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?

Chris Kastner: Not really. I will — Mission Technologies is pretty stable, adding throughout the year with really industry standard attrition rates in a very competitive market. We plan to add about 5,000 shipbuilders throughout the year and then there are some positive indications in not only hiring, but also over time, attendance and attrition. So there are some positive indicators. I wouldn’t necessarily relate it back to margin. Newport News will hire more this year than Ingalls. We don’t break that out separately. But I wouldn’t necessarily relate that back to margin, no.

Robert Spingarn: Okay. And then just as a follow-up to that, could there be upside to the 3% topline growth if Congress appropriated more funds to expand shipyard capacity and the fund training and apprenticeship programs?

Chris Kastner: Yeah. But the constraint is labor. Our shipyards are facilitized to grow in excess really of that 3% and — but we need to be conservative and how we project — how we are going to add labor over the next few years. But is there upside? Yes, of course.

Robert Spingarn: Yeah. I guess I am asking you is can they help you attract labor faster and train labor faster. The benefit to get the ship…

Chris Kastner: Yeah. Interesting enough, there’s a lot of initiatives both at the state and federal level to help in workforce development. And we are actively communicating with both states that are involved in that and the federal government for infrastructure and workforce development support.

Robert Spingarn: Okay. Thanks, Chris.

Chris Kastner: Sure.

Operator: Thank you. Our next question comes from Scott Deuschle from Credit Suisse. Please go ahead. Your line is now open.

Scott Deuschle: Hey. Good morning.

Chris Kastner: Good morning, Scott.

Scott Deuschle: Tom, did CVN 79 book a net-net negative EAC in Q4? Just trying to interpret what’s in the press release on the year-over-year comparison there? Thanks.

Tom Stiehle: Yeah. So we don’t provide the actual margin booking rates to step up, so step backs on any individual program. I would tell you — to give you some color on that, on the adjustments, there was nothing significant either are up or down on any individual program. So the answer to your question is no on that. I would tell you that the effect that you are seeing at Newport News there is, although it’s net down as far as the adjustments it has, it was really a function of not having the upside that we would normally see. So if you kind of range bound to what we saw on the downside of EAC adjustments, because the timing on the milestones and just where they saw a little bit of a draw short on labor, a little bit of pressure on overhead costs, overhead absorption is a little bit higher on all the programs there and CVN 79 is not immune to that effect as well. But it was not significant enough as you see it’s not called out in the K.

Chris Kastner: Scott, I’d also add that

Scott Deuschle: Okay.

Chris Kastner: CVN 79 had a pretty solid year. They met their compartment commitments for the year, EMALS is essentially built out. It’s pretty amazing. I was up there last week and the equipment is in and they started that test program. The topside test program has begun. So they have got a bit of momentum. I hate to use football reference, but the big game is this weekend, but 79 is what I call four yards in a cloud of dust, right? They are — every week they are executing on a lot of volume work. They met their commitments for last year. They have got a lot of work in front of them, but I have high hopes for success on that program.

Scott Deuschle: Great. And then, Chris, what were the, sorry, if I missed this, but what were the gross and net headcount additions in the Shipbuilding business in 2022 and then just curious on how attrition trended in Q4 sequentially relative to Q3? Thank you.

Chris Kastner: Yeah. So attrition got better throughout the year. I don’t have the specific number here. We added about 5,000 heads, but it did trend better as we move through the year and it’s gotten better in January as well. It’s pretty — it’s what I call this a bit of stability showing up in the Shipbuilding organizations from not only a labor standpoint, but also supply chain and inflation. It’s not back to pre-pandemic levels, but it’s definitely stabilized and that’s what we need to execute.

Scott Deuschle: Thanks, guys. Appreciate it.

Chris Kastner: Sure.

Tom Stiehle: Thanks, Scott.

Operator: Thank you. Our next question comes from Pete Skibitski from Alembic Global. Please go ahead. Your line is now open.

Pete Skibitski: Hey. Good morning, guys.

Chris Kastner: Hi.

Pete Skibitski: Just going back to Kennedy, it’s a big contract for you guys at fixed price, and I was just wondering, my recollection was 2023, 2024, you guys are going to have some big risk milestones on that project. It sounds like that’s still going to happen. But is just the labor situation has kind of eaten up the upside on that potential risk retirement, is that the right way to think about it?

Chris Kastner: I wouldn’t necessarily say it’s eating up all the upside. I would say that we are very conservative in how we deal with the EAC and there’s a lot of really complex work in front of us. So I would not necessarily say it’s eating up all the upside.

Pete Skibitski: Okay. Okay. Just a follow-up to that, in Newport News, is VCS Block IV the bigger muscle mover margin wise? Is that kind of — is the Block IV kind of roll-off over the next two years? Does that just give you a lot more relief than anything else?

Chris Kastner: It will definitely give us a lot more confidence moving forward after we get those Block IV boats delivered and transition into Block V.

Pete Skibitski: Okay. And Chris, just on that, it’s — obviously, labor impacts all your programs, but Block IV had kind of the unusually aggressive schedule. Is that a combination why that’s been such kind of a door on your side, is that fair?

Chris Kastner: Well, remember, Block IV was impacted the most by COVID, right? We had a pretty material impact back in 2020, which really reduced our profit expectations on those boats. So we just need to get through them. We need to get them delivered. The program schedules are pretty stable right now and a lot of cooperation between electric boat Newport News and really senior Navy to get through those program schedules. So we just need to get through them and then we will transition into Block V.

Tom Stiehle: Chris, if I could hop on that too. Pete, so on that, to your question of IV or V, yeah, Block IV has been with COVID in 2021, 2022. So it’s long run rate, those contracts have had in the EACs with some additional costs. I think it’s two-fold. One, getting those Block IV boats done alleviates the mix in the portfolio at Newport News, so there’s a list that you talked about there. But then also it’s just — those boats give us time to come down the learning curve, the lessons learned, the metrics and the operating system and the pressure on that we have on boat there. It truly is a production line of all programs you have, it’s the most serial production line with the modules go and then the boats are there, some will go from unit-to-unit with the same personnel.

So getting through IV and then that kind of benefit lifts the Block V, which has higher profit potential. And then it will take the preponderance of the portfolio mix at Newport News. We crossed over the end of last year. So already now the sales proportion between Block IV and V is now more in V and IV. So there’s going to be a natural progression of improvement with learning for boats being accomplished and then that learning and higher profit potential on Block V is going to be affecting the New Port’s portfolio.

Pete Skibitski: Got it. Thanks, guys.

Tom Stiehle: Thanks.

Operator: Thank you. And our next question comes from David Strauss from Barclays. Please go ahead, David. Your line is now open.

David Strauss: Thanks. Good morning.

Chris Kastner: Good morning.

David Strauss: Tom, I have similar question that I have asked in the past around working capital. I mean you obviously had a big improvement in working capital in the fourth quarter. Looks like in your guide for cash, I guess, back into that, it looks like you are assuming relatively neutral working capital for 2024, is that correct or sorry, for 2023. And then could you help bridge us how you go from $400 million and $400 million, $450 million in cash to — in 2023 to the number you are looking at in 2024, I guess, maybe a little bit of CapEx help, but what else gets us there?

Tom Stiehle: Sure. Yes. I will break that down. I have several points I want to hit. I will hit the percentage on working capital last as I walk you through that. So we have updated on slide 11 of the PowerPoint presentation there. So we finished at $494 million, pretty healthy against an expectation of start the year at $300 million to $350 million, we pulled that down to $200 million to $250 million kind of midyear with the re-guide and then Q3 we told you $350 million, we finished $494 million with healthy free cash flow in 2022. Obviously, that pulls ahead a little bit and so we have taken down the 2023 expectation. We hedge our $545 million to $595 million or midpoint of $570 million last time we discussed and because of the pull ahead that we have here right now, we reset expectations of $400 million to $450 million.

You — to your point of working capital, you are right, just a couple of quarters ago, we were at 11.1%, last quarter we were in the 10% range and we finished 2022 up at 6.1% of working capital. As we have been guiding over the last three years or four years, we saw that the workload and just the cadence of the ships, we are going to have more deliveries and launches on the back half of the five-year free cash flow commitment in the front half and that’s exactly what we see here. If you look at the milestone chart, you will see that we are going from three deliveries in 2022 to five deliveries in 2023. We also have three launches in 2023. So that’s a pretty big year. And then kind of it going forward to the following year on that, we take that perspective up and we have two deliveries and three launches in 2024.

So a lot of activity there, which will continue us leading the working capital, getting rid of the retention that we have and helping in the free cash flow lift as we go forward. Also, I would tell you that, as much as we finished up at 6.1% on working capital, it will just grow a little bit. We have got a couple of advancements on incentives that we have had. So we will go from 6.1% to about 6.5-ish working capital in 2023. So more deliveries helped slight rise in working capital in 2023 slightly hurts. We re-guided on CapEx from 2.5% to 3%, so a couple of dollars of headwinds there. So two things against us, but with all those deliveries and launches, we will see working capital finish up around $425 million. And mind you, 2023 has to repay COVID, which right now is about $125 million, right?

The way I look at it and give you confidence on where we are going with that. We have three years in the whole now against the five-year commitment, $757 million, $449 million and $494 million, that averages out to $567 million straight stick at BSC about $600 million a year that you need. So we are running behind for the first three years, but we knew there was a natural grant with retention with revenue and margin expansion. And also we have Alion on board now. 2022 we had them onboard for the first year. I was happy with the contribution they made. If you recall, we took the $3 billion to $3.2 billion with Alion and I am happy with the contribution they made in 2022 and Alion will be on board for 2023, 2024. As we look — going forward, right, EBITDA margin stay flat from 2021 to 2022.

We are foreshadowing some margin expansion into 2023. We have the topline growing in Shipbuilding right now that we gave you in the guidance $486 million and we expect we will continue incrementally guiding higher revenue and margin into 2024. And also I’d ask you to take a look at the three years that we have had, the $757 million, $449 million and $494 million free cash flow. That $757 million really had two things that actually helped it, and if you normalize it out, how to make sense of how we are marching to be north of $700 million in free cash flow as we get out to the 2024 timeframe, but the $757 million had the FICA release, which was $130 million and it also has the COVID repayment benefit for $160 million. So $160 million and $130 million is $290 million.

$290 million of the $757 million is about $467 million is really how I look at the first of the three years, $467 million. The $449 million to 2021 has the FICA repay in it. So you throw another $65 million in that, that’s about $510 million for a normalized 2021 and now for 2022, $494 million, there’s $65 million of FICA in that too, that’s $550 million. So I really look at it, we have normalize for what we have seen because of COVID with FICA and repay, it’s more like a match of $460-ish million to $510 million last year to $555 million, $550 million this year. The guide we gave you is $450 million for 2023 only because I have the COVID repay. So it’s another with $125 million on top of the midpoint, that’s a $550 million year and I have the year in front of me to burn down risk and pulling cash.

So I am comfortable with how margin passed by average of $567 million in the first three years. And then the last piece on how we get that up to, how do you get to $780 million is the working capital we see is going to swing about 2 points down. As I mentioned earlier, we finished 6.1% 2022, we will be in the mid-6s for 2023 and then it’s going to swing down below 5% for 2024 and 2 points of margin against the topline of $10.8 million, is about $200 million. So $550 million plus $200 million is $750 million. I got you at the midpoint of $780 million, because we still have revenue growth and margin expansion. So I am quite comfortable with where we are right now. The numbers play out. If you have any questions, you can — as we have our calls afterwards, we can break that down for you further.

David Strauss: Okay. That’s a lot of detail. Thank you for that. And Chris, as a follow-up on Mission Technologies, the EBITDA margin there, which I guess is the right way to look at 18.5%. How do we think about those as longer term? I mean those are well below kind of what we see out of typical kind of services companies and you pitch this is not just your typical kind of services business. So how do we think about those EBITDA margin, I guess, the potential there? Thanks.

Chris Kastner: Yeah. Thanks, David. You have to remember that the vast majority of that work is cost plus. So that would indicate that you would have a lower EBITDA percentage. I do think there’s opportunity for upside as we present more solutions and move into a fixed price sort of arrangement. We are not prepared to say that it’s going to get better than that right now, but there is opportunity for improvement and that’s something we are evaluating.

David Strauss: Thank you.

Tom Stiehle: Thanks.

Operator: Thank you. Our next question comes from Doug Harned from AllianceBernstein. Please go ahead. Your line is now open.

Doug Harned: Great. Thank you. Good morning.

Chris Kastner: Good morning.

Tom Stiehle: Good morning.

Doug Harned: So I want to go back to Newport News and you had a 5.1% margin this quarter. That follows Q3 that if I take out the Columbia-class benefit, that was 4.1%. And what I want to understand is you have still got certainly the Massachusetts and the New Jersey flowing through there. And so the work that you have done on Block IV where you have taken charges in the past, I mean, how much of this, what I would call, kind of a low margin in Newport News is due to the overhang of those past charges. So then when you get out from under those, should we expect a step up?

Chris Kastner: Well, yeah, Doug, this is Chris. I will start and then Tom can jump in there. There’s absolutely an overhang related to Block IV boats that we are dealing with and so we should expect a margin step up. Now we haven’t guided beyond 2023 and we need to be conservative, because we need to make sure the labor shows up and we get them trained up and they go execute. But I think you are right, relative to that overhang on Block IV, so we need to get those delivered. And as I said previously, those schedules are being very consistent right now. Cost performance, we are working on every day. Go ahead, Tom.

Tom Stiehle: Sure. If I can hop on the back of that, right? So we talked about Block IV here and what we took back in Q2 of 2020, I would tell you the portfolio with Colombia that’s coming on board and sales. So that’s a new stock program that’s booking along right now across that contract. I have some change, change in unadjudicated change that still has to get proposed and pushed through the system. So that’s going to increase, we are very conservative on that until those unadjudicated changes are definitized. That’s boat RC 73 and 74 as is in infancy too both cost type contracts. So the portfolio just has a little bit higher level of that as we see it. And then, lastly, I think, as we go forward, burn down risk as 79 marches to its completion, as Chris said earlier, there’s a potential with good performance there for additional upside here.

So I think we just find ourselves in a situation where the ships are right now, not too many milestones, a little bit of drag on overhead, down on labor. And I think we are booking prudently to conservatively right now as we want to see us pushing ships over the goal line. Those deliveries I mentioned is two each for 2023 and 2024, and I think, that will assist in the margin list, as well as Block IV gets small in the portfolio mix with the potential of Block V as we move forward. I think the Columbia program will mature and with 73 out of here at this year, a 74 focus and maturity will assist the portfolio of profitability as well.

Doug Harned: So if I have it right, then Block IV, the overhang of these past charges is a contributor, but there’s still other — there are a number of other things you just raised. So it’s sort of a blend of things that you are working through. I just wondered General Dynamics when they did their Q4 call and highlighted the number of issues that somewhat similar related to labor across shipyards and they did mention Virginia-class. Can you talk about how you are working with electric boat sort of together to deal with these problems and if they have been changed over time and how the — how you work together and work through attrition issues

Chris Kastner: Yeah.

Doug Harned: inflation, all these sorts of things.

Chris Kastner: Thank you for that question, Doug. It’s an important one. The Newport News and EV team, they work very closely together in understanding when the work, what work and how that work gets executed. So there could be movement of work between the yards where it’s most efficiently done if there’s labor issues and they are working very closely together. Their objectives are completely aligned to deliver all the Block IV boats. And I would add also the Navy is engaged as well. It’s all from the deck plate to the senior executive force. Everybody is all in and all of our objectives are aligned to get those Block IV boats delivered. And I will say that we are fully staffed on Block IV and Colombia, and we are working very hard on execution there. And not only is a Newport News working between each other, but working to ensure that any sort of outsourcing is effectively managed to ensure that we get — that we meet our production schedules.

Doug Harned: Okay. Very good. Thank you.

Chris Kastner: Sure.

Operator: Thank you. Our next question comes from Gautam Khanna from Cowen. Please go ahead. Your line is now open.

Chris Kastner: Gautam, are you out there. Are you on mute, Gautam?

Operator: Unfortunately, we are not getting any audio from the line. So we will move on to the next question. And our next question comes from George Shapiro from Shapiro Research. Please go ahead. Your line is now open.

George Shapiro: Yes. Good morning.

Tom Stiehle: Good morning, George.

George Shapiro: I was curious that you wound up with 7.7% Shipbuilding margins and when you did the third quarter call in early November, you were looking for 8% to 8.1%. So just wondering what you missed here in two months, because I thought that Shipbuilding would be somewhat predictable sort of business?

Tom Stiehle: Yeah. It was just the drag that we talked about at the end of the year. We had a strong first half of the year over 9% and we guided to 7% for the back half of the year and even Q3 was in that lane and we thought that the remaining 13 weeks of the year, we had that. But the shortfall of labor that we saw, a couple of the overhead or the non-programmatic issues drove hit boat yards actually on the cost that we talked about, on medical and just that shortfall as we go through and take a look at EAC performance and then the cost and how overheads flow through there, there’s a little bit of a drag on where we thought we would land. So if you call it on the call, I was focused on saying I want to see how the year plays out.

We did stay on the guide at 8% to 8.1% and we thought we could get that home. But as the EACs kind of rolled up, there was just a little bit of a drag. I would say both to this question, George, and the previous one. From a Newport News perspective, 6.2% last year, 6.1% this year, about the same type of performance overall, if you think about it, another year with some drag upfront, with the effects of COVID and then supply chain, inflation, big year on inflation and then the hiring demands that we had here. So I am quite comfortable with promise as far as what the Newport News team accomplished it. But to your point, we thought we would get that home and Q4 came in a little flattish on Newport News than we expected.

George Shapiro: And Tom, did you give the EACs for the quarter?

Tom Stiehle: Not yet, but I can. No. I did, yeah. I referenced them, just that we didn’t have a tremendous downside. We just didn’t have upsides at Newport News. But from a — for the quarter perspective, what we saw was the gross favorable were $29 million, the gross unfavorable were $56 million. That was a net of $27 million. And effectively, about 100% of that was at Newport News, basically Neutral Ingalls and Mission Technologies. So it was quiet at the other two divisions and Newport News saw a net down of that unfavorable for the corporation of 27 now.

George Shapiro: Okay. Thanks very much.

Tom Stiehle: Thanks, George.

Operator: Thank you. Our next question comes from Seth Seifman from JPMorgan. Please go ahead, Seth. Your line is now open.

Seth Seifman: Hey. Thanks very much and good morning.

Chris Kastner: Good morning, Seth.

Seth Seifman: Just maybe to follow up on that — good morning. Maybe to follow up on that question, Tom, you talked about Newport News being in the low 6s for 2022 and 2021. I know you guys don’t typically guide segment margins. But if we are just to think kind of maybe qualitatively, overall Shipbuilding margins should be up 10 basis points to 20 basis points at the midpoint of the guidance. Does that mean there’s a little bit of improvement in each yard or given the way that some of the one-timers or some of the potential upside associated with the milestones that you are expecting at the shipyards. Is there opportunity for more expansion import news and maybe some headwinds in Ingalls? How do we think about that for this year?

Chris Kastner: So I will start and then Tom can get into the details and thank you for saying we don’t guide by shipyards. We don’t do that. But I firmly expect Newport News will be better this year. I think they are executing their operating system very well. I think labor is more stable. I think the supply chain is more stable. I think the team has some momentum and I think Newport News is going to do better this year. So, with that, Thomas, you want to add anything about Ingalls, I think, they are pretty stable as well.

Tom Stiehle: I am with you that we don’t guide by division, but from a historical perspective, things 10.5, 11, 11.1 for the last three years, they have the same portfolio basically done there finding labor overheads, the pressures that we talked about, but very strong operating team, a leadership. They know what they are building, those ships are under production. So I would think historically, they are going to continue perform well. And I think from a Newport News perspective, as they just fight it way through here, new technology started with Ford and now Colombia. We had that booking we talked about back in 2020, a little bit of COVID pressure, inflation, supply chain and hiring. But you can see some stabilization both in the performance over the last two years. We see stabilization and some stability in hiring and the schedule here and our expectation is that that yard can perform better. So I would expect that to increase as we go forward in the year here too.

Seth Seifman: Okay. Great. Great. And then maybe to follow up real quick on a similar type of question on Mission Technology, I think you said, the EBITDA margin there ex the valuation allowance was like 8.6% in 2022 and so what’s driving it down in 2023?

Tom Stiehle: We are probably just being conservative on the guide. So we had a 6.6% quarter with the impairment out of it, it was 8.3%. We have had quarters at Mission Technology anywhere from the low 8s to the low 9s. Last year was 8.6%. And as I said, adjusted it — was unadjusted was 8% to 8.6% right now. So I think it’s just a function of net sales base. We have fixed and semi-variable costs there. It’s a good sized operation. We think we have the right people on board with the right strategy. The pipeline has grown year-over-year and the pipeline is more mature. And I think with the Mission Technologies integration into the HII family, with that behind us, as I mentioned in my notes, it was done under budget and is on time.

That the team can completely focus on that pipeline, bids, execution and performance. So I think the 8% to 8.5% is just being conservative. Obviously, we want to see a couple of more dollars out of that division last year. We are guiding growth year-over-year right now. We did see Mission Technologies to grow 4% from 2021 to 2022 and each of the business units had growth in them. So those are all positive signs. I think the 8% to 8.5% is just waiting and seeing the awards happen. When the sales hit, I would expect we are going to be on the upper end of that range, if not over it.

Seth Seifman: Great. Thank you very much.

Chris Kastner: Thanks, Seth.

Operator: Thank you. The next question is from Gautam Khanna from Cowen. Please go ahead. Your line is now open.

Gautam Khanna: Hey. Sorry about that. I hope you can hear me.

Chris Kastner: No. Yeah. Thanks. Now we had you, Gautam.

Gautam Khanna: Great. Great. Hey. Thanks. I was curious if you could just give us some color on the timing of the milestones through the year. If you can tell us like, if there’s anything that’s in the month of December that has the potential to move out or things we should be watching

Chris Kastner: Yeah. Just

Gautam Khanna: in terms of Q4 the way things happened

Chris Kastner: Sure. Sure, Gautam. When you look at the 2023 milestones, I think, Tom already mentioned that Q1 was pretty light. The pretty evenly distributed across Q2 and Q3, but then CVN 79, excuse me, LPD 29, yeah, is in Q4. So that’s at the end of the year. So that’s the one we will have to watch. We got a lot of confidence in and the team down in Mississippi, but that’s the one towards the end of the year.

Gautam Khanna: Okay. Thank you. And then just curious on VCS, anything incremental from last quarter on schedule with respect to…

Chris Kastner: Not really. Pretty stable from a schedule standpoint on the VCS program. We have movement here and there, but it’s pretty stable. I got to hand it to that team, the program team and the construction team. They are getting after it and they are learning every day. So it’s been pretty stable. We need to stay on.

Tom Stiehle: Chris has talked about that rhythm of the program, launch one and sell one-off when we saw that in 2022 and in the milestones, you will see that in 2023 and 2024. So we are working it.

Gautam Khanna: Okay. And just on that last point, anything with respect to negative catch-ups or you can talk about 422 on VCS in aggregate anything, yeah, you can never call it out as material, but can we assume that there were kind of consistent negative marks in the program or anything you can tell us about that?

Tom Stiehle: Nothing really significant to highlight here. I mean I mentioned in the keel the — the keel net was at Newport News on that, which was down and they just kind of sprinkled over the programs, but there was nothing really to highlight here.

Gautam Khanna: Okay. Thank you, guys.

Chris Kastner: All right, Gautam.

Operator: Thank you. Our final question today comes from Noah Poponak from Goldman Sachs. Please go ahead, Noah. Your line is now open.

Noah Poponak: Hi. Good morning, everyone.

Chris Kastner: Hi, Noah. Thanks for joining.

Noah Poponak: Yeah. Sure. Tom, so just back to the cash flow breakdown and appreciate all the detail you gave there and I appreciate that there are a lot of moving pieces. But if I just kind of zoom out on the cash flow statement and look at a long history, it sort of ranged $400 million to $600 million for a while and the business is pretty stable topline and margin. I recognize you have some opportunity to grow the business and expand margins going forward. I think the pension looks pretty net neutral. The CapEx looks pretty stable. It sounded like you said earlier that you expect in that 2024 $780 million midpoint about $200 million of working capital. And I guess, should I think of working — change in working capital is not a sustainable recurring part of the free cash flow, and therefore, that kind of $580 million, $600 million as sort of a predictable, sustainable engine of the cash flow statement going forward or is there some other reason to think of the base business is eventually making up that $200 million?

Tom Stiehle: Yeah. So that’s a great question and we study that all the time and it’s the former — it’s former with a caveat, right? So we are hitting the point right now. We have been impacted. If you look at the cash flow statement, we were in the $400 million to $600 million. I’d tell you from 2020, 2021 and 2022, those COVID, FICA repays and the COVID payments have tripped up and you have to normalize after that. A couple of things are happening. Obviously

Noah Poponak: Okay.

Tom Stiehle: prior to this window, the margin has dropped in Shipbuilding as we have kind of run through COVID. So we are fighting and working ourselves back with incremental improvement. The revenue growth with the backlog that we have shown you there and we expect at least have 3% here kind of going forward when we get through this labor crunch, that’s in place. So I think you can model that out. The — as we go forward, the working capital I believe we will be in that 5% to 6% range and both yards are in a good rhythm right now, the DDG program annually, what we are doing with launch and sell off boat on VCS, the rhythm of Block V is behind that, the two carry by following 79, the Columbia Build 1, Build 2. So I think we are settling down on the mix of the portfolios in each yard and the timing on when they are going to pop out so.

We have told you in the past, traditionally a Shipbuilding is like 6% to 8% of what we would expect. That gets water down a little bit, because now with Mission Technology and Alion with more sales in the base the numbers kind of pop down. If you normalize in just to the traditional Shipbuilding what we have talked about, right, we were at 12%, I think, in Q1 of 2022, Q3 of 2023, we are at 14%. We finished the year at 7.8% just for Shipbuilding and now as we go from 7.8% to 8.3% for Shipbuilding sales, we will see ourselves go down to 6% in 2024. That’s in the range that we were highlighting, say, for the first 10 years of the corporation of 6% to 8% in working capital. We were at that range in 2018. We were in the 6% or so. I think that’s sustainable as long as we are in a normal rhythm of adding work, which we have the backlog, we are performing to schedule, so we are selling ships off timely.

And although being either at 6% our Shipbuilding sales or is subside, including all my sales with Mission Technology is on the low end of the range. I think what offsets that is the revenue — an incremental revenue and margin that we think we are going to have in the coming years. So I am still bullish on the north of $700 million is going to be a run rate in a couple of years from now and I think 2024 is that inflection point to kind of start that run.

Noah Poponak: Okay. The north of $700 million in a few years, I guess, if 2024 is $780 million midpoint about $200 million of working capital, once you get to the working capital goal, you then cease to have positive change in working capital flow to the cash flow. So 2025 million, I mean, who knows exactly what it’s going to be, but sort of directionally would not have that. So is there a step down from 2024 as — and then as the business grows, you over time get back to that $700 million?

Chris Kastner: Yeah. Noah, we are not going to discuss.

Noah Poponak: You are not.

Chris Kastner: We are not going to forecast 2025 free cash right now. But I think your logic is okay. The business is going to grow. And if we stay down with those working capital numbers, you are not going to get a benefit from it. You are going to have to get it from growth and margin improvement. So I think your logic is sound. But we do definitely believe that free cash is going to get north of $700 million in 2024 and then continue to grow from there.

Tom Stiehle: I will tell you stick with a lot of the numbers, right? So I walk through how we normalize out the 2021 and 2022 because of COVID that you can see we are incrementally going from that $460-ish million to $510 million to $550 million with the guide of $425 million this year, COVID-adjusted, that’s another $550 million. And then I am telling you the working capital is going to get us there in 2024. So that is just say what’s the run rate. I think you are looking at

Noah Poponak: Okay.

Tom Stiehle: the right way on how you model it and we will provide guidance

Noah Poponak: Okay.

Tom Stiehle: for 2025 a year from that.

Chris Kastner: Yeah.

Noah Poponak: Great. And then, Chris, just on labor, you spent some time on it, but — and it’s unpredictable, but I guess maybe just how — when do you think you could get to something close to normal on your labor churn and development of the people you are hiring in. I guess with the amount of time you spent on it, the amount of time you have been in the business, obviously, it’s an unprecedented situation, but how much more time do you need to get to something that’s pretty stable?

Chris Kastner: Yeah. Well, it’s absolutely more stable now than it was a year ago, okay? And that’s a testament to the hard work, the shipyards have put in to really kind of pivot who they were hiring, increase the training, increase the leadership training. So it’s absolutely better. I don’t know if you have ever done, right? There was a pretty generational change in our workforce where we lost a large swath of people through COVID. So we are retraining a workforce and retraining foreman and general foreman and construction superintendence and that’s happening. And the best thing we can do and the greatest learning potential is delivering ships. We are going to deliver five this year. Once you have been through that, you have learned a lot and they are going to continue to learn a lot. So I think it’s only improvement from here. I don’t think you have ever done, but I think we have made great progress.

Noah Poponak: Okay. Thanks for the time.

Chris Kastner: Yeah. Thanks, Noah.

Tom Stiehle: Okay.

Operator: Thank you. This concludes our Q&A session for today. I would now like to hand the call back over to Mr. Kastner for any closing remarks.

Chris Kastner: Thank you for joining today. I am proud of all the hard work put in by the team and I am confident the hard work we are doing will pay off and value creation for all our stakeholders moving forward. Thanks again for joining the call.

Operator: Thank you. That does conclude today’s conference call. You may now disconnect.