Huntington Ingalls Industries, Inc. (HII) Earnings Call Transcript & Summary

Alrighty. I think we're live.

Great.

Welcome. It's a pleasure to welcome Huntington Ingalls here to the conference this week. We've -- I'm just trying to get this straight. We have Chris Kastner, EVP and Chief Financial Officer; and Dwayne Blake from Investor Relations. So welcome, everybody. Thanks for joining us again this year.

Thanks, Rob.

Thanks, Rob.

And I think we'll just go right into Q&A, if that's okay.

Yes. Sure, Rob. If you don't mind I'd like Devin -- excuse me, Dwayne to step through a safe harbor before we step into Q&A. I apologize for that.

Sure. Not at all. Not at all. Thanks, Dwayne.

Yes. No worries. Just as a reminder, statements made in today's call that aren't historical fact are considered forward-looking statements made pursuant to the safe harbor provisions of federal securities law. Please refer to our SEC fillings for a description of some of the factors that may cause actual results to vary materially from anticipated results. So with that, back over to you, Rob.

All right. Perfect. Thank you, everybody, for being here. If anybody has a -- I'm going to go through a list of questions I have. If you in the audience have any questions, we will certainly attempt to get to those. Please e-mail them to me, we'll ask them anonymously. Chris, without further ado, I just want to jump in high level with a strategy and budget-type question. I think 1 issue that investors face as they look at the shipbuilding industry is the actual path that the future will take. That is you have the Department of Defense calling for more ships, newer types of ships, smaller ships, autonomous ships, the talk about a lot of different things, significant change. Then you have a Congress that at least appears to have -- to be heavily resistant to any changes. And often for good reason, given the Navy somewhat a consistent track record with technology transitions, and of course, I'm speaking to things like DDG 1000 and the Ford-class and LCS, well, so on. So we've had some rocky transitions. So apologies for the long preamble, but where do you see these 2, the Navy and Congress, striking balance?

Yes. So the good news there, Rob, you said it, is there's kind of a universal desire for more ships, right? We haven't really seen a formal 2045 plan. We've seen new stories about it. So we kind of know where we think it's going. And you mentioned smaller, more agile, connected-type shipbuilding, more unmanned ships. That's actually positive. More ships is positive for us. We're going to be involved in any of those discussions with the Navy moving forward on how they're going to develop those requirements. So the good news there, we have a $45 billion backlog, we build large capital ships. We're going to continue to build large capital ships. And I think we've made the right investments in the unmanned space to prepare for that as well with the Hydroid acquisition. So absolutely, there's a bit of an evolution taking place, and we're going to participate in that.

Whichever way it goes, I guess.

Absolutely. And it's not going to happen quickly. This is something that's going to evolve over time.

And how do you position the company to make this transition financially successful? You've got this huge plant between the 2 major facilities and a lot of people. And again, if we start talking about Hydroid and smaller craft, I'm thinking about it maybe from an asset perspective.

Yes. We're doing it right now, right? We've deployed some capital into the Hydroid acquisition and into the COE or the manufacturing facility here in Hampton for unmanned. So we're deploying our capital for that future growth. So we think we made the right bet there. Hydroid is a very class act, well positioned with the Navy and international customers. And so we think we're making the right decision there with capital deployment.

And how do you characterize the barriers to entry in the new USV space?

It's definitely different, right? We've put our Hydroid and our unmanned business in our Technical Solutions organization. So they're much more agile than they are in the shipbuilding group. There are definitely less barriers to entry in the space, more players, not only the traditional shipbuilding players but also smaller, more technology-type companies. So it's definitely a broader competitive environment that we're participating in. But we think we have the premier player in the space. And the interesting thing about Hydroid with our autonomy technology and our relationship with Kongsberg, who has very good technology as well, it's helping us in our unmanned surface space where Ingalls is going to participate. So you're right, there's less barriers to entry in that space, but we think we're in a very good position.

And how do we think about margins given the lower barriers to entry? I mean is unmanned ultimately a lower-margin business for that reason?

Yes. I don't think so. I think there's going to be more quantities and more opportunity for sale production. And so I actually think there's some upside in margin opportunity after you get into a kind of a solid funded program because with higher quantities, you get opportunity for additional margin.

And how -- this is sort of a nuanced question. But shipbuilding has long been a favorite of Congress, if you will, because it's a strong job business, a lot of touch labor and jobs. As we move to unmanned and smaller ships, I mean, the presumption is we'd be a little more automated, maybe you don't have quite the level of touch labor. You think you get the political support you're used to?

Yes. I think it's complementary, right? I think unmanned is complementary. I think they're going to complement the larger ships. I don't see a Virginia or a Mississippi being replaced by unmanned technology. Those large capital ships, I think, will remain. So I expect full support of the congressional representatives from those states.

If we -- if those ships remain, do we maybe lose the benefit of these either multi-ship awards or serial awards? I imagine they won't remain, at some point, in the same quantities.

Yes. That's an interesting question. I think when you think about submarines, they absolutely -- there's a requirement for additional submarines. So I think it's recognized that the best way to buy ships, large ships is to do it in quantity. That's the best way to get on the learning curve. That's the best way to not only earn margins but also reduce the cost for the taxpayer. So I think quantity buys and buying ships in quantity is the right way to do it. And I don't think that's put at risk just simply because we're going to buy more unmanned ships to complement that we carry on with the force.

Okay. Let's talk about submarines a little bit. Obviously, Virginia-class is an important program for HII. How would you characterize the current program from an execution standpoint?

Well, the good news there is the labor force has returned, right? So the major issue on the Virginia-class going through the virus was kind of a reallocation of resources and reduced resources, which drove some schedule movement on those boats. So the real good news there on the Virginia-class is we have recovered our workforce in Newport News. They're being applied to the boats, and it has stabilized. So I'm comfortable with where we are. And it's early after Q2, hasn't been that long yet, but the labor force has recovered. We're meeting our milestones, and I'm comfortable with that performance right now.

And how do we think about it a little longer term, Virginia-class in terms of growth and from a margin perspective?

Yes. So it's -- there's a need and a desire for additional Virginia-class submarines. If -- and we'll get on the 2 per year cadence that's required there and that our customer needs. If there's a 3rd per year, that's something that -- in order to support that, we would need to invest some additional capital in our manufacturing facilities in order to do that. But I think that the opportunity for additional submarines is definitely there. It's definitely a requirement. The customer definitely needs it. And that's something we would support. Now I still think that HII from a medium- to long-term basis, medium or 5- to 10-year basis is a 3% growth story in shipbuilding. And that doesn't really change with adding a 3rd submarine in the medium term.

Okay. And then just -- since we're on submarine, let's talk a little bit about Colombia and the role that you will play on that boat.

Sure. Sure. Yes. So we build a little bit over 20% of that boat. We build the same structure we built on the Virginia-class, the curve structure and the bow and stern. So we're a major subcontractor to General Dynamics on that. Encouraged by the contract we just received, and we're ready to get going. We're ramping up both staffing and the manufacturing on that now, and we think it's going to be a very successful program.

And there's been some recent talk about an extension of that program, maybe not exactly the specs to the Columbia-class. But maybe giving it some more conventional capabilities, but that particular boat form. Have you guys been thinking about that at all?

Yes. I'll let the Navy talk about requirements. If that is being discussed, the prime contractor, Electric Boat, with the Navy and us, will be discussing that. But I think that's really more a Navy statement than a HII statement.

Yes. But it's reasonable to assume that you all would play a similar role in something like that. It's essentially part of an offshoot at same program.

Absolutely. Absolutely.

I wanted to just quickly ask you on amphibs. The -- really 2 questions here. Overall, where we stand, but also specifically, just referring to the news out on LHD-6. LHD-6, which of course, had the unfortunate fire over the summer. And now there's talk that it's going to be -- they are not going to repair the ship, it's too expensive, but instead possibly replace it.

Yes. Really a tragedy on that ship, great capability built down at Ingalls, F-35 capable. So yes, really a tragedy on that boat. From an amphibs standpoint, generally, it's really important that we continue the LPD line and get LPD 32 and 33 under contract and then LHA 9 as well. And then potentially LHA 10 because the aviation capability on those 2 boats are pretty impressive. So from an Ingalls standpoint, with the loss of the NSC program where that's going to wind down eventually here. It's very important that we get the LPDs under contract, not only the LPDs, but also the LHAs.

And how far out do those take you, the ones you just spoke of, if they go under contract. And again, on LHD 6, that would be additive to all of that, right?

Yes. Well, LHD 6 is not -- I think they made that decision, they're not going to repair that, right?

So at that point is a replacement for that would be something additive to the current manner of what we just talked about.

Yes, definitely, you're right. And that would take the form of probably LHA 10. And if that can be accelerated, that would be great. And so if you get LPD 32, 33, LHA 9 and LHA 10, you've really solidified Ingalls for the next 5 to 10 years.

Okay. Okay. And then on the carrier program, maybe just a quick update on where you are and then I have a couple of others.

Yes, really positive developments on the single phase delivery on CVN 79. Comfortable with the progress they're making. We are on contract for that now, even though we need to definitize it subsequently. They're resetting the schedule for that, the testing schedule and incorporating the new requirements. So very comfortable on that. It really derisked the program, I think, for the Navy and us going forward and gets that ship deployed sooner. So I think that's a positive story all around. 80 and 81 has started off to a good start, just really the initial phases there. It's much too early on 80 and 81 to draw any conclusions. But it goes without saying the best way to buy an aircraft carrier is together, seem to get economies of scale.

A lot of investors call us and ask about 80 and 81 and the change in administrations and what could be -- we could maybe say a somewhat unknown national security strategy at this point. Can you give some comfort to invest -- 80 and 81 are a done deal, there's nothing that can change there? Or is there some risk?

Well, 80 and 81 are a done deal. I'd be very surprised if anything ever changed there. We're ordering long-lead material. We started manufacturing of 80. There's a lot of water under that bridge already. The Navy is a full supporter of 80 and 81 and even 82 actually. So look, anything can happen in this world, but I'm pretty confident that 80 and 81 will be built and be great ships.

Just mechanically, for those of us who may not be familiar with a multi-carrier buy, and obviously, these are not common. But how do we think about the procurement in this multi-carrier buy versus the actual production? It sounds like certain things happen simultaneously, but other things don't.

Yes. So you will -- we will buy everything together that we can that will make sense and we can get economies of scale. So all your material, all your major material, your major equipment, is bought together so they can set up once and build twice and you're going to get the savings there. So you don't have a 5- or 6-year difference between when you're building in. Now obviously, when you're getting into the actual fabrication of the boat and buildup of units and integration of all those, you're going to have to do it separately. But you're absolutely -- you're getting economies of scale and material. You're getting shared resources while they're overlapping and support labor, it makes all the sense in the world.

Does some of this material or some of these systems that get built together, does that mean that those things for 81 go into inventory earlier or maybe the government's inventory, I imagine. They're the ones carrying this. But earlier than it would otherwise?

Absolutely. Yes, you're exactly right.

So they will be -- so and that's why 81 is pretty solid because it's actually -- it's being bought alongside 80?

Yes, yes.

Okay. There's been some discussion of fielding smaller aircraft carriers. Does that make sense strategically? What's the opportunity? And I assume at Newport News to accommodate those?

Yes. So smaller aircraft carriers, there's always studies about smaller or different configured aircraft carriers. We build a smaller aircraft carrier. Now we don't call it at, we call it the large deck amphib that carries up to 35. So we build those at Ingalls now, and it's a very successful program. The question that is always asked on aircraft carriers when you think about -- are you going to build a different configuration, is it going to be nuclear or not? And yes, you ask that first question. And if it's going to be nuclear, volume is the cheapest thing we build, right? So it's going -- the best solution is the Ford-class aircraft carrier, if it's going to be nuclear. And then we -- I think it's healthy to always ask that question. It is always asked, and we tend to come up with that same conclusion.

So to be clear here, if they want a smaller carrier and it's nonnuclear, it sounds like that would be built at Ingalls?

Yes. Potentially, yes.

And/or you go larger, you go nuclear at Newport News. But what you don't want to do, it sounds like, is build a smaller nuclear carrier at Newport News because it's just not as efficient.

It just doesn't make sense. It just doesn't make sense from a capability standpoint.

Okay. Okay. Why don't we switch, spend a couple of minutes on margins?

Sure.

What I wanted to talk -- when we talk to people about -- who are new to the industry, it always surprises them to learn that your business generates more earnings volatility than any of the other companies we cover. There really is quite a bit of move from quarter-to-quarter. And that may be inherent to the low volume business of shipbuilding. But your peer is a little bit more consistent on margins. So at the risk of putting you on the spot a little bit, could you walk us through why this is?

Yes. So I appreciate you not putting me on the spot relative to my peer and how they do their accounting. They're great shipbuilders and a great company. So I'll just -- I'll let them answer there questions on how they do their bookkeeping. But I think for us, it's a function of having few programs and some large programs and large ships. And a philosophy that says, "we're not going to retire risk before it's time, right?" We're just not going to do that. And if it creates some volatility quarter-to-quarter, so be it. When we get into serial production, you actually have less volatility because you have more cost predictability. So serial production, I think, solves a bit of this. But I think it's a size and just our risk retirement process, where we're -- we want to make sure we've retired that risk before we take it to the bottom line. It tends to resolve within a year. So quarter-to-quarter, we're going to have volatility just because of how we do it. But within a year, it's pretty consistent and consistent with how we talk about it.

So it's not really an accounting difference. It's just -- or I suppose that ties into how you retire risk. I mean at the end of the day, EACs and so forth are accounting-based adjustments. But I hear what you're saying about you're going to be very on top of retire risk as you need to. But is there anything else about this that would explain the difference?

Well, I guess -- I mean we do have large ships, right? We have larger ships with more space in between them. We're not in serial production, similar to our competitor. So we have aircraft carriers. We have large -- we have LPDs. We have a large deck amphibs with more space. So we're not in serial production like our competitor is on the boats that they build. So I think there might be some of that as well, just the nature of the business, and our portfolio is a bit different from our peer.

Another question, which is more about the industry than you specifically, or then Huntington specifically, is why is the industry in an 8% to 10% margin paradigm, given the greater capital intensity and risk in this business compared to other defense businesses, which seem to earn a few hundred basis points higher margin?

Yes. I think that's a great question. I think about it a lot. It's -- as a CFO, and quite honestly, I came from Northrop Grumman, where I participated in those programs with higher margins. So I get it. So I think a lot of it is about serial production and getting into serial production. And when you get into serial production, you can actually generate the returns that you would expect. But along with that, you've got a lot of large programs not in serial production where it's just a challenge to allocate risk, right? And the returns on those to get that price right, and your expectations of returns on those large boats, and first-of-class-type boats is just a bit of a challenge. And so I think it's all about serial production, the more you're in serial production, the more the returns are going to be higher into that more competitive range. The less you're into serial production, the less you're going to be in that range.

Yes. So essentially, it's a volume-driven answer?

I think it is. I think it's a volume-driven answer. And just the nature of very high-priced items and very few quantities factor into it as well.

And isn't it fair to say even with serial production, you're -- almost nothing is being built simultaneously or immediately one after the other. There's even a year or 2 years between the smaller ships. So there are changes even in a multi-ship order with serial production.

That's true, but you do get the opportunity to learn, ship over ship, where it's primarily the exact -- primarily the same configuration. You can have small changes running through it. But it's primarily the same configuration, and you're going to give all the elements of learning that you would expect in a manufacturing environment. You're going to have the same material, you're going to have the same vendors, you're going to have the same people, you're going to have the same manufacturing process. When you get all those characteristics in a manufacturing environment, you have the opportunity to drive down the cost. And that's really what happens on shipbuilding programs. All the large -- NSC program, DCS program, DDG program, you get the opportunity to learn.

So if I were to ask you if there's a path for the reward to better approximate the risk, the answer is more serial production?

Absolutely. More serial production and less change in the environment.

Okay. Let's just switch to M&A. You and Mike were pretty focused on the government services acquisitions a few years back. It seems like valuations have come down recently. And from what we understand, there's a decent number of sellers out there in the defense industry. And so a couple of questions would be, one, are you seeing that? Are you seeing a lot of properties for sale? Two, why? And what might we expect from Huntington Ingalls?

Yes. So there was definitely a pause in all that activity during Q2 and over the summer. We're seeing reemergence of properties available for sale now. Expectations for value have not really come down, notwithstanding the valuations of public companies. So the expectations are still high. From an HII perspective, we think we have TS positioned in 3 markets right now where we can absolutely utilize our balance sheet and our cash generation over in shipbuilding to grow in those markets. So we've got unmanned, where we've invested in Hydroid. Hydroid is a premier player in the unmanned space. We might do niche acquisitions in that space for technology companies, primarily in autonomy, in undersea and in surface technology. Then we have nuclear, which is our DOE business, but there's also commercial nuclear opportunities in D&D where you're doing environmental cleanup and closing commercial nuclear facilities, where -- we're really an environmental nuclear operations company. We have a lot of expertise with Newport News shipbuilding and within our nuclear organization in DOE to participate in that and deploy capital there. And then our classic government services business. When you think about the businesses that we have there, it's C4ISR, it's training and simulation, modeling and simulation, intel and cyber. Those are markets that there's opportunity for growth. And if we see opportunities there, we could deploy our capital for M&A in that space.

What do you say to investors who questioned that last part as being too far afield? And simply because you are thought of as a shipbuilder. And most of everything else you've talked about ties to that except maybe for that last piece or is that being misunderstood?

I think it's a bit misunderstood because we were already doing it. We were just doing it buried within our shipbuilding business in the form of AMSEC. So we were already doing C4 activity, information gathering sort of activity within our AMSEC organization. And then we started building on that and seeing that we could provide these services to other customers. So I understand it wasn't a large part of the shipbuilding business, but it's absolutely something we had been doing. We're now doing it to a greater extent for a broader set of customers beyond the Navy and there's really opportunity for growth there.

When you look at that third segment and you think long term, and if we assume that some of the unmanned would go there or most of it. Now when you and Mike sit down with the board and strategize over the next, I don't know, 5 years plus, is there a number that describes the ratio of traditional business to these new businesses?

Yes. We don't have a specific number or timing of the number, but we absolutely think that there's opportunity for growth and all 3 of those businesses within Technical Solutions. We don't have a specific number. We need to -- we don't want to put a number like that out there because we need to be disciplined in making sure that we can generate the returns for any investment we make.

Let me ask the question differently then. That third group, Technical Solutions, over time, should that have a higher growth rate than the 2 yards? And therefore, should it become a bigger portion of the pie?

It will be -- it has a higher growth rate organically. And if we add M&A, it will even be greater than that.

Okay. And then the last question is just -- because we're about there on time. I just wanted to ask you on COVID cost reimbursement, COVID disruption. If you can just describe to investors here to the extent -- to what extent the government can reimburse you, what we might expect down the road from the disruption that this pandemic has caused?

Yes. Thanks for that question because it's confusing, and there's a lot of information out there on it. I really break it into 2 different pieces. One is the COVID-related cost, that's quarantining and cleaning your facility, keeping your people safe, all of that testing. That's all COVID-related stuff, driven by a 3610. That is all -- will be all allowable costs. There will potentially be made whole for all those costs in the future, and I expect us to be -- I don't think it's a material number. But I expect us to be made whole for that. It is some upside in the future. The second part is delay and disruption on our programs, which were impacted because of COVID. And we reset those schedules and we took that and we provided that information in Q2. The Navy is obligated to fund those programs, they're incentive and cost-type contracts. So they're going to fund them. The question is are they going to have to pull that funding out of existing programs or go to get additional funding? They're trying to get additional funding, which is appropriate because it is really a new requirement. You don't want to impact your current requirements for that. Now do I think that we'll be made whole relative to that? I just don't. I think that's too long a put. We are very conservative in how we account for all of this. And so anything we would receive would be upside.

Okay. All right. Well, thank you for clarifying that. And thank you for being here today. We really appreciate Huntington Ingalls participation in these conferences.

Thanks. And nice to see you, Rob.

Great to see you, too. And thanks -- thank you so much Dwayne and Davin.

You bet.

Take care.

Thanks.

Bye-bye.