Huntington Ingalls Industries, Inc.

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

Thank you, Operator, and good morning, everyone. Welcome to the HII Third Quarter 2022 Earnings Conference Call. Joining me today on the call are Chris Kastner, our President and CEO, and Tom Steele, Executive Vice President and CFO. As a reminder, any forward-looking statements made today that are not historical fact are considered our company's estimates or expectations and are forward-looking statements made pursuant to the safe harbor provisions of federal securities law. Forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially. For additional information regarding factors that could cause actual results to differ materially from expected results, refer to our SEC filings. Also in their remarks today, Chris and Tom will refer to certain non-GAAP measures. For reconciliations of these metrics to the comparable GAAP measures, please see the slides that accompany this webcast, which are available on the Investor Relations website at hir.hii.com. With that, I would like to turn the call over to our President and CEO, Chris Kastner. Chris?

Thanks, Christy. Good morning, everyone, and thank you for joining us on today's call. I would like to begin today by highlighting the HI teams that work hard day in and day out to support our national defense customers, craftsmen and women constructing and overhauling the most powerful and survivable naval ships ever built, engineers and technology specialists developing critical capabilities and mission-driven solutions, all aligned with supporting our customers' priorities and pressing national defense needs. Thank you to the entire HAI team. Now let's turn to our results on page three of the presentation. In the third quarter, we had sales of $2.6 billion, which were 12% higher than 2021 and diluted EPS with $3.44 for the quarter, down from $3.65 in 2021. New contract awards during the quarter were approximately $2.1 billion. which results in backlog of approximately $46.7 billion at the end of the quarter, of which $23.2 billion is currently funded. We continue to make progress across all of our shipbuilding programs. At Ingalls, we recently completed acceptance trials on DDG-123, Lena Sutcliffe-Higbee, and during the third quarter, the keel was authenticated for DDG-129, Jeremiah Denton. In our amphibious ship product lines, fabrication began on LPD 31 Pittsburgh, and last week we were awarded a $2.4 billion detailed design and construction contract for LHA 9. Also, we have commenced the work to complete the combat system installation and activation on the Zumwalt-class destroyer Lyndon B. Johnson, DDG 1002. At Newport News, CBN 79 Kennedy, is moving further into the test program and began testing of the electromagnetic launch system. And on the other side of the shipyard, the keel was laid in the dry dock for CVN 80 Enterprise. The RCOH program continues to make progress with CVN 73 USS George Washington on track to re-deliver next year. Also, we continue to see progress on the Virginia-class submarine program and expect to deliver SSN 796 New Jersey, and float off SSN 798 Massachusetts next year. In the quarter, we experienced continued challenges from the broader macroeconomic environment, most notably a persistent tight labor market with really no material improvement in general economic conditions. Through the third quarter, we have hired over 3,600 craftsmen and women against our full-year plan of approximately 5,000, and we continue to utilize the levers of outside lease labor and overtime to offset the short-term deficit of employees. In addition, supply chain challenges continue across our supplier ecosystem, resulting in longer material lead times and inflation pressure. As we've discussed previously on inflation, we do have some contractual mitigation, and we continue to actively manage the supply chain and our production schedules to minimize impacts. To address our shipbuilding labor challenges, we have aggressively enhanced our skilled workforce development pipeline. To this end, while we broadened our recruiting efforts to bring in more shipbuilders, we are also expanding our very successful apprenticeship programs, including revised curricula, reduction in completion timelines, a focus on pre-apprenticeships and youth apprenticeships, and expansion to underserved populations and women in the industry. Moving to our emissions technologies business, our pipeline remains very strong, with $4 billion in proposal or evaluation and $17 billion in capture. Our third quarter book to bow was 2.2 and was a healthy 1.1 year to date. Integration of operations and business systems following the Alliant acquisition is largely complete, and we are already seeing strong synergies, such as the recently announced DMAT and MAP DMO awards, totaling over $900 million in total contract value. We also received a couple of major contract actions in our nuclear and environmental business that were driven by sustained strong performance. At Savannah River, our joint venture received an extension for four years, plus an additional option year. And at the Nevada National Security Site, our joint venture received a simultaneous early exercise of all five of its option years, These are significant wins, and we are very proud to support DOE across the complex. Despite headwinds earlier in the year due to the delayed omnibus spending bill and the ongoing intense competition for talent, we continue to gain momentum and see strong growth potential going forward. This includes both domestic and international markets, where we are expanding our presence in regions consistent with the national security strategy. In summary, I'm confident that our presence across all the combatant commands, coupled with an increasing demand signal for advanced technology solutions from our DoD customers, positions mission technologies well going into FY23. Shifting to activities in Washington, the federal government began the new fiscal year under a continuing resolution, which funds government operations through December 16th. We continue to urge Congress to proceed expeditiously and remain optimistic that the annual defense appropriations and authorization processes will be completed in the months ahead. While final outcomes will depend on eventual respective appropriations and authorization conference committee negotiations, we are pleased to see defense oversight committees provide strong support to shipbuilding to include recommendations for new DDG 51, multi-year procurement authority, additional funding for amphibious ships, and requirements for not less than 31 amphibious warfare ships. The strong shipbuilding demand driven by our national defense requirements is shown on slide five. These critical customer needs spanning destroyers, amphibs, submarines, and aircraft carriers, and including new construction, overhaul, and maintenance and modernization will result in significant contract award opportunities driving continued backlog stability. And now I will turn the call over to Tom for some remarks on our financials. Tom?

Thanks, Chris, and good morning. Today I'll briefly review our third quarter results. For more detail of the segment results, please refer to the earnings release issued this morning and posted to our website. Beginning with our consolidated results on slide six, our third quarter revenues of $2.6 billion increased approximately 12% compared to the same period last year. This increased revenue was attributable to the acquisition of a line in the third quarter of 2021, as well as growth at Newport News Shipbuilding. Operating income for the quarter of $131 million increased by $13 million, or 11% from the third quarter of 2021. An operating margin of 5% was essentially flat from the prior year period. The increase in operating income was primarily due to more favorable non-current state income taxes and operating fast cash adjustment compared to the prior year period. as well as improved results at Newport News Shipbuilding. Other net expense was $13 million in the quarter, which was primarily driven by losses on equity investments to given market volatility in the quarter. Our effective tax rate in the quarter was approximately 14.8% compared to negative 4.3% in the third quarter of last year, which included research and development tax credits for tax years 2016 through 2020. Net earnings in the quarter were $138 million compared to $147 million in the third quarter of 2021. Diluted earnings per share in the quarter were $3.44 compared to $3.65 in the third quarter of the previous year. Moving on to slide seven, Ingalls revenues of $623 million in the quarter decreased to $5 million or less than 1% from the same period last year, driven primarily by lower revenues on the NSC and LPD programs and partially offset by higher DDG program revenues. Ingalls' operating income of $50 million and margin of 8% in the quarter declined from last year, primarily due to lower risk retirement on the DDG program, partially offset by higher LPD risk retirement. At Newport News, revenues of $1.4 billion increased by $91 million, or a robust 6.7% from the same period last year due to higher naval nuclear support services, as well as submarine and aircraft carrier revenues compared to the previous year. Newport News operating income of $102 million and margin of 7.1% were up from the last year due to contract incentives on the Columbia-class submarine program, partially offset by lower risk retirement on the VCS program. The Columbia-class contract incentives are related to Newport News' support of continued growth in the submarine construction enterprise. At Mission Technologies, revenues of $595 million increased $201 million compared to the third quarter of 2021, primarily driven by the acquisition of Align in the third quarter of last year. Mission Technologies operating income of $14 million compared to operating income of $13 million in the third quarter of last year. Current results included approximately $24 million of amortization of Align-related purchased intangible assets compared to $8 million in the third quarter of last year. Mission Technologies EBITDA margin in the third quarter was 8.4% and 8.7% year-to-date. Turning to slide 8, cash used by operations was $19 million in the quarter and net capital expenditures were $77 million or 2.9% of revenues, resulting in free cash flow of negative $96 million. This compares to cash from operations of $350 million, net capital expenditures of $73 million or 3.1% of revenues, and free cash flow of $277 million in the third quarter of 2021. While third quarter free cash flow was below the projection we provided on our last earnings call, this is simply a function of timing, as well as the tax payment of approximately $80 million that we elected to make in the third quarter, given the lower probability of delay and deferral of changes to the R&D tax treatment. In fact, we are increasing our overall free cash flow outlook for fiscal year 2022 which I'll discuss in more detail in a moment. Cash contributions to our pension and other post-retirement benefit plans were $11 million in the quarter, of which less than $1 million were discretionary contributions to our qualified pension plans. During the third quarter, we paid dividends of $1.18 per share, or $48 million. We also repurchased approximately 66,000 shares during the quarter at an aggregate cost of approximately $14 million. Moving on to slide nine, and our updated outlook for the 2022 and 2023 pension and post-retirement benefits. First, I would like to highlight that our funded status remains strong and has improved year-to-date. Additionally, I will note that the cash flow impacts related to the pension changes remain muted. For 2023, the FAS benefit has come down considerably from our last update, given the more immediate recognition of the negative asset returns experienced thus far in 2022. While the increase in the discount rate does partially offset the impact of asset returns, the magnitude of the impact related to lower asset returns is clearly more significant. Please remember that pension-related numbers are subject to year-end performance and measurement criteria. We will provide a multi-year update of pension estimates on our fourth quarter earnings call in February. Turning to slide 10, we are narrowing our 2022 shipbuilding and mission technologies revenue guidance to the lower end of our prior guidance ranges, giving results through the third quarter and the current operating environment. We are now expecting shipbuilding revenue to be between $8.2 and $8.3 billion and expect mission technologies revenues to be approximately $2.4 billion. The narrowing of the shipbuilding revenue guidance is a function of the challenging labor environment that we have frequently discussed. as well as our expectations for the timing of the material as we near year end. The mission technologies revenue is a reflection of the slowest start of the year, as well as the current hiring environment. As Chris noted, third quarter book-to-bill ratio exceeded 2.0, a very positive indicator as we move forward, and we remain very enthusiastic about the growth opportunities at mission technologies. We are reaffirming our shipbuilding operating margin guidance range of 8 to 8.1%. For mission technologies, we are slightly revising our margin guidance to approximately 2.3%, which is largely a function of the lower volume of work in the year. Moving to free cash flow, we are increasing our guidance to 2022. Under current Section 174 R&D tax law, the midpoint of our prior guidance was $225 million, which has now been raised to approximately $350 million. The most significant driver of that increase is the COVID progress repayment. which we initially expected in 2022, moving to 2023. Given our free cash flow through the third quarter, we are expecting very strong free cash flow generation in the fourth quarter. On slide 11, we have provided an update view of our free cash flow expectations. This outlook assumes the current R&D amortization treatment for tax purposes remain in place. And given that adjustment, our 2020 through 2024 free cash flow expectation is now approximately $2.9 billion. As we have noted before, the impact of the R&D treatment is approximately $250 million over the 2022 through 2024 timeframe. We are reaffirming our capital allocation priorities, including our commitment to return substantially all free cash flow after planned debt repayment to shareholders through 2024. As we have noted, this is a significant commitment, which should result in increased share repurchases, particularly in 2024, after we have reached the desired debt level. I will also note that we have recently announced an increase to our quarterly cash dividend to $1.24, a 5% increase over the prior amount. To summarize, the operating environment remains challenging, and we were not able to overcome the slow start to the services contracting pace, which has resulted in revenue guidance moving to the low end of our prior ranges. We are pleased to reaffirm our share building margin guidance and increase our free cash flow expectations as we aggressively manage through current business conditions. Regarding fiscal year 2023, we plan to provide detailed guidance on our fourth quarter call consistent with our normal cadence. With that said, we continue to view a long-term shipbuilding revenue CAGR of 3% as appropriate, and we are pleased to reaffirm our long-term free cash flow target through 2024, as I have discussed. We would normally expect incremental shipbuilding operating margin improvement in 2023. However, given the current economic environment, we'll need to close out the year to assess risk retirement and operational efficiencies before we can provide more insight. We will finish the year just as we started, focused on execution, and we will provide a more comprehensive update on our view for 2023 in February. With that, I'll turn the call back over to Chris for some final remarks before we take your questions.

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

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

Good morning. Thank you. Morning, Doug.

Morning, Doug.

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

Yeah, thanks for that, Doug. Definitely some stability in the Virginia class program right now. The Block 14 and 796, which is the next boat to be delivered, some positive developments from a schedule standpoint. They're very, very stable and looking towards beginning of next year to get that boat delivered. So I'd say stability in the schedule, still working very hard on the fundamentals of cost and efficiency. But I think we're in a pretty good place from a schedule standpoint there.

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

Yeah, sure. So fundamentally... When you have stability in your schedules and stability in your planning documentation, and you know what work is in front of you, then you're going to have a better chance to have an efficient performance from a cost standpoint. So first things first, let's get the schedule right. We've got the labor. They are fully staffed on Block 4 and Block 5. They're making progress on their milestones. And now it's just knocking down that work, getting through the test program on 796 and progressing forward. So I'm not going to give you a trajectory on margins on the VCS program. I will say the best indicator within the submarine program is are you making your milestones? Are your schedules stable? And if they are, you're going to meet your cost objectives. But there's a lot of fight in that team. They're working very hard to get that done. I know the team's working very hard on the fundamentals and the operating system. If they get that right and they work on that every single week, which they are, they're going to be successful.

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

As I said previously, we do have some protection. The biggest issue for inflation for us is going to be really on our new contracts and ensuring that we get the bids right from the supply chain. and ensure that the cost and schedule is correct when we bid those new contracts. So that's probably the greatest risk for us. We do have some inflation area issues within some of our piece parts in the supply chain where we didn't have those under contract. But as I said previously, we have some protection for that, although not fully protected. So the real issue for us related to inflation is getting the bids right on our new contracts, and we're working very hard to ensure we do that.

Okay, great. Thank you. Sure.

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

Hey, good morning. Morning, Rob. Morning, Rob. Tom, what was the organic growth for emission technologies in the third quarter since you have a partial inclusion last year in the third quarter? And then I know Alliant has a lot of cost plus work, but how much might wage inflation have contributed to the top line growth there?

Yeah, so when I look at that, you are right. We closed August 19th of last year, so the third quarter of last year was incomplete. So the organic growth for the quarter specifically was about 1.5%. But I look at it for the year. It can be choppy because of the CR at the beginning of the year. We've talked about the slow contracting environment. the winds, and then the supply chain issue a little bit on the operational side of that. The overall emission technologies growth for the year is 4.3%. Alliance stuff grew 8%. Q2, we told you about 6% for emission technologies as a whole. Emission technologies revenue top line was a little light. Usually that third quarter for us or the fourth fiscal quarter is a sweep-up quarter. For both Alliant and Legacy MDIS, we had anticipated when we told you about an 8% growth against the Q2 top line, we would see about 650, and that didn't materialize there. As I said, factors were that we didn't sweep up as much as we thought we would in funds, have open seats we've talked about in hiring professionals there, and then just some material, some minor material didn't hit in the quarter. So that's where we stand with growth.

I would also mention that I don't know. Sorry, Rob, but I don't recall if you just said that, Tom, but I think that we had pro forma growth of 8% year-to-date within mission technology. So I'm feeling very positive about the business. We had two real good wins in DMATs and the Air Force training contract, which is very positive. The book bill is positive. So I think that team has a lot of opportunity moving into 23rd.

Okay, and then just a high-level one, Chris, but on this potential five-unit block buy for the Columbia class, could you talk about what that might mean for Huntington Ingalls as a cost savings and labor continuity opportunity?

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

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

Uh, absolutely. But you think, geez, you think about the, the, the defense strategy and you think about the, uh, CNO NAV plan and the amount of visibility we have right now into what our backlog will be and our, the demand signal we're going to get in shipbuilding. Um, we have very good visibility and high confidence that we're going to be in a pretty good place over the next 10 to 15 years from a visibility standpoint. The important thing we need to do is focus on execution. make sure we get these bids correct, and then get these ships delivered because the Navy needs them.

Okay, fair enough. Thank you.

Yes.

I'd comment, too, on the back end of that. We added a new slide to kind of hit the strong demand for shipbuilding. You can see a backlog chart in slide five there, which shows the backlog at the $46 billion range. That's sustained itself through at least 2026. We have excellent visibility. from both the 30-year shipbuilding plan, the five-year fire plan, and then the more immediate FY23 budget of expectations, what we see in the near term. And we have tremendous visibility of the awards we expect to come in the next three to five years.

Hey, Rob. You still there?

Thank you. The next question comes from the line of Scott Dorshall with Credit Suisse.

You may proceed. Hey, good morning. Thank you so much for taking my question.

Good morning.

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

Yeah, sure. So you'll see that in the queue later this morning when it comes out. The quantification is $41 million of Columbia incentives. Over the last two or three calls, we've highlighted that as we're working closely with our customer, our needy customer, on how the Virginia class and the Columbia class play out, both the additional boats, the Block 5, the Block 6 boats, and then the Build 2. We're working closely with the program offices as far as what those requirements look like, what are the schedule requirements the boats have to flow out here, and that drives capacity and capability requirements within Newport News. We've worked close with the program office there, and we see a need for additional capacity that we have in the yard. We've negotiated a position right now, and we've achieved those incentives in the quarter. So it's $41 million.

Got it. Thank you. And then, Chris, apparently the Ukrainians recently used unmanned service vessels in combat, I think last Saturday. I think there were these kamikaze-style USVs. If I recall correctly, you've said in the past that the CONOPS was something that still needed some work on the unmanned service vessels. So I guess now that we've actually seen these in combat, do you think that's a big moment for a class of weapon systems broadly? And what does that mean for Huntington? Thank you.

Yeah, Scott, I don't want to comment on the specific mission. but I think getting these assets in the water, executing missions for the customer is very important because it's going to demonstrate how positive and productive these can be as a force multiplier, and we think it's the most positive thing we can do is get these in service so they can demonstrate their pretty impressive capability. Now, I don't know if we've hit an inflection point from a revenue standpoint as of yet, but there's definitely momentum that's being gained both subsea and on the surface, and a number of different con ops and missions that are being contemplated for these type of vessels. So we only think it's a positive development, and we think it will continue to gain momentum, and we really like where we're positioned.

Got it. Thank you so much. Sure.

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

Thanks. Good morning. Good morning, David. Good morning, David. Tom, could you just go through the rundown of EACs on the quarter?

The cumulative adjustments that we had, Dennis, that was 84 favorable, 57 unfavorable, a net of $27 million. And a proportion of that was about half of that was on Newport News, and then 25% each for Angleton MT.

Great. And then, you know, as we think about the opportunity for improved ship building margins next year, I mean, you obviously talked about that there, you know, potentially could be some leverage on the volume side, but What about, Chris, I guess from a milestone perspective, how do you see the milestones in 23 relative to 22 giving you an opportunity to enhance margins?

Yeah, so we'll give you a comprehensive update on the milestones on the next call. But the five deliveries in 23, we're still very positive on those schedules are holding, and we're pacing towards delivery on those ships and the balance of those Those milestones are in process and on schedule as well, as we previously indicated to you. So yeah, there's some opportunity, but we're going to assess the risk and opportunity every quarter. It's definitely still a tight labor market. There's been some positive indicators here as of late, but I don't think two data points is necessarily a trend. So we're going to be measuring how we deal with that, assess our risk and opportunities and then provide you a comprehensive update at the end of the year. But the milestones in 23 are holding. We're very comfortable with that. We need to get these assets delivered, and the team's working very hard to do that. Thank you very much.

Sure.

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

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

I appreciate the question. Yeah, so we did raise that. You know, when we look at the company as a whole in business now, 11 full years. This is the 12th. Nine of the 11, we've exceeded the target of seven and a quarter that we've had. Obviously, this is a down year. These two years, we were less than seven and a quarter. And as we've highlighted to the street, as our peers are, too, we're in double-digit negative returns against the pension plan that we have here. We do think it's prudent when we looked at it going forward that at least for next year we have an expectation that the return on assets could be 8%, so we raised that three-quarters of a point. Relative to the pension, you can see from our table that we gave you that updated the parameters for 2023. The discount rate has changed. It's gone from 3% to 490, so that's up 190 bps. We gave you the returns on what we saw through the year-to-date at minus 15%. And you can see that flows through the FAST-CAS adjustment goes down about $102 million. So that's some headwinds on EPS next year. But we'll keep you updated. And at the next call, we give you the entire table for a five-year projection going forward.

Okay, thank you.

Thank you. The next question comes from the line of Seth Seisman with J.P. Morgan. You may proceed.

Thanks very much, and good morning. I'd actually just say that I was going to ask the question about the asset returns, and I figured no one else would ask that question, but if someone did, I knew it would be George. Maybe thinking about a different kind of bigger picture question, and I apologize if this is a little bit squishy, but I was looking for something on your website recently, and you go on the site, and I think initially there's a there's a picture of like a soldier, like an army soldier, you know, holding a gun, and you've got kind of sea, cyber, land, air, joint, all domain. When you think long-term, Chris, about how you want to position the company during your tenure, is there a point, you know, by, I know it's far out there, about 2030 or whatever, where, you know, you want to see shipbuilding be you know, a certain percentage of sales, and it's much lower than it is right now?

Well, it's going to be a lower percentage simply because we think we've made really good investments in growth markets. When you think about the technology markets that we're in in Mission Technologies, they really directly relate to the national priorities. When you think about AI, ML, cyber, unmanned, um, uh, ISR, uh, all, uh, live virtual constructive training and advanced, uh, synthetic training. They, they, those directly, uh, relate, uh, and apply to, um, the defense, uh, uh, priorities, uh, moving forward. So they will naturally grow. Uh, and so shipbuilding will be a less of a percentage of the portfolio, but, uh, make no mistake, uh, shipbuilding will always kind of be at the heart of this company. Uh, and, and, and we're focused on it, but I think they'll naturally, uh, reposition a little bit, uh, based on the, uh, the technology. And, and it's, it's interesting. Um, you know, the Navy's asking for this, right? These are Navy priorities and I can think of no better way to serve your customer than to answer their call relative to additional, uh, more, uh, complicated missions that they need to execute. So, um, it's a good question. It's one when we think about a lot. And we think we're making the appropriate investments in these technology areas.

Cool. Thank you very much.

Sure.

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

Wanted to ask, just to be clear, the labor shortfall this year, How does that impact the timing of any milestones in the next couple years? Are the eight milestones you cited last quarter for 23 still on for 23? Is there any Q4 weight to those, et cetera?

They're still on for 23. And we assess the labor situation, and this got them thanks to the question, this is Chris. And we assess our labor plans and our program schedules on a quarterly basis. All of the labor situation that we've seen this year, what we expect for next year is only included in those program schedules, and we're still comfortable with those milestones.

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

Well, we're on pace to get to 5,000. I'm still comfortable with that number. We're going to have to see how it goes. We've had a couple good indicators here, so we're still comfortable with that. As we said previously on this call, we'll give you a better highlight on what we think about 23 in February.

Okay. And do you have a preliminary view on what you need to add next year?

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

Thank you, guys. Sure.

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

Good morning.

On the topic of milestones... Miles, welcome back. Sorry.

Hey, thanks, Chris. Thanks, Chris. Glad you noticed my brief absence, albeit.

Yeah, very brief.

On the topic of milestones, I was hoping you could touch on the two that were still on the slate for 22, DDG 123 and then eMiles.

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

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

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

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

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

Sorry, Tom. I was referring to the progress payment rule shifts. that you thought it would be reversed in 22. Now it's going to be reversed in 23. Oh, I'm sorry. Just the timing of progress statements. And I'm asking, do you actually see legislative inertia there?

So I would tell you that, as I told you at the Q2 call, that I believe it was going to be pushed to the end of the year right now. And that's a piece of the uptick that we have in our free cash flow guidance that we gave you. So we told you it was 225 was the midpoint. we now project to have to pay those payments back in 2023 timeframe. So it's an uptick. And for this year, it's an adjustment in the free cash flow bridge that we gave you in the briefing. And we anticipate paying those back in the first quarter of 23. Okay. All right.

Thank you. Thanks, Miles.

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

Hey, good morning. Morning. Looking at Mission Tech, do you still feel confident on that 6% to 8% margin target by 24?

Yeah, so we're on cost right now. When we look at the EBITDA right now, we've given you the numbers and where we finished the previous year in 8% range. If you notice, we just adjusted the EBITDA NDEA target down from 85 to 83 because of the volume pressures that we have, but we feel comfortable with that right now. In the briefing we have, we still have a robust pipeline. We feel comfortable. that we're getting our momentum, the portfolio itself, and the technology that we're going after, many opportunities at this. So I do. I think there's a little stress on it right now for 2022 just for the volume of sales as we adjust our base and overheads around that. But that's still a target that we've been highlighting, and it's good for modeling going forward.

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

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

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

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

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

Okay.

All right. Thanks.

Sure.

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

Hi. Good morning, everyone. Hi, Noah. Why did you choose to exclude the milestone slide from the deck this quarter?

Yes. We only do that twice a year. We kind of inserted that as a convention. So we've done it twice a year. I can comment on any one of them that you'd like. As I said previously to some of the questions, the last two for this year are on schedule. Deliveries for next year are on schedule. So it's just been our convention twice a year to go back in time. Yeah, sure.

Okay. I had forgotten that. So, yeah, I wasn't sure if it was, hey, something's happening with the milestones or – nothing's changed, so it doesn't need to be there, and I just had forgotten that it was twice a year.

If something was happening with the milestones, I'd tell you. But they're on schedule, so thanks for that. It's just that that's our convention. Got it.

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

Yeah, I'll start and then Tom can chip in here. So we do have some protections, right, from an inflation standpoint. We're very fortunate. that with our relationship with the labor unions, we're able to get long-term arrangements there, which helps us mitigate it to some extent. Having suppliers under contract before we entered into this mitigates it to some extent. And then our EPA clauses mitigates it some. But absolutely, when you think about our exempt workforce and some of the increases that we've had to provide from a salary standpoint, For new hires, that impacts our labor rates a bit. And then some of the general inventory that you can't put under contract could impact it a bit as well. So I would say it modestly impacts it. We've assessed all of it in our EAC process, and we think we have it, but we're going to have to be mindful of it moving forward.

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

I think it's more of the latter there. Obviously, we want to come through. We're watching the risk profiles, the risk registers, what gets burnt down this quarter. The performance and the cadence, are we maintaining schedule, the hiring and the experience in the yard, the progress that we make with the experience and the material that hits into the yard. We'll run our EFT process. A piece of that EFT process is the contract adjustments we get for EPA and other type of provisions that we'll handle for inflation. To piggyback on what Chris said earlier, you know, depending on the portfolio and the mix, Ingalls is more 90-10 fixed price. Newport News is 50-50 cost type and fixed. which contracts have EPA clauses, which contracts are being impacted. So a lot of things are moving around there between inflation, supply chain, interest rates, performance, material receipt, and progressing. So we really want to get a look-see on where we stand right now. We told you 8 to 8.1, and we still feel comfortable with that right now. We had a strong first half, which we kind of foreshadowed. We told you the back half would be about 7 percent for shipbuilding. We came in at 7.4 with those incentives. So you can do the math. We're still holding at 7% for the back half of the year. So you can do the math on what Q4 looks like. But I think 8 to 8.1 is still a valid endpoint for us. I'd like to see where we land on that, see our run rates, and then we'll factor that into the baseline going forward on the February call.

Okay. Thanks so much.

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

Thanks for taking the other question. Sure. Just want to, Tom, maybe if you could run through the expectations on networking capital now. You know, I think you had said, I think right now we're at about 11%. I think you had said getting down to eight at the end of this year. relatively flat on a percentage of sales basis from there, but coming down in absolute terms. If you could just give an update, thanks.

Sure, yeah. So for, yep, that's exactly what I left her at, at 9.3, about 9.3% was the working capital sales in Q2. We are just about 11%, 11.1 for Q3. I anticipated that. We'll turn the corner a little bit as we exit the year here, as we kind of work ourselves through the trades, the invoicing, payments, and progressing, that will come down. And then we've talked about the milestones with the five deliveries of next year, which are still in play here. So I see 23 of that dropping back to more traditional 6% to 8% range. And I would expect that we would run in that rate over the next couple of years. And that's the plan, and we're on that trajectory.

Thank you. Mm-hmm.

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

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

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