Huntington Ingalls Industries - Q3 2022

Transcript

Operator (participant)

Ladies and gentlemen, thank you for standing by, and welcome to the third quarter 2022 HII earnings conference call. At this time, all participants are in a listen-only mode. After the speaker's presentation, there will be a question and answer session. To ask a question during the session, please press star followed by one on your touch tone keypad. Please be advised that today's conference is being recorded. If you need further assistance, please press Star followed by zero for an operator. I would now like to hand the call over to Christie Thomas, Vice President of Investor Relations. Ms. Thomas, you may begin.

Christie Thomas (VP of Investor Relations)

Thank you, operator, and good morning, everyone. Welcome to the HII third quarter 2022 earnings conference call. Joining me today on the call are Chris Kastner, our President and CEO, and Tom Stiehle, Executive Vice President and CFO. As a reminder, any forward-looking statements made today that are not historical facts are considered our company's estimates or expectations and are forward-looking statements. Forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially. For additional information regarding factors that could cause actual results to differ materially from expected results, refer to our SEC filings. Also, in their remarks today, Chris and Tom will refer to certain non-GAAP measures. For reconciliations of these metrics to the comparable GAAP measures, please see the slides that accompany this webcast, which are available on the investor relations website at ir.hii.com.

With that, I would like to turn the call over to our President and CEO, Chris Kastner. Chris?

Chris Kastner (President and CEO)

Thanks, Christie. Good morning, everyone, and thank you for joining us on today's call. I would like to begin today by highlighting the HII teams that work hard day in and day out to support our national defense customers. Craftsmen and women constructing and overhauling the most powerful and survivable naval ships ever built. Engineers and technology specialists developing critical capabilities and mission-driven solutions, all aligned with supporting our customers' priorities and pressing national defense needs. Thank you to the entire HII team. Now let's turn to our results on page three of the presentation. In the third quarter, we had sales of $2.6 billion, which were 12% higher than 2021, and diluted EPS was $3.44 for the quarter, down from $3.65 in 2021.

New contract awards during the quarter were approximately $2.1 billion, which results in backlog of approximately $46.7 billion at the end of the quarter, of which $23.2 billion is currently funded. We continue to make progress across all of our shipbuilding programs. At Ingalls, we recently completed acceptance trials on DDG 123, Lenah Sutcliffe Higbee. During the third quarter, the keel was authenticated for DDG 129, Jeremiah Denton. In our amphibious ship product lines, fabrication began on LPD 31 Pittsburgh, and last week, we were awarded a $2.4 billion detail design and construction contract for LHA 9. Also, we have commenced the work to complete the combat system installation and activation on the Zumwalt-class destroyer Lyndon B. Johnson, DDG 1002. At Newport News, CVN 79 Kennedy is moving further into the test program and began testing of the electromagnetic launch system.

On the other side of the shipyard, the keel was laid in the dry dock for CVN-80 Enterprise. The RCOH program continues to make progress with CVN 73 USS George Washington on track to redeliver next year. Also, we continue to see progress on the Virginia-class submarine program and expect to deliver SSN 796 New Jersey and float off SSN 798 Massachusetts next year. In the quarter, we experienced continued challenges from the broader macroeconomic environment, most notably a persistent tight labor market with really no material improvement in general economic conditions. Through the third quarter, we have hired over 3,600 craftsmen and women against our full-year plan of approximately 5,000, and we continue to utilize the levers of outside lease labor and overtime to offset the short-term deficit of employees.

In addition, supply chain challenges continue across our supplier ecosystem, resulting in longer material lead times and inflation pressure. As we've discussed previously on inflation, we do have some contractual mitigation, and we continue to actively manage the supply chain and our production schedules to minimize impacts. To address our shipbuilding labor challenges, we have aggressively enhanced our skilled workforce development pipeline. To this end, while we've broadened our recruiting efforts to bring in more shipbuilders, we are also expanding our very successful apprenticeship programs, including revised curricula, reduction in completion timelines, a focus on pre-apprenticeships and youth apprenticeships, and expansion to underserved populations and women in the industry. Moving to our Mission Technologies business, our pipeline remains very strong, with $4 billion in proposal or evaluation and $17 billion in capture. Our third quarter book-to-bill was 2.2 and was a healthy 1.1 year-to-date.

Integration of operations and business systems following the Alion acquisition is largely complete, and we are already seeing strong synergies, such as the recently announced DMAS and MAP DMO awards totaling over $900 million in total contract value. We also received a couple of major contract actions in our nuclear and environmental business that were driven by sustained strong performance. At Savannah River, our joint venture received an extension for four years, plus an additional option year. At the Nevada National Security Site, our joint venture received a simultaneous early exercise of all five of its option years. These are significant wins, and we are very proud to support DoE across the complex. Despite headwinds earlier in the year due to the delayed omnibus spending bill and the ongoing intense competition for talent, we continue to gain momentum and see strong growth potential going forward.

This includes both domestic and international markets, where we are expanding our presence in regions consistent with the national security strategy. In summary, I'm confident that our presence across all the combatant commands, coupled with an increasing demand signal for advanced technology solutions from our DoD customers, positions Mission Technologies well going into FY 2023. Shifting to activities in Washington, the federal government began the new fiscal year under a continuing resolution, which funds government operations through December sixteenth. We continue to urge Congress to proceed expeditiously and remain optimistic that the annual defense appropriations and authorization processes will be completed in the months ahead.

While final outcomes will depend on eventual respective appropriations and authorization conference committee negotiations, we are pleased to see defense oversight committees provide strong support to shipbuilding to include recommendations for new DDG 51 multiyear procurement authority, additional funding for amphibious ships, and requirements for not less than 31 amphibious warfare ships. The strong shipbuilding demand driven by our national defense requirements is shown on slide five. These critical customer needs, spanning destroyers, amphibs, submarines, and aircraft carriers, and including new construction, overhaul, and maintenance and modernization, will result in significant contract. Now I will turn the call over to Tom for some remarks on our financials. Tom?

Tom Stiehle (EVP and CFO)

Thanks, Chris, and good morning. Today, I'll briefly review our third quarter results. For more detail of the segment results, please refer to the earnings release issued this morning and posted to our website. Beginning with our consolidated results on slide six, our third quarter revenues of $2.6 billion increased approximately 12% compared to the same period last year. This increased revenue was attributable to the acquisition of Alion in the third quarter of 2021, as well as growth at Newport News Shipbuilding. Operating income for the quarter of $131 million increased by $13 million or 11% from the third quarter of 2021, and operating margin of 5% was essentially flat from the prior year period.

The increase in operating income was primarily due to more favorable nonrecurring state income taxes and operating FAS/CAS adjustment compared to the prior year period, as well as improved results at Newport News Shipbuilding. Other net expense was $13 million in the quarter, which was primarily driven by losses on equity investments given market volatility in the quarter. Our effective tax rate in the quarter was approximately 14.8% compared to -4.3% in the third quarter of last year, which included research and development tax credits for tax years 2016 through 2020. Net earnings in the quarter were $138 million compared to $147 million in the third quarter of 2021.

Diluted earnings per share in the quarter was $3.44 compared to $3.65 in the third quarter of the previous year. Moving on to slide seven, Ingalls revenues of $623 million in the quarter decreased by $5 million or less than 1% from the same period last year, driven primarily by lower revenues on the NSC and LPD programs and partially offset by higher DDG program revenues. Ingalls operating income of $50 million and margin of 8% in the quarter declined from last year, primarily due to lower risk retirement on the DDG program, partially offset by higher LPD risk retirement. Newport News revenues increased by $91 million or about 6.7% from the same period last year due to higher naval nuclear support services as well as submarine and aircraft carrier revenues compared to the previous year.

Newport News operating income of $102 million and margin of 7.1% were up from last year due to contract incentives on the Columbia-class submarine program, partially offset by lower risk retirement on the VCS program. The Columbia-class contract incentives are related to Newport News' support of continued growth in the submarine construction enterprise. At Mission Technologies, revenues of $595 million increased by $101 million compared to the third quarter of 2021, primarily driven by the acquisition of Alion in the third quarter of last year. Mission Technologies' operating income of $14 million compared to operating income of $13 million in the third quarter of last year. Current results included approximately $24 million of amortization of Alion-related purchased intangible assets compared to $8 million in the third quarter of last year.

Mission Technologies' EBITDA margin in the third quarter was 8.4% and 8.7% year-to-date. Turning to slide eight, cash used by operations was $19 million in the quarter and net capital expenditures were $77 million or 2.9% of revenues, resulting in free cash flow of -$96 million. This compares to cash from operations of $350 million, net capital expenditures of $73 million or 3.1% of revenues, and free cash flow of $277 million in the third quarter of 2021.

While third quarter free cash flow was below the projection we provided on our last earnings call, this is simply a function of timing as well as a tax payment of approximately $80 million that we elected to make in the third quarter given the lower probability of delay and deferral of changes to the R&D tax treatment. In fact, we are increasing our overall free cash flow outlook for fiscal year 2022, which I'll discuss in more detail in a moment. Cash contributions to our pension and other post-retirement benefit plans were $11 million in the quarter, of which less than $1 million were discretionary contributions to our qualified pension plans. During the third quarter, we paid dividends of $1.18 per share, or $48 million. We also repurchased approximately 66,000 shares during the quarter at an aggregate cost of approximately $14 million.

Moving on to slide nine and our updated outlook for the 2022 and 2023 pension and post-retirement benefits. First, I would like to highlight that our funded status remains strong and has improved year-to-date. Additionally, I will note that the cash flow impacts related to the pension changes remain muted. For 2023, the FAS benefit has come down considerably from our last update, given the more immediate recognition of the negative asset returns experienced thus far in 2022. While the increase in the discount rate does partially offset the impact of asset returns, the magnitude of the impact related to lower asset returns is clearly more significant. Please remember that pension-related numbers are subject to year-end performance and measurement criteria. We will provide a multiyear update of pension estimates on our fourth quarter earnings call in February.

Turning to slide 10, we are narrowing our 2022 Shipbuilding and Mission Technologies revenue guidance to the lower end of our prior guidance ranges, given results through the third quarter and the current operating environment. We are now expecting Shipbuilding revenue to be between $8.2 billion and $8.3 billion and expect Mission Technologies revenues to be approximately $2.4 billion. The narrowing of the Shipbuilding revenue guidance is a function of the challenging labor environment that we have frequently discussed, as well as our expectations for the timing of the material as we near year-end. The Mission Technologies revenue is a reflection of the slower start of the year as well as the current hiring environment.

As Chris noted, third quarter book-to-bill ratio exceeded 2.0, a very positive indicator as we move forward, and we remain very enthusiastic about the growth opportunities at Mission Technologies. We are reaffirming our shipbuilding operating margin guidance range of 8%-8.1%. For Mission Technologies, we are slightly revising our margin guidance to approximately 2.3%, which is largely a function of the lower volume of work in the year. Moving to free cash flow, we are increasing our guidance for 2022. Under current Section 174 R&D tax law, the midpoint of our prior guidance was $225 million, which has now been raised to approximately $350 million. The most significant driver of that increase is the COVID progress repayment, which we initially expected in 2022 moving to 2023.

Given our free cash flow through the third quarter, we are expecting very strong free cash flow generation in the fourth quarter. On slide 11, we have provided an update view of our free cash flow expectations. This outlook assumes the current R&D amortization treatment for tax purposes remain in place. Given that adjustment, our 2020-2024 free cash flow expectation is now approximately $2.9 billion. As we have noted before, the impact of the R&D treatment is approximately $250 million over the 2022-2024 time frame. We are reaffirming our capital allocation priorities, including our commitment to remit to shareholders through 2024. As we have noted, this is a significant commitment, which should result in increased share repurchases, particularly in 2024 after we have reached our desired debt level.

I will also note that we have recently announced an increase to our quarterly cash dividend to $1.24, a 5% increase over the prior amount. To summarize, the operating environment remains challenging, and we were not able to overcome the slow start to the services contracting pace, which has resulted in revenue guidance moving to the low end of our prior ranges. We are pleased to reaffirm our shipbuilding margin guidance and increase our free cash flow expectations as we aggressively manage through current business conditions. Regarding fiscal year 2023, we plan to provide detailed guidance on our fourth quarter call, consistent with our normal cadence. With that said, we continue to view a long-term shipbuilding revenue CAGR of 3% as appropriate, and we are pleased to reaffirm our long-term free cash flow target through 2024, as I have discussed.

We would normally expect incremental shipbuilding operating margin improvement in 2023. However, given the current economic environment, we'll need to close out the year to assess risk, retirement, and operational efficiencies before we can provide more insight. We will finish the year just as we've started, focused on execution, and we will provide a more comprehensive update on our view for 2023 in February. With that, I'll turn the call back over to Chris for some final remarks before we take your questions.

Chris Kastner (President and CEO)

Thanks, Tom. Before wrapping up, I would like to highlight on slide 12 that we will release an updated HII Sustainability Report in the coming days, which will be available on our website. We are focused on the alignment of the program with our mission, values, and purpose, and structuring our strategy around securing our business, building our community, and protecting our resources. We have enhancements in process for future sustainability reporting and expect another update to be re-released in the spring of 2023. Finally, turning to slide 13, we remain focused on successfully executing on our strong backlog and positioning for long-term growth, which will generate value for our employees, customers, and shareholders. Now, I will turn the call over to Christie for Q&A.

Christie Thomas (VP of Investor Relations)

Thanks, Chris. As a reminder to everyone on the call, please limit yourself to one initial question and one follow-up so we can get as many people through the queue as possible. Operator, I will turn it over to you to manage the Q&A.

Operator (participant)

Absolutely. As a reminder, if you would like to ask a question, please press star followed by one on your telephone keypad. If for any reason you would like to remove that question, please press star followed by two. As a reminder, if you are using a speakerphone, please remember to pick up your handset before asking your question. The first question comes from the line of Doug Harned with Bernstein. You may proceed.

Doug Harned (Senior Analyst Covering Global Aerospace and Defense)

Good morning. Thank you.

Chris Kastner (President and CEO)

Morning, Doug.

Tom Stiehle (EVP and CFO)

Morning, Doug.

Doug Harned (Senior Analyst Covering Global Aerospace and Defense)

Yeah. On Newport News, can you give us a sense of how things are progressing on Virginia-class? I mean, that's been. I know you had less risk retirement this time around, but you talked a lot about this and the importance of getting labor back and trained. Where does that stand now in terms of your outlook?

Chris Kastner (President and CEO)

Yeah, thanks for that, Doug. Definitely some stability in the Virginia-class program right now. The Block IV and 796, which is the next boat to be delivered, some positive developments from a schedule standpoint. They are very, very stable and looking towards beginning of next year to get that boat delivered. So I'd say stability in the schedule. Still working very hard on the fundamentals of cost and efficiency. But I think.

Doug Harned (Senior Analyst Covering Global Aerospace and Defense)

In terms of cost, the cost and efficiency, I guess what I'm trying to get at is there a clear path to a point where you're really happy that you've, you know, you've got everything under control in terms of cost and so forth. I mean, I'm just trying to get a picture for what that trajectory looks like to you now over the next few quarters, say.

Chris Kastner (President and CEO)

Yeah, sure. Fundamentally, when you have stability in your schedules and stability in your planning documentation, and you know what, work is in front of you, then you're gonna have a better chance to have an efficient performance from a cost standpoint. First things first, let's get the schedule right. We've got the labor. They are fully staffed on Block IV and Block V. They're making progress on their milestones. Now it's just knocking down that work, getting through the test program on 796 and progressing on 798. I'm not gonna give you a trajectory on margins on the VCS program. I will say the best indicator within the submarine program is, are you making your milestones? Are your schedules stable?

If they are, you're gonna meet your cost objectives. There's a lot of fight in that team. They're working very hard to get that done. I know that the team's working very hard on the fundamentals and the operating system. If they get that right, and they work on that every single week, which they are, they're gonna be successful.

Doug Harned (Senior Analyst Covering Global Aerospace and Defense)

If I can squeeze just one more in here, related to cost. You mentioned inflation in the last quarter, and historically, you know, I felt that your view has been that, you know, you can handle inflation. You've got enough opportunities in terms of escalators and so forth to deal with that. Can you talk about what may be different this time? Because we're seeing in a lot of defense companies now that inflation in the short term is more difficult than we've seen in, you know, prior periods.

Chris Kastner (President and CEO)

Yeah. Well, as I said previously, we do have some protection. The biggest issue for inflation for us is gonna be in our really on our new contracts in ensuring that we get the bids right from the supply chain and ensure that the cost and schedule is correct when we bid those new contracts. That's probably the greatest risk for us. We do have some inflationary issues within some of our piece parts in the supply chain where we didn't have those under contract. As I said previously, we have some protection for that, although not fully protected.

The real issue for us related to inflation is getting the bids right on our new contracts, and we're working very hard to ensure we do that.

Doug Harned (Senior Analyst Covering Global Aerospace and Defense)

Okay, great. Thank you.

Chris Kastner (President and CEO)

Sure.

Operator (participant)

Thank you for your question. The next question comes from the line of Robert Spingarn with Melius Research. You may proceed.

Robert Spingarn (Managing Director, Aerospace, Defense and Space Equity Research)

Hey, good morning.

Chris Kastner (President and CEO)

Morning, Rob.

Robert Spingarn (Managing Director, Aerospace, Defense and Space Equity Research)

Tom, what was the organic growth for Mission Technologies in the third quarter, since you have a partial inclusion last year in the third quarter? Then I know Alion has a lot of cost plus work, but how much might wage inflation have contributed to the top line growth there?

Tom Stiehle (EVP and CFO)

When I look at that, you are right. We closed August 19th of last year, so the third quarter last year was incomplete. The organic growth for the quarter specifically was about 1.5%. I look at it for the year. You know, it could be choppy because of the CR at the beginning of the year. We've talked about the slow contracting environment, the wins and then the supply chain issue a little bit on the operational side of that.

The overall Mission Technologies growth for the year is 4.3%. Alion itself grew 8%. Q2, we told you about 6% for Mission Technologies as a whole. Mission Technologies revenue top line is a little light. Usually, that third quarter for us or the fourth fiscal quarter is a sweep up quarter for both Alion and legacy MDIS. We had anticipated when we told you about an 8% growth against the Q2 top line, we would see about $650, and that didn't materialize there. As I said, factors were that we didn't sweep up as much as we thought we would in funds, have open seats we've talked about in hiring professionals there and then just some minor material didn't hit in the quarter. That's where we stand with growth.

Chris Kastner (President and CEO)

I would also mention that. Sorry, Rob. I don't recall if you just said that, Tom. I think that we had pro forma growth of 8% year-to-date within Mission Technologies. Two real good wins in DMAS and Air Force training contract, which is very positive. The book-to-bill is positive. I think that team has a lot of opportunity moving into 2023.

Robert Spingarn (Managing Director, Aerospace, Defense and Space Equity Research)

Okay, just a high-level one, Chris. On this, potential five-unit block buy for the Columbia-class, could you talk about what that might mean opportunity?

Chris Kastner (President and CEO)

Well, we assume that the Columbia-class will kind of orderly from the Navy and Electric Boat that that's been included in all our capacity planning and how we think about the business going forward on our 3% growth rate. I think the Navy has been very thoughtful in how they order material and how they're thinking about bundling procurements to ensure they get the best economics relative to ordering material from the supply chain. I think it's a smart way to do it. We're just in the initial stages of kind of talking about it. It'll definitely be involved a part of our growth rate going forward.It'll be a source of growth in Newport News, and I think the team is smartly working on it.

Robert Spingarn (Managing Director, Aerospace, Defense and Space Equity Research)

Is it fair to think that's better visibility than normal, you know, five boats?

Chris Kastner (President and CEO)

Absolutely. You think, geez, you think about the defense strategy, and you think about the CNO nav plan and the amount of visibility we have right now into what our backlog will be and the demand signal we're gonna get in shipbuilding. We have very good visibility and high confidence in years from a visibility standpoint. The important thing we need to do is focus on execution, make sure we get these bids correct, and then get these ships delivered 'cause the Navy needs them.

Robert Spingarn (Managing Director, Aerospace, Defense and Space Equity Research)

Okay, fair enough. Thank you.

Chris Kastner (President and CEO)

Yes.

Tom Stiehle (EVP and CFO)

I'd comment too on the back end of that. We added a new slide to kind of hit the strong demand for shipbuilding. You can see a backlog chart in slide five there, which shows that backlog, you know, at the $46 billion range. That sustains itself through at least 2026. We have excellent visibility from both the 30-year shipbuilding plan, the five-year defense plan, and then the more immediate FY 2023 budget and expectations, what we see in the near term. We have tremendous visibility of the awards we expect to come in the next 3-5 years.

Chris Kastner (President and CEO)

Hey, Rob, you still there?

Operator (participant)

Thank you.

Chris Kastner (President and CEO)

Okay.

Operator (participant)

The next question comes from the line of Scott Deuschle with Credit Suisse. You may proceed.

Scott Deuschle (VP and A&D Equity Research)

Hey, good morning. Thank you so much for taking my questions.

Chris Kastner (President and CEO)

Morning.

Scott Deuschle (VP and A&D Equity Research)

Tom, can you quantify the benefit of the Columbia-class incentives? Just wondering if that's something that could also help the business in the coming quarters or maybe if that's a one-off. Thank you.

Tom Stiehle (EVP and CFO)

Yeah, sure. So you'll see that in the queue at later this morning when it comes out. The quantification, that's $41 million of Columbia-class incentives. You know, over the last two or three calls, we've highlighted that as we're working closely with our customer, our Navy customer, on how the Virginia-class and the Columbia-class play out, both the additional boats to Block V, the Block VI boats, and then the build two. We're working closely with the program offices as far as what those requirements look like, what are the schedule requirements the boats have to fly out here. That drives, like, capacity and capability requirements within Newport News.

We've worked close with the program office there, and we see a need for additional capacity that we have in the yard. We've negotiated a position right now, and we've achieved those incentives in the quarter. It was $41 million.

Scott Deuschle (VP and A&D Equity Research)

Got it. Thank you. Chris, apparently the Ukrainians recently used unmanned surface vessels in combat, I think last Saturday. I think they were these kamikaze style USVs. If I recall correctly, you've said in the past that the ConOps was something that still needed some work on the unmanned surface vessels. I guess, you know, now that we've actually seen these in combat, do you think that's a big moment for the class and weapon systems broadly? What does that mean for Huntington? Thank you.

Chris Kastner (President and CEO)

Yeah, Scott. I don't wanna comment on the specific mission. I think getting these assets in the water, executing missions for the customer is very important because it's going to demonstrate how positive and productive these can be as a force multiplier. We think it's the most positive thing we can do is get these in service so they can demonstrate their pretty impressive capability. Now, I don't know if we've hit an inflection point from a revenue standpoint as of yet, but there's definitely momentum that's being gained both sub-sea and on the surface. A number of different ConOps and missions that are being contemplated for these type of vessels.

We only think it's a positive development, and we think it will continue to gain momentum, and we really like where we're positioned.

Scott Deuschle (VP and A&D Equity Research)

Got it. Thank you so much.

Chris Kastner (President and CEO)

Sure.

Operator (participant)

Thank you for your question. The next question comes from the line of David Strauss with Barclays. You may proceed.

David Strauss (Managing Director and Equity Research of Aerospace and Defense)

Thanks. Good morning.

Chris Kastner (President and CEO)

Morning, David.

David Strauss (Managing Director and Equity Research of Aerospace and Defense)

Tom, could you just go through the rundown of EACs on the quarter?

Tom Stiehle (EVP and CFO)

Cumulative adjustments that we had, David. It was 84 favorable, 57 unfavorable, a net of $27 million. Portion of that was about half on Newport News and then 25% each for Ingalls and NT.

David Strauss (Managing Director and Equity Research of Aerospace and Defense)

Great. You know, as we think about the opportunity for improved shipbuilding margins next year, I mean, you obviously talked about that there, you know, potentially could be some leverage on the volume side. What about, Chris, I guess, from a milestone perspective, how do you see the milestones in 2023 relative to 2022 giving you an opportunity for, you know, to enhance margins?

Chris Kastner (President and CEO)

Yeah. We'll give you a comprehensive update on the milestones on the next call. The five deliveries in 2023, we're still very positive on. Those schedules are holding, and we're pacing towards delivery on those ships. We're gonna assess the risk and opportunity every quarter. It is definitely still a tight labor market. There have been some positive indicators here as of late, but I don't think two data points is necessarily a trend. We're gonna be measured in how we deal with that, assess our risk and opportunities, and then provide you comprehensive update at the end of the year. The milestones in 2023 are holding. We're very comfortable with that we need to get these assets delivered and the team's working very hard to do that.

David Strauss (Managing Director and Equity Research of Aerospace and Defense)

Thanks very much.

Chris Kastner (President and CEO)

Sure.

Operator (participant)

Thank you for your question. The next question comes from the line of George Shapiro with Shapiro Research. You may proceed.

George Shapiro (Managing Partner)

Yes, I just wanted to pursue. You raised the long-term assets for the pension to 8%. I guess that's maybe just based on how bad it is this year, but if you give some color on it. Then also, how that affected your, not the contribution, how it affected your adjustments for next year.

Tom Stiehle (EVP and CFO)

Yeah, sure, George. I appreciate the question. Yeah. We did raise that. You know, when we look at the company as a whole in business now 11 full years, this is the 12th. Nine of the 11 we've exceeded the target of 7.25 that we've had. Obviously, this is a down year. These two years we've less than 7.25. As we've highlighted to the street, we're, as our peers are too, we're in the double-digit negative returns against the pension plan that we have here. We do think it's prudent when we looked at it going forward that at least for next year, we have an expectation that the return on assets could be 8%. We raised that 0.75 of a point.

Relative to the pension, you can see from our table that we gave you that updated the parameters for 2023. The discount rate has changed. It's gone from 3% to 4.90%. So that's up 190 basis points. We gave you the returns on what we saw through the year-to-date at -15%. You can see that flows through the FAS/CAS adjustment goes down about $102 million. So that's some headwinds on EPS next year. We'll keep you updated. At the next call, we give you the entire table for a five-year projection going forward.

George Shapiro (Managing Partner)

Okay, thank you.

Operator (participant)

Thank you. The next question comes from the line of Seth Seifman with JPMorgan. You may proceed.

Seth Seifman (Executive Director)

Oh. Thanks very much, and good morning.

Chris Kastner (President and CEO)

Good morning.

Seth Seifman (Executive Director)

I'd actually just say that I was gonna ask. Good morning. I was gonna ask the question about the asset returns, and I figured no one else would ask that question, but if someone did, I knew it would be George. Maybe thinking about a different kind of bigger picture question. I apologize if this is a little bit squishy, but I was looking for something on your website recently. You go on the site, and I think initially there's a picture of like a soldier, like an army soldier, you know, holding a gun, and you've got kind of sea, cyber, land, air, joint, all domain.

When you think long term, Chris, about how you wanna position the company during your tenure, is there a point, you know, by 2030 or whatever, where you know, you wanna see shipbuilding be, you know, a certain percentage of sales and much lower than it is right now?

Chris Kastner (President and CEO)

Well, it's going to be a lower percentage simply because we think we've made really good investments in growth markets. When you think about the technology markets that we're in in Mission Technologies, they really directly relate to the national priorities when you think about AI, ML, cyber, unmanned, ISR, all live virtual constructive training and advanced synthetic training. Those directly relate and apply to the defense priorities moving forward. They will naturally grow, and shipbuilding will be a less of a percentage of the portfolio. But make no mistake, shipbuilding will always kind of be at the heart of this company, and we're focused on it.

I think we'll naturally reposition a little bit based on the technology. It's interesting, you know, the Navy's asking for this, right? These are Navy priorities, and I can think of no better way to serve your customer than to answer their call relative to additional more complicated missions that they need to execute. It's a good question. It's one we think about a lot, and we think we're making the appropriate investments in these technology areas.

Seth Seifman (Executive Director)

Cool. Thank you very much.

Chris Kastner (President and CEO)

Sure.

Operator (participant)

Thank you for your question. The next question comes from the line of Gautam Khanna with Cowen. You may proceed.

Gautam Khanna (Analyst)

Wanted to ask, just to be clear, the labor shortfall this year, how does that impact the timing of any milestones in the next couple years? Are the eight milestones you cited last quarter for 2023 still on for 2023? Is there any Q4 weight to those, et cetera?

Chris Kastner (President and CEO)

They're still on for 2023. We assess the labor situation, our labor plans and our program schedules on a quarterly basis. Gautam, thanks for the question. It's Chris. We assess our labor plans and our program schedules on a quarterly basis. All of the labor situation that we've seen this year, what we expect for next year, is all included in those program schedules, and we're still comfortable with those milestones.

Gautam Khanna (Analyst)

Okay. What do you anticipate your labor hires to be this year relative to the 5,000? You know, what is the impact on an annual basis from, you know, the delta between 5,000 and whatever it's likely to be?

Chris Kastner (President and CEO)

Well, we're on pace to get to 5,000. I'm still comfortable with that number. We're gonna have to see how it goes. We've had a couple good indicators here. We're still comfortable with that. As we said previously on this call, we'll give you a better highlight on what we think about 2023 in February.

Gautam Khanna (Analyst)

Okay. Do you have a preliminary view on what you need to add next year in terms of labor?

Chris Kastner (President and CEO)

Not at this time. We're working on that now. We're coming through our plans and we'll provide you that information in February, Gautam.

Gautam Khanna (Analyst)

Thank you, guys.

Chris Kastner (President and CEO)

Sure.

Operator (participant)

Thank you for your question. The next question comes from the line of Myles Walton with Wolfe Research. You may proceed.

Myles Walton (Managing Director)

Good morning. On the topic of milestones, I just wanted.

Chris Kastner (President and CEO)

Myles, welcome back. Sorry.

Myles Walton (Managing Director)

Hey, thanks, Chris. Glad you noticed my brief absence, albeit. On the topic of milestones.

Chris Kastner (President and CEO)

Yes, very brief.

Myles Walton (Managing Director)

On the topic of milestones, I was hoping you could touch on the two that were still on the slate for 2022, DDG 123-

Chris Kastner (President and CEO)

Yeah

Myles Walton (Managing Director)

EMALS.

Chris Kastner (President and CEO)

Sure. 123's on schedule, had some really good trials. They're on pace to get delivered before the end of the year. EMALS has been initiated. I was actually down the spaces last month, maybe two months ago. All the equipment's installed, doing localized testing, starting that test program, so some positive developments there. Yeah, each of those are on schedule.

Myles Walton (Managing Director)

Okay. Got it. I was just going off the. I think the release talked about few, if any, milestones in the fourth quarter, so those must be minor milestone releases or risk reserve releases.

Chris Kastner (President and CEO)

Well, we'll assess it. We'll assess them when they're complete and review the entire EAC risk and opportunities and then deal with the outcomes of each.

Myles Walton (Managing Director)

Okay. All right. Maybe Tom, on the progress payment rule, or Chris, is there any legislative indication that that rule is going to be reversed at some point? Because I mean, I know it's favorable, but I'm imagining you're flowing it to your suppliers as well. I'm just curious, are you anticipating a rule change, or are you actually seeing legislative action or policy action that would suggest it's going to change next year?

Tom Stiehle (EVP and CFO)

We think there's interest. It's Tom here. Yes, thanks for the question. We think there's interest there up on the hill. I don't think it's a top priority right now. We'll have to see how that plays out as we get through the elections. Does it get inserted into a bill by year-end or not? As the year progresses, since there's just one last tax payment on May, kind of mid-December timeframe, the benefit this year doesn't play out. Obviously, as soon as that law swings over, as we've been highlighting, it's a $250 million impact, a positive impact to the free cash flow. We're eagerly awaiting that. I'm hopeful that it does get changed, but we'll just have to see how that plays out.

Myles Walton (Managing Director)

Sorry, Tom. I was referring to the progress payment rule shift that you thought it would be reversed in 2022. Now it's gonna be reversed in 2023.

Tom Stiehle (EVP and CFO)

Oh, I'm sorry.

Myles Walton (Managing Director)

Just the timing of progress payments.

Tom Stiehle (EVP and CFO)

Yep, I got it.

Myles Walton (Managing Director)

I'm asking, do you actually see legislative inertia there?

Tom Stiehle (EVP and CFO)

I would tell you that, as I told you at the Q2 call, I believed it was gonna be pushed to the end of the year right now, and that's a piece of the uptick that we have in our free cash flow guidance that we gave you. We told you $225 million was the midpoint. We now project to have to pay those payments back in 2023 timeframe. It's an uptick. For this year, it's an adjustment in the free cash flow bridge that we gave you in the briefing. We anticipate paying those back in the first quarter of 2023.

Myles Walton (Managing Director)

Okay. All right. Thank you.

Tom Stiehle (EVP and CFO)

Yep.

Chris Kastner (President and CEO)

Thanks, Myles.

Operator (participant)

Thank you. The next question comes from the line of Ronald Epstein with Bank of America. You may proceed.

Ronald Epstein (Senior Equity Analyst)

Yeah. Hey. Hey, good morning.

Chris Kastner (President and CEO)

Morning

Ronald Epstein (Senior Equity Analyst)

Looking at Mission Technologies, do you still feel confident on that 6%-8% margin target by 2024?

Tom Stiehle (EVP and CFO)

Yeah. We're on cost right now. You know, when we look at the EBITDA right now, we've given you the numbers and where we finished the previous year in 8% range. If you notice, we just adjusted the EBITDA and the target down from 8.5% to 8.3% because of the volume pressures that we have. We feel comfortable with that right now. As in the briefing we have, we still have a robust pipeline. We feel comfortable that we're getting our momentum, the portfolio itself and the technology that we're going after, many opportunities out there. I do.

I think there's a little stress on it right now for 2022, just for the volume of sales as we adjust our base and overheads around that. That's still a target that we've been highlighting, and it's good for modeling going forward.

Chris Kastner (President and CEO)

Yeah. Ron, remember, a lot of that work is cost plus. We think there'll be a lot of stability in the margin rate moving forward, so we're still comfortable with that.

Seth Seifman (Executive Director)

Got it. If you look at Newport News and you back out the Columbia, right, the $41 million, that suggests the balance of the business was at maybe 4% margin in the quarter. Can you kind of walk through what was going on there?

Chris Kastner (President and CEO)

We had minor adjustments or what I'll call tweaks in EACs within the quarter on a few programs at Newport News. Non-material enough to be mentioned here, and it was offset by the Columbia-class incentives. Now incentives and schedule incentives, performance incentives are normal in our contracts. It's a normal way to incentivize performance. We think it's a good method to incentivize performance, so it's not out of the ordinary. But we have to assess our EACs every quarter. We make minor adjustments where we see fit to the risk and opportunities, and there was just some minor adjustments on a few of the programs there.

Seth Seifman (Executive Director)

Can you give any more color on, like, what programs?

Chris Kastner (President and CEO)

Yeah. Not material enough to mention. It was across a number of them.

Seth Seifman (Executive Director)

Okay. All right. Thanks.

Chris Kastner (President and CEO)

Sure.

Operator (participant)

Thank you for your question. The next question comes from the line of Noah Poponak with Goldman Sachs. You may proceed.

Noah Poponak (Managing Director of Aerospace and Defense Equity Research)

Hi. Good morning, everyone.

Tom Stiehle (EVP and CFO)

Good morning.

Chris Kastner (President and CEO)

Hi, Noah.

Noah Poponak (Managing Director of Aerospace and Defense Equity Research)

Why did you choose to exclude the milestone slide from the deck this quarter?

Chris Kastner (President and CEO)

Yeah. We only do that twice a year. We've kinda inserted that as a convention. We've done it twice a year. I can comment on any one of them that you'd like.

Noah Poponak (Managing Director of Aerospace and Defense Equity Research)

Okay.

Chris Kastner (President and CEO)

As I said previously to some of the questions, the last two for this year are on schedule. Deliveries for next year are on schedule. It's just been our convention twice, you know, twice a year to go back in time.

Noah Poponak (Managing Director of Aerospace and Defense Equity Research)

Okay.

Chris Kastner (President and CEO)

Yeah, sure.

Noah Poponak (Managing Director of Aerospace and Defense Equity Research)

Okay. I had forgotten that. Yeah, I wasn't sure if it was, hey, something's happening with the milestones, or it's, you know, nothing's changed, so it doesn't need to be there.

Chris Kastner (President and CEO)

No, it's

Noah Poponak (Managing Director of Aerospace and Defense Equity Research)

I just had forgotten that it was twice a year, so.

Chris Kastner (President and CEO)

If something was happening with the milestones, I'd tell you.

Noah Poponak (Managing Director of Aerospace and Defense Equity Research)

Yeah. Okay.

Chris Kastner (President and CEO)

They're on schedule. Thanks for that. It's just that that's our convention.

Noah Poponak (Managing Director of Aerospace and Defense Equity Research)

Got it. Okay. Perfect. With your discussion of inflation, I mean, I guess at the highest level of addressing it, do you expect inflation to actually negatively impact the margin in any noticeable way in the medium term, or do you feel you have the contracting conventions to offset it?

Chris Kastner (President and CEO)

Yeah, it could. I'll start, and then Tom can chip in here. We do have some protections, right, from an inflation standpoint. We're very fortunate that with our relationship with the labor unions, we're able to get long-term arrangements there, which helps us mitigate it to some extent. Having suppliers under contract before we entered into this mitigates it to some extent. Our EPA clauses mitigate it some. Absolutely, when you think about our exempt workforce and some of the increases that we've had to provide from a salary standpoint for new hires, that impacts our labor rates a bit. Some of the general inventory that you can't put under contract could impact it a bit as well.

I would say it modestly impacts it. We've assessed all of it in our EAC process, and we think we have it, but we're gonna have to be mindful of it moving forward.

Noah Poponak (Managing Director of Aerospace and Defense Equity Research)

Okay. I guess your commentary about next year's shipbuilding margin, do we need to consider the potential that it is down year-over-year, or were you more just saying, you know, the plan was some expansion that's still possible, but flattish is also possible?

Tom Stiehle (EVP and CFO)

I think it's more of the latter there. Obviously, we wanna come through. We're watching our risk profiles, the risk registers, what gets burnt down this quarter, the performance and the cadence. Are we maintaining schedule? The hiring and the experience in the yard, the progress that we make with the experience and the material that hits into the yard. We're running our EAC process. A piece of that EAC process is the contract adjustments we get, the EPA and other type of provisions that will handle for inflation. To piggyback on what Chris said earlier, you know, depending on the portfolio and the mix, Ingalls is more 90/10 60 price. Newport News is 50/50 cost type and fixed. Which contracts have EPA clauses, which contracts are being impacted.

A lot of things are moving around there between inflation, supply chain, interest rates, performance, material receipt and progressing. We really wanna get a look-see on where we stand right now. We told you 8%-8.1%, and we still feel comfortable with that right now. We had a strong first half, which we kinda foreshadowed. We told you the back half would be about 7% for shipbuilding. We came in at 7.4% with those incentives. You can do the math. We're still holding at 7% for the back half of the year. You can do the math on that, what Q4 looks like. I think 8%-8.1% is still a valid endpoint for us.

I'd like to see where we land on that, see our run rates, and then we'll factor that into the baseline going forward on the February call.

Noah Poponak (Managing Director of Aerospace and Defense Equity Research)

Okay. Thanks so much.

Tom Stiehle (EVP and CFO)

Mm-hmm.

Chris Kastner (President and CEO)

You're welcome.

Operator (participant)

Thank you for your question. We now have a follow-up question from the line of David Strauss with Barclays. You may proceed.

David Strauss (Managing Director and Equity Research of Aerospace and Defense)

Thanks for taking the other question.

Tom Stiehle (EVP and CFO)

Sure.

David Strauss (Managing Director and Equity Research of Aerospace and Defense)

Just wanted to, Tom, maybe if you could run through the expectations on net working capital now. You know, I think you had said, I think right now we're at about 11%. I think you had said getting down to 8% at the end of this year and then relatively flat on a percentage of sales basis from there, but you know, coming down in absolute terms. If you could just give an update. Thanks.

Tom Stiehle (EVP and CFO)

Sure, yeah. Yep, that's exactly what I left it at 9.3%. About 9.3% was the working capital sales in Q2. We are just about 11%, 11.1% for Q3. I anticipated that. We'll turn the corner a little bit as we exit the year here, as we kinda work ourselves through the work, the trades, the invoicing, payments, and progressing. That will come down. Then we've talked about the milestones with the five deliveries of next year, which are still in play here. I see 2023, that chop dropping back to more traditional 6%-8% range, and I would expect that we would run in that rate over the next couple of years. That's the plan, and we're on that trajectory.

David Strauss (Managing Director and Equity Research of Aerospace and Defense)

Thank you.

Tom Stiehle (EVP and CFO)

Mm-hmm.

Operator (participant)

Thank you for your question. That concludes the question-and-answer session. I will now pass the line back to the management team, Chris Kastner, for final remarks.

Chris Kastner (President and CEO)

Thanks a lot. Thanks very much for your interest and or continued interest in HII. We welcome your continued engagement and feedback. Thank you.

Operator (participant)

That concludes the conference call. Thank you for your participation. You may now disconnect your line.