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Huntington Ingalls Industries Inc
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Ladies and gentlemen, thank you for standing by, and welcome to the Second Quarter 2020 Huntington Ingalls Industries Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. [Operator Instructions] Please be advised that today’s conference is being recorded. [Operator Instructions]
I would now like to hand the conference over to your speaker for today, Dwayne Blake, Vice President, Investor Relations. You may begin.
Thanks, Wanda. Good morning, and welcome to the Huntington Ingalls Industries second quarter 2020 earnings conference call. With us today are Mike Petters, President and Chief Executive Officer; and Chris Kastner, our Executive Vice President and Chief Financial Officer.
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. Actual results may differ. Please refer to our SEC filings for a description of some of the factors that may cause actual results to vary materially from anticipated results.
Also in their remarks today, Mike and Chris will refer to certain non-GAAP measures. Reconciliations of these metrics to the comparable GAAP measures are included in the appendix of 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 earnings release.
With that, I’ll turn the call over to our President and CEO, Mike Petters. Mike?
Thanks, Dwayne. Good morning, everyone, and thanks for joining us on today’s call. I do hope that everyone is staying healthy and safe during these trying times. So I want to start by expressing my very deep appreciation and gratitude to the workforce of HII. Since the COVID-19 pandemic started back in March, our team has been on the front lines of this battle. They have balanced fighting this highly contagious virus, while at the same time using every bit of their energy, focus, skill and creativity to achieve key milestones on our programs and help us navigate through one of the most challenging times of my 30-plus year career. And I can say without a doubt that what I have witnessed from this team over the past five months absolutely epitomizes our motto of hard stuff done right now.
Now turning to Slide 3 of the presentation. I want to help you understand the thought process behind our approach to dealing with the COVID-19 pandemic in our shipbuilding business. We have hired about 25,000 people in the last five years in an environment where unemployment was historically low. And we have invested over $0.5 billion to train and certify those folks to execute the backlog that we’ve been able to capture over the last five years, which now totals $46 billion. So as the pandemic broke, our first priority was to protect this investment in the workforce so that they would be trained, ready and available to execute our record backlog as we emerge from this difficult time. And at the outset, we decided to give our workforce the flexibility they needed to deal with the disruption in their personal lives.
Think back to what it was like across the country in the middle of March. Schools were closing; many companies were forced to layoff portions or in some cases all of their workforce; and in some parts of the country, people were being told to isolate. And this backdrop created a lot of uncertainty and disruption for our workforce. So we introduced several benefit changes, including liberal leave to make it easier for our employees to stay home if they were sick or if they had child or elder care challenges, so those absences would not count against them. At the same time, we also had to stay in step with the CDC guidelines in order to assure those that could come to work, that it was safe to do so. And this included adjustments to shift schedules, to facilitate social distancing, temperature screenings, enhanced cleaning of high touch point areas between shifts, and requiring face coverings by everyone entering our shipyards.
So during the second quarter, attendance of our hourly production workforce at both shipyards was approximately 65% with several days during April and May around 50%. Following the end of our liberal leave policy in May, we did see those metrics improve. And during June and July, attendance of our hourly production workforce at both shipyards was approximately 77%. Now cases have been increasing in our shipyards as states have opened up, but we are now seeing a sustainable and manageable level of attendance, and we continue to refine our policies to adapt to the changing circumstances.
Now as a point of reference; after Hurricane Katrina hit the Gulf Coast in 2005, we lost a significant portion of the experienced workforce at Ingalls. With COVID-19, we took a lot of bold and aggressive actions to make certain that this pandemic did not result in a similar outcome. And I am confident that we have made the right decisions to preserve our workforce for the path ahead.
Now we have also been making significant investments over the past several years to digitize shipbuilding processes, to accelerate efficiency and training of our young workforce. This investment created the infrastructure in our shipbuilding support functions that allowed us to increase the number of people we had working remotely by a factor of 10 in a matter of days. COVID-19 has been an extremely disruptive factor on our business and we have been pursuing all potential avenues for recovery of our costs with our customers. Now there are indications that we may be able to recover directly related COVID-19 labor costs like quarantining and other paid time-off per the provisions in the CARES Act or any subsequent legislation. However, at this point, there remains no clear path for recovery of delay and disruption impact, though the customers’ intentions still appear to be favorable.
Now turning to Slide 4 of the presentation. During the quarter, we recognized a charge of $167 million, driven primarily by updated cost and schedule assumptions across all of our programs. The majority of the impact $111 million is on the Block IV boats of the Virginia-class submarine program, driven by recent cost and schedule performance and updates to assumptions for future program performance and efficiencies, which include the impacts of COVID-19. And let me provide some additional color for context and clarity.
Our plan called for cost and schedule improvements as we work down the learning curve on the Block IV boats in support of a two-boat per year cadence. As we conducted our regular second quarter program status reviews, it became clear that the VCS program was particularly impacted by staffing and efficiency challenges as we reprioritize work to align with our customers priorities at Newport News. This in turn disrupted the cadence of work and significantly impacted our ability to reasonably rely on the assumptions we were using in our risk registers for both the boat learning and cost improvement. As a result, we are resetting our risk registers to reflect the performance trends we experienced in the quarter, including the impact of COVID-19. Note that the slide includes key milestones for our next two Block IV delivery boats.
I am very proud of the team for their tireless work and uncompromising commitment to safety and quality during the ongoing pandemic. Going through these challenging times together will give the team invaluable insights and experiences that will help them learn, grow and drive performance that meets our safety, quality, cost and schedule targets as we move forward.
Now let me share some highlights from the quarter, starting on Slide 5 of the presentation. Sales were $2.0 billion and diluted EPS was a $1.30 for the quarter. These results included the aforementioned $167 million charge. New contract awards during the quarter were approximately $3 billion, including a $1.5 billion contract for the construction of LPD-31, resulting in backlog of approximately $46 billion at the end of the quarter, of which approximately $21 billion is funded. Our backlog is a tremendous source of visibility and stability with over 85% of expected FY2020 to FY2024 shipbuilding revenue under contract, and it’s well supported by the annual congressional authorization and appropriations process to this point.
And regarding activities in Washington, we supported COVID relief efforts by the Navy, the Department of Defense and Congress to help ensure liquidity of the supply base, provide contractual relief and promote workforce retention. We also continue to work with Congress in supporting consideration of the fiscal year 2021 President’s budget request, and we are very pleased with the strong support for shipbuilding and other national security priorities reflected by respective defense authorization bills in the House and the Senate. The House’s recent passage of appropriations measures is encouraging, and we have urged the Senate to complete the appropriations process as soon as possible. And finally, we will continue to work with Congress and the administration to support additional authorities and investments that will enable our nation’s economic recovery through the defense industrial base.
Now, let me share a few business segment highlights from the quarter. At Ingalls DDG 119 Delbert D. Black was delivered to the Navy, production was started on DDG 128 Ted Stevens, the first ship of the FY 2018 multi-year contract. And DDG 62 Fitzgerald sailed away from the shipyard.
On the LPD program, the contract for LPD 31, the second ship and the Flight II class was awarded. And in addition NSC 9 Stone is continuing to progress through the test program and is expected to deliver late this year. Notable events since the end of Q2 include the contract award for the DDG FY 2020 option ship, the eighth Flight III ship and the sail away of LHA 7 Tripoli from the shipyard.
At Newport News, CVN-79 Kennedy is approximately 74% complete and the team remains focused on compartment completion and completion of our single-phase delivery proposal for submission to the Navy. CVN-73 USS George Washington is continuing to progress through its final outfitting and test phase and is approximately 78% complete, the next major milestone for the ship is the start of crew movable later this year.
In our Technical Solutions business, the team had two re-compete wins – two key re-compete wins, including a contract award to provide analytical support services to the U.S. Special Operations Command and an award from the U.S. Postal Service Office of Inspector General to continue providing support services to the office of the Chief information Officer. TS also recently announced a major IDIQ contract award worth up to $3 billion over a 10-year period from the Department of Energy to provide nationwide deactivation, decommissioning and removal service at excess DOE facilities across the nation.
Overall these recent wins reaffirms HII’s longstanding strategic partnerships with several of our key customers. In addition, TS recently completed a strategic equity investment in Sea Machines Robotics, a Boston based autonomous technology company that specializes in advanced software for unmanned surface vessels. This investment represents our commitment to advanced innovation across the unmanned systems market and our drive to form complimentary partnerships in this important and growing domain.
I would like to conclude my prepared remarks by highlighting a few key attributes of our business. And these attributes point to a very stable foundation, a bright future as we work our way through this undoubtedly challenging period. We have a management team that in my estimation is the best in the business, the thoughtfulness, rigor, and resolve that the team has exhibited by continuing to meet programmatic milestones while dealing with the disruption from COVID-19 across the business has only reinforced my view.
Over the past five years, we have made significant investment in human capital and took the right steps as the COVID-19 pandemic broke, to preserve our workforce so they would be trained, ready and available to execute our record backlog as we emerge out of this difficult time.
In addition, our balance sheet is very strong. As Chris will discuss, we have taken a number of prudent actions recently that will lower our cost of capital and provide more than ample liquidity. And we continue to see free cash flow generation accelerating over the next several years as we complete the generation of capital investments in our shipyards this year. And finally our backlog of $46 billion, were over five times last year’s revenues, represents an incredible amount of work for us to execute and as a key reason, we took very aggressive action to preserve the investments we made to train and qualify our workforce over the past five years. This workforce is now operating in a significantly recapitalized more efficient shipyards with better technological tools at their disposal and is crucial to our success as we work through and accelerate out of this period of uncertainty. I want to thank them for the work they’ve done, particularly during the ongoing pandemic.
As I said earlier, this is by far the most challenging operational environment I have experienced in my career, but I know we have the right team in place to answer the call. And I am very confident that we will emerge stronger and even more capable over the long-term. So now I will turn the call over at Chris Kastner for some remarks on the financials. Chris?
Thanks, Mike and good morning. Today, I will briefly review our second quarter results and also provide some comments on our updated 2020 outlook.
Beginning with our consolidated results on Slide 6 of the presentation, our second quarter revenues of $2 billion decreased 7.4% compared to the same period last year. Operating income decreased by $118 million to $57 million when compared to the second quarter of 2019. And operating margin decreased 519 basis points to 2.8%. The decreases were primarily driven by unfavorable adjustments totaling $167 million resulting from updated cost and schedule assumptions across our programs that Mike discussed earlier. Net earnings in the quarter were $53 million compared to $128 million in the second quarter of 2019. The decrease in net earnings for the quarter was mainly due to the result of lower operating income, partially offset by more favorable FAS non-service pension benefit.
From a segment standpoint Ingalls revenues in the quarter of $622 million were unchanged from the same period last year. Ingalls’ operating income of $55 million and margin of 8.8% in the quarter were down from second quarter of 2019, mainly due to unfavorable adjustments, including delaying disruption from COVID-19 and lower risk retirement on the NSC program, partially offset by higher risk retirement on the DDG program related to the delivery of DDG 119 as well as the recognition of incentives related to capital investments for the DDG program.
Newport News revenues of $1.1 billion in the quarter decreased 12.3% from the same period last year. Newport News operating loss of $69 million in the quarter was down from operating income of $71 million in the same period last year. Both the revenue and operating income declines were due to unfavorable cost and schedule performance, and updates to assumptions for future program performance, primarily related to Block IV boats of the Virginia-class submarine program. Technical Solutions revenue in the quarter was essentially flat compared to the second quarter of 2019, while operating margin improved by 344 basis points to 2.8%.
Turning to Slide 7 of the presentation, we’ve made it a priority to strengthen our balance sheet through this period of uncertainty. As I said in last quarter, we issued $1 billion in new senior notes and also entered into an additional 364 day revolving credit facility with $500 million of capacity. We ended the quarter with a cash balance of $631 million and total liquidity of $2.4 billion. As I noted in last quarter, we planned to delever in November by calling $600 million of our senior notes due in 2025.
In the second quarter, cash from operations was $201 million and net capital expenditures were $75 million or 3.7% of revenues, compared to cash used in operations of $44 million and $91 million of net capital expenditures in the second quarter of 2019. We continue to expect to generate over $500 million of free cash flow for the year. During the second quarter, we paid dividends of $1.03 per share or $42 million. Additionally, we contributed $56 million to our pension and post-retirement benefit plans in the quarter of which $45 million consisted of discretionary contributions to our qualified plans.
Moving onto Slide 8, we have provided an updated view of our upcoming key program milestones. These milestones support our updated financial outlook for 2020, which is summarized on Slide 9. For 2020, we now expect shipbuilding revenue to be between $7.6 billion and $7.9 billion, and shipbuilding operating margin to be between 5.5% and 6.5%. In addition to updates to our assumptions for cost and schedule performance, our shipbuilding assumptions have been updated to reflect a single-phase delivery approach for CVN-79. The revised approach will result in an updated program schedule and we’ll move risk retirement milestones to future periods, consistent with that updated schedule.
For Technical Solutions, we expect 2020 revenue to be between $1.2 billion and $1.25 billion. Operating margin to be between 2% and 2.4% and EBITDA margin to be between 5.7% and 6%. These Technical Solutions assumptions include results from the San Diego Shipyard through August, 2020 and results from UniversalPegasus through December, 2020. For your reference, we’ve also provided a view of our full-year expectations for Technical Solutions that excludes San Diego Shipyard and UniversalPegasus in our outlook table. For both revenue and operating margin, we expect fourth quarter performance to be modestly stronger than third quarter performance, given the timing of milestones for the remainder of the year.
Finally, I want to provide a very high-level view of how we currently see 2021. We’re fortunate to have $46 billion backlog that provides a very stable foundation for the business. For shipbuilding, we expect revenue to be between $7.8 billion and $8.1 billion and operating margin to be between 7% and 8%. And for Technical Solutions, we expect revenue of approximately $1 billion and EBITDA margin to be between 7% and 9%. We will come through our planning process over the back half of this year, and we’ll provide further detail for our 2021 outlook during our fourth quarter earnings call.
Now I’ll turn the call back over to Dwayne for Q&A.
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. Wanda, I’ll turn it over to you to manage the Q&A.
Thank you. [Operator Instructions] Our first question comes from the line of Carter Copeland with Melius Research. Your line is open.
Hey, good morning, guys.
Good morning.
I’ll take my initial and follow-up and just ask twp quick ones together. One, can you provide us any insight on cost reimbursement that you may get, that may influence some of this in the future, depending on what happens with that, with the DOD? And then secondly, on the Block IV negative cumes, was there any of that, that was not directly related to the disruption you’ve seen in the yards? Was there something idiosyncratic there that is worth noting? Any color on that you can provide would be great. Thanks.
Sure. So I think as we – as you’re reading in the papers all the time, I think there was authorization for some relief for COVID impact that legislatively that the Pentagon has authorization for, but it was never funded. And so there is a debate right now about, how do you get that funded? And that speaks to stuff that you could say was 100% related to the virus, the – whether it was new cleaning stations or quarantines or things like that. What’s behind that, though, is any sort of follow-on delay in disruption.
Our customers have told us that they want to cover that. They want to find a way to cover that. It’s not really clear to us right now how that’s going to play itself out. There’s legislative work going on. There’s work with the customer going on. But our basic assumption for our report today is that while we think that there’s a possibility that could happen, and we’re pursuing all the angles, our basic assumption is we’re assuming that’s not in the numbers yet. And so that’s definitely an effect for us.
Secondly, Carter, you know us pretty well. Whenever something doesn’t quite go right, our first inclination is to say, hey, that’s on us. We didn’t manage that right. We didn’t have the right qualified person or we didn’t have the right instruction. I mean, getting the quality and the qualified person and the sequence right and getting the instruction right, we start in with a very clear eye view, say, hey, look, that’s on us. We did not get that. That inefficiency was our issue. And we had some of that here in this quarter.
But you don’t have to scratch very far behind those things. And we have those every quarter, but you don’t have to scratch very far behind those things that either there was a direct or indirect or direct impact of COVID or an indirect impact of COVID or we just don’t have the degrees of freedom that we need to be able to recover from that inefficiency because of COVID. And so the challenge is we can isolate costs in our business that are 100% COVID related, but when you move to the rest of it and say, we have inefficiencies in the program performance, to try to separate out how much of that is, this is because we didn’t have the right person at the right time, and this is because we had impact from virus, it becomes really hard to separate all of that. And that’s why we reported it the way we did.
Okay. That makes immense amount of sense. Thanks, Mike.
You bet.
Thank you. Our next question comes from the line of Doug Harned with Bernstein. Your line is open.
Good morning. Thank you.
Good morning.
Staying on the – on Virginia class, you attributed a $95 million to sort of non COVID. And I guess, as you were just saying, like, COVID could have played a role perhaps in some of that, I guess. We hadn’t really seen these kind of issues general dynamics. And I’m just trying to understand how the issues you see there fit into the overall Virginia class Block IV program or are these things that are, in the sense, Newport News specific rather than something that’s impacting the broader lot work?
I’m going to suggest, Doug – that’s a hard question. I’m going to suggest that that’s probably a little bit more related to the uniqueness of Newport News shipbuilding. Newport News has got a wide assortment of different products and different conditions of those ships. And at the beginning of this process, working with the Navy to try to make sure we prioritize deployable ships and then unit deliveries, that starts to move around the priorities in the business a little bit.
And so that’s – when you think about deployable assets, you’re thinking about the submarine repair work that we’re doing. You’re thinking about the RCOH that we’re doing. We’re supporting the Ford at sea right now with weapons elevator work. We’re supporting – we’re, frankly, supporting naval shipyard work around the country in some – with some key skills.
What happens is that you start – when you’re at less than full attendance, you start moving people from one area to another and you start trying to make sure that you are focused on getting the right skills on to the right place. And so I think that’s unique to Newport News. I think that dealing with commission ships and deployable assets is a unique challenge for them in this environment. Having said that, I would say that the focus on near-term milestones across the business has been pretty good. It’s the tail and the opportunity to recover in the tail that is the challenge.
So I don’t know, Chris, if you want to add anything to that.
No, I think that’s it.
And just to follow up. Then as we think forward, in the past, we had been looking to Block IV as you move down the learning curve. And if that matures, there’s a good source of margin expansion. You were looking at more in this 9% to 10% range before for next year and pulled that back some. Are we – as we look longer term, I mean, you’re heading into what, I think, is the more challenging part of CVN-79, the back last fourth of it. I mean, how are you sort of thinking about the margin trajectory at Newport News next year and beyond compared to where you were before?
Well, I’ll start. But for the – thanks, Doug. For the total business, we thought it was important to get some 2021 information out to you all. We’re still coming through our plans for the future years. I’ll give a comprehensive analysis of 2021 and how we see shipbuilding margins evolving, but I only see it improving from the numbers that we gave you for 2021 as we move into future periods.
And let me just add. I think that in general, the trajectory at Newport News today compared to what it was four months ago is going to be a little bit – it’s going to take a little bit longer to get there. And I think it’s two parts of it. One is, how is Block IV going to play itself out? Two is we haven’t negotiated the single phase delivery on 79 yet. And as Chris mentioned in his remarks, that’s going to push milestones that we were looking at for this year and the beginning of next year, it’s going to push those milestones out. So the trajectory is going to be a little bit flatter, but my overall view of what’s going to happen in Newport News is they’re going to hit home runs. It’s just going to take them a little bit longer to get there because of the kind of work mix they have right now.
Okay. Thank you. Thank you.
Thank you. Our next question comes from the line of Myles Walton with UBS. Your line is open.
Thanks. Mike, a quarter like this kind of stands out, where Huntington was more exposed to an abnormality, externality in the market. And I just wonder – versus peers. And I just wonder, as you talk to your customer, and you point out something like this or something like Katrina or pick the externalities that you see more exposed to than not, why doesn’t this enter the discussion about what profitability should look like for the seemingly idiosyncratic risk that you carry in such a long cycle business?
I think that’s a really good question. And it’s certainly a topic of conversation that we have with the customer. I would suggest we probably have that conversation with them weekly, if not daily. The other side of that, Myles, and I’m just going to tell you how the conversation goes, is that the other side of it is it’s – there’s $45 billion of backlog. And there’s revenue for this business that we can see into the next decade. And so there is a lower risk around the stuff that’s under contract and the other stuff that they’re working. So this is all part of the contract negotiations. And I’m not sure that we actually had pandemic in our risk registers when we entered our last round of contract negotiations. It will certainly influence the way that we think about negotiations going forward, but it is a bit of the conversation.
And Chris, if the grand settlements were to come out, how much of the identified costs that you had in the press release would be reversed? Is it the $61 million of discrete items? Is it larger than that? Do you have any visibility on what’s the sales number?
Yes. Well, no doubt, the $61 million is discretely identified as delay and disruption that we estimated against our programs. So it’s very difficult to estimate the impact on the balance of the negative adjustments. No doubt it is included in there, but it’s just very difficult to estimate it at this point.
Okay. I’ll leave it at two. Thank you.
Thank you. Our next question comes from the line of Jon Raviv with Citi. Your line is open.
Thank you. So I guess now that we have 2021 numbers, we’ll be asking about 2022 now. Thank you for that color. But Mike, you mentioned in your opening remarks that you do expect free cash flow to continue to grow here. I mean, Chris, you reiterated $500 million at least this year. Can you talk about the multiyear target? And I think you previously communicated on the $3 billion through 2024 and how you get attention and how you made a pension in that context?
Yes. Okay, Jon. This is Chris. I think it’s – there’s a lot of moving parts in cash right now. We have line of sight on 2020 where we’re comfortable with a bit over $500 million. But with the CARES Act and shipbuilding schedules moving a bit, the single phase delivery, I think it’s a bit early to talk about 2021 and beyond from a free cash standpoint. We’ll give you a comprehensive look at that at year-end in February.
Okay. I mean can you talk about some of the moving pieces that we should be – a little more specifics on some of the moving pieces because that’s a target. I think you’ve previously talked about, so what are some of the big swinging items that could be shifting here? Just because it’s a cumulative target that captures several years and theoretically captures a lot of the maybe year-to-year volatility that UPIs typically see.
Sure. CARES Act, obviously, is timing, timing-related capital, and pension seem to be very consistent. Working capital will move between the years, but I don’t see much impact there. And then obviously, less profitability this year and next will impact us a bit. But that’s really the moving parts at this point. So to give you a good timing and a cumulative number, I’ll just wait until the end of the year.
Well, I’ll keep it at two. Thank you.
Sure.
Thank you. Our next question comes from the line of Robert Spingarn with Credit Suisse. Your line is open.
Hi, good morning.
Good morning.
This could be either for Mike or for Chris, but what’s the framework you apply to your capital allocation decision-making? Thinking about the money you put into the yards, the $1.8 billion, and just the latest returns on the business, ex-COVID, they just aren’t necessarily what you want them to be or consistent compared to peers, particularly when I compare this to your cost of capital. So just curious on the high level framework you applied, the decision making, both in terms of internal investments and then also really M&A as well.
Well, I’ll start, Rob, and then Chris can chime in and correct me. I’m going to take you back and remind you from the very beginning that the capital investment that we made was a generational capital investment. We described it that way from the very beginning. We actually started down the path and said, this is not going to create new sales and, it’s not going to necessarily improve any current program performance. It’s going to be a generational reset of how the business is going to be operating for the next 25 to maybe even 50 years.
What happened is that as we made that investment, they created confidence in our customer that they could – as they saw requirements for more ships, they basically came back and said, we need to go buy more ships. And so the last three years, the order book has filled up. Where we are today is that we’re on the back end of the capital investment, and we have a backlog that is historically high. I wish I could say I was smart enough to say that investing in that capital was going to create that backlog. I was not that smart, but it sure worked out. Now we have recapitalized facilities, and we have – the investment we’ve made in workforce sets us up to go execute the backlog.
The returns that we’re seeing here so far, I’d say that jury is still out. Quite frankly, the – we’ve had to reset the workforce over the last five years. We’re on the front end of several major – with the backlog, we’re on the front end of several major big programs. We have three carriers under contract for construction right now. It’s been 30 years since we’ve had that situation in Newport News. Ingalls continues to compete successfully in the destroyer program and the Navy continues to move forward with amphibious programs, and then the Coast Guard program seem – goes very well. And the investment that we’ve made in the shipyard of the future in Pascagoula has been very effective in driving efficiency into the programs.
So I think that – I’d say that the jury’s still out on the returns, but I’m excited about where we’re going to go because I do think that kind of narrowly around COVID first, we had about 10 days from the time we stood up our crisis team until we had our first case. We absolutely did not have mature set of protocols when we started. And we started down the path trying stuff. And some stuff worked and some stuff didn’t work, and we backed out of things and we tried new stuff. But let me give you a sense of where we are today.
Today, we are – we’ve had as many cases in our business in the last 2.5 weeks as we had in all of the time before that. And yet we’re operating in a very sustainable way with a mature set of protocols that’s allowing us now to be able to predict the business going forward. And beyond that, we have a workforce that’s been through this particular event as a common behavior that will be a unifying then or catalyst for them for the remainder of their careers. And I think that now they’re moving into, and we’ve even seen their ingenuity to take advantage of the capital investment, take advantage of the technology investment and accelerate the opportunity to do better on that.
So it’s been a rough three months, but, man, we have learned a lot, and we’ve accelerated a lot of opportunity here to transform the business. And I’m very excited about that. I’m really interested and really, really excited to be leading a chance to go after those returns that you’re talking about on capital. And I hope Chris…
Yes. And I’ll add, Rob, we use all the appropriate measures to measure capital or capital deployment decisions, but I’d also point to some investments we’ve made over the first part of the year in the unmanned space in Hydroid and Sea Machines. These are very important to the future of the Navy and the future to HII. So we’re very – we’re pleased with those investments, and those are the type of investments we’re looking for in the future.
Okay. Well, you guys both make good points. And Mike, I understand that’s a fair point that it’s expanded the backlog. But – and again, beyond COVID, not factoring that in, but longer term, are the returns the same as they’ve been with that larger backlog? Is this still a 9% to 10% shipbuilding business?
Yes. Why not? I mean I think it’s actually – could be, yes, 9% to 10%. The question is, when are you going to get there? And that’s going to be driven by some of the contracting things that we’re doing around 79 and the activity around CARES Act and that sort of thing, but it’s also going to be driven by, how do we come through the pandemic and accelerate out the other side of it? Whatever the other side of it is. But yes, it’s definitely a 9% to 10% business.
Okay. Thank you.
Thank you. Our next question comes from the line of Ron Epstein with Bank of America. Your line is open.
Good morning guys.
Good morning.
So Mike, I think you can probably sense this from the tone of the questions. You reiterated this 9% to 10% business, but we had to stumble here on the Virginia class. You got the big backlog. How can the outside community feel comfortable that you’ll execute on that backlog after this stumble, right? I mean – I think you can – probably it’s probably pretty palpable, the questions that are being asked. I mean, how can investors feel comfortable that you’ll execute on that backlog?
It’s a show-me story, Ron. I mean, our view of it is that we know we’ve got to go do. We’ve built the team to go do it. We’ve made the investments we need to make, go do it. It’s going to be just the rhythm of actually executing over and over again. I’ve been through this before. I haven’t had – I haven’t been through the pandemic before, but I think I mentioned in my remarks, coming on the back end of Katrina, where, when we started at Katrina, we did not have really the cohesive workforce that we have today across the business.
And in fact, I used to say that at the beginning of 2008 in Katrina, we had the youngest workforce in the industry at Ingalls, and in three years, they delivered 10 ships. And three years later, they were still the youngest workforce at Ingalls, but they had been the – they were the most experienced workforce in the industry, and that has served them very well over the last decade. I think that’s where – I thought that’s where Newport News was anyway before the pandemic. And what I see in the pandemic is this young workforce is accelerating the transformation of the business. I can’t tell you anymore than you got to – we put milestones out there. We’re going to go achieve those milestones, and you’re going to track the performance. That’s probably the best thing I could say.
As we go through the next quarter or two or three as outsiders looking in, what sign post should we look for? When – what’s the next thing that folks can say, okay, yes, they’re really doing it. What should we be looking for?
Yes, Ron, that’s a good question. This is Chris. So specifically on the VCS program, the story is going to be told by 794 and 796. So the float off of 794 over the back half of the year here and then pressure hole complete at the beginning of next year. Those are the next major milestones on those boats. And we’re going to provide you information on every quarterly release until we get those done to give you progress against those.
Okay. All right. Thank you.
Sure.
Thank you. Our next question comes from the line of George Shapiro with Shapiro Research. Your line is open.
Good morning.
Good morning.
I just wanted to pursue the margins that are implied here. So if you took out the charges from Newport News or added them back, the core margin is like 3.5%. And normally, that’s been running at better than about 6%. So is this 3.5% the normal margin we should expect going forward because it’s calibrated for the adjustments on Virginia class as well as the Kennedy?
No, no. And so we don’t give ship margins by division, but we’re between 7% and 8% for the last Q3 and Q4 for the balance of the year in shipbuilding, consistent with how we guided for shipbuilding for the year.
Okay. And then on the other hand, if you looked at – if I assume the balance of the $56 million unfavorable adjustments, and I guess is at Ingalls, the margin at Ingalls would have been extraordinarily high, like 16% or so, it seems, kind of out of the norm or maybe not all the charges go there. Or if you could explain why the implication is you get such a high margin.
Let me give you the kind of a comprehensive look at the cume adjustments, okay, George? Unfavorable of $167 million, favorable of $56 million for a net of $111 million. Of that net negative $126 million is Newport News. Ingalls is positive $13 million, and TS is positive $2 million, okay?
Okay.
Dwayne can walk you through that after the call as well, George.
Okay. And then maybe just one for – more general one. So the revenue guidance that you implied for ships for next year after lowering this year, is that just reflecting the scheduled delay over several years? Or so why wouldn’t – otherwise, why wouldn’t the revenues be somewhat better next year than what you’re guiding to?
It’s simply projecting the schedules for the ships out into next year. We wanted to provide an anchor out there for you all to do your modeling. We’ll provide an update to that at the year end.
Okay. Thanks very much.
Sure, George.
You bet.
Thank you. Our next question comes from the line Seth Seifman with JPMorgan. Your line is open.
Great. Thanks very much. And good morning.
Good morning.
Just to follow up a little bit on the profitability heading into next year, I think the guidance implies kind of mid-to-high 7% in shipbuilding for the remainder of 2020. You talked about 7% to 8% for next year. When we think about the moving pieces, what kind of prevents any margin expansion next year? And what’s kind of pushing out milestone on the carrier that might allow you to deliver some of that margin expansion?
Yes. So we wanted to provide you an anchor for next year. So she could do your modeling, as I just told George. We’re coming through that single-phase delivery on 79 and we will adjust our plans based upon that final negotiated settlement and the schedules that result from it. So right now, the best outlook we have is what I provided in my script and what I provided in the outlook. If that changes, I’ll definitely let you all know.
Great. Okay. Thanks. And then just as a follow-up, could you remind us the period of time remaining that you expect to be working on the Block IV boats that this $111 million negative adjustment applies to your expected profits over what’s the period of time on that to lock for?
Delivery of 800. It’s at least three to four years out. We’ll follow up with that, okay, Seth?
Okay. Great. Thank you very much.
Sure.
Thank you. Our next question comes from the line of Gautam Khanna with Cowen. Your line is open.
Hey, thanks. Good morning.
Good morning.
Two questions. I guess, the first, is a follow-up to one of the earlier ones, on the VCS Block IV, if I recall a couple of years ago in Q4, there was a negative cume catch-up. And I just want to make sure, like was – is there any way to disaggregate the current cume catch as to whether – I’m just – like what was the realism implied in the – as of Q1 accrual rate versus Q2? Was there a lot of productivity that was baked in, and it was always going to be a bit of a stretch to get there? And I’m just trying to figure out like how much of this is residual from what were the issues earlier a couple of years back in Q4, well, versus just COVID disruptions that really kind of you threw you off the rails?
Yes, that’s a hard answer, Gautam, hard question and a difficult one to answer. I will tell you that it’s very disciplined process we use every quarter to assess our EACs. And as Mike indicated in his script, when we came through the VCS EAC, it just became apparent that we needed to reset our risk registers and reset our expectations for that program. So it’s kind of a challenging answer relative to the way you asked the question. But this adjustment in this quarter is a product of an EAC process that’s very disciplined and that we need to follow on a quarterly basis and similar to what we use on all of our shipbuilding programs.
And we do it every quarter. And the review at the end of first quarter did not indicate that there was an issue.
Right. And I guess, Mike, I think last quarter, you had made a comment that you thought you might be able to catch stuff up later in the year. Is the only difference that workforce absenteeism, et cetera, that – I’m just trying to isolate for the variables that could have explained the difference one quarter to the next. Obviously, COVID is lasting longer. And – but I think it’s – yes.
I think it’s – I don’t remember the specific comment. I would say that we know a lot more about it today than we did at the end of April, beginning of May when we had that call. I do think that we said we were going to be working near-term milestones, given the attendance. We’re going to be working near-term milestones at the expense of long-term ones. And we thought our suppliers were going to be doing the same thing. And so we’re kind of working our way through that now.
But I’ll go back to – where we stand today, we have a pretty predictable, sustainable understanding of the effort that we have and the protocols we have in place. And so we can now start to predict how the business is going to go forward. I would not tell you that we’re going to make up all the milestones from Q2 by the end of the year. I don’t think that’s going to happen. And some of those things may take quite a bit longer to make up. So we’ll have to just see.
Yes. I appreciate. It’s a very difficult question to answer precisely. Chris, just separately, the long term – you’ve given a five-year guide on free cash flow and puts the back into that time period, I think it was approaching $700 million. Any revision to that view based on what’s happened today?
Yes. As I said previously, we need to come through our planning process prior to updating that. But essential factors that made up that guidance haven’t changed the backlogs there. Profitability, it will take longer to get to 9%, as Mike indicated. Capital is the same. Pension is the same at this point, and we’ll provide updates if we need to. But yes, there’s no reason to change it at this point, and I’ll provide a comprehensive update at the end of the year.
Thanks guys.
Thank you. Our next question comes from the line of David Strauss with Barclays. Your line is open.
Hey, good morning guys. This is actually Matt Akers on for David.
Good morning.
Can you comment on the free cash flow guidance? You maintained the guidance for the year, even though it sounds like CapEx is maybe a little bit higher in the shipbuilding outlook a little bit worse. Could you just talk about what maybe the positive offsets were there?
Yes. So CARES Act absolutely helps us with the deferral of the payroll tax. That’s a positive. The Navy customer has – have done an outstanding job of ensuring that we get paid through this entire process. So we’ve been paid on time, and we’ve been making our milestones, right? We deliver 119, delivered 62, been making most of our milestones. So pretty comfortable with where we are from a cash flow standpoint this year.
Okay. Thanks. Okay. And then, I guess, just getting back to the Virginia class. What’s the mix of Block IV versus V that you’re working on now? And does this negative cume incorporate anything for Block V? Or is it all Block IV? And sort of how do you think about the risk for Block V?
It’s all Block IV. We’re very comfortable with where we are in Block V right now. We just started that program, and we’re very conservative when we start off a block.
Got it. Thanks guys.
Sure.
Thank you. Our next question comes from the line of Joseph DeNardi with Stifel. Your line is open.
Hey, good morning. I promised to ask a non margin question, but my first one will be on margins. Mike or Chris, do you have visibility into getting back to 9% to 10% for ships? And like best case, can you get there in 2022? Or is it beyond that? And does going to single phase on CVN accelerate getting back there or delay it?
Well, we have to come through the negotiation of CVN-79 to determine what that impact will ultimately be. And I hate to be a broken record, but there are a lot of moving parts right now. And while we’re confident we’re going to get there, we just need to finish our planning process before we can give you a better guide at this time.
Okay. And then, Mike, you all talked at the Investor Day around capital deployment and building out your services division with a focus, I think, on nuclear services assets. Is that still your mindset? Has COVID kind of delayed capital deployment via M&A at all? And how’s the pipeline of opportunities look? Thank you.
Yes. So we’re – we completed the Hydroid acquisition after all of this started. And we just made an investment in Sea Machines for some autonomy in the unmanned space. We’re very comfortable with where we are in unmanned and where we need to go, and we have a view as to how to proceed there. And so the market is really the issue in terms of how things are getting valued today. But that’s kind of – it’s just the environment we’re in.
On the DOE side, the energy side, it’s the same thing. I mentioned that we are – we continue to increase our presence as a prime to the Department of Energy. We continue to increase our presence across all of the DOE sites. And so we’re – we have line of sight there on things that our customers are looking for and capabilities that they need and we have thoughts as to how to go and provide that in the remaining piece, the government services piece. I think where we have to go there is because that’s where valuations are really kind of hard to pin down. I think we have to go there is, a, demonstrate that we can execute in that business; and then, b, understand the niches in that business where specific capabilities will make a big difference for our customers and proceed down that path.
So that’s the way we’re thinking about it. We’re not changing that. We’re maybe refining it a little bit, given the current environment that we’re in, but we remain committed to it. One of the things that we have – we are kind of living the dream on right now is that we are in a place where we are very heavily centered on manufacturing.
The nonmanufacturing part of our business, the services part of our business actually did pretty well and is doing okay during this pandemic. So the challenges that we’ve had in manufacturing haven’t really replicated to any extent on the services side, and that just validates our idea that we have to continue to try to diversify the business.
Thank you.
At this time, I would like to turn the call back over to management for closing remarks.
Well, I want to thank everybody for joining us today. I hope that you and your families continue to stay safe and healthy. And as always, we do appreciate your time, and we look forward to speaking with you again real soon. Thank you.
Ladies and gentlemen, this concludes today’s conference. Thank you for your participation. You may now disconnect. Everyone, have a wonderful day.