to 84.4% from 77.6%. Service cost as a share of service revenue improved to 83.7% from 85.7%. The effective tax rate was 20.8%, versus 20.0%.
Balance sheet, cash flow, and capital
- At March 31, 2019, cash was $51 million, down from $240 million at year-end 2018. Current assets were $1,922 million and current liabilities were $1,960 million.
- Long-term debt was $1,496 million, including $212 million drawn on the $1,250 million revolving facility. A further $1,016 million of the facility was unused; $22 million of letters of credit were issued but undrawn. HII reported compliance with debt covenants.
- Operating cash flow was $11 million; capital expenditures were $110 million and grant proceeds for capital expenditures were $36 million, resulting in free cash flow of negative $63 million. Management attributed the year-over-year cash-flow decline mainly to working-capital timing.
- Q1 financing included $212 million net revolving-credit borrowings, $36 million in dividends paid, and $84 million in common-stock repurchases settled in cash (including prior-period repurchases). The declared dividend was $0.86 per share, up from $0.72.
Material changes, outlook, and risks
- Backlog increased to $40.6 billion from $23.0 billion at December 31, 2018, following approximately $19.6 billion of new awards, including contracts for aircraft carriers Enterprise (CVN 80) and CVN 81 and amphibious ship LPD 30. Backlog included $20.0 billion funded and $20.6 billion unfunded; the filing cautions that unfunded orders are not currently contractually funded. Remaining performance obligations were also $40.6 billion; HII expected to recognize about 30% through 2020 and another 25% through 2022.
- HII acquired Fulcrum IT Services for approximately $195 million in cash in February 2019, adding $133 million of goodwill and $49 million of intangible assets, primarily to Technical Solutions. The purchase-price allocation remained preliminary. G2, acquired in December 2018, also contributed to Technical Solutions growth.
- Management expected 2019 maintenance and sustainment capital spending of 2%–2.5% of annual revenue and discretionary capital spending of 3%–3.5%. It said cash from operations, existing cash, and credit facilities should be sufficient for debt service, contractual obligations, and capital expenditures for at least 12 months. No specific earnings or revenue guidance is provided in the supplied filing text.
- Budget uncertainty remains a key risk: sequestration was scheduled to resume in fiscal 2020 and 2021, and the FY2020 budget request proposed canceling the USS Harry S. Truman refueling and complex overhaul. Reduced, delayed, or canceled government funding could affect awards, suppliers, workforce, revenue, earnings, and cash flow.
- On March 29, a transported dry dock struck an Ingalls work barge and damaged the barge, the dry dock, and destroyer DDG 119. HII was assessing direct and consequential damages and seeking recovery from third parties or insurance; management expected sufficient recovery but warned that failure or delay could be material. A $75 million security was posted in April in connection with HII’s suit.
- Other notable matters include a sealed False Claims Act case concerning allegedly non-conforming supplier parts, ongoing asbestos litigation, and a Newport News DCAA audit of its material management accounting system that resulted in corrective-action requests. Loss amounts or outcomes for certain matters could not be estimated clearly. The company also holds an approximately $151 million arbitration award against Venezuela, subject to enforcement efforts and uncertainty.
- HII adopted the new lease accounting standard on January 1, 2019, recording $220 million of operating lease assets and $215 million of lease liabilities at adoption, with no material retained-earnings impact. The filing reported effective disclosure controls and no material change in internal controls; a new ERP system was implemented at Ingalls.
Important facts for investors to verify
- Whether the large increase in backlog converts into funded orders and revenue on expected schedules, particularly the substantial unfunded Newport News balance.
- Whether product-cost trends, submarine program performance, and contract estimate revisions improve after the Q1 margin decline.
- Whether working-capital movements normalize and operating cash flow supports planned capital spending, dividends, and repurchases.
- Final Fulcrum purchase accounting and the acquired business’s contribution to Technical Solutions results.
- Resolution and recovery of costs from the DDG 119 dry-dock incident, and developments in government investigations, claims, and the Venezuela award.
- How future defense appropriations, sequestration, and the proposed Truman cancellation affect HII’s programs and backlog.