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

So I'm Doug Harned, Bernstein's Aerospace and Defense Analyst. And I'm really happy to have with us again Chris Kastner, the President and CEO of Huntington Ingalls, are now HII is the right name.

HII. It's easier to say.

Okay. So to start with, you have?

Safe harbor statement, yes. Remember, all safe harbor rules apply during the presentation. So just keep that in mind.

Good. Well, Chris, I wanted just to start, like we were sitting here 2 years ago, I think, and that was shortly after you had taken over as CEO. Maybe you could start out by telling us a little bit about how things have evolved over these 2 years? What kind of progress you see at the company and where you're headed?

Yes. So I think shipbuilding, the demand in shipbuilding is pretty unprecedented, the $32 billion budget that showed up in contrast to $12 billion to $15 billion that we had historically kind of counted on. We were always concerned about the Columbia-class crowding out other shipbuilding programs and other ship classes, specifically amphibs, that has not happened with Columbia-class, has happened, and the other ship classes have continued. So the demand environment and the demand for ships is new and positive and important for us to react to AUKUS, it was an unexpected highlight where we essentially have 2 markets that are open to us now, when you think about Australia and the U.K. Mission Technologies has developed beyond what our expectations were, and we had pretty high expectations for Mission Technologies, but their growth has been pretty significant. You think about 13% last year and 20% quarter-over-quarter. So it's developed pretty positively. We're essentially out of debt from the Alion transaction, have our balance sheet where we want it to be, but there's still challenges that persist. Supply chain, we think, has stabilized. The lead times have stabilized, but their inflationary pricing that's showing up, which could impact buying power. And then labor, which is our biggest risk. We need to continue to attract. We're doing okay in hiring. Retention is still a challenge, mostly in the new workforce that we get, keeping them. So that's our major risk going forward. And we're actually in a pretty good place from a demand standpoint. I'd much rather be in this place than in the alternative, with too many people and not enough work to do. So we've done it before. We fixed labor before. After Hurricane Katrina, we built a workforce down in Mississippi, so we know how to do this at our core. Mike used to say, we're a workforce development company, the ex-CEO, my old boss. And we really are, we're a workforce development company and that's what we're going to do. So I'm really happy with where we are right now. But we have to execute, now it's time to execute.

You mentioned the budget. And when you look at the budget, like the 2025 budget is coming in, but it's constrained by congressional caps. I know shipbuilding is tending to do pretty well. But perhaps you can talk a little bit about how you see that environment, particularly with respect to Congress. As we work through this, it was a brutal process last year. Do you see the potential for things to get better in a sense because I think if you want to keep that ramp going, it's going to need to?

I'm not sure the process is going to get any better. It's going to be a challenge going through the election. So that's going to be a challenge. I obviously, I think there's going to be -- I'm not the only one out there, pretty much everyone thinks there's going to be a CR, and we'll wait for the election before we get a budget done. It's positive, even at the baseline levels, the constrained levels of the budget agreement, that's a $32 billion deal. All our programs are supported. They support all our growth rates. So that is a pretty great place to be, that $32 billion. Now if it grows from there, we'll be in a better place. And all our programs are supported in the '25 budget. I actually got some added language this last week on the aircraft carriers, getting a long way for CVN 82, which is positive. And some of the discussions around the additional submarine, the material will get funded for that. Now we just have to see if the entire submarine is funded. It won't really impact our guidance much, but it's an indicator. So yes, the budgetary environment is very positive. The Navy really needs our ships, we need to deliver.

Well, but one of the other aspects of this is inflation. And when you look at the DDGs that you won, you had a great win with 7 from that in this last tranche. But the prices look to us like about 40% higher than the previous ones back in 2018. How do you see the budget working when you've got this back up? On one hand, I could say this is positive because you get funded for all of this, and you get a similar percent margin on fixed price contracts on a bigger number. So that's what could be really good for dollar value. But on the other side of this, it's all got to fit within that budget number. How do you work that?

Yes, the call comes down to the negotiation table. We have really good cost and pricing data on those inflationary increase. We're one of the few companies that -- we're building the same thing every other year or every 2 years or every 3 years. We have really good bill of material and have very good data on inflation, which we can support with our customer. Now the challenging part is, I can't build half an aircraft carrier or 0.8 aircraft carriers. You got to build a whole aircraft carrier. So that puts some pressure on it, as you indicated. I'd like to think the former, is that I deserve an appropriate level of profit based on the cost basis that we propose. I understand there's inflationary issues on the budget and could impact buying power. But we deserve a fair deal. So that's going to be the challenge at the table, at the negotiation table. There's a lot of levers we can pull relative to EPA clauses. One of the benefits that I think we've talked about previously is some of these larger ships are incrementally funded. So you can push some of the inflationary impacts down the road to the next fiscal year. So that's a benefit. But your issue is very real. It's not just shipbuilding, this inflation has grown. It's starting to show up in prices. I'm not sure the budget has reflected that.

Yes. When you put all of this together for shipbuilding, I mean, when Mike Petters was CEO, he used -- it was sort of like a universal constant that you would grow it, shipbuilding at 3%, maybe 3.5% per year. And now you're talking about 4-plus percent. And can you describe what has happened that gets you to that higher growth rates?

Well, just a lot of confidence in the demand environment and then it will be constrained by labor, right? So you have to actually earn the progress in order to book the sales. So we absolutely have line of sight on the work because the budgets have been so good. Now it's executing in the supply chain, executing on your programs to generate the sales. That's kind of a risk-adjusted growth rate, so it's kind of right down the middle and it's something we feel good about in the medium to long term for sure. There could be some variations over the next couple of years. But in the medium to long term, 4% makes a lot of sense to us in shipbuilding.

And how does that fit? How does that 4%? Is that 4% -- you've got higher input costs that affect that. You've got more program wins that affect that. Is there a way to discern like getting from the 3% to the 4-plus? What's been more important there? In other words, higher pricing or program?

It's more programs contribute to it significantly. I think inflation could add to that and create a bit of a tailwind there as we realize that within the programs. But your issue relative to buying power factors into that as well, and how much you can get through your factory. So we wrap all of that together when we develop those forecasts.

Okay. On margins, you've talked about it, Mike Petters has talked about it. Long-term, good shipbuilding program, good shipyard, should be earning a 9% to 10% type margin. Consider the mix of maturing fixed price, development work.

That's right.

It means you've certainly been doing that and doing better at Ingalls. When you look at import news, what's the path to get there?

Yes. So it's not a different recipe than what we did at Ingalls. I was a CFO in Ingalls when we executed that actually. We had 5 ships in a forward loss at Ingalls. We were coming out of that, and the key was to get to the other side, understand all that cost data and ensure that you get the next contract with all that cost data in the pace. So we negotiate LPD 26, LPD 27, NSC 4, NSC 5, NSC 6, LHA 7, all of those ships on the back of those 4 in a forward loss. And those ships form the basis of the pretty excellent performance along with DDGs. At Ingalls, over the last 10 years, they've been very consistent. Newport News is in a similar place that Ingalls was. Fortunately, they don't have forward losses. It's been stable. It's not where we want them to be, but it's been stable. And we need to get to the other side of the ships that were negotiated pre-COVID and then get to the ships negotiated to post-COVID where all that cost data is in it. Now we still have Block V to get through. We have the CVN 79 to get through, Block IV is not done. The 2 aircraft carriers, fortunately, we put -- we attached them in there for inflation on material, which has protected us on aircraft carriers a bit. But really, you need to get to the other side on the new ships. We're going to negotiate 21 ships over the next 12 months, both in the submarine, VCS, Columbia, Block VI, built 2 of Columbia-class and the amphib bundle, 4 ships, 4 amphibs. So it's the same recipe that we executed down at Ingalls, we're executing at Newport News.

So does that suggest that at Newport News, once you -- if you get through these Block VI negotiations well, once you've got a significant amount of work on the Block VI group, you could be up at that?

Well, I expect Block V will be better than Block IV, simply because Block IV was built during COVID, right, not only negotiated before COVID but built during COVID. Block V, I think, has some upside even though it was priced and negotiated before COVID. But then when you really get into Block VI and the next submarines, I think you have an opportunity to increase the profitability. But as you know, we're pretty conservative when we start a ship and we start a ship program. So we got to retire risk before we get there.

In Block V, your -- I mean, scope for you is pretty similar to Block IV.

Yes. Now the payload modules, we don't do, which is a part of the Block V, that's Electric Boats statement of work. But it's a little less total value, but about the same, bolster sales.

Where are you now? Can you say -- I mean I thought you pretty much through Block IV, right?

Right? We have 2 more to deliver. 798 will be delivered this year. 800 will float off this year and delivered subsequently. So most of our content is Block V right now by far. But we're only between 40% and 50% complete on the first Block V boat. So they're going through the production process, but it's still new, it's still starting.

But one would think that because of the similarity, you could get better performance out of Block V, so as that goes through, you should see better margin performance?

We should. We should.

So one of the -- switching gears a little bit. CapEx, it was low in Q1. You're guiding to 5.6% of sales. You do have advances. Can you just walk through -- that looks like a big CapEx increase. But I think effectively, it's probably not.

Yes. So the customers, we work with the customers and we have large CapEx projects that we think will have an impact on our programs. And they -- we say, hey, look, there's not an ROI for us to make this total investment. So we need you to contribute. And we work out with them so we can offset a significant amount of the expense of the capital. From a net cash standpoint, it doesn't impact you as much. So the $3.6 billion that we've committed to over 5 years in free cash flow is not impacted. Even with the increase in capital, we could still meet that commitment.

And you expect that you'll be back kind of in that 2.5%?

Unless there's a capital project that the customer wants to partner with us that could impact the facility significantly.

Yes. So on Newport News, one of the things that I think you all have seen as challenging over time has been the amount of complexity there. You've got the overhauls, you've got programs, you've got Virginia-class, Columbia-class. So a lot going on there. How do you manage that? It's quite different than if you're sitting up at bath or something where you're kind of doing one thing.

Yes, it's completely different. And Ingalls had this as well, they had 5 ship classes coming out of Katrina. And when Mike came, he said, "Hey, look." And brought Irwin Edenzon, who was the President there when I was a CFO. I was like, we're going to have an operating system. Everybody is going to manage every program in the exact same way. Same nomenclature, same tools, systems, processes. You're going to report out the same way. It's going to be an operating system that I can take a foreman from the LPD class over the DDG class. We did the exact because historically, Newport News has been a 2-program yard. Some range aircraft carriers, right? And they did not necessarily manage those 2 programs the same way. Leadership didn't move around very much between the 2. When we saw the complexity showing up, we said, "Hey, look, we need this operating system very similar to what Ingalls does over Newport News." And they've seen it. They've implemented it. They've improved upon it. So they have a very robust operating system in Newport News now such that all those programs are managed the same way. It takes a lot of the complexity out of it.

So how do we see that? I know there's among most of us, there's this hunger to see that margin uplift, haven't really seen it yet. So like when should we start seeing more evidence of all the things you're doing there in the margins?

Yes. So leading indicators that may not show up in margin right away is adherence to program schedules. We talk about milestones and they're not directly related to margin performance because step-ups, sometimes there's more or less or you've done in the quarter earlier. But in shipbuilding, because there's so much labor involved, schedule and costs are pretty closely related. So if you miss schedules or you make schedules, you are going to heavily impact how you're performing. So I think the best indicator is to look at the program schedules, adherence to milestones, and that will be a pretty good relationship to how we're performing.

Because you had a couple of slips, right?

We did.

And when you look forward, how do we get -- I'm just trying to understand what?

So 796, 798 and 800 are important this year, right, getting those done by the end of the year. Now it's not a -- it's really risk retirement on those boats, because if they stay until the first and second quarter of next year, it's going to cost more, which is a P&L impact.

Yes. Now as far as labor goes, you've talked about getting 5,000 in this year.

6,000. Yes.

6,000. Yes. And I mean, this has been an ongoing process each year. Can you talk about how things have evolved over time? You've had to really rebuild sort of post-COVID. How has that process gone on the larger workforce?

Yes. So we're miles better from a hiring standpoint and knowing where to go get and hire people, hire them quickly, get them trained to get them on the deck play. That's just miles better from when we started post-COVID. We still have challenges on attrition and keeping people on the job. There's not just one thing, unfortunately, there's a number of things that we're addressing to deal with that, and they revolve around 3 issues. One is increasing pay. That's kind of the easy default. Let's just pay them more. I can't afford to pay everybody more like that. So we're doing pilots, select pilots with participation from the Navy on some interesting incentives they put on the [ 23 ] DDG 51 contract. If you're aware of that, the workforce incentive they have on that contract. We're using that and doing some internal investment down at Ingalls to pay select, perhaps more, to see if it will impact attrition. There are some positive indicators, but it's not an update yet for us to think that it's the only thing that's going to solve it. We're doing that in Ingalls and Newport News as well with the specific performance incentives for specific high-risk crafts, stuff like machinists and welders. We're also recruiting, using analytical tools, in regions, micro regions around the shipyards where we know that if you hire someone from there, they'll stay, high likelihood to stay. We know that we hire people from a specific region, they come for 2 weeks and leave, we're not recruiting there anymore. And we're also having to be much more flexible with the workforce. Gone are the days where you hire somebody and just say, go to work, right? That just doesn't work anymore. So you have to train them, you have to talk to them about their career, about their future. You have to ensure that you check in once they're hired and out the deck play. You have to treat them well. You have to get more flexibility and give them more time off, so they don't just quit. And so unfortunately, it's just not one thing. If we can get people into the community colleges, regional development centers or apprentice schools, in the high schools, if they can choose being a shipbuilder and get enrolled in those programs, they stay. The people who just show up and respond to an ad and walk in, it's a challenge. Veterans is very powerful, with 17% veterans in the company. If I can get a veteran and that's a win, that's a win because they believe in the mission and they'll stay.

Now have you had -- I know at one time, there was a concern that there are other businesses that would be hiring. And that certainly happened a long time ago in Ingalls with oilfield services.

Construction during Katrina? Yes. So I was there, I was on the major EPC and I were on a panel. I won't name the company, but they said they have 115,000 people in the Gulf Coast. And I looked at it and like, what are you doing? But they've got an LNG terminal in Texas they're going to build. So they're going to hire a bunch of people. So that demand is out there, construction, any manufacturing organization needs good people.

Has there been more pressure on Newport News or less recently from competing industries today?

It's been pretty consistent in both facilities. It's been pretty consistent. It hasn't gotten worse, haven't gotten really better yet either.

Well, you said you're on track for hiring this year.

Yes. Yes.

But you and I talked about this before. One of the things that has always been a concern for us has been getting that sort of Top 100 shipbuilders that really have that institutional expertise. And I think of it as more important in shipbuilding than a lot of other things because there's a lot, probably the wrong word, but it's sort of an art to this because they take a long time, they're so complex. Like where are you in terms of having, kind of after losing people during COVID, this highly experienced people?

So we did lose a lot of people during COVID. A couple of things, what started to show up. I was asked yesterday or last week, what most excites you about the business right now? And there's a core group of 35 to 45 year olds that are working on the VCS program that you can just see it in their eyes that they don't want to fail. I ask the people managing 798 and 800 right now. And I asked them, look, we just missed last year, both those, I call it the drift, a little scheduled drift at the end of the year. We're supposed to get done, we didn't. Explain to me how you're going to get done this year, 798, 800. And they were aggressively adamant that they're going to get it done, right? So there's a group of 35 to 45 year olds that are emerging, that are taking the place of those shipbuilders that are between 55 and 65 that have taken every ship to sea at Newport News over the last 25 years. And a shipbuilder really learns when they travel the last 12 months of a ship, they get it ready to go to sea, they take it to sea because you can't pass your problems down the road. When you go to sea, you need to be done. So I'm encouraged by that. I think the more deliveries you make, the better it's going to be, and we're going to build back that core group of people that we lost during COVID.

Yes. Well, when we look at Newport News, you talked earlier about this 4-plus percent growth rate over the next, like, 5 years or so?

Yes, 10 to 15 years. This is a long-term business, right?

Well, so here's something that we have struggled with. So if I look at the Newport News and take like the Navy plan for Virginia-class, and look at how that goes up to the 2 boats per year between you and Electric Boat. And then I look at where pricing goes, we end up with something that's way higher than 4% growth rate.

Well, you have to be able to execute it. So you have some limiting factors here on your delivery schedules from your suppliers and the labor that you have employed in the shipyards. So you could call me conservative, that's fine, but we need to mitigate that. We want to get ahead of ourselves relative to a growth rate.

What either this does generally.

That's right.

I mean so what I'm trying to understand is if there's a disconnect between what the Navy is putting out there in their plans and what is really achievable, given all of the operational constraints on the ground?

Well, so the Navy is making significant investments to offset all those constraints on the ground. The industrial base funding gets into the supply chain, gets into our shipyards, gets into technology with additive manufacturing. It gets into workforce development. So they're really leaning in to try to solve a lot of those problems. If we do get back on a cadence that accelerates during Block VI and Columbia-class, it could be in excess of 4%, absolutely.

I guess, does it -- when you look at future budgets, there's the progress you're making. In other words, if they keep budgeting to per year, but in Electric Boat, they're going at 1.4, isn't there a point where they would have to slow that deal?

Then you would think, but we're going to recover. It's going to recover. We're building that capacity now. All that industrial base capacity, all the tooling, all the equipment or just the expansion that's going on, all the investments in the supply chain, we're going to incrementally get better.

Yes. Is there any way to project when you might be able to get to that, too?

We have a lot of projections on us getting better to achieve that. I don't think any of that's public, but we're going to incrementally get better.

Okay. And when you're talking about the industrial base, is that the -- were you specifically referring to like the supplemental money that's coming in?

Yes. So in the baseline budget in '23, there was seed money as well. But yes, the $3 billion, $3.3 billion of seed in the supplemental. There'll be more supplemental. I think, over the 5 years, it was about $11 billion allocated for industrial submarine, industrial base money.