Huntington Ingalls Industries, Inc. (NYSE:HII) Q4 2022 Earnings Call Transcript

Huntington Ingalls Industries, Inc. (NYSE:HII) Q4 2022 Earnings Call Transcript February 9, 2023

Operator: Ladies and gentlemen, thank you for standing by. And welcome to the Fourth Quarter 2022 HII Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. Please be advised that today’s conference call is being recorded. I would now like to hand the call over to Christie Thomas, Vice President of Investor Relations. Ms. Thomas, you may begin.

Christie Thomas: Thank you, Operator, and good morning, everyone. Welcome to the HII fourth quarter 2022 earnings conference call. Joining me today on the call are Chris Kastner, our President and CEO; and Tom Stiehle, Executive Vice President and CFO. As a reminder, any forward-looking statements made today that are not historical facts are considered our company’s estimates or expectations and are forward-looking statements made pursuant to the Safe Harbor provision of federal securities law. Forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially. For additional information regarding factors that could cause actual results to differ materially from expected results, refer to our SEC filings.

Also in their remarks today, Chris and Tom will refer to certain non-GAAP measures. For reconciliations of these metrics to the comparable GAAP measures, please see the slides that accompany this webcast, which are available on the Investor Relations website at ir.hii.com. With that, I would like to turn the call over to our President and CEO, Chris Kastner. Chris?

Chris Kastner: Thanks, Christie. Good morning, everyone. And thank you for joining us on our fourth quarter 2022 earnings call. First, I would like to thank the entire HII team for a solid year and express my gratitude for their outstanding contributions throughout 2022. It was through their dedication and commitment that we were able to deliver results that demonstrated consistent performance in a pretty tough economic environment. Now let’s turn to the highlights for the quarter and the year on page three of the presentation. In 2022, we reported record sales of $10.7 billion, net earnings of $579 million and free cash flow of $494 million. The demand for our products continues to drive a tremendous backlog of $47 billion and we grew sales and earnings across all three of our segments in 2022, setting the foundation for continued growth in 2023 and beyond.

At Ingalls, in the fourth quarter, we delivered DDG 123 Lenah Sutcliffe Higbee and completed builder’s trials on DDG 125 Jack H. Lucas, the first Flight III ship just one quarter after DDG 123 completed her trials. Our DDG 51 team also started fabrication on DDG 133 Sam Nunn. In our amphibious ship product line, we were awarded a $2.4 billion detailed design and construction contract and started fabrication for LHA 9 Fallujah, the fourth big deck amphibious warship in the America class. Also at Ingalls, in January, we were awarded the advanced planning contract for the modernization period for Zumwalt-class guided missile destroyers. At Newport News in the fourth quarter, we authenticated a keel for SSN 800 Arkansas, honoring the ship sponsors to Little Rock 9.

We continue to remain focused on reducing risk and meeting cost and schedule objectives on the Virginia-class boats. As for nuclear aircraft carrier, CVN 79 Kennedy is well into the test program. Distributed systems such as fire main, potable water, air conditioning and ventilation are coming to life. The EMALS Catapult system, which we began testing in 2022 remains on track and is progressing as planned through her test program and we expect to enter into the Combat Systems Test program later this quarter. And finally, for the refueling and complex overhaul of CVN 73 USS George Washington, we are 98% complete as we near planned re-delivery later this year. At Mission Technologies, we achieved solid revenue growth for 2022, with all of the business groups growing year-over-year and we ended the year with a robust potential business pipeline of $66 billion, of which over one-third is qualified.

Significant wins in 2022 included, the Decisive Mission Actions and Technology Services contract, Mobility Air Forces Distributed Mission Operations contract and the Remus 300 selection as the U.S. Navy as small UUV program of record. From an operational perspective, we have integrated Alion into our Mission Technologies and HII team and with the integration complete, we can turn our full attention towards executing our growth strategy. Moving on to slide four. We are providing the major milestones for 2023 and 2024. I am proud to say that we met all of the Shipbuilding milestones that we highlighted back in the second quarter of last year for 2022 and we are maintaining all of the 2023 milestones. This demonstrates growing confidence in our ship schedules and provides a solid platform to continue to improve our cost performance.

Notable anticipated 2023 milestones at Newport News include the planned delivery of SSN 796 New Jersey and planned float off of SSN 798 Massachusetts, as well as the planned re-delivery of CVN 73 and planned crew move aboard on CVN 79. At Ingalls, DDG 125, NSC 10 Calhoun and LPD 29 Richard M. McCool Jr. are all forecast to deliver this year, while LHA 8 Bougainville is expected to launch. In addition to these Shipbuilding milestones, Mission Technologies expects to see continued growth resulting from our large opportunity pipeline, including the several award decisions that we expect to be made in the first half of the year. Now I would like to discuss our operational focus areas. Our top operational priority remains hiring and workforce development.

I am confident in our plans for hiring, and as importantly, our retention and training strategies. These strategies that center around employee skills and leadership development are gaining traction and we have had a good start to the year. After hiring over 4,900 craft personnel in 2022, we expect a similar hiring rate in 2023, while at the same time, improving our productivity, attendance and over time together to drive performance. Regarding inflation, we have some installation through our contracting terms and conditions. However, non-programmatic elements of inflation have impacted us across all of our programs. And finally, the supply chain is stabilizing and we have worked closely with our customers and suppliers to achieve the best possible schedules.

To summarize and notwithstanding being our most significant risk, as labor and supply chain impacts continue to stabilize and inflation abate, we believe we have the opportunity for improved performance over the next few years. Turning to the budget environment, we are pleased with the passage and enactment of the fiscal year 2023 Defense Appropriations and Defense Authorization Bills. Both pieces of legislation strongly support Shipbuilding, including funding and authority for an additional DDG 51 Flight III ship for a total of three DDGs, 2 Virginia-class attack submarines, the Columbia-class ballistic missile submarine program, Ford-class nuclear aircraft carrier programs and the refueling and complex overhaul of CVN 74 John C. Stennis. Both Appropriations and Authorization Bills continue funding for LPD 32 and LHA 9 and provide new advanced procurement funding for LPD 33, LHA 10 and a third DDG 51 in FY 2024.

The Defense Authorization Act also includes language requiring a naval fleet of no less than 31 operational amphibious warships, including a minimum of 10 amphibious assault ships. We continue to see bipartisan congressional support for our programs. We look forward to working with the administration and Congress on the President’s fiscal year 2024 budget request. So, with that, I will turn the call over to Tom for some remarks on our financial results and guidance, and then I have a few additional comments before we move on to Q&A.

Tom Stiehle: Thanks, Chris, and good morning. Today, I will briefly review our fourth quarter and full year results and also provide an outlook for 2023. For more detail on the segment results, please refer to the earnings release issued this morning and posted to our website. Beginning with our consolidated fourth quarter results on slide five of the presentation. Our fourth quarter revenues of $2.8 billion increased approximately 5% compared to the same period last year. This growth was driven by higher year-over-year revenue at all three segments, leading to record quarterly revenue for HII. Operating income for the quarter of $105 million decreased by $15 million or 12.5% from the fourth quarter of 2021 and operating margin of 3.7%, compared to margin of 4.5% in the prior year period.

The decrease in operating income was primarily due to lower segment operating income. Net earnings in the quarter were $123 million, compared to $120 million in the fourth quarter of 2021. Diluted earnings per share in the quarter were $3.07, compared to $2.99 in the fourth quarter of the previous year. Moving to our consolidated results for the full year on slide six, revenues were $10.7 billion for the year, an increase of 12.1% from 2021. The increase was driven by year-over-year growth at all three segments, along with a full year of Alion revenue. Operating income for the year was $565 million and operating margin was 5.3%. This compares to operating income of $513 million and operating margin of 5.4% in 2021. The operating income growth was driven by year-over-year improvement at all three segments, as well as a more favorable non-current state income taxes and operating FAS/CAS adjustment.

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Net earnings for the year were $579 million, compared to $544 million in 2021 and diluted earnings per share were $14.44, compared to $13.50 in the previous year. Moving on to slide seven. Ingalls’ 2022 revenues of $2.6 billion increased $42 million or 1.7% from 2021, driven primarily by higher revenues in the LHA and DDG programs, partially offset by lower NSC program revenues. Ingalls’ 2022 operating income of $292 million and margin of 11.4%, both improved from $281 million and 11.1% last year. These results were driven primarily by favorable changes in contract estimates and price adjustment clauses, as well as higher risk retirement on the LPD program, partially offset by lower risk retirement on the DDG program compared to 2021. At Newport News, 2022 revenues of $5.9 billion increased by $189 million or 3.3% from 2021, primarily due to higher revenues in both aircraft carriers and submarines, partially offset by a lower revenue in naval nuclear support services.

Increased aircraft carrier revenues were driven by higher volumes on the refueling and complex overhaul of the USS John C. Stennis CVN 74 and the construction of Doris Miller CVN 81 and Enterprise CVN 80, partially offset by lower volumes on the refueling and overhaul of the USS George Washington CVN 73 and USS Gerald R. Ford CVN 78. Submarine revenue growth was due to higher volumes on the Columbia-class and Block V boats on the Virginia-class, partially offset by lower volumes on the Virginia-class Block IV boats. Newport News 2022 operating income of $357 million and margin of 6.1% were relatively consistent with the performance in 2021 of $352 million and margin of 6.2%. 2022 results included favorable changes in contract estimates from facilities, capital and price adjustment clauses, as well as contract incentives on the Columbia-class submarine program, partially offset by lower risk retirement on the VCS program and the refueling overhaul of the USS George Washington CVN 73 compared to 2021.

2022 Shipbuilding margin of 7.7% was consistent with the performance of 2021, but below our expectations for year-over-year improvement, as the back half of the year provided limited risk retirement opportunities. Continued labor challenges, including high attrition rates, the impact of non-programmatic inflation and supply chain disruption all contributed to slower margin progress. At Mission Technologies, revenues of $2.4 billion increased $911 million or 61.7% from 2021, primarily driven by the acquisition of Alion in the third quarter of 2021. Mission Technologies’ operating income of $63 million compares to operating income of $50 million in 2021. Primary drivers of growth are the acquisition of Alion in 2021, as well as higher equity income from a joint venture, partially offset by higher amortization of purchased intangible assets in 2022 due to the Alion acquisition.

2022 results included approximately $96 million of amortization of Alion-related purchased intangibles compared to approximately $33 million in 2021. I will also note that the fourth quarter and 2022 results included a non-cash downward valuation adjustment of approximately $10 million or approximately $0.20 per share related to an equity method investment. Mission Technologies’ EBITDA margin in 2022 was 8.2% and adjusting out the onetime downward valuation adjustment, EBITDA margin was 8.6%, consistent with 2021 performance. Turning to capital deployment on slide eight. We ended 2022 with a cash balance of $467 million and liquidity of approximately $2 billion. 2022 cash from operations was $766 million and free cash flow was $494 million.

Free cash flow generated in the fourth quarter of 2022 was significantly above our prior expectations, as we were able to accelerate several large cash collection events. This has a direct impact on our expectation for 2023 free cash flow, which I will discuss in more detail in a moment. I am pleased to report that the net capital expenditures were $272 million or 2.5% of revenues in 2022 at the very bottom end of the guidance range. Cash contributions to our pension and other postretirement benefit plans totaled $41 million in 2022. During the fourth quarter, we paid dividends of $1.24 per share or $50 million bringing total dividends paid for the year to $192 million. Over the course of 2022, we repurchased approximately 245,000 shares at an aggregate cost of approximately $52 million.

Moving on to slide nine and our updated outlook for pension and post-retirement benefits. Our outlook for 2023 has improved modestly from the update we provided in November, given the increase in discount rates since that time. Asset returns for 2022 of negative 16.1% or about as expected compared to our update in the third quarter. Expectations for 2024 through 2026 have been updated and consistent with the Q3 update, the FAS benefit has come down considerably from our last update given the more immediate recognition of the negative asset returns experienced in 2022. This is partially offset by the impact of higher discount rate. We also have provided an initial review of our 2027 expectations. Turning to slide 10 and our outlook for 2023, while we continue to expect Shipbuilding growth of approximately 3% over time, our 2023 outlook range of $8.4 billion to $8.6 billion acknowledges uncertainties around the current environment, particularly the labor challenges we have discussed.

For 2023, we expect Shipbuilding operating margin between 7.7% and 8%, as we continue to target incremental margin improvement, but acknowledge the current challenges have tempered the pace of that progress. For Mission Technologies, we expect 2023 revenue of approximately $2.5 billion, organic growth of approximately 5% year-over-year. We expect operating margins of between 2.5% and 3% and EBITDA margins of between 8% and 8.5%. In 2023, amortization of purchased intangible assets is expected to total approximately $128 million, of which $109 million is attributable to Mission Technologies. We expect 2023 capital expenditures to be approximately 3% of sales. Moving on to expectations for the first quarter of 2023, we expect overall revenue growth for the first quarter to be quite modest given normal seasonality in Mission Technologies and the strong fourth quarter performance for Shipbuilding, which benefited from favorable material timing.

Additionally, given the timing of the Shipbuilding program milestones and the mentioned Mission Technology seasonality, we expect first quarter segment operating results to be the weakest of the year, with the Shipbuilding operating margin near 7% and Mission Technologies operating margin near 1%. The outlook we are providing today is based on the best information we currently have and assumes no further degradation in our supply chain, that non-programmatic impact from inflation continue to abate, and most importantly, that we are able to continue to hire and retain employees at a pace that supports our staffing plan. Additionally, on slide 10, we have provided our updated outlook for a number of other discrete items to assist with your modeling.

On slide 11, we have provided an update — updated view on our free cash flow expectations through 2024, consistent with how we presented this data in the third quarter, this outlook assumes the current R&D amortization treatment for tax purposes remains in place and we are reaffirming the $2.9 billion target. If Section 174 is deferred or repealed, all else equal, there would be an opportunity of approximately $215 million in total over the cost of 2023 and 2024. As I noted earlier, we significantly outperformed our 2022 free cash flow expectation of approximately $350 million by accelerating collections. This timing difference, along with the delay of the planned COVID-19 repayment now into this year have impacted 2023 free cash flow expectations.

Consistent with our normal seasonality, we expect the first quarter of 2023 free cash flow will be the weakest of the year and given the pull-forward of collections into the fourth quarter of 2022 is likely to be an outflow of $200 million to $300 million. Our free cash flow expectation for 2024 remains unchanged, as it will not be burdened by COVID-19 repayment, will benefit from continued topline growth, and margin expansion potential as compared to 2022. Additionally, we expect to see sub-6% working capital levels as a percentage of sales in 2024. We are reaffirming our capital allocation priorities focused on debt paydown, which is on pace to retire about the $400 million bond this year and the remainder of our Alion acquisition term loan in 2024, and our commitment to return substantially all free cash flow after planned debt repayment to shareholders through 2024.

To close my remarks, it was no doubt a challenging year, but I am proud of the entire HII team and the important work we accomplished across the business, from successfully meeting all of our planned Shipbuilding milestones to the critical integration work that was completed timely and under budget at Mission Technologies. Across the enterprise, we made meaningful progress in 2022, which resulted in growth across all segments and free cash flow results that were well ahead of our projections. We entered 2023 intent on driving execution and are well positioned to deliver profitable growth. With that, I will turn the call back over to Chris for some final remarks before we take your questions.

Chris Kastner: Thanks, Tom. In summary, we delivered consistent results in 2022 and we believe we are well positioned to grow in markets of critical importance to our customers, while executing on almost $50 billion of backlog in 2023 and beyond. We will continue to make long-term strategic decisions that benefit our employees, customers and shareholders, creating long-term value for all of our stakeholders. Now I will turn the call over to Christie for Q&A.

Christie Thomas: Thanks, Chris. As a reminder to everyone on the call, please limit yourself to one initial question and one follow-up so we can get as many people through the queue as possible. Operator, I will turn it over to you to manage the Q&A.

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Q&A Session

Operator: Thank you. Our first question today comes from Myles Walton from Wolfe Research. Please go ahead, Myles. Your line is now open.

Myles Walton: Thanks. Good morning.

Chris Kastner: Hi, Myles.

Myles Walton: The first one, maybe at a high level, is this still a 9% plus Shipbuilding margin business?

Chris Kastner: Yeah. Definitely. I believe that we have come through some challenging times with COVID and we have got some ships that are still working through that. Ingalls is obviously north of that and Newport News is making great strides. And I think the biggest issue we can work on a Newport News is simply work in the operating system, getting the Block IV boats delivered over the next two years and three years and transitioning to Block V. So, yeah, absolutely, it’s a 9% business. I am not going to give a forecast for when that’s going to happen, but I do expect performance to continue to improve from here.

Myles Walton: Okay. And then, Chris or Tom, I don’t know, in terms of the plug for capital deployment for share repurchase, I guess, it’s $250 million to $300 million in 2023, 2024 is what you plan to do. Do you have any sights on doing that a little bit earlier or do you have to wait until 2024 as big cash flow come through to have confidence to execute against it?

Tom Stiehle: Yeah. Myles, this is Tom. We haven’t given an exact number, obviously, if you work yourself through the math of where we are, expectations on the revenue and the margin expansion, the free cash flow bridges that we have given you and then the capital expense as long — as well as with the working capital, the numbers fall that way. So as we work ourselves through the year, we — the cash is generated. We anticipate to continue to buy back shares as we see value in the share price. But we haven’t really guided on how that is going to be portioned over 2023, 2024. We stand behind our commitment to that all excess free cash flow will be given back to the shareholders after debt repayment schedule.

Myles Walton: And then just one clarification, what is non-programmatic inflation?

Chris Kastner: Yeah. So I will give you an example of that, Myles. It’s related to expenses towards the end of the year that we didn’t — that the actuals were higher than what we forecast, stuff like medical benefits, the insurance premiums, we just didn’t get that right.

Tom Stiehle: And we have seen tight marketing expense .

Myles Walton: All right. Thank you.

Tom Stiehle: Yeah. Sure. So it’s overhead tight expenses for us.

Myles Walton: Thank you.

Operator: Thank you. Our next question comes from Robert Spingarn from Melius Research. Please go ahead, Robert. Your line is now open.

Robert Spingarn: Hi. Good morning.

Chris Kastner: Good morning, Rob.

Tom Stiehle: Good morning.

Robert Spingarn: Chris, you talked a lot about the labor constraint and I wanted to see if you could give us some granularity as to how that number splits between the two shipyards and Mission Technologies. One thing I have noted is if we look at your job postings, it seems like Newport News has 10x the openings of Ingalls and does that factor into the margins there?