Building Ships

Analysts from Wall Street firm Credit Suisse met with shipbuilder Huntington Ingalls Industries execs this week and noted "a cautiously optimistic tone." In a research note, Credit Suisse analysts write: "While HII sees upside in earnings and cash flow over the long-term, it is now focused on the heavy lifting required in the short and mid-term to build a cultural and operational foundation to achieve that end." Further:

■      No Guidance Yet: HII has yet to offer EPS guidance, citing visibility around Avondale as a key factor, and instead suggested investors track ship progress & milestones over financial targets.

■      Gulf Coast Margin Remains Key Driver & Watch Item: Mgmt reiterated its 9%+ L/T margin target by year-end 2014 (currently at 5-6% overall, and near 2% in the Gulf Coast).  Poorly priced contracts on LPDs 22-25 and LHA-6 (now at or near zero margin as prior mgmt’s plan for serial efficiencies were never realized) will begin to roll off later this year.  As new ships (DDG-113, LHA-7, LPD-26) move from planning to construction, margin should ramp, albeit slowly. HII noted that normally, lead ship contracts should earn ~8% while serial production ships represent a ~10% margin opportunity.

■      Mgmt Frames Report of Higher Potential Cost on Aircraft Carrier:  A June 2011 CBO report estimates that CVN-78 (Ford) may exceed its $12B budget target by $600M or more.  HII cautioned that its portion of the work is far below the $12B total cost, and the excess cited may not be attributable to HII.  Under this cost-plus contract, higher costs are recoverable, but fee could be impacted, depending on the responsible party & the share line.

■      No Near-Term Catalysts; Reiterate N with $35TP: While we see eventual EPS growth as bad contracts roll off, the linearity of improvement is unclear, especially since new work (with presumably better pricing) will be booked conservatively at first. Thus, visibility on margin improvement (the key catalyst) is still a year or more distant in our view. Reiterate N with a $35 TP.

Inside the Pentagon reported in April that HII, according to DOD, was not moving fast enough to fix its management deficiencies:

Huntington Ingalls Industries' shipyards stumbled last year in Defense Department reviews concerning earned value management, the Pentagon's top tool for ensuring industry delivers weapons on time and on budget. Since then, the shipbuilder has not made enough progress addressing the problems, said Capt. Cate Mueller, spokeswoman for Navy procurement chief Sean Stackley.

"The Navy participated in the recent EVM reviews with the Defense Contract Management Agency at the shipyards and, while noting progress, is not satisfied with the rate of progress," said Mueller. "We will continue to provide oversight while working with the shipyards to ensure appropriate priority is placed on correcting these deficiencies."

The Navy's comments came in response to remarks by Mike Petters, the shipbuilder's president and CEO, who recently said his company has "more work to do" on earned value management but also questioned whether all the rules should apply (Inside the Pentagon, April 7, p1).

DOD uses the EVM tool to flag problems, forecast cost and schedule performance, and get troubled Pentagon procurement programs back on track. Asked whether the company should apply all 32 of the Pentagon's management rules to each of its contracts, Petters said no.

"I wish it was that simple, but it's not," he said. "We get certified by our customer to invoice and report. And we do that, we go through all those certifications and we don't have any issues. Then we have another agency monitor and inspect and they come up with areas that we need to go work on. And then we take a look at those and say, 'Is that something that really makes sense for this business or not?' And then we have a discussion with our customer about that."