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

Okay. Good morning, everyone. I'm Kristine Liwag, Head of Aerospace and Defense Research here at Morgan Stanley. I'm very excited to have Chris Kastner, CEO of Huntington Ingalls with me. Last time I saw Chris, we were at a dinner with the Secretary of the navy, it was pretty fun.

Out in New York.

Yes. With some scotch, that's what defense people do. So before we begin, we're going to read a bunch of disclosures. So I'll read mine and you can read yours.

Mine's easy. Just we're not breaking any news today, safe harbor rules supply. So over to you.

Great. For important disclosures, please see the Morgan Stanley Research Disclosure website at www.morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley representatives.

So with that, Chris, thank you for coming all this way to Laguna. Let's start with the budget environment. The debt ceiling deal negotiated earlier this summer capped the defense spending at 3% for fiscal year '24 and at 1% for fiscal year '25. But it seems like Congress still needs to work through its annual appropriations process. We're heading into an election cycle. So how does this framework look for HII? And how do you think about the budget environment? And what are you looking for?

Well, first, thanks for having me. I grew up about 30 minutes from here. So I got to fly over my mom's house when I came in.

Welcome home.

So thank you for having me here. Thanks very much. Good to be home. Yes, so the budget environment is actually progressing pretty well through the committees and better than they have over the last couple of years. So the programs that are supported are pretty consistent in the House and the Senate. And the good news for us is LPD-33 is supported, VCS, DDG 51, CVN 75 advanced planning of the RCOH. So all our programs are supported. I really can't predict how it's going to unfold with the potential government shutdown and a CR. I think we think there's going to be a CR. I think everybody believes that. Question, does it go through November or December, I'm not really sure yet. But our programs are supported. We're just going to have to see how it unfolds. Presidential election, I don't think that's a real issue for us. We have really bipartisan support for our programs. And really based on the national defense strategy, it's been pretty consistent through Republican and Democratic administrations and really threat-based, not politically based. So we're pretty comfortable with where we're at.

And you mentioned the CR. I mean it seems like in the past 15 years, I've been doing this, the CR is more the norm. So if we were to start a CR this year, but then on top of that, we have an extra risk, right, because Congress may still deliver all the spending bills for all the different appropriations. Otherwise, we get an automatic 1% cut to the federal spending by calendar year-end. So how does that risk versus the normal CR risk affect your outlook? And then when we look at some of your programs, there's also the White House anomalies list, like the Columbia-class submarine where they might be a little bit more protected. So where do you live?

Yes. So I think they're very mindful of that 1% reduction. They're paying attention to it. And that's why you see the committee process unfolding as kind of as efficient as we see it unfolding. So if that does happen, I don't know where they're going to take it from, right? But I'm pretty comfortable that our programs are supported. But I just don't think that's going to happen.

And what does it mean to be on anomalies list?

It just means that even though there's a CR, they'll be able to fund and start a program, right, even though it's under the CR rules, you have ongoing programs continue to be funding, it's not greater than the previous year funding. But if you have an anomaly, they can go ahead and start it.

You have other programs in your portfolio in the anomaly list besides the Columbia-class?

Potentially, there could be, but I don't think we need them actually.

And earlier, I guess, we were here with boards, so building cars is kind of hard. Now let's start building, I don't know, our next panel with submarines and aircraft carriers. So labor has been a big constraint for shipbuilders, and it seems like it's improving a little bit with COVID. So where are you now for shipyards for labor availability, productivity? And how are retention rates trending versus where you need them to, to meet the demand in front of you?

Yes. So labor is better, right? We're ahead of our plan for labor for the year. We said we'd hire about 5,000. We're ahead of that plan through Q2. And I think we figured out the availability part of labor. Retention is something we're still working very hard at. We're doing somewhat unorthodox things in manufacturing, where we're doing pilots of 4/10s, which is interesting because we're having a hard time just getting people to stay at work. And if we give them another day off and they work 10 hours, we think we can get some traction there. We're doing stuff with the walk-in people. So first, let me say that if you get people through our apprentice schools and junior colleges and the high schools and they choose the career, they stay. We're at very high retention rate on those people. Then unfortunately, that's only between 10% and 30% of our workforce. The balance of it are walk-ins. And so we've changed our walk-in strategy. 20 years ago, walk in, trained, put them out in the yard and they stay. Now we have to -- in the training program, keep them with their cohort that they're training with. We bring a foreman into the training -- into the training building, and they train with them, and then we put the foreman with that team out into the shipyard. So they have a community, and we believe that will improve retention. We're not quite there yet, but we're working very hard at it.

On the retention issue, where are you losing them? Where are they going?

Everywhere, right? And the challenge here is they're just not showing up to work, right? If they don't come in, it's hard to track down where they've gone, right? It's different than giving a notice, right? So that's -- we're trying to beat that by the cultural part of it, which is if you believe -- if you understand the career, if you understand you're on a team, and you can get through the first 6 to 12 months, then you have a much higher probability of staying.

Great. That's helpful color. So last month, you were awarded a multiyear contract for 6 DDG 51s after a competitive bid. So how does this award impact Ingalls and do you have sufficient capacity to layer in this incremental work for this destroyer?

Well, actually, it was 7. So it was 9 with an option for 1. We won 6 out of the 9 and then we got the option contract, so 7 out of 10. So Ingalls is performing very well. They delivered their first Flight III ship earlier in the year, and they're progressing on other Flight IIIs. So Ingalls is solid. The LPD, LHA and DDG work really solidifies that portfolio for the next 6 to 10 to 12 years. And you add on to that LPD 33 and potential additional amphibs where it's pretty clear that 31 amphibs is the law, right? And so you add that in and then Ingalls is really solid for the next 10 to 15 years.

Great. That's good to hear. I can't believe I missed the 1 option.

That's okay. That's why I'm here.

So Congress has grown increasingly vocal about the fragility in the shipbuilding industrial base. So do you see any appetite for public investment in shipyards? And then also, with that fragility, what are you getting from the government regarding incremental support?

Well, it's interesting, the government is really stepping up through industrial-based funding. Primarily submarine industrial-based funding, where they're contributing to not only our shipyards and helping us out with capital investment, but also the supply chain. Because as fragile as the shipyards are and we're just trying to get more capacity, right? We're going to be there. The issue is supply chain where you have single source or sole source suppliers that don't have the capital or the balance sheet to make investment. And that we're reaching down through our DDG and DCS contracts, reaching down to the supply base to keep them healthy. So the government is absolutely stepping out to try to bolster that supply base.

And does that change margin profile? Are they providing more...

Just creates stability. It definitely creates stability for the -- for your schedules.

Great. And also not having disruptions through CRs is probably helpful for multiyear programs?

Correct.

For acquisitions, you guys have made strategic acquisitions over the years. You bought Hydroid, Alion. I don't know if I pronounced it well.

Alion, think a lion.

Alion. And that's broadened out your technology and capability for AI, ML and AI is like the big Wall Street theme.

It's funny to bring that up because we've had -- we've been working in AI for 5 years, right? It's embedded in a number of our programs within Mission Technologies that we're using for our customers, not only Navy, but other customers. So I think the defense space is kind of an early adopter of AI tools, not -- it's not broadly on platforms, but there are AI tools out there that are being used.

So can you expand on that to the extent that you can? I'm sure there are a lot that you can't talk about. What does AI mean for a shipyard?

Well, see, that's the issue in the shipyard. I can give you examples of how we're employing AI in the shipyard to pull quality data to get a root cause analysis on what's going on within that quality data to help us make decisions more quickly on where we need to focus, right? So we're employing it there. But more importantly is using AI tools to help the customer fight the fight. So Mission Technologies is $2.6 billion, almost $2.5 billion this year, I think, but growing. They employ a material amount of AI in tools that they're providing for the government in cyber, in offensive defensive cyber, in ISR, in bundling capabilities of space. It's something that we've been doing for a while and we'll continue to do it.

And so what's your appetite for more M&A into more AI capabilities?

We're going -- we're getting out of debt now, right? So we just paid off $400 million payment on one of our debt instruments. We've got, I think, $150 million to $200 million left to go to pay off really the debt we acquired the majority of it through Alion. No real appetite right now. We evaluate opportunities from time to time, but it's not really on our list right now. We don't think we need to acquire AI assets. We think we have them already.

Great. Maybe moving on to the traditional ships, AUKUS. So it's an agreement with the U.S., U.K., Australia and its plans to equip Australia with up to 5 Virginia-class submarines. So with the Pillar 1 of AUKUS, like what is that opportunity for HII? How should we think about the timing? And then also, what's the shape of AUKUS? Do the government know like what does this actually look like?

So the interesting thing -- the submarine or the program or the shape of, I'm not sure what you're asking about.

All of the above. [indiscernible]

It's universally supported, right. I've got friends in the audience. So it's universally supported, Australia, U.K., U.S., right? I'm a little distracted here. So I got an old college drilling teammate in the audience here. So universally supported by all 3 countries, Pentagon, White House, Congress. So it's rare that you get a program like that, that is as supported as it is. So for us, it's opening up 2 markets. It's the U.K. and Australia, it's nuclear shipbuilding. So we obviously do shipbuilding very well. We do nuclear very well, not only nuclear and Newport News, but nuclear and Mission Technologies where we are on the DOE sites. So it's really an opening up of 2 markets for us. We're helping already with the Navy as they're leading the AUKUS efforts on Pillar I. And we're answering RFIs on Pillar 2 now in cyber, AI/ML and all the different technologies that are in Pillar II.

And part of the partnership is also with building up indigenous capabilities for them, so how do you think about your role versus the indigenous capabilities that they want to build? And how do you see your role in AUKUS. Like are you going to build it for them? Are you going to teach them how to build it?

Both. Actually both. So one of the interesting things we're doing in AUKUS and in Australia is offering to help them with the supply chain. So doing the valuation of their supply chain in Australia to see what they can build and building a capability over in Australia to build parts of the submarine. So we'll build some of it potentially. We will help them build some of it potentially. We'll develop suppliers. But that's down the road a bit. We think of it as a -- there's really not material short-term revenue possibility there. It's more medium and long term.

And what are the milestones we should watch with Pillar 1?

A good milestone is getting the export rules approved through Congress. I think there's support for that. We've been working very closely to ensure that those get approved. I know Senator Wicker had some comments about -- he's doing all the right stuff. He wants to make sure there's adequate funding for all of the activity before that gets approved. But we need to make sure that that gets approved. And then you need to start to look for funding to start showing up in the shipyards for activity to get them ready. They had the first cadets, I think, graduate from Nuclear Power School, which is really interesting. So embedding Australia, Australian individuals within Newport News and Electric Boat will be next, both to learn the nuclear culture, how to build, how to engineer and the quality process around nuclear ships, that is happening, will happen over the next couple of years. So what's happening, it's going to be very deliberate, and we're going to have to follow the Navy's lead, but we think it's a pretty interesting opportunity.

And Chris, would you like to quantify how much AUKUS could mean for HII?

No, but it's about $350 billion over the next 30 years in U.S. dollars, I believe.

How much of that could you get?

I don't want to project at this time.

It's a pretty chunky number though.

It's a big number, right.

Great. And maybe on -- back to the M&A portion, again, like over the past few years, you've gone about your portfolio, you talked about the delevering portion. You mentioned that AI/ML may not necessarily be a priority for that. But as you delever, what are you going to use the capital for? And how much appetite do you have to do more deals? And are there portions of the portfolio that you want to expand into?

So we've been pretty clear that over the next couple of years, we're going to provide all excess cash back to back to shareholders, right? We've gone through an acquisition sort of activity over the last couple of years. We've been paying down our debt. So we need to step up the share buyback over the next couple of years on all like excess cash, and that's what we're going to do. Beyond that, we'll evaluate if we can generate a return that we'll evaluate opportunities as they arrive.

Great. Now I feel like this comes up pretty seriously every, what, like 10, 20 years. The Navy's discussion, the never-ending debate of big aircraft carriers that you can't hide versus a more distributed force. How should we think about where we are in the debate now?

It's an interesting hide. I can hide an aircraft carrier better than I can hide a fixed landing strip, okay? So that's an interesting point. There's no debate. There's really not -- it's not an ongoing debate on aircraft carriers right now. We're building 3. There's another one in the budget, and China is building aircraft carriers. And so what do we think they're going to do with them, right? So we think the aircraft carrier business is solid, and we're going to continue it at Newport News. But the interesting thing is it's not either or. It's not technology or aircraft carriers, it's both. So you need to couple the aircraft carriers and other large capital ships with technologies just increases their power.

And how do you think about the distributed force? Is there an opportunity for you for more unmanned surface vehicles or unmanned undersea vehicles? And when you think about the volume that we could need and right now that amount is a lot lower than the air drones that the U.S. Air Force has versus what the U.S. Navy has for unmanned capabilities. Where are we on that evolution for...

So we're the largest provider of unmanned underwater vehicles to the U.S. Navy. And we sell 30% of them internationally. So we have commercial variance that we sell in the Pacific, in Europe to our allies. It's coming. There's going to be more unmanned platforms, both surface and undersea. They're going to be coupled with manned platforms and they do a lot of missions. One of them is sensor nodes, right? So that's distributed maritime operations. And that's what they talk about when they talk about having an unmanned fleet with sensors connected to manned ships and connected through big data and AI and ML. So it's coming. The technology is coming. There are a number of projects taking place in the Pacific over the next 12 to 18 months where we'll test out different systems with unmanned and manned platforms and technology to connect all those platforms. So it's absolutely coming. It's not going to replace manned platforms, but it does definitely expand the power of the manned fleet.

So for the international component of the export piece, how much more profitable is that versus your existing portfolio? Is this accretive?

Absolutely.

And when you think about coverage, right? I mean, I guess, innings-wise, where are we in the cycle for unmanned undersea or surface technologies? Because I think on the aviation side, it's pretty mature and where would you characterize us in the Navy? And also, should we get to that peak? I mean, what could that mean for you?

Yes. So it's not -- I'm not going to provide guidance on how big that could potentially be for us. We are the largest provider of it. We've got some good program wins in that regard. They're not at the elbow in the curve yet. It's still fairly modest. But as these tests happen, as the war games happen, as you test out the technology, it will definitely ramp over the next 10 years.

Great. And maybe looking at the next 12 to 24 months, what are you most worried about?

Look, we have a significant backlog in shipbuilding, enough work to do. We've got -- we had $4 billion -- over $4 billion of awards in Mission Technologies through the first part of the year. It's growing very well. We're very happy with how Mission Technologies is doing. I'm very happy with the bundling we've been doing within the organizations and the reach out we've done into the CoComs and helping them solve their problems. So it's not an issue of enough business. It's -- the biggest challenge for me is labor. And it's not really hiring anymore, it's solving the who we're going to retain and make them productive. So that's the biggest. It's the #1 thing I talk about almost every staff meeting. It's what I deal with the shipyard organizations in their hiring and their retention plans. They're being very innovative. We've done it before. We rebuilt a shipyard after Ingalls. We built the labor force after Ingalls. We can do it again. But that's my biggest issue over the next 12 to 24 months.

Great. And maybe the opposite of that, I'm turning optimist. What are you most excited about in terms of the business in front of you and opportunities for the company?

Yes. So I think the growth in front of us, if we can capture this labor force, looks very positive. I'm not prepared to talk about that as of yet. We need to roll up our plans and ensure that we have that squared away before we provide guidance. But the growth in Mission Technologies with all the wins they've had over the first part of the year, the labor getting squared away and ship building -- all the wins we've had in shipbuilding and that growth rate potentially being better, I think it was a real opportunity over the next 5 to 10 years that to provide pretty significant growth in cash flow that provides us a lot of alternatives providing it back to shareholders, potentially growth opportunities. We're investing in IRAD and the customer is investing in IRAD to solve some of the largest problems that we have in the Pacific. We're getting some traction there. So I think the next 5 to 10 years could be very, very good. We just need to focus on the fundamentals in our shipyards, getting the people hired, get them trained up and being productive. And I think we'll be in a great place.

Great. So we have some time for questions in the audience. So if you want to ask a question, please raise your hand, and we'll give you a mic. Sorry, can you wait for the mic? Yes.

Can you just expand on the labor issues? Because from the outside in, it'd be pretty awesome to work on some of your stuff. So I just don't understand from a high level what's going on. So I'd love you to drill down a little deeper.

Yes. So it is awesome to work on our stuff, right? So the most powerful weapons in the world. It's -- and the challenge is you get an 18- or a 19-year-old come into the yard, they walk in, they see an ad. They apply. Historically, they respond to that ad. We trained them up and got them efficient, and we sent them out in the yard and -- with people, they don't know. And 20 years ago, that was okay, right? They sucked it up and they dealt with it. Kids now you have to meet them where they're at, right? They want some flexibility, they want a culture that they can believe in, they want a mission. And so if we -- what we've done is we're going earlier in the process before they get into the shipyard, we've got to get on the same page with them relative to the mission, the culture, who their teammates are, who their leader is. And if they trust their leader and their teammates around them, they'll stay. And so that's what we're working on. We've got to solve that problem before they actually go into the shipyard and start to work. And if we can do that, then we're going to be in a pretty good place. So our initial returns on the 4/10s are interesting, right? They're a little better. And so the absentee is down a little bit. And if we can take advantage of that, it's all about attendance, showing up for work and getting repetitive in what you're doing to get on the learning curve. So my old boss, Michael, the last CEO used to call, "Really, we're a labor development company. It's what we do. We develop labor." And so we're testing this right now, and we're going to continue to -- I think we'll be successful at it. I do. Because we're very focused on it. The -- both shipyards are behind it 100%. So first thing we talk about every meeting is how we're doing labor attrition, what's the overtime. Overtime is solid. Attendance is getting a little better. So yes, just capturing the hearts and minds of those 18- and 19-year-olds is more challenging than it used to be.

Also on Wall Street.

Is it the same issue?

I finally got a new person in my team. She's not here today, but be nice to Gabby and my team, please. I don't want her to quit. So I got her from the campus class, very competitive. So I'm excited. But back to that labor thing. I mean I remembered a few years ago, I visited Newport News in June, it was hot. And if you're welding in the Virginia summer out in a shipyard and sun, I mean, that must be a difficult -- what are...

Shipbuilders are one of the toughest people in the world. You can come down in June whenever you want. You go out now it's...

I'd like to join in winter. I came out of that tour like covered in rust. I didn't even roll around the shipyard.

Interesting, if you survive 12 to 18 months, you learn to love it, it gets in your blood. It's the romance of shipbuilding. So it's just part of that. We just got to keep them for that 12 to 18 months. They understand it's a career. There's great benefits. And if I can get them there, then they stay.

Yes. But then is there an opportunity in terms of either better working conditions. I remember, right, if you're building something in a shipyard that's like x times, but then if you're doing it modular, where you're in the shade or in air-conditioned conditions, are these investments that you could meet with the government in order to improve the working conditions because I mean I think well...

They absolutely pay off. Getting things under cover is very important. Ingalls had an initiative over the last couple of years to get as much as they could under cover. And they did that. Ingalls' deck yard has transformed over the last 10 years from a lot of stuff, a lot of units being built outside to undercover. Newport News is doing similar things now. The more we can improve the working conditions, it just gets better and it's more efficient. So we're doing that. But unfortunately, you can't put a building on top of the entire shipyard.

Yes, it's a big ship. 13 stories. It is wider than it is all for an aircraft carrier.

I'm sorry?

13 stories wider than it is tall, right? I mean...

Yes, it's interesting, once you get in the water, you can start to put air conditioning in it. So the real challenge is when you're out in the [indiscernible] and you're building up the units, that's where the real challenge is you need to get that under cover because you can't air condition that.

So any other questions from the audience? What do you think investors are most missing from your stock?

I think they're starting to get the Mission Technologies story. It's a cost-plus business, so the margin profile isn't as attractive as some of their peers. But the converse of that, it's a lot of development projects that is IRAD, so it has got really talented technical teams over at Mission Technologies solving the biggest problems for the DoD across not only the Navy, but the other services as well. And so that's kind of a hidden -- this isn't an IT company doing IT services. This is a technology company solving technology issues for the customer. So I don't think that The Street has fully understood that yet. I think they're starting to understand it. But there's this intersection between platforms and pure technology that's happening between services and platforms that's happening, which is how you're going to fight the fight. You are going to fight the fight with platforms, big data, AI/ML and sensors. And people can't make those decisions quickly enough. We have an LVC enterprise that starts this training -- live virtual constructive training, but it's so much more than that. They don't -- they aren't doing the actual classroom training. It's software, it's games. It's the ability to develop OPLANs very quickly so that you can reposition your force very quickly in a game, right? It's game software. So I just don't think people understand that. You think about contested logistics. And in the Pacific, you've got to have a very good contested logistics technology because things are going to happen so fast. And if you don't know what -- if you don't have a OPLAN that's prepared to take advantage of that contingency, then you're going to be out of the game. You've got to have that software already ready when if anything should ever happen, so that your logistics is squared away because the Pacific is a very large ocean. So they're starting to understand it. But the ability to solve those problems for the customer has opened doors for us within shipbuilding and the ability to couple those 2 together, it's been very important. So they're starting to understand, but not fully yet.

Yes. That's a really interesting takeaway, right, because it's a little bit away from the traditional shipbuilder type work. So can you expand a little bit more? Is there a particular project that you could talk about that showcases that differentiation? And also why you? Why HII? Why are you guys are better at this than some of the other?

Alion has been doing it for a long time. Think of the big data platform, it's a cyber platform where we ingest, I think the most publicly available data have anyone, right, with the relationship with AWS. And that big data platform has been in use by the government and various government agencies for a while now. No one would know that, that HII does that. It was a legacy Alion organization that had been in place doing this. So our cyber capability is pretty amazing. People don't think about HII and cyber, but we're embedded in some of the most important programs that exist in those agencies. So it's just -- they're getting there. They'll get there. We're still thought of as a shipbuilder, but we're opening some eyes. And if we continue to grow, the $4 billion of awards is pretty amazing over the first half of the year, which should add some pretty good growth. And so they'll get there.

That's really interesting takeaway. Well, great. Thank you very much, Chris. This concludes our presentation with HII, and hope to see you guys later this afternoon.

Thanks, Kristine.