亨廷頓·英格爾斯工業 (HII) 2018 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Q3 2018 Huntington Ingalls Industries Earnings Conference Call. (Operator Instructions) As a reminder, this conference is being recorded.

I would now like to turn the call over to Dwayne Blake, Vice President Investor Relations. Please go ahead.

Thanks, Sara. Good morning, and welcome to the Huntington Ingalls Industries Third Quarter 2018 Earnings Conference Call. Chris Kastner, Executive Vice President Business Management and CFO is out with the flu, so Mike Petters, President and Chief Executive Officer and I will be handling the call today.

As a reminder, statements made in today's call that are not historical fact are considered forward-looking statements and are made pursuant to the safe harbor provisions of federal securities law. And actual results may differ. Please refer to our SEC filings for description of some of the factors that may cause actual results to vary materially from anticipated results.

Also in our remarks today, Mike and I will refer to certain non-GAAP measures. Reconciliations of these metrics to the comparable GAAP measures are included in the appendix to our earnings presentation that is posted on our website.

We plan to address the posted presentation slides during the call to supplement our comments. Please access our website at huntingtoningalls.com, and click on the Investor Relations link to view the presentation as well as our earning presentation.

Mike, turn the call over to you.

Thanks, Dwayne. And I want to pass along our best wishes to Chris, I hope he feels better. I hope this call will help him feel better. Good morning to everyone else, and thanks for joining us. Today, we released third quarter 2018 financial results that continue to meet our performance expectations for the business. So let me share some highlights starting on Slide 3 of the presentation. Our sales of $2.1 billion for the quarter were up 12% higher than the third quarter of 2017. Diluted EPS was $5.29 for the quarter compared to $3.27 last year. We received approximately $2.8 billion in new contract awards during the quarter, including full funding for the first 2 ships of the Flight III DDG competition. As a result, our backlog was approximately $22 billion at the end of the quarter, of which approximately $17 billion is funded.

The 6 ship DDG contract represents one of the first awards that will form the foundation to support the business for the next 10 to 15 years. On the horizon, our CVN-80 and 81, VCS Block V, NSC 10 and 11, and LPD Flight II, as noted during our first quarter earnings call, all of this contracting activity supports our sales outlook for the next 5 years and is expected to result in the award of base contracts or options to be exercised for 20 to 30 ships by the end of 2020.

Turning to capital deployment for a moment. During our November 2015 Investor Day meeting, we committed to investing in the business through CapEx and returning substantially all free cash flow to shareholders through dividend increases of at least 10% annually and share repurchases. Since that time, we have made substantial progress in modernizing our shipbuilding facilities at Ingalls and Newport News, by investing over $900 million in capital expenditures. In addition, we have increased our dividend in excess of 10% each year and our most recent increase from $0.72 to $0.86 per share, announced yesterday, continues this commitment.

And we have also repurchased 4.9 million shares at a cost of roughly $1 billion from 2016 through the third quarter of this year.

Regarding activities in Washington, the President recently signed a minibus appropriations bill for 2019 that included funding for the Department of Defense and other agencies. We are very encouraged by the support for Navy shipbuilding in the final preparations measure, which includes the following: alignment with the National Defense Authorization Act permitting funding for CVN 81 under a 2 carrier buy, if anticipated savings can be confirmed. Funding for LPD Flight II advanced procurement material for either LPD 31 or for several ships across the future multiyear procurement. Funding to accelerate the purchase of advanced procurement material for LHA 9 as well as R&D money to accelerate the purchase of LHA 9 to 2021 and increase funding for the DDG program.

We continue to urge lawmakers to proceed expeditiously in finalizing the FY '19 appropriations for those agencies that are currently under a continuing resolution. For the 2020 budget request, we are hopeful that we can continue to leverage our hard shipbuilding production lines and critical supply chains to affordably achieve fleet requirements and address the challenges identified by the administration's recently released report on the industrial base.

Now I'll provide a few points of interest on our business segments. At Ingalls, the team delivered NSC-7 Kimball in September and is driving to complete, test and deliver NSC-8 Midgett early next year. On the DDG program, the team completed builder's trial on DDG-117 Paul Ignatius last month and is focused on completing acceptance trials in Q4 with delivery expected in the first half of 2019.

For DDG 119 Delbert D. Black, the focus continues on integration and testing to support plan, trials and delivery late next year. On amphibs LPD-28 Fort Lauderdale continues to perform well on both cost and schedule and the focus for LHA-7 Tripoli is on the test program with trials and delivery expected next year. At Newport News, CVN 79 Kennedy is nearing completion of manufacturing work, and the team is beginning to utilize transformation initiatives, such as integrated digital shipbuilding to support construction activities.

The ship is approximately 84% structurally complete with 376 of 448 lifts joined together in the dry dock and approximately 53% complete overall. The team lowered the final piece of the ship's underwater hall into place at the end of September, which completes the erection of all of the ships structures from main deck down. These activities support the team's plan to achieve an early launch at the end of next year. I continue to be very pleased with the progress on this ship and look forward to seeing the team meet this commitment.

For Submarines, SSN 791 Delaware, was recently christened and remains on track to delivery in the first half of next year. This is the final Block III boat to be delivered by Newport News.

Turning to Technical Solutions, the U.S. Department of energy's National Nuclear Security Administration issued a notice to proceed for the management transition process at Los Alamos National Laboratory to Triad National Security LLC. After 4-month transition period, the joint venture team will assume full management and operational responsibility for the laboratory. And Technical Solutions is an integrated subcontractor to the joint venture team.

Additionally, improving energy market conditions are beginning to translate into modest profitability in the oil and gas business. In closing, it is clear that the focus on execution in our shipbuilding business is a primary reason behind the favorable outcome for our programs in FY '19 minibus appropriations bill and prior year appropriations.

And recognizing this, we are focused on negotiating fair and profitable contracts that grow the top line, while remaining steadfast in our commitment to execution on our shipbuilding programs by keenly focusing on safety, quality, costs and schedule.

These efforts combined with solid execution by the Technical Solutions team and a capital deployment strategy that invest in our shipyards while returning excess cash to shareholders, keep us on a path to continue creating long-term sustainable value for our shareholders, our customers and our employees.

So before I turn the call over to Dwayne for some remarks on the financials, and this part probably isn't going to make Chris feel as good, let me share a few thoughts on our pension strategy. He always gets nervous when I think about pension. When higher discount rates used to establish cash contributions were introduced with pension relief under the Moving Ahead for Progress act in 2012, our senior leadership team made a conscious decision to stay with market-based rates in lieu of the safe harbor rates. This caused our cash expense to be higher in the short term because of the use of lower market-based rates with be expectation that cash expense would be lower in the future.

At the same time, we're able to make discretionary contributions to our qualified pension plans and recover those contributions in our overhead rates. Our view was, that as a company with a long horizon, our future costs position would be more competitive as a result of lower future cash expense, and we could move our qualified pension plans closer to being fully funded. As a result of the favorable funded status of our plans, and the recent increased in discount rates consistent with our strategy, we anticipate a decrease in our cash expense and FAS/CAS Adjustment over the next few years. This, in turn, will make our business more competitive and our products more affordable.

So now I'll turn the call over to Dwayne Blake for some remarks on the financials. Dwayne?

Thanks, Mike. As I review our third quarter financial results and provide a few updates to the full year, please follow along with the slide presentation we included with our earnings release this morning.

Beginning with our consolidated results on Slide 4 of the presentation. We had another strong quarter as revenues of $2.1 billion increased 12% over third quarter 2017, due to increased volume in our shipbuilding segments. Operating income in the quarter of $290 million increased $49 million or 20% from third quarter 2017. And operating margin of 13.9% increased 99 basis points. These increases were primarily driven by higher segment operating income and a favorable change in the operating FAS/CAS Adjustment in the quarter compared to the same period of 2017.

Turning to Slide 5 of the presentation, cash used in operations was $93 million in the quarter after contributing $434 million to our pension and postretirement benefit plans. This includes the final portion of the $508 million discretionary contributions to our qualified plans in 2018.

Free cash flow in the quarter with the use of $195 million and year-to-date free cash flow was $6 million.

Net capital expenditures in the quarter were $102 million or 4.9% of revenues. We expect capital expenditures for the year to be approximately 5% of revenues.

We returned $130 million to our shareholders in the quarter by repurchasing approximately 412,000 shares at a cost of $99 million and paying $31 million in dividends, bringing our cash balance at the end of quarter to $68 million.

Now to segment results on the Slide 6 of the presentation. Ingalls results in the quarter of $694 million increased 17% from the same period last year driven by increased volume on LHA, LPD and NSC programs, partially offset by lower volume on the DDG program. Ingalls' operating income of $82 million in the quarter, was up $8 million year-over-year, primarily because of higher revenues.

Ingalls' operating margin in the quarter of 11.8% was 66 basis points lower than the same period last year, primarily due to lower risk retirement on LPD 27, partially offset by higher risk retirement on the NSC program.

Turning to Slide 7 of the presentation, Newport News revenues of approximately $1.2 billion in the quarter increased 12% from the same period last year, mostly due to higher volumes in aircraft carriers and Navy nuclear support services.

Please keep in mind that the increase in Navy nuclear support services volume is primarily driven by Los Angeles-class submarines maintenance and overhaul activities.

While this is good work, we expected to start ramping down towards the end of next year, and therefore, do not consider it to be a sustainable source of long-term revenue growth.

Newport News operating income of $119 million and margin of 10.1% in the quarter were up $23 million and 98 basis points year-over-year, respectively, mainly due to a $43 million workers' compensation benefit in 2018 due to favorable medical and loss experience trends and a higher discount rate. And this was partially offset by the resolution of contract changes on CVN 65 and CVN 72 in 2017.

Now to Technical Solutions on Slide 8 of the presentation. Technical Solutions revenues of $245 million in the quarter increased 1.7% from the same period last year, driven by higher oil and gas and mission driven innovative solutions revenues, partially offset by lower fleet support and nuclear and environmental revenue. Technical Solutions operating income of $16 million and margin of 6.5% in the quarter decreased $6 million and 260 basis points year-over-year, respectively, primarily due to the release of a portion of an accounts receivable allowance related to the Westinghouse bankruptcy filing in the third quarter of 2017, partially by -- offset by improved performance in oil and gas services.

Before we transition to Q&A, let me address a couple of additional items. We completed the sale of our Avondale facility in Q4 and the final details of the transaction were within our expectations. So there were no material impacts to earnings or cash. We expect 2018 interest expense to be approximately $59 million and our effective income tax rate to be approximately 18%.

Turning to Slide 9 of the presentation, we've updated our 2019 pension and postretirement benefits outlook. Note that 2019 projected CAS expense and cash contributions are down by $92 million and $32 million, respectively, from our previous outlook provided there in the fourth quarter 2017 earnings call.

These reductions are driven by higher discount rates. Projected 2019 total FAS expense is up by $3 million, primarily due to an assumed 0% asset return in 2018, partially offset by higher discount rates. Consequently, the 2019 FAS/CAS Adjustment has also decreased from the prior outlook and it's now projected to be $234 million for the year. Please remember that pension-related numbers are subject to year-end performance and measurement criteria. And as in the past, we'll provide you with an updated pension estimates for 2019 and 2020 on the fourth quarter call.

That concludes my remarks. So let's turn to Q&A for a moment. And as a reminder, please remember to limit your initial -- yourself to one initial question and one follow up. So we can get as many people through the queue as possible. Sarah, I'll turn the call over to you to manage the Q&A.

(Operator Instructions)

(Operator Instructions) Our first question comes from the line of Jon Raviv with Citi.

Well, it’s a pension and free cash flow question. So you guys have previously talked about 2019 free cash flow being in the neighborhood of $750 million, with this lower net pension cash item. Would it be fair to think that, that $750 million will get lower in 2019? And then just rolling forward from there, how do you think about sustainability of that number given that what you guys have strategically approached the pension as you talked about earlier, Mike, with the pension net cash rolling off be able to be offset by, well the CapEx, for example?

So when you think about the free cash outlook, remember, 2018, we talked about, in essence, being about $100 million headwind from where we finished last year. So I would directionally put you in 350-ish range. You talked about the $400 million headwind and you're right. When you look at the table that we provided in the presentation deck and it does indicate roughly $60 million reduction from what we we're looking at before. So that would directionally take that tailwind in 2019 from $400 million, down to, call it, $340 million. Given the fact that we still don't know what the final discount rates and asset returns will be, so call it a range, say, tailwind of $330 million to $340 million, is probably the safe place to think about it. And then, kind of, thinking about it moving on -- going into 2020, we talked about the fact that we are positioning ourselves with -- putting our pension plans to a point where it closed to fully funded. So that puts us in a place where the need and the demand for higher contribution is not as significant as it has been in the past. So that nuance really puts us in a place where we don't have to really concern ourselves with the big contributions and there, in turn, keeps the CAS recoveries lower, but at the same time with lower CAS recoveries, to Mike's point earlier, puts us in the place of affordability. And so that's really what we focused on. And I think that's got away, we set ourselves up to do.

And to your point in your question you alluded to, it is our intention to come off of the CapEx spending on schedule.

Got it. And then as a follow up on that CAS point. In your new slides you have $247 million of CAS recoveries over cash contributions. I understand the contribution requirement goes down. Could you speak to when the CAS piece goes down? Or the shape of how that CAS piece goes down given your pension strategy?

So the CAS recoveries, we talked in the past that things will naturally gravitate towards kind of 0. We really haven't talked specifically about the timing of that. But as you can imagine, there is a reduction that you can expect. We'll give the specific number on the Q4 call, so standby.

Our next question comes from the line of Myles Walton with UBS.

Mike, I was hoping you could comment on the status of providing that evidence to the Navy to provide Congress for the savings of the block buy. And kind of what the timeline is that you expect? And what the hurdle of savings that your -- that you have signed up for or the need to have to see and provide evidence to support for you to get the go ahead?

Yes. So I'm -- look, I guess, I can say that we submitted our proposal to the government several months ago. And we've had, I'd say, a very substantive and constructive dialogue, working our way to closure on what that looks like as we go forward. We've remained very -- first of all, we remain optimistic starting with the legislative side, both authorizing and appropriations. We're looking forward to receiving the information, and we're trying to put that together. I'd say that's more of a near-term than long-term issue, because in order to get the savings that we're talking about, we need to get this done. But I -- given that we're into pretty steady conversation, I don't think I want to try to predict the timeline at this point. I'm just going to say we're working really hard to do this as soon as we can.

Okay. And Dwayne, you mentioned that the Los Angeles-class refurb work or aftermarket work that you're doing that you kind of don't see as a, sort of, ongoing for multiple years. So what's the size of that contribution this year? And what's the, kind of, headwinds for next year? And is that pretty attractive margins relative to the base business?

Yes. So those availabilities, on average, Myles, can run $200 million and $300 million and run 18 to 36 months on average. So you basically got 3 of them going on right now. And so as I mentioned, you'll start to see the first of those kind of the peel off in the middle part of next year. So we see that as a little bit of a headwind, but nothing substantial. And at the same time, the Navy, as they're continuing to make their push to increase the efforts on the modernization side, there is always opportunities on that front. So the team is certainly engaged on that front, and that we're prepared to support the Navy if they have the availability that may need to come our way.

Yes, I -- let me just add, this falls into the whole readiness discussion that has been ongoing between the Pentagon and the services and the Congress. And the issue from the industry standpoint is if you create a team that is capable of doing the work, the feast or famine nature of this in the past has really had pretty negative impacts on the ability to efficiently achieve the readiness targets that you want. So our engagement today is not only in the work that we're doing to support the Navy's requirements for 2018 and 2019, but it's also, we're in discussion with the Navy, along with the rest of the industry, about how can you more efficiently support the readiness of the platforms that are out there, whether they be surface ships or submarines. And so we'll see how that all works out. It's -- at this point, there's -- we're only at the discussion phase. But my personal view is that what we've been doing doesn't really support the fleet that well. What we as a team have been doing that doesn't support the fleet that well. And as a team, we got to come to a better solution and we stand ready to help do that.

Our next question comes from the line of Carter Copeland with Melius Research.

I wonder if you could just expand a little bit on that -- on Myles' question on the repair and mod work, I know that you've had some strength in that in the last few quarters, but you didn't explicitly mention it in the release or the slides today. So just wondering did the growth there -- is that sort of leveling off? That's first question. And then second one, just to -- we make sure we cover all the geeky accounting questions in addition to pension, Dwayne, can you give us the gross favorable and unfavorable EACs? And just maybe some color around, which segment they apply more to?

Sure. So I'll take the second one first. So the cume adjustments net 34, 61 positive, 27 negative. No material negative adjustments. And the split was roughly 85 Ingalls, 15 Newport News.

Awesome.

And relative to the repair activity, beyond -- some of what's driving that is the work we're doing in refueling overhaul. And we're at that phase of putting the ship back together and so trying to get the delivery condition of the ship sorted out. And so that's kind of the phase that we're in. And these are somewhat sequential, you're planning the next one while you're kind of running to the end of this one. And then you'll start on the follow up when the ship leaves. And so that's kind of -- there's a little bit of a cycle to that refueling business that you're seeing in the numbers this time too.

Yes. And as it relates to the availabilities, again, the pace that they are on, they're kind of at a steady state now with those that are actively working at Newport News and so I think, all 3 of them are kind of in the, I guess, in the steady state mode, if you will. And as I mentioned, you'll start to see the first of those kind of peel off about middle towards the end of next year.

Our next question comes from the line of George Shapiro with Shapiro Research.

Two questions. One for you, Mike, and one for Dwayne. For Dwayne, I'm estimating the workers compensation expense in the quarter was about $15 million and if you could explain where that came from? And then for you, Mike, if you do get approval for the second carrier, when do you need to get the money in the budget because the budget this year was kind of funny. It said, "Yes, maybe we'll give you approval", but didn't put in any money for it?"

George, so your first question on the workers comp, it was actually $43 million. And it's basically a function of remeasurement of our workers comp liabilities. Do that periodically looking at historical trends in terms of medical expenses and just the workers comp experience as well as discount rate. So it's something that is done periodically and that is the $43 million that I called out in my remarks.

And George, relative to the question about the funding, relative to the shipbuilder portion of carrier construction acquisition, when we looked at, not just the next year funding, but the 5-year plan for funding for aircraft carriers, it was our view that you could reapportion that funding between the 2 ships and actually generate the savings. And that you wouldn't need to actually add any funding to make that happen. And that really was the -- kind of the tipping point where you could say, "look, you've already programmed the money for a ship, if you actually just allow us to do 2 ships instead of 1, you don't need to add any more money to the budget. You just need to get the authorization done and we can proceed and actually generate savings". That's actually why -- if we'd had to go and put more money in the budget to actually acquire these 2 ships, I'd say that -- I'd be a little less optimistic about what the possibility of getting it done. But the fact that we can actually reprogram the money between the 2 ships to generate the savings became a very exciting prospect for everybody we talk to. So now it's just a matter definitizing it.

And just a quick follow up for you, Mike. You've been saying 3% to 5% revenue growth. I mean, this year you're up 10% year-to-date. And it looks like you've got pretty much approved everything you said you hoped for in the '19 budget. So you willing to up that number?

Well, actually George to correct you, I've only said 3%. I've never said 3% to 5%. And that -- no, I'm not willing to change that because think about what's happening. I mean, on the one hand we are in a great spot that ships have been authorized and appropriated in the '18 or '19 window. And it takes a lot of the uncertainty about '20 and '21 out of our business. But as I said before if you're going to sustain this, the level of shipbuilding, the SCN account for the last couple of years with Columbia on the horizon, with frigates on the horizon, with the LHA on the horizon, the LPDs on the horizon, in addition to the Flight III destroyers, the Block 5 submarines, you have to be able to sustain the level that you are at today. And we've seen comments where the Pentagon is already now stopping to think about maybe we need to prepare 2 budgets for '20. That's not really consequential to us, but it does indicate that there's a lot of uncertainty about whether we can sustain where we are today or not. And as I've said before, are we looking at a long-term sustained commitment to a higher level and a higher rate or is this just the rat and the snake that's going to be good for us, but it's going to -- we're going to go back to our historic levels? And I think that jury's still out on that. So I'm sticking to my number.

Our next question comes from the line of Rob Spingarn with Crédit Suisse.

I just -- you just kind of touched on this with George, but Mike, with regard to this potential flattening out of the budget, I'm thinking -- you just mentioned 2 budgets, I'm thinking of the lower one, the $700 billion one, and the spending on Columbia, which just seems to be a very top priority and that number is rising. How do we frame the risk to the rest of your portfolio?

Yes. This Rob, is what we've been talking about. I think, I feel like I've been -- we've been talking about this for 4 or 5 years now that we've got to figure out -- first of all, we've got to figure out sequestration. We're -- '18 and '19 were great because we had a budget deal. We're going to '20 and '21, there is no budget deal. Everyone expects that there will be another one, but you got to go do it. So sequestration is the first blanket. The second blanket then is the one that we have talked a lot about is how you're going to pay for Columbia without causing collateral effects in the account. And so we managed to do that in '18 and '19. As we head into the next couple of years over and we get ready to start the construction of the lead ship. We're going to be working really hard to make sure that the affordability of the programs that might be affected works our way through. So you see efforts on the multiyear for the LPDs, the frigate competition is still out there. What happens to the option ships on the destroyer? The Congress was interested in a couple of more submarines in addition to the base contract for Block 5. The question is how you're going to work all that through with the priority of getting funding for Columbia done. And our view is to -- the best thing for us to do is to stay engaged and make sure people understand the impact and consequences of any particular course of action. We come at that -- those discussions from a position of, we're executing really well on our business so we can tell you what the efficient way to do the work will be. And we have made significant capital investment in our business to actually make us more affordable. Both of those help the argument that the sustainable higher rate of funding for shipbuilding is actually the most efficient course for the taxpayers to take. And that's the path that we're taking.

Well, okay. And then with regard to the strong execution that you're talking about, Mike, just switching to the carrier, on CVN 79, if indeed, you're ahead of schedule, should we think about that as meaning that labor hours are coming in below budget? Or have you had to put in more labor than expected to get ahead of this schedule, as -- given your results here?

Yes. So we have a pretty disciplined process around both costs variances and schedule variances that we manage down there and review. The program is reviewing that daily. I'm reviewing that every month.

And so I think that -- and earned value system that we use when we -- if we want to accelerate something we better make sure that it's worth it to us, that it's not going to costs us more than what it would have cost us to begin with to accelerate it. Or that there's a payback to the acceleration. And so what I really worry about in our construction program, typically, is we get so focused in on one particular critical path that we'll go and knock the heck out of the critical path, but we will neglect some of the just more mundane volume stuff that we need to be doing. And we kind of create this backlog of volume stuff that needs to be done and it pushes it to the right in the program. That's not really happening in this program right now. We're basically -- we're making decisions about the path and the sequence and the program managements teams' intent to accelerate the schedule. Actually, that's a way to reduce the risk in the program. And so that's why I'm very supportive of that and very encouraged by their initiative.

And then just to refresh, we're not going to know how -- we won't know how well you've done there until you put the ship in the water, which is around a year from now?

Yes, I mean -- yes, about a year from now. And our process is very disciplined. And we've been through the process that's not discipline, and if you lose that discipline, then you are setting yourself -- may feel good in the short term but you're setting yourself up for some long-term problems. So we will know more when we put the ship in the water.

Our next question comes from the line of Ron Epstein with Bank of America.

Just a couple of quick ones. When -- for the Columbia-class, is there going to be any additional CapEx needed for that? Or is you kind of capitalize for what you're going to need to do on Columbia-class?

Right now, the capital plan that we have supports the portion of work that we intend to do. As the -- my sense is that, that's pretty firm. But as we get closer to construction, if there's something that pops up, we'll have evaluate that. But we've made a pretty significant investment in the program already, and we kind of like what we've done and what it means to the program. So...

Okay. Great. Mike if you could talk -- there's been some discussion, I think, on the hill, about possibly doing second refueling of the carriers so you could get some more carriers in the fleet by just refueling them yet again. What's your sense on that? What's that mean? Is an opportunity for you guys? Where is that going to go?

You know what, I guess, my experience with these ships and we went -- we all lived through the end of life of enterprise. And kind of like -- I don't want to be mundane about it, but kind of like your car there's a point where every time you take the car in, it costs you a whole lot more than you thought it should. And as ships get older and you take them in for maintenance, that curve -- that maintenance cost curve isn't linear. It starts to accelerate and becomes a real burden on -- it becomes a real burden for the rest of the fleet. So I would think that if you are -- I mean, there's a whole lot of technical stuff to talk about, about whether you can actually really do that from a science and materials and technology standpoint. But even if you decided that you wanted to do that, you better actually really understand the cost curve of just your maintenance. And I would not be an advocate of that. I would argue that the better way to increase the number of carriers in the fleet is to build them more frequently and efficiently.

Our next question comes from the line of Krishna Sinha with Vertical Research.

I got a 2-part question on margins. So a couple of quarters ago, you gave sort of midterm guidance for 7% to 9% margins. And I just wanted to know when you put that margin guidance out there, was there a particular point in time where your mix became headwinds -- enough headwinds to push that down towards the 7% because so far you've been doing much, much ahead of that? And similar to that, I mean, you've talked about some of this ad hoc work like the Los Angeles stuff or other modernization work that could come down the pipe. Was that 7% to 9% inclusive or exclusive of that ad hoc work? So meaning is there -- were you thinking more about the core business being 7% to 9% and then this ad hoc work being layered on top or were you factoring in some of this ad hoc work into that 7% to 9% guidance

Well. You probably give us a lot more credit than we deserve. When we look at 7% to 9%, we were coming off of our perspective that if you have a healthy balance in the business between new work and mature work, you ought to be operating in the 9% to 10% range. And our outlook, we couldn't see all of the different pieces, and we couldn't see all of the different timing. But what we could see was, and still see, frankly, with the -- now that we've kind of come through on appropriations bill for '19, what we could see is that we're going to be very heavily weighted towards new work. If you just think about what we could be doing here, starting with the destroyers in this past quarter, look, we award for the destroyers, but then followed that up with a contract for 2 carriers and a contract for Block 5 and submarines, the backlog is going to go up pretty significantly. And that's going to create a significant amount of new work, which we just felt that it was really important for you to understand that, that was going to push the 9% to 10% balance out of balance. It's healthy and positive for the business because it's work we're capturing, but it's going to push us out of balance and you should not expect that we would be at 9% to 10% range as we work our way through that. Now, we don't have those stuff on the contract yet, so the timing of when we start to phase out of that and get to a place where we're retiring the risk in a way that gets us back in the zone is something that we keep looking to. And I think that the fact that we have been able to perform in this arena, even with that kind of balance starting to shift, I think that actually speaks well of the folks in the shipyards that are executing. It's on them that we've actually done better than we might have thought we were set up to do. So I'm proud of the team, I'm proud of what we're doing. But I think that you just got to keep your eyes open. A 2-carrier contract is going to completely weight down the front end of the balance being. So that's kind of the way we're thinking about it.

Let me just add to on the front end, Krishna, when you look at where we are this year for shipbuilding and with the reported number is kind of a big number, a 10.7% for shipbuilding. But when you take out the kind of one timers it kind of put you back towards that 8.4% for the quarter, and even year-to-date, is at 8.4%. So when we talked about the 7% to 9% is kind of where -- it's relatively kind of in the middle of that sweet spot.

Okay, great. Yes. And then just again, on the ad hoc work do you have any sense -- you talked about Los Angeles and you talked about maybe some other modernization type work in the wings that you could see coming down the pipeline. Do you have any sense of the size of those opportunities? And the timing of when that would come through? Not like in terms of a quarter, but maybe in terms of years when that would get through?

Yes. I think it's -- frankly, it's too early to tell. It kind of depends on how the Navy comes through. It's discussion about how to improve its ability to get the fleet ready. And what our role in that's going to be. And I -- it's just not mature enough to be able to make any predictions on it.

Our next question comes from the line of Finbar Sheehy with Bernstein Research.

You've talked about returning essentially all the free cash flow back to the shareholders and you've been doing it, primarily, through repurchases. But you've also said you plan to increase dividend at least 10% annually. Can you give us any thoughts on how you're thinking about ultimately dividing the payouts between dividends and repurchases? Is there, for example, a long-term dividend payout ratio you want to get to or a split between repurchases and dividends?

Yes. So Finbar, when you look at the commitment and we talked about the fact that we would have at least a 10% increase on the dividend, which we've done. And then, the share repurchases would be opportunistic. So we continue to take advantage of opportunistic repurchases. So we don't really have any set targets that we're shooting towards in terms of a payout dividend or anything of that nature. But suffice to say, we'll be focused on, continuing the commitment on the dividend increasing being opportunistic on the share repos.

Okay, great. And then just on Q4 on some of the EACs, are there any significant risk preserve events coming up that you expect to be positive or negative in the quarter?

Yes. So for the second half, we don't have any additional ship deliveries. We had NSC 7 that delivered in Q3, as Mike mentioned, DDG 117 is prepping for trials in Q4. And so that's pretty much it for this year.

Our next question comes from the line of Gautam Khanna with Cowen and Company.

You may have covered this, I apologize, I joined late. But just to be clear Chris, on cash flow, I know you haven't officially guided it, but next year, previously, we were thinking $750 million. Is it now -- the delta is just the lower pension recoveries are, right?

So yes. So I talked about the fact that change in the net CAS cash the roughly $60 million. And then also mentioned the fact that we still don't know what the final discount rates and returns would be. So that could put some additional variance in the number. So use, kind of, $330 million to $340 million tailwind versus the $400 million that we've been talking about before would put you in the same spot.

Okay, and then on CapEx just to be clear, should we assume that 2019 is relatively flat with '18, and so 2020 drops about $200 million to get to the cumulative 1.8%, thereabout?

Yes, that gets you to the number we've been talking about. So yes, that's the fair way to think about it.

Okay. And is there any update on icebreaker -- some of the longer-term pursuits that you guys have talked about. Any update on sort of where those things stand today?

Yes. I mean, those -- you can read about those programs are proceeding a pace whether say icebreaker or the frigate. We're engaged in both of those programs and we're engaged with those customers. And we keep moving ahead at their pace.

And I mean, the pace on the icebreaker seems to be slowing. Is that fair? Or what do you expect this to actually, ultimately, get done?

Yes. I am -- that's a good question. I'm kind of the mind that they still have kind of reconcile how much they want to spend with what they want to buy. And so I think you see that sort of -- whenever programs -- it's not just the icebreaker, whenever a program has a huge appetite for what it wants to buy, but doesn't have a huge budget, it takes a little bit longer to get it -- get that sorted out because you have to kind of go through and figure out what's important to you. And so I think that's kind of where they are.

Our next question comes from the line of Joseph DeNardi with Stifel.

Mike, it surprised me a little bit that you called out lower CVN 79 sales in the quarter. Was that just an anomaly? Or have sales kind of peaked on that contract at this point?

Yes. So, I guess, comparatively speaking Joe, it's Dwayne so the timing maybe a bit of a nuance. But I think when you look at where 79 is, the team is marching full steam towards launch. So in terms of how the actual volume compares quarter-over-quarter can vary but it's not slowing them down at all in terms of where they are focused.

Okay. And then, Mike, just want to make sure I understand what you're trying to communicate, I guess, on the pension commentary. Was the message that we should kind of temper expectations from a cash flow standpoint? Or that there's margin upside as you realize the cost savings of that strategy?

Well, I will tread gingerly here and just suggest that we were given the opportunity several years ago -- with everybody in the industry, we we're given the opportunity to make some choices that would free up cash in the near term for -- related to pension that would then create a longer tail in terms of recoveries. We chose not to do that. We chose not to do that because we already had figured that how to allocate our capital. And that we were -- our focus in this business is to continue to make our businesses more competitive and our products more affordable. And so by making that choice, I think, we're a bit of an outlier. But we're in a place today where that choice is something that is pretty evident that we made that. So as we work our way through how we describe impact of pension for next year and cash recoveries for next year and the year after, I'm pretty happy with where we are. Because I think, we are in a much more competitive position. And I think our products are going to be more affordable. And in an environment where every dollar in the budget is a knife fight, that's not a bad place for us to be.

We do have a follow-up question from the line of Jon Raviv with Citi.

Just coming back to Krishna's question about the margin. So on the 7% to 9% certainly appreciate that you're on the midpoint year-to-date. With all this new stuff picking up, should we expect that to go down in 2019 and then potentially recover once you get CVN in the water late next year? Or is this 7% to 9% perhaps apply a little bit beyond '19 as well?

We've -- again, the 7% to 9% range was a '18, '19 phenomenon, marching back in the sweet spot, as Mike mentioned, in the 2020, 2021 time frame. So that remains our drive. The fact that we're doing a little bit better, thus far, it's certainly a positive phenomenon. But we're still going to keep that 7% to 9% range out there for the current view of the world.

And the lumpiness of the business, I'm not going to try to handicap quarter-by-quarter. We are typically not very good at that.

We have a follow up question from the line of George Shapiro with Shapiro Research.

Yes, Mike, what -- can you just tell us what is the learning curve that you're now running on the Kennedy versus the Navy's always been skeptical that you could achieve it given their history of what second ships are?

Yes. So the history -- in the history, I think, that GAO did a report and pointed out that the best manhour reduction from one ship to the next in the carrier program was like 9% or something like that, which is -- and that's an interesting benchmark. Our performance to date is 15%, or in some places, better than that. So I am very pleased with what's going on there. And very happy with the way the team is looking for ways to continue to create value for customers and shareholders.

And if you look at this, say, over the last 6 months or so, has that 15% improved, stayed about the same?

You know without getting too technical, it's been about the same. It's been a pretty steady rate.

That concludes our question-and-answer session for today. I would now like to turn the call back to Mike Petters for closing remarks.

Well, thank you, and thanks to all of you for your interest in Huntington Ingalls and for joining us today. Appreciate your perseverance as we model through without Chris. And we hope Chris will feel better going forward. Our hope -- my hope, anyway, is also that you can see that over time, all of the strategies that we have are designed to make our products -- make our businesses more competitive and make our products more affordable. I think, you can see that whether it's in our capital improvement programs, our digital strategies, our transformation initiatives, our engagement opportunities, all of that is designed to improve that experience for our customers. And so we think that's the best way for this business to create value. We believe that we are on track for that. And we appreciate the time that you put into working with us and we look forward to seeing you soon. Thank you all very much.

Ladies and gentlemen, thank you for participating in today's conference. This does conclude today's program. You may all disconnect. Everyone, have a great day.