Huntington Ingalls Industries Inc

NYSE:HII

Earnings Call Transcript 2019-Q4

[Operator]

Ladies and gentlemen, thank you for standing by and welcome to the Q4 2019 Huntington Ingalls Industries, Inc. Earnings Conference Call. [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 today, Dwayne Blake, Vice President of Investor Relations. Please go ahead, sir.

[Dwayne Blake, Vice President-Investor Relations]

Thanks, Josh. Good morning, and welcome to the Huntington Ingalls Industries fourth quarter 2019 earnings conference call. With us today are Mike Petters, President and Chief Executive Officer; and Chris Kastner, 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 laws. 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 the 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?

[Mike Petters, President and Chief Executive Officer]

Thanks, Dwayne. Good morning, everyone and thanks for joining us on today’s call. 2019 was a great year for HII and I want to personally thank each of our 42,000 employees for continuing to execute their daily activities with an unwavering commitment to our core principles of safety, quality, cost and schedule.

I would characterize 2019 is a year of positioning for the future. We captured major contract awards that resulted in a record backlog of $46 billion at the end of the year. We enhanced our shipbuilding facilities by bringing new projects online to improve efficiency and affordability, as we completed the fourth year of our five-year generational CapEx program. And we challenged our employees to remain focused on execution, while driving continuous improvement, innovation and creativity.

Now specifically during 2019, we delivered three ships, the guided missile destroyer, USS Paul Ignatius, the National Security Cutter, Midgett and the attack submarine, USS Delaware, and we redelivered the USS Gerald R. Ford following her post shakedown availability. We were awarded an historic $15 billion contract to build two more Gerald R. Ford-class aircraft carriers as well as an $8 billion contract for the Virginia-class Block V submarines. And we successfully navigated through the second year of our shipbuilding program maturity transition and achieve shipbuilding return on sales that were in line with our expectations.

We expanded our portfolio by acquiring Fulcrum in early 2019, and additional portfolio shaping activities are continuing with the pending acquisition of Hydroid that was announced last week as well as the recent decision to divest our oil and gas business. Additionally, yesterday we announced an agreement to contribute our San Diego shipyard assets to a recently formed fleet sustainment venture backed by The Carlyle Group and Stellex Capital Management. All of our 2019 activities, as well as the recent portfolio shaping activities were approached with three key outcomes in mind driving growth, managing risk and generating strong returns.

So now let me share some additional highlights from the quarter and full year starting on Slide 3 of the presentation. Sales of $2.4 billion for the quarter and $8.9 billion for the full year were approximately 9% higher than 2018 and represent record highs for the company. Diluted EPS was $3.61 for the quarter and $13.26 for the full year. Adjusted EPS, which excludes the impact of a non-cash impairment charge related to the pending sale of our oil and gas business was $4.36 for the quarter and $14.01 for the full year. Chris will provide more details on this charge in his comments.

New contract awards during the quarter were approximately $10 billion, including the aforementioned VCS Block V contract resulting in backlog of approximately $46 billion at the end of the year of which $18 billion is funded. And regarding activities in Washington, we are very pleased that the House and Senate passed and the President enacted the National Defense Authorization Act as well as all 12 appropriations measures for fiscal year 2020. These measures strongly supported ship construction and repair as well as other national security imperatives, including acceleration of both LPD-31 and LHA 9 and approval of incremental funding. The legislation also restored the refueling complex overhaul of CVN 75, USS Harry S. Truman and supported investment in submarines surface combatants, unmanned platforms, Department of Energy, nuclear and environmental programs and cyber defense.

Now with the release earlier this week of the President’s fiscal year 2021 budget request, tradeoffs were made across various accounts, including shipbuilding to fit within the administration’s budget top line. Even so, we are pleased to see investment for priorities, including destroyers, amphibious ships, Columbia class, ballistic missile submarines and restoration of the CVN 75 refueling complex overhaul as well as increased integration of critical capabilities such as unmanned underwater vehicles and C5ISR. We look forward once again to working with the administration and Congress in supportive outcomes that best leverage our hot production lines, our supply chains and our service expertise to deliver the ships and capabilities that our nation requires.

Now let me share a few business segment highlights from the quarter. At Ingalls, the LHA 7, Tripoli is essentially complete and the team is working towards delivery in the next few weeks. LPD 28, Fort Lauderdale is approximately 70% complete and it’s on track for launch in the first half of this year. DDG 119, Delbert D. Black completed builder’s trials in December and it’s preparing for delivery in the first half of this year. NSC 9, Stone is progressing through final assembly and test activities and is on track for delivery later this year. And finally, DDG 62, USS Fitzgerald completed sea trials last week and it’s on track for redelivery in the first half of this year.

At Newport News CVN 79, Kennedy was christened and subsequently launched in December and has successfully transitioned into final assembly and test activities at the pier as we bring the ship systems to life. The ship is approximately 69% complete and performance remains in line with our expectations. CVN 73, USS George Washington has transitioned into its final outfitting and test phase. The refueling and complex overhaul is approximately 68% complete and the ship is scheduled for redelivery to the Navy in late 2021.

On the submarine program, SSN 794, Montana achieved the pressure hall complete milestone in December and remains on track to deliver in the first half of 2021. And SSN 796, New Jersey is on track to achieve the pressure haul complete milestone in late 2020. In our Technical Solutions segment performance remains healthy across the business. For example, our teams continue to do a great job supporting the Air Force with training and ISR activities both domestically and abroad. Performance is strong at key department of energy sites, including Los Alamos, Savannah River and the Nevada National Security site with more Department of Energy, new business opportunities on the horizon.

And we continue to support Boeing as their key partner in the production of the extra large unmanned undersea vehicle. And with the acquisition of Hydroid, we are well positioned to compete for future unmanned undersea and surface vehicles. TS ended the year with a lot of momentum, heading into 2020. And their recent portfolio shaping activities create a sharpened focus for the business, which will allow them to create innovative solutions for growing and evolving customer requirements.

In summary, I’m very excited about where we are as a company. Our shipbuilding programs continue to be well supported in Washington and we have captured a record $46 billion backlog that provides unmatched stability and visibility. We are creating modern recapitalized facilities to efficiently execute our contracts and we are seeing improving operational performance that produce shipbuilding return on sales, that was right in line with our expectations in 2019. And we have a well trained workforce that is laser-focused on execution while driving continuous improvement, innovation and creativity.

In addition, our recent portfolio shaping activities create a sharpened focus in the technical solutions business, and position the team to capture growth opportunities in unmanned systems, defense and federal solutions, and nuclear and environmental services. The acquisition of Hydroid is particularly exciting as we combine this entity with our unmanned maritime systems business unit to form one of the leading autonomous and unmanned maritime systems companies in the world.

I firmly believe that we are taking the right steps to drive growth, manage risk, and generate strong returns, which will in turn continue to create long term sustainable value for our shareholders, our customers, and our employees.

So now I will turn the call over to Chris Kastner for some remarks on the financials. Chris?

[Chris Kastner]

Thanks, Mike, and good morning. Today, I will review our fourth quarter and full year consolidated results and provide some additional information on how we view 2020. For more detail on the segment results, please refer to the earnings release issued this morning and posted to our website.

As Mike mentioned earlier, we continued to refine our areas of strategic focus within the technical solutions division. We recently announced the acquisition of Hydroid, which we expect will close by the end of the first quarter. The total purchase price is $350 million. This represents a multiple of approximately 16 times, expected 2020 EBITDA, when adjusting for approximately $50 million of related tax benefits.

Moving on our oil and gas business, UPI is now considered an asset held for sale and as reflected as such on our balance sheet. During the fourth quarter, we recorded a $35 million non-cash asset impairment charge, primarily related to goodwill associated with the valuation of UPI as we prepare to divest that business.

UPI had a very good year in 2019 and they have a strong backlog moving forward. Excluding the impact of the impairment at UPI, adjusted EPS for the quarter was $4.36 and $14.01 for the full year. GAAP diluted EPS was $3.61 for the quarter and $13.26 for the full year.

Turning into our consolidated fourth quarter results on Slide 4 of the presentation, revenues in the quarter of $2.4 billion increased 9.7% over fourth quarter 2018, primarily due to higher volumes in submarine construction for Virginia and Columbia class boats in Newport News, and growth in our Technical Solutions division, due primarily to the acquisitions of G2 and Fulcrum. For the quarter, G2 and Fulcrum contributed revenues of approximately $55 million.

Operating income for the quarter of $186 million, decreased $27 million or 12.7% from fourth quarter of 2018 and operating margin of 7.7%, decreased 197 basis points. These decreases were primarily driven by a less favorable operating FAS/CAS adjustment and an asset impairment charge related to our oil and gas business.

Moving onto consolidated results for the full year on Slide 5, revenues were $8.9 billion for the year, an increase of 8.8% from 2018. This increase was primarily driven by higher volumes in aircraft carriers, submarines and Navy nuclear support services in Newport News and growth in our Technical Solutions division, due primarily to the acquisitions of G2 and Fulcrum, as well as higher fleet support in oil and gas revenues. For the year, G2 and Fulcrum contributed revenues of approximately $201 million.

Operating income for the year was $736 million and operating margin was 8.3%. This compares to operating income of $951 million and operating margin of 11.6% in 2018. The decreases were primarily due to a less favorable operating FAS/CAS adjustment compared to 2018, an asset impairment charge related to our oil and gas business and losses on a fleet support services contract, as well as lower risk retirement at Ingalls.

These were partially offset by contract changes on submarine support services, higher volume in Newport News and higher risk retirement on the CVN 73 RCOH contract. Our effective income tax rate was 13.4% for the quarter and 19.6% for the full year. This compares to 3.2% and 13.9% for fourth quarter and full year 2018 respectively. The lower tax rates in 2018 were driven by higher estimated research and development tax credits for the 2011 through 2018 tax years.

Turning to cash flow on Slide 6 of the presentation, cash from operations was $566 million in the quarter and free cash flow was $408 million. For the full year, cash from operations was $896 million and free cash flow was $460 million. Fourth quarter capital expenditures were $150 million and for the year, capital expenditures were $436 million or 4.9% of sales. Cash contributions to our pension and post retirement benefit plans were $59 million in the year, of which $21 million were discretionary contributions to our qualified plans.

Additionally, we repurchased approximately 254,000 shares in the quarter at a cost of $58 million, bringing the total number of shares repurchased in 2019 to approximately 1 million at a cost of $214 million. We also paid dividends of $1.03 per share or $42 million in the quarter, bringing total dividends paid for the year to $149 million.

Now turning to Slide 7, let me provide an update on pension. As we announced in late January, we will adopt the Safe Harbor methodology for CAS pension cost accounting beginning in 2021. The transition to Safe Harbor method reduces CAS pension costs volatility and improves program cost predictability. While the transition does create an unfavorable impact to GAAP EPS starting in 2021, it is cash flow neutral over the long term.

As you can see on the pension table provided on Slide 7. Cash recoveries and cash contributions become fairly well matched beginning in 2021 and moving forward. For ease of analysis, we’ll expect or we expect to begin providing EPS adjusted for FAS/CAS adjustment starting with first quarter 2020 results.

Now let me provide you with an update on some additional 2020 items as shown on Slide 8. We expect shipbuilding revenue to grow between 3% and 5% in 2020. We expect shipbuilding return on sales to be 9% in 2020, with the majority of significant risk retirement events weighted towards the latter part of the year, resulting in shipbuilding return on sales averaging 8% for the first three quarters.

Regarding Technical Solutions and given the recent portfolio shaping events underway, we expect revenues to be approximately $1 billion in 2020. This figure excludes results from UPI in the San Diego shipyard and assumes the Hydroid acquisition closes in the first quarter of 2020. Also for Technical Solutions, we expect return on sales to be in the 5% to 7% range.

On Slide 8, we’ve also provided 2020 modeling considerations for your reference, including taxes, interest expense, depreciation and amortization and capital expenditures. Finally, on Slide 9, we’ve provided an updated view of anticipated major shipbuilding program milestones for 2020 and 2021.

That concludes my remarks. I’ll turn the call back over to Dwayne for Q&A.

[Dwayne Blake, Vice President-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 from the queue as possible. Josh, I’ll turn it over to you to manage the Q&A.

[Operator]

Thank you. [Operator Instructions] Our first question comes from Myles Walton with UBS. You may proceed with your question.

[Myles Walton, UBS]

Thanks, good morning. I was wondering on the free cash flow for 2019 kind of where did that came out versus your expectations. And then maybe as you look at capital deployment, you didn’t really pick up the repurchase effort in the fourth quarter and wondering if that reverses significantly in 2020?

[Mike Petters, President and Chief Executive Officer]

Yes. So cash in Q4 was a little bit below expectation – $50 million to $60 million below, it was only timing with some receipts primarily at Newport News, that weren’t paid. That shifted into 2020. So not really concerned about that, that is normalizing. Relative to capital deployment, we really don’t see a change. We’re going to invest in our shipyards continue to comply with our commitment relative to dividends and analyze that throughout the year. But still the 10% increase – at least a 10% increase this year and then continuous share buyback, it was pretty consistent in 2019 with previous years in share buyback, obviously in 2018, we’re pretty opportunistic, but really no change there.

[Myles Walton, UBS]

But still the band aid is to return versus all cash – free cash flow to shareholders.

[Mike Petters, President and Chief Executive Officer]

No. There is no change in that commitment. That commitment to 2020 definitely stands.

[Myles Walton, UBS]

Okay. Thank you.

[Operator]

Thank you. Our next question comes from Carter Copeland with Melius Research. You may proceed with your question.

[Carter Copeland, Melius Research]

Hey, good morning, gentlemen. Two quick ones. One Mike, if you could just speak to the Hydroid acquisition and unmanned and the longer term growth opportunity, maybe in a little bit more detail how you see the competitive landscape and that part of the market evolving, I realize there’s a lot going on. But any color there would be helpful. And then just on housekeeping, Chris, I wondered if you might give us the EACs gross and net? Thanks.

[Chris Kastner]

Let me do that, housekeeping, first. Yes. So positive is $89 million, negative $50 million, net plus $39 million. About 90% of that was Newport News.

[Carter Copeland, Melius Research]

Awesome. Thank you.

[Mike Petters, President and Chief Executive Officer]

Sure. Okay. Relative to Hydroid, we began – I guess, we identified the Navy’s potential to move towards more unmanned systems several years ago. And we recognize that while we had engineered out a lot of manpower on the Ford design, that was not what – that was not where the Navy was talking about. They were talking about unmanned vehicles in particular, and we didn’t really have a footprint there. We – you recall, we invested in a small company in Panama City that had a platform called Proteus, which was a two man or unmanned, or it was both, either or could be operated with two people or be unmanned platform that was actually in the water and being tested and being used by many customers, not just the Navy.

We acquired that group and the first thing we found out was that there’s a whole set of technologies and customers and people and processes that we were not very familiar with. And so not only did we get some technology there, we got some access. And in the course of that access, we then realize that, we can bring some of our own core capability to this area that might actually accelerate the adoption of the technology as well as create a business for us.

And that led to an arrangement with Boeing, who had invested in their large unmanned vehicle. They’d actually put it at sea, but they needed somebody to build it. So we could bring our manufacturing expertise to bear on that. We did that. We’ve, and in the course of that, we kind of realized that, okay, we’re starting to really get an understanding of these large unmanned undersea vehicles. But when we looked around, we saw there’s a lot of activity on the smaller side. And Hydroid was a company that we noticed was really a big player in the smaller UUV space.

And so we began a journey and a process with Kongsberg to walk our way through and resulting in the acquisition we hope. We’ve signed the agreement and we hope to close that deal, but that gives us a footprint in basically the full range of unmanned undersea capability. And it speaks to a larger kind of belief that I have, personally, is that – I mean the Navy can have lots of things that they say they need and lots of things that they want to do, but they need to do that when the industry can get there and provide it for them, they can go a lot faster.

And so our view is, let’s bring some of our capability, our ability to build workforce, our technology, our manufacturing expertise, our contact information. Let’s bring all of that to bear in this space to accelerate the development of the unmanned space on behalf of our customer. And so we think that this is a step in that direction. As you say, there’s a lot going on in there. And but I would say that there’s a lot of folks who could talk about this scientifically. What I would tell you is that, if you’re in the water, you’re learning about it and we’re in the water. And so we’re really happy about that and we’re optimistic about where this business is going to go.

[Chris Kastner]

Yes. I would also add that, that business just organically posts the transaction getting complete with in HII will grow at high single digits. So that’s the near term growth rate we see in that business. So we believe it can only get better beyond that.

[Carter Copeland, Melius Research]

That was going to be my follow-up. Thanks for the color, gents.

[Mike Petters, President and Chief Executive Officer]

You bet sir.

[Operator]

Thank you. Our next question comes from Jon Raviv with Citi. You may proceed with your question.

[Jon Raviv, Citi]

Thanks very much. Good morning. On the – just following up on a cash flow question, I know, you mentioned, $50 million to $60 million rely on Newport News receipts, something in the 2020. Any other big building blocks we should think about heading into this year. CapEx come down a bit perhaps. Anything else we should keep in mind in terms of underlying cash flow?

[Chris Kastner]

Not really, as you’re aware, this is the last year of our major capital program and we get back down to 2.5% of sales in 2021. What you’re going to see over the near term is us start ramping our free cash such that we become a $700 million a year cash flow story. Now I can’t tell you whether that happens in 2021, 2022 or 2023, we’re going to ramp towards that. But at the end of the day, $700 million becomes the new normal for HII for free cash flow.

[Jon Raviv, Citi]

And just to clarify, Chris, that’s a with or without pension benefit?

[Chris Kastner]

That’s all in.

[Jon Raviv, Citi]

Okay, thank you. And then just a quick follow-up on margin cadence, can you talk a little more on the back loaded nature of this year. I know, in the last call, you mentioned that there could be some – probably what’s the comp…

[Chris Kastner]

Yes. Sure. The major items, the back half of the year, our delivery of NSC 9, 796 getting to pressure all complete and then bringing to life CVN 72, excuse me, CVN 73 and CVN 79 to their test program.

[Jon Raviv, Citi]

Thank you.

[Operator]

Thank you. Our next question comes from Doug Harned with Bernstein. You may proceed with your question.

[Doug Harned, Bernstein]

Good morning. Thank you. I want to go back to, Mike, the discussion about unmanned systems. And last week, Secretary Esper talked about moving to a very different kind of 355-ship Navy in 2030, which is I think it’s pretty aggressive with smaller platforms, lower manning, including optionally manned. I asked you a while back about this, as it related to the Marine core strategy that had been laid out, but if the Navy moves aggressively in this direction, how might that affect your core programs, the larger ships and your business mix? And what’s your understanding of how the Navy is looking to proceed here?

[Mike Petters, President and Chief Executive Officer]

Well, Doug, I think, this is – this continues to evolve. The Navy is trying to match up the requirements that they see out in the world that they feel like they need with the ability of the industry to support it. And so our view of that is that we need to be on the front edge of that and trying to help them evolve that.

Relative to our core business though, I mean our strategy for the last three years, if you go back over the last three years, the shipbuilding accounts have been historically high, doesn’t actually talk about how high they’ve been. I mean, my whole career, they’ve been in the $14 billion to $16 billion a year, year-in and year-out. And for the last three years anyway, we’ve been just short of $25 billion, even this year that for all of the discussion over the past few days about what’s going on with the shipbuilding budget and all that sort of thing, it’s still at $20 billion.

And so I think that where you’re going to see is, you’re not going to see a hard left turn here where we’re going to say, okay, we don’t need big platforms with people on them anymore and we’re going to make – we’re going to have a Navy that’s completely unmanned and think what you’re going to see is an evolution. You’re going to see the unmanned space become amplification of the presence and platforms that the Navy needs. And so I don’t know how that counting works and all that sort of thing because that becomes an interesting discussion about what actually counts as a ship and I just kind of stay out of that.

I think about it more in terms of capability to provide presence for the Navy and the ability of the industry to bring technology to bear on the problems that they have. I think that the Navy is going to be moving towards more unmanned systems to amplify the platforms that they have and then see where that goes from there. And we want to be as their principal partner, we want to be right there with them and help them make that successful.

[Doug Harned, Bernstein]

Well. When you think about growth I think of shipbuilding as a fairly predictable business because – on top line, because of the very long contracts. And you’ve talked about five-year growth rate of around 3%. But this year you gave – you’re giving revenue guidance of 3% to 5%. What factors create that range of outcomes? Is this repair work or uncertainty about the timing of milestones? I mean, how do you get that, that broader range this year in guidance?

[Mike Petters, President and Chief Executive Officer]

There’s really some minor timing issues that could move it between 3% and 5% on some of our programs. It’s not really new programs drive that, although timing of some material on some of the new awards would help us out of that. But the majority of that as you indicate is already under contract.

[Doug Harned, Bernstein]

Okay, great. Thank you.

[Operator]

Thank you. Our next question comes from Ron Epstein with Bank of America. You may proceed with your question.

[Ron Epstein, Bank of America]

Hey, good morning. Mike, could you give us a little more maybe background of color on the $950 million contract that you guys got in ISR work for the Tech services division, right? And that’s doing support work for the Air Force in Europe, right? So if you could give us some more background on that? And then I have a follow-on question.

[Chris Kastner]

Yes. So that’s – Ron, this is Chris. That’s Air Force contract, Persistent Multi-Role Operations, ISR contract that’s split over four or five years, all that revenue. And we’re really excited about it. We’ve done similar work through one of our acquisitions. So this is essentially follow-on with a different scope. I can’t really go into too much detail what they’re doing. I got to be careful on the call. But we’re really excited about that. We think it’s an important area going forward.

[Ron Epstein, Bank of America]

Okay. And then, Mike, just maybe a broader question. One of the things that’s come up in some of the conversations that we’ve had around Naval strategy. Do you – are you up to view, do you see a future, where there’s more underwater operations beyond just kind of the typical Virginia class, Columbia class, that there’s going to be a need for a broader underwater infrastructure and met this unmanned underwater play as part of potentially building out broader underwater infrastructure?

[Mike Petters, President and Chief Executive Officer]

Well, Ron, I remind you that you’re talking to a former submarine officer. So I need to kind of do my Safe Harbor on that. But the thing about the undersea environment and platforms in the undersea environment is that they are very asymmetric. There’s lots of history of a single submarine can bottle up an entire fleet in port. And the fact that you can look out across the harbor and can’t see it, gives it an advantage. And so being undersea is a multiplier just that, just the simple fact that your underwater is a multiplier for the your capability. There’s a lot of things that you can do underwater that you may not want to send a Virginia class submarine with a bunch of people on it to go do.

And so being able to – on the other hand, there’s a significant amount of things underwater that you want to be able to do that you want to have a Virginia class submarine or something like that, fully man, fully capable of complying with rules of engagement and all that sort of thing. You want to be able to do that too. And so what we see is that this asymmetry that comes from being undersea is going to be something that the Navy has to find a way to take advantage of. And if you just go back, gosh, it’s getting to be close to 30 years now, but you go back and start to look at how did the unmanned aerial systems take off, right? There was a technology that was being developed and we were kind of doing this and then suddenly there was a knee in the curve where nobody could get enough of it. Everybody wanted more and there wasn’t enough capacity. I mean, literally the curve just shot almost vertical.

We’ve been talking in the unmanned space for probably 10 years or 15 years about when is the knee in the curve going to come for the unmanned space, undersea – the unmanned undersea space. I would say the undersea space is a much harder environment in terms of the physics of it. And I’m not sure the knee in the curve is going to look like the unmanned aerial vehicles space did. I believe you’re starting to see now the maturation of technologies, more and more folks are getting in the water and they’re getting to understand what the art of the possible is. And so there – whether it’s a knee in the curve or if it’s just an acceleration. I think we’re kind of getting there now.

And so it’s really important for us to be in the middle of all of that. And I think that 15 years from now you could see it – you can see a Navy that is talking a lot more about what they can and want to do undersea. I just think that’s where it goes. The final thing, I’d say, Ron is, this is just my own personal amateur historian view is that, when countries can no longer afford the full Navy that they want, they buy submarines because they’re asymmetric for the money that you put into them. So, I mean, I think we have history that says that, I don’t know that it’ll quite play out that way here because presence is important, and presence actually keeps conflict from becoming hot conflict. And so I think the Navy has a great understanding of that. But in marriage, I think it’s marrying undersea capability with the presence is a way for us to go.

[Ron Epstein, Bank of America]

Great. Thank you.

[Operator]

Thank you. Our next question comes from Robert Spingarn with Credit Suisse. You may proceed with your question.

[Robert Spingarn, Credit Suisse]

Well, good morning. I wanted to ask you for a little more detail on shipbuilding margin both forward and also Q4 2019 from the perspective of the CVN 79? So trying to understand you book that very conservatively in the beginning of the program, I think we were looking for some kind of write-up upon launch. So Chris, can you tell us anything about CVN 79 EACs in Q4? And then maybe the other way to look at this is how does the 9% in 2020 divide between Ingalls and Newport News and what’s happening with the carrier relative to plan?

[Chris Kastner]

Well, I’ll comment on margin, then Mike, you can talk about CVN 79, if you like. But Q4, 79 met their milestone. We evaluated the risk and I had previously indicated that there’s a lot of risk in front of us on that ships. So it just simply wasn’t material enough – material enough of an issue to mention. But we did our very good Q4 in shipbuilding both Ingalls and Newport News actually. In 2020, I expect both Newport News and Ingalls be at 9%. I expect them both to get there.

[Robert Spingarn, Credit Suisse]

Okay. Just on the carrier, I mean, was I wrong in thinking that the launch would release a fair amount of positive EAC or is it next year’s Q4 with the system build out milestone that you’re talking about?

[Mike Petters, President and Chief Executive Officer]

Yes, I think that was our view of this is that the risk that we incurred on the Ford was really in the test program, which is kind of we’re walking into the test program now on Kennedy and we just – we’re going to be conservative about this. The Ford actually for a lead ship came together better than any lead ship I’ve ever seen. But as we tested systems, we had to work our way through a whole bunch of new technology there. So this is our next go on that. And we’re going to continue to be pretty conservative on that until we actually retire those risks. And I don’t think we ever really expected that launch would be open the floodgates on risk retirement. We just, frankly, the early launch that the program team put together was a way for us to mitigate downstream risk. And that’s, it was part of a step, but not a floodgate.

[Robert Spingarn, Credit Suisse]

Are you on plan with 79?

[Mike Petters, President and Chief Executive Officer]

We are.

[Robert Spingarn, Credit Suisse]

Okay. Thank you.

[Operator]

Thank you. Our next question comes from George Shapiro with Shapiro. You may proceed with your question.

[George Shapiro, Shapiro]

Yes. Thank you. I just wanted to follow – good morning. I just wanted to follow-up a little bit in the last question from Rob. Can you just give us the specific EACs in the quarter and then also can you explain, you mentioned that you got to pick up in margin on the Block V contract. So that assumes that the contract was more favorable than what you might’ve thought before. If you could comment on that. And then also the other benefit that you had there on the LA class ships the support services increase in margin.

[Chris Kastner]

Yes. So Block V in Columbus, neither one is material enough to mention the number. It’s all included in the Newport News results. I can’t get back to your first question, George. I don’t even recall it. What was the first question again?

[George Shapiro, Shapiro]

Like, what are the EACs?

[Chris Kastner]

I already gave that to [indiscernible] at the beginning. It was gross favorable of 89% unfavorable of 50%, 90% of that being Newport News.

[George Shapiro, Shapiro]

Okay. And then how about the support contract changes for the LA class that you referenced? I mean, can you be a little more specific what they were?

[Mike Petters, President and Chief Executive Officer]

No. They were all embedded in Newport News performance in the quarter.

[George Shapiro, Shapiro]

Okay. And then just one more general one, Mike. You looked in detail at the 21 budget for shipbuilding. Do you think that Congress leaves it as is? I mean, there are quite a bit of changes, right? One less destroyer, one less Virginia-class to also support Columbia.

[Mike Petters, President and Chief Executive Officer]

Well, George, I’m going to suggest that, I’m not sure that I’ve ever seen the Congress leave any part of the administration’s budget as is. And so I think that the budget submission is a beginning of a process. It’s a long process to go from submitting the budget to appropriating the bills. And I’m not talking about just defense, I’m talking about all of the areas of the budget. So I think it’s going to – our role in this is typically to talk to – if that’s what you want, what’s the most efficient way to do it? So that’s kind of the way we work this and we’ve worked it over the years and sometimes it works out and sometimes it’s not necessarily the way we would like. But I think we’re just at the very beginning of the process right now and it’s going to play out over the next several months.

[George Shapiro, Shapiro]

What in it would you like to have changed?

[Mike Petters, President and Chief Executive Officer]

Well, I think the biggest issue is the one that we’ve been talking about here all along. And that is that you got to find a way to pay for Columbia. If you decide that you’re going to pay for Columbia inside the shipbuilding account, then it’s going to squeeze ships out unless you’re going push the budget up. And in the last three years, I think that, at the very beginning of the ramp up into Columbia at a time when our strategy was take advantage of the budget and get as much stuff under contract as you possibly can, because there’s going to come a time where you’re going to have a lot of arm wrestling over the budget. And I think we’ve done that very well and that’s how we ended up with the backlog that we have.

But I think the uncertainty about how you’re going to pay for Columbia is going to show up. And I think that’s what really showed up here. The pluses and minuses were really squeezed out because you have to go pay for Columbia. And I absolutely think we have to go pay for it and I think that’s a national priority. But I just think it’s going to be, it’s the elephant in the room that has to be dealt with if you want to keep all the other programs going. So I think that’s where this ultimately goes. Each ship, certainly we’d like to see – more ships are better and they’re better not just for us, but they’re better for the whole industry. So we’ll continue to advocate for that. But that’s a way to keep the industrial base healthy and happy.

[George Shapiro, Shapiro]

Okay. Thanks very much.

[Operator]

Thank you. Our next question comes from Pete Skibitski with Alembic Global. You may proceed with your question.

[Pete Skibitski, Alembic Global]

Hey, good morning, guys. Bit of a follow-on. Mike, how are you feeling about the outlook for big deck amphibs at Ingalls right now? I know you’ve been trying to kind of bring one of the ships forward in the Navy’s plan, Congress has helped out a little bit I think. And we’ve got the new budget. How are you feeling about that right now?

[Mike Petters, President and Chief Executive Officer]

Well, I feel pretty good about it. Frankly, the Marine Core wants it, the Congress is trying to find ways to push it through. I just think it’s an example, some of the pluses and minuses. I think what you see in the budget is really the squeezing, there’s only so much air that can go into the balloon from the budget submission standpoint. So I feel pretty good about it. I think that there’s a lot of support for what the big deck amphibs can do and what they are doing out there today. And so, I remain optimistic about where that’s going to ultimately end up. There’s going to be days when we feel really good about it and days when we kind of wonder where it’s going on. But I think in total it’s going to be – we’re going to end up in a good place and a good outcome.

[Pete Skibitski, Alembic Global]

Okay. Got it. Just one follow-up for me. On the sale of Continental Maritime to Carlyle, I don’t think it’s a lot of revenue, maybe $100 million or so. But I thought it was always viewed as a positive to have a repair yard on the West Coast for you guys. So I’m just wondering, how you’re thinking about that now?

[Mike Petters, President and Chief Executive Officer]

We contributed, just to be clear, we contributed this asset so that now we’re part of the joint venture. So our view is that the business model – let me step back. I think I’ve talked about this before. There is more demand for repair activity in the Pacific area of responsibility than there is capacity to provide it right now. But the Navy is kind of trying to work its way through a business model that’s going to allow for more efficient support for the requirements that they have.

In our case, we’ve – as the business model has changed, we’ve kind of struggled with that a little bit. Our view is, we needed to restructure this business anyway. Here’s a way for us to keep our hand in that business and be able to help the Navy figure out the right way to get the business restructured and get the business – get the industry in a place where it can actually effectively support what the Navy’s doing. I mean, we’ve had cases where in a space where there is not enough capacity to meet the demand, we’ve actually had operations that have been closed.

And so you have to step back and say, there’s something bigger going on here and we need to be part of that. So we need to be part of that discussion. But we also have to make sure that, we try to find a solution. And this is what we think is – working with Carlyle and Stellex and Vigor and MHI, the other assets that are there. We think this is a way for us to effectively engage and help the Navy find a solution.

[Pete Skibitski, Alembic Global]

Okay. So you’re not losing either from that, because of the accounting change, you’re losing the revenue for the guidance.

[Mike Petters, President and Chief Executive Officer]

Correct.

[Pete Skibitski, Alembic Global]

Okay. Thanks guys.

[Mike Petters, President and Chief Executive Officer]

You bet.

[Operator]

Thank you. Our next question comes from Gautam Khanna with Cowen & Co. You may proceed with your question.

[Jeff Molinari, Cowen & Co]

Hi. Good morning. This is Jeff Molinari on for Gautam today. Thanks for taking my questions. So just some cleanups, all the questions had been answered already. So TS sales has guided to be $1 billion, few more moving pieces than normal. What are you kind of assuming for annualized sales, even margins for Hydroid and the businesses to be divested or excluded because of the JV? Three moving pieces if you could just kind of size those for us, it’d be helpful. Thanks.

[Chris Kastner]

Yes. So we haven’t provided that and we think given the $1 billion of sales and 5% to 7% return on sales, I should probably get you there from a modeling standpoint. But we haven’t provided that data as of yet.

[Jeff Molinari, Cowen & Co]

Okay. Fair enough. And then on the margins, we talked about shipbuilding margins kind of 8% through the first three quarters and then bumping up substantially in Q4. How do you think about that momentum continuing into 2021 at that level?

[Mike Petters, President and Chief Executive Officer]

Well, I think that, if you look at this business quarter-by-quarter, you’re bound to have good surprises and maybe not so good. But I think that what we know is that and our experience here is that over the long haul, this business executes – the shipbuilding industry executes at around 9%. So I think over the long haul, that’s where we are. And our ambition is to execute our backlog that you see out there at that level or better. And so that’s kind of the way we’re seeing this. The driver that we’re seeing for this specific year is still a little bit of the hangover of the maturation of the backlog.

And we’ve gone through a couple of years where we’ve had a heavy weighted portfolio towards brand new work. We just added two more carriers and a whole another set of submarines into that mix. And it takes a little while to start to accumulate the milestones that we need to get them up. But we think that we’re pretty sustainable here over the long haul.

[Jeff Molinari, Cowen & Co]

Okay. Thanks. Thanks for the color guys.

[Operator]

Thank you. Our next question comes from Seth Seifman with JPMorgan. You may proceed with your question.

[Seth Seifman, JPMorgan]

Thanks very much and good morning.

[Mike Petters, President and Chief Executive Officer]

Good morning.

[Seth Seifman, JPMorgan]

So Mike, I wonder if you could talk a little bit about the frigate and are you still expecting an award this July? And kind of how you’re thinking about the positioning there and how that could ultimately fit in with the kind of work in Ingall?

[Mike Petters, President and Chief Executive Officer]

Well, the bids are in and we put our best foot forward. We have invested in some facilities and we have a very robust execution plan to be able to build that platform. And we’re just standing by to help the Navy decide what they want to do. Now the competition is tough, I’ll say that. But we’re still expecting award in the first half of the year.

[Seth Seifman, JPMorgan]

Okay. And then maybe a real quick follow up. Chris, the working capital still pretty low as a percentage of sales about 6% and if you had the $50 million of receipts in the fourth quarter, probably even would have been down slightly a percentage of sales year-on-year. Is that a maintainable level of working capital that sort of 6%? So the business grows, working capital dollars maybe up slightly but not significantly.

[Chris Kastner]

It’ll move around a bit from time to time, but I think 6% is a really good target for shipbuilding.

[Seth Seifman, JPMorgan]

Great. Thank you very much.

[Operator]

Thank you. Our next question comes from David Strauss with Barclays. You may proceed with your question.

[David Strauss, Barclays]

Thanks. Good morning.

[Chris Kastner]

Good morning.

[David Strauss, Barclays]

So I think previously you had talked about 9% to 10% margin range for shipbuilding in 2020. Is 10% not doable anymore? And in 2020 is 10% still kind of an aspirational target looking further out.

[Chris Kastner]

David, this is Chris. It was simply coming to our plan and seeing how the programs were going to unfold in 2020 and the risk retirement potential there, which allowed us to arrive at the 9%. We’re going to have quarters that are better than 9% and worse than 9%. We always challenge the organization to do better. But I think the best way to think about it is 9% moving forward.

[David Strauss, Barclays]

Okay. And then probably another one for you, Chris. The $700 million in free cash flow, you talked about getting to. Can you – I guess, building off of what you did in 2019 at $460 million, I know you’ve got CapEx coming down over the course of the next couple of years, probably helps by about $200 million. But it looks like, pension, CAS less contribution is about equivalent kind of headwind. So what takes us from $460 million to $700 million?

[Chris Kastner]

Well, it’s growth, right? We’re going to grow. Margin is improving as well. So you couple that with the reduced capital expenditures and pension normalizing and reaching milestones on ships, you get to $700 million. It’s going to naturally float up to $700 million of free cash over the next two years.

[David Strauss, Barclays]

Okay. Thanks.

[Chris Kastner]

Sure.

[Operator]

Thank you. Our next question comes from Joseph DeNardi with Stifel. You may proceed with your question.

[Joseph DeNardi, Stifel]

Yes. Good morning Mike, just on the margin profile of the business going forward. I get that that there’s a cost plus component of your business that that’s probably greater than some of your peers. But if you look out over the next several years, it’s more of the production, the fixed price side of the business that will be growing. And so, longer term, why is it that a margin tailwind potentially such that maybe the margin profile can go from 9% to 10% to 10% to 12% at some point? Thank you.

[Mike Petters, President and Chief Executive Officer]

Well, I mean, I wish I could say that you were right. But the fact is that the whole blend ends up and if you go now and we’ve gone back and looked at this every which way you can look at it. You end up in a place where no matter where you are. The first thing you want to do is, you want to know that you’re actually executing well. And that’s where the whole discussion around 9% to 10% came from was, you’re executing well, if you’re in that range and you have a good mix of new programs and mature programs. If you’re out of that range high, that means that you’re probably overweighted on mature programs. And if you’re out of that range low, you’re either not executing well or you’re out of balance with new programs.

So that’s kind of where it came from. And right now, with a $46 billion backlog, our work kind of on the heavy end on new programs. We’ve gone through a couple of years where we’ve been maturing programs, but we just added $20-some-billion to the backlog last year. So we’re going to continue to work our risk through that. But the other side of it is, that if you just go and look at the entire industry over the last, I don’t know, 10 or 15 years, the industry just tends to operate at 9%. And that’s takes in account of mature programs and new programs and everything else. And so we aspire to 10%. We push our teams to that level and that’s our ambition. But I think in terms of the way to think about our businesses, this is a 9% business with a $46 billion backlog that plays out over the next 10 or 12 years.

[Joseph DeNardi, Stifel]

Okay. That’s helpful. Could you maybe quantify, just given submarine growth and carrier transitioning from cost to fix. What the mix looks like as you see it five years from now in terms of costs versus fixed as a whole. Thank you.

[Chris Kastner]

The way to think about that is the RCOH contracts are the cost plus contracts moving forward. So I don’t have a specific percentage, but that’s really the majority of the cost plus work in our base.

[Joseph DeNardi, Stifel]

Okay. Thank you.

[Chris Kastner]

Sure.

[Operator]

Thank you. Our last question comes from Noah Poponak with Goldman Sachs. You may proceed with your question.

[Noah Poponak, Goldman Sachs]

Hey, good morning, everyone.

[Mike Petters, President and Chief Executive Officer]

Good morning.

[Noah Poponak, Goldman Sachs]

Chris, just wanted to try the walk from today’s free cash to $700 million, again, because it sounded, if I heard your answer to David’s question correctly, it really comes down to just growth in the segments but with CapEx and pension largely offsetting. But if it’s a $9 billion business growing top line, 3% to 4% with margins in the zone of flat, that’s only kind of $20 million, $25 million share of free cash flow growth per year. Should I – is there something in grant proceeds that have been large for you recently or something else outside of the segments? Or is it just more when you said it could be 2021, 2022, 2023 that it’s likely to the backend of that when you’ve had time to compound the segments?

[Chris Kastner]

Yes. So there’s some compounding there. But it’s also the timing of the milestones and how that works through working capital. When you look at our plans and all our ships going through our plans over the next three years it gets to $700 million and that really becomes the new normal. So I think you’ve essentially got it right, Noah.

[Noah Poponak, Goldman Sachs]

Okay. And then when you’ve stated that now pointing to 9% as a shipbuilding margin versus the prior comments of 9% to 10%. You stated that, that’s really just kind of honing in on the specific plan as you’ve moved into 2020 itself? Can you help us with the specific things that changed in the plan? What specific ship inputs are different versus what you thought previously?

[Chris Kastner]

No, there’s really nothing specific that I would drop on Noah there. It’s just going through each ship, laying them out over the next few years and looking at the risk retirement opportunities and the risk on those ships that 9% was the best way to look at it.

[Noah Poponak, Goldman Sachs]

Okay. So it’s more of just moving to a bottoms up ship by ship plan versus a prior sort of directional what the business is capable of type of framework.

[Chris Kastner]

And some of it is the fact that we, the previous plan had these – a lot of these contracts we didn’t have. So it is working through the large volume of contracting as it comes into our plan now. And how is that going to play out with our teams and our execution and all of that. So we just felt like it’s really important to kind of clarify that.

[Noah Poponak, Goldman Sachs]

I see. Okay. Thanks so much.

[Chris Kastner]

Thanks, Noah.

[Operator]

Thank you. And I’m not showing any further questions at this time. I would now like to turn the call back over to Mr. Petters for any further remarks.

[Mike Petters, President and Chief Executive Officer]

Okay. Well, thanks for joining us. I want to remind you that you can still sign up to participate in our Investor Day meeting next week via webcast. It’s Tuesday morning on the 18th starting at 8 o’clock. So just go to our website at huntingtoningalls.com. Click on the Investor Relations page and follow the Investor Day link to register. We’re excited about the chance to meet with you all and share a lot more detail, what we think the next five years will bring. So we appreciate you joining us on today’s call. And we look forward to seeing you soon.

[Operator]

Thank you, ladies and gentlemen. This concludes today’s conference call. Thank you for participating. You may now disconnect.