Huntington Ingalls Industries, Inc. Q4 FY2021 Earnings Call

Ladies and gentlemen, thank you for standing by and welcome to the Fourth Quarter 2021 Huntington Ingalls Industries Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. Please be advised that today's conference is being recorded. I would now like to hand the call over to Christie Thomas, Vice President of Investor Relations. Ms. Thomas, you may begin.

Thanks. Good morning and welcome to the Huntington Ingalls Industries fourth quarter 2021 earnings conference call. With us today are Mike Petters, President and Chief Executive Officer; Chris Kastner, Executive Vice President and Chief Operating Officer; and Tom Steely, Executive Vice President and Chief Financial Officer. As a reminder, statements made in today's call that are not historical facts are considered forward-looking statements and are made pursuant to the safe harbor provisions of federal securities law. Actual results may differ. Please refer to our SEC filings for a description of some of the factors that may cause actual results to vary materially from anticipated results. Also in their remarks today, Mike, Chris and Tom 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 will turn the call over to our President and CEO, Mike Petters. Mike?

Thanks, Christie. Good morning, everyone, and thanks for joining us on today's call. Before getting into the results for the quarter and the full year, I want to personally thank each of our 44,000 employees for continuing to execute their daily activities with an unwavering commitment to our operational pillars of safety, quality, cost of schedule. 2021 was a year of solid performance and resiliency during the COVID pandemic. At HII, we are committed to promoting and protecting the health and safety of our employees, their families and their communities and continuing to serve our customers in a vital national security interest of our country without disruption as an essential contributor to the nation's critical infrastructure. Most recently faced with uncertainty around the Omicron variant, our employees remain focused on execution while driving continuous improvement, innovation, and creativity. While HII has not become subject to a vaccine mandate through any of our shipbuilding contracts at this time, we continue to be committed to promoting the benefits of a vaccinated workforce. Our Technical Solutions division does have the vaccine requirement in a number of contracts. Currently, we estimate that approximately 81% of our HII full-time employees are fully vaccinated. Earlier this morning, we released our 2021 results which we believe reflect consistent shipbuilding program execution, with year-over-year margin expansion and a transformational year for our Technical Solutions division. During the year, we captured major contract awards resulting in maintaining record backlog levels, and we expanded our portfolio by acquiring Alion in our Technical Solutions division. With these actions, HII persevered to diligently pursue the business outcomes of driving growth, managing risk, and generating strong returns. Some highlights from the quarter start on Slide 3 of the presentation. Sales of $2.7 billion for the fourth quarter are down 3% from the fourth quarter of 2020, and sales of $9.5 billion for the full year are up 2% from the full year of 2020. Given the numerous challenges in 2021, we were pleased to finish the year with shipbuilding revenues at the low end of our guidance and we remain confident in the 3% shipbuilding average growth rate over time. We also saw strong growth as anticipated in our Technical Solutions division. Diluted EPS was $2.99 for the quarter and $13.50 for the full year, down from $6.15 in the fourth quarter of 2020 and $17.14 for the full year in 2020. Full year segment operating income of $683 million is an increase of $128 million or 23% over 2020. These returns are in line with our expectations as a result of continued performance improvement in shipbuilding margins and strong performance in our Technical Solutions division. New contract awards during the quarter were approximately $1 billion, resulting in our backlog of approximately $48 billion at the end of the quarter, of which approximately $23 billion is currently funded. Now entering 2022, our shipbuilding programs backlog provides, we believe, unmatched stability and visibility, and we are laser-focused on methodically executing our contracts, while the Technical Solutions business is positioned to capture growth opportunities. We remain extremely pleased with the technology, capability, talent, and solutions that Alion has brought to the HII family. Now shifting the activities in Washington for a moment. We are pleased with the passage and enactment of the fiscal year 2022 Defense Authorization Bill and its strong support for shipbuilding. However, more than one quarter into the fiscal year, congressional appropriations have yet to be finalized, and the federal government continues to operate under a continuing resolution through February 18. It remains uncertain at this point when annual funding measures will be finalized, and we continue to urge Congress to proceed expeditiously. We do remain optimistic that the appropriations process will be completed in the weeks ahead. Now, before I close, let me take a moment to address the recent announcement that, at my recommendation, our Board of Directors elected Chris Kastner to the role of President and CEO effective March 1. This is consistent with the company's succession plan and I fully endorse this transition. I truly believe this is a fantastic development for HII. As the Executive Vice Chairman of the Board, I will remain an HII employee through the rest of the year and will be able to support Chris and the Board. As the first CEO of this great company, I can tell you confidently that there is no better choice than Chris to lead HII into this bright new chapter, where I believe we are positioned better than ever before to successfully leverage our substantial backlog to generate strong free cash flow, demonstrate growth in our Technical Solutions division, and create long-term sustainable value for our shareholders, our customers, and our employees. And now, I will turn the call over to Chris for his remarks on the operations.

Thanks, Mike, and good morning, everyone. Let me first congratulate Mike on his transition to Executive Vice Chairman of the Board and thank him on behalf of myself and our 44,000 employees for his extraordinary leadership. I also want to thank the Board of Directors for electing me to succeed Mike as HII's next CEO. Thanks to Mike's vision, HII is positioned well today and the value creation opportunity in front of us is as strong as ever. I'm honored to lead HII in its next chapter. Now shifting to our results. I'm very pleased to report another solid operational quarter. Let me share a few highlights. At Ingalls, the Navy continues to fund advanced procurement for the amphibious patrol ship, LHA 9, and LHA 8 Bougainville is achieving cost and schedule performance in line with our expectations. On the DDG program, the team delivered guided missile destroyer DDG 121, Frank E. Petersen Jr. to the Navy and began fabrication of DDG 131, George M. Neil. This seal production line continues to show positive momentum in 2022, with planned delivery of DDG 123 Lenah Sutcliffe Higbee. On the LPD program, LPD 28 Fort Lauderdale has completed sea trials and is on track for delivery to the Navy in the first quarter of this year. In addition, LPD 29, Richard M. McCool, Jr., was launched in early January. We continue to watch the upcoming budget release for advanced procurement funding for LPD 32 to maintain the benefits of the serial production on LPDs. At Newport News, the Ford-class aircraft carriers are progressing well. CVN 79 Kennedy is approximately 83% complete and the team is focused on compartment completion and key propulsion plant milestones. Later this year, Kennedy will begin testing of EMALS, the electromagnetic launch system. CVN 80 Enterprise and CVN 81 Doris Miller continue material procurement and early unit construction and CVN 80 plans to lay the keel this year. On the RCOH program, CVN 73 USS George Washington reached 94% complete and is focused on propulsion plant testing and is planned for redelivery later this year. Regarding CVN 78 USS Gerald R. Ford, the planned incremental availability is on track to complete this year to support the Navy's first deployment of this critical asset. On the VCS program, SSN 794 Montana completed work as planned in Q4 2021 and will complete sea trials and delivery in Q1 2022. SSN 796 New Jersey was christened last year and is expected to achieve its float-off milestone early this year. While we did not achieve our projected end-of-year milestones, the VCS program continues to improve its progress towards a consistent cadence of two ships per year. Finally, on a submarine fleet support program, SSN 725 Helena recently completed sea trials and was redelivered to the Navy last month. This Los Angeles class submarine maintenance completion marks the first redelivery from Newport News of a submarine following a major availability since 2009 and demonstrates the successful reconstitution of our submarine maintenance capability in support of the Navy. At Technical Solutions, the Alion integration is progressing on plan. Our organizations are already operating as a consolidated business. Back-office systems integration is in full swing and should be largely complete by the end of the year. Book-to-bill for 2021 was healthy at $1.1 million and the new business qualified pipeline is very robust at over $20 billion, a level strong enough to support our growth expectations for this business. Moreover, the velocity of the pipeline has already increased significantly entering 2022, with nearly $5 billion currently in evaluation or in proposal development. This includes multiple opportunities over $1 billion in total contract value that are expected to move to award this year. Before I close, I want to provide some remarks regarding our labor and material availability. We continue to keep COVID-19 impacts as watch items and are focused on ensuring our supply chain and labor supply will be able to continue to support our performance. Given the nation's overall labor pressures, we have increased attention with regard to hiring and attrition rates and we have detailed plans in place to accelerate hiring for 2022. We are leveraging targeted hiring events and actively utilizing our world-class apprentice schools as well as relationships with community colleges and high schools to increase the pace of talent acquisition and development. Now, I'll turn the call over to Tom for some remarks on the financials.

Thanks, Chris, and good morning. Today, I'll briefly review our fourth quarter and full year results and also provide our outlook for 2022. For more detail on the segment results, please refer to the earnings release issued this morning and posted to our website. Beginning with our consolidated fourth quarter results on Slide 5 of the presentation. Our fourth quarter revenues of $2.7 billion decreased approximately 3% compared to the same period last year. This was due to a decline at Newport News and Ingalls shipbuilding, which was largely driven by a very high level of material volume in the fourth quarter of 2020, partially offset by the growth in Technical Solutions from the acquisition of Alion in the third quarter of this year. Operating income for the quarter of $120 million decreased by $185 million from the fourth quarter of 2020 and operating margin of 4.5% decreased 658 basis points. These decreases were largely due to a less favorable operating FAS/CAS adjustment compared to the prior year as well as lower segment operating income driven by lower risk retirement on the DDG and NSC programs at Ingalls as well as lower risk retirement on submarine fleet support at Newport News. Moving to our consolidated results for the full year on Slide 6. Revenues were $9.5 billion for the year, an increase of 1.7% from 2020. The increase was primarily driven by the acquisition of Alion in the third quarter, as well as growth at Newport News shipbuilding in the Virginia class and Columbia class submarine programs and carrier construction and overhaul. This was partially offset by a decline in revenue at Ingalls due to lower volumes on NSC and amphibious assault ships programs, as well as the divestiture of our oil and gas business and the contribution of the San Diego shipyard to a joint venture early in 2021. On an organic basis, revenue for Technical Solutions was essentially flat year-over-year. Operating income for the year was $513 million and operating margin was 5.4%. This compares to operating income of $799 million and operating margin of 8.5% in 2020. The decreases were due to a less favorable operating FAS/CAS adjustment compared to 2020, partially offset by stronger segment operating results. Segment operating income for the year was $683 million and segment operating margin was 7.2%. This compares to segment operating income of $555 million and segment operating margin of 5.9% in 2020. Our effective income tax rate was 18.4% for the quarter and 12.5% for the full year. This compares to 17.8% and 14.1% for the fourth quarter and full year of 2020, respectively. The decrease in the annual tax rate was primarily due to additional research and development tax credit for tax years 2016 through 2020 recorded in the third quarter of 2021. Net earnings in 2021 were $544 million compared to $696 million in 2020. Diluted earnings per share in 2021 was $13.50 compared to $17.14 in the prior year. Pension adjusted diluted earnings per share in 2021 were $13.03, an increase of 30% from 2020 results due to stronger segment operating performance. 2021 results included approximately $20 million of pretax transaction and financing expenses related to the acquisition of Alion. Additionally, 2021 results include amortization of purchased intangible assets totaling approximately $86 million, of which approximately $33 million was related to Alion. Turning to cash flow on Slide 7 of the presentation. We ended 2021 with a cash balance of $627 million, up from $512 million at the end of 2020. Cash from operations was $271 million in the fourth quarter and free cash flow was $165 million. For the full year, cash from operations was $760 million and free cash flow was $449 million. Net capital expenditures in 2021 were $311 million or 3.3% of revenues. Cash contributions to our pension and other postretirement benefit plans totaled $106 million in 2021. During the fourth quarter, we paid dividends of $1.18 per share or $48 million, bringing total dividends paid for the year to $186 million. We also repurchased approximately 75,000 shares during the quarter at an aggregate cost of approximately $14 million. In 2021, we repurchased approximately 544,000 shares at an aggregate cost of approximately $101 million. On Slide 8, we have provided our updated 5-year pension outlook. The notable change from our prior outlook is the increase in the FAS benefit. This was largely driven by asset returns in 2021 of 12.7% and, to a lesser extent, the modest change in the discount rate. Moving on to Slide 9. We have provided details on our outlook for 2022. While we continue to expect shipbuilding growth of approximately 3% over time, our 2022 outlook range of $8.2 billion to $8.5 billion acknowledges uncertainties around the current environment. We finished 2021 with shipbuilding operating margins at 7.7%, the high end of our initial guidance range and at the midpoint of our revised guidance range. This was a marked improvement from the shipbuilding margin of 6.2% in 2020. We expect shipbuilding operating margin to be between 8% and 8.1% for 2022 and we expect 2023 shipbuilding operating margin will continue to improve beyond 2022 results. For Technical Solutions, we expect revenue of approximately $2.6 billion in 2022, operating margins of approximately 2.5%, and EBITDA margin between 8% and 8.5%. These are all consistent with our guidance and messaging at the time of the Alion announcement, and current run rate in 2021 results firmly support our expectations. In 2022, amortization of purchased intangible assets is expected to total approximately $142 million, of which $121 million is attributable to Technical Solutions. Given the timing of the shipbuilding program milestones and the normal seasonality for Technical Solutions, we expect the first quarter segment operating results to be the weakest of the year, with shipbuilding operating margin near 7% and Technical Solutions operating margin near 1%. Additionally, we expect that the first quarter 2022 shipbuilding revenue will be the lightest of the year given Omicron and the challenging labor market driving to a slow start of the year. Our expectation is for shipbuilding revenue to be approximately $100 million lower than results in the first quarter of 2021, with that equally split between the shipyards. Moving on, we expect 2022 capital expenditures to be between 2.5% and 3% of sales. This guidance does include modest incremental capital expenditures above our prior guidance related to investments in infrastructure and tooling to support the submarine industrial base. We are working with our Navy partner regarding the shared investment and capital incentive structure and believe these critical investments will have minimal impact on our overall free cash flow generation. We expect 2022 free cash flow to be between $300 million and $350 million, which includes a number of nonrecurring items. First, as we noted on the third quarter call, we now expect the repayment of the advanced progress payments we received in 2020 to occur in 2022, which totals approximately $160 million. Additionally, we have a repayment of approximately $70 million in 2022 due to the 2020 payroll tax holiday. Our 2021 free cash flow results were also about $125 million better than the midpoint of our latest guidance, simply due to timing of collections and distributions. The outlook we are providing today is based on the best information we have now and assumes no further degradation in our supply chain. It also assumes that we're able to continue to hire employees at a pace that supports our staffing and that we continue to see limited impacts from inflation given the nature of our contracts and the long-term arrangements that we have in place with our labor unions and suppliers. Additionally, on Slide 9, we've provided our updated outlook for a number of other discrete items to assist you with your modeling. Regarding our longer-term targets, we remain confident in our free cash flow target of $3.2 billion from 2020 through 2024. This outlook does assume the continued expensing of research and development costs for tax purposes. For context, we now believe the impact to 2022 free cash flow would be approximately $100 million if the current R&D amortization treatment remains in place. On Slide 10, we have provided a walk-up from our 2022 to 2024 free cash flow outlook. First, 2023 free cash flow is enhanced by the lack of discrete headwinds I just mentioned for 2022, the advance payments and payroll tax holiday repayments. Secondly, we do expect a working capital tailwind in 2023 that, along with continued top-line growth in shipbuilding, is expected to drive approximately $200 million of incremental cash flow. Finally, the growth in margin expansion of Technical Solutions is expected to contribute meaningful incremental free cash flow in 2023 and beyond. As a reminder, working capital can be quite lumpy as we saw at the end of 2021 and we have provided ranges to help account for that variability. For 2023, we are expecting free cash flow to be between $750 million and $800 million and between $800 million and $900 million for 2024, which is all consistent with the target of $3.2 billion between 2020 and 2024. In closing, given the persistent challenges presented in 2021, we are pleased that we were able to complete the year with the results generally consistent with our guidance, including shipbuilding margin at the high end of our initial range and free cash flow well above our guidance. Notwithstanding the current environment, we remain enthusiastic regarding our long-term outlook as we begin 2022, with nearly $50 billion in backlog and a Technical Solutions business that we believe is poised for very strong growth. We are laser-focused on consistent execution and generating sustainable long-term value. Now, I'll turn the call back over to Christie for Q&A.

Thanks, Tom. 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.

And the first question will be from Myles Walton with UBS. Please go ahead.

Hi, good morning. I would like to focus on cash flow for a moment, particularly looking beyond 2023 and 2024. Can you discuss the algorithm and conversion ratios that you consider sustainable? In 2023 and 2024, it seems you are converting significantly above the implied rate, especially after adjusting for noncash pension income, exceeding 100%. Could you explain what the conversion structure or equation might look like after 2024?

Sure. Thanks, Myles. I'll take that. Tom here. Sure. As we've been guiding and as we get into the out year this year, the portfolio is maturing. The ships are getting deeper into their build cycles. We're seeing additional progress, and we're getting more ships as we've highlighted in the past in deliveries into '22, '23, '24 time frame from where we've come from. So we're seeing additional progress and improvement in working capital in the out years and then a higher conversion rate as we release retentions and run through the deliveries of those ships. So, I'm with you that there's a couple of years that we're playing catch-up actually, and the bridge I've given here in half of Page 10 actually kind of shows that there's some headwinds that we have in working capital exiting '21 going into '22. The working capital actually gets a little bit worse. And on the top end of our range, almost 8%, in the high 7s. But then as we get into '23 and out, we actually see that turn back and become favorable for cash and cash contribution as we work off the progress of the ships and we deliver the ships.

But we shouldn't assume any substantive drop-off post '24 from working capital materials on the opposite direction.

No. No, I think what we've highlighted is long-term, I mean, as we work the ships off, have the collections and then deliver, the margin and free cash flow will gravitate into a one-off. You'll see years where there's some pressure on that as the maturity of the enterprise is on the front end of the cycle. And then as we kind of move a little bit more on the back end of the cycle, we've accumulated this backlog of $48 billion. And now that we're kind of heavy in the ramp-up of pushing that work through the state here, hiring up and then achieving the progress, you'll see that swing back to favorability both in 2023 and 2024.

Myles, it's Chris. I think you're getting into a new normal from a free cash flow generation standpoint up at those elevated levels. So it just naturally gets there.

Okay. And congratulations, Chris and Mike. Thanks, again.

Thanks, Myles.

And the next question will be from Doug Harned with Bernstein. Please go ahead.

Good morning, thank you. First, Mike, I just want to wish you all the best in this transition. It's been great working with you even from before there was an HII, so it's been a pretty exciting road, I think.

Thanks, Doug.

The question I've got is, you all talked a lot about a 3% top line growth rate which is pretty consistent when we model out where the ship by ship things should go. But if I look at the 2022 guidance, there's really negligible growth versus your shipbuilding revenues in 2020. And so is this consistent with your expectations? And can you break it down between Ingalls, Newport News and also the impact of services?

Sure, I'll take that. I appreciate that. Thanks, Doug. So yes, we provided some insights on how 2020 finished compared to 2019. Each year's results can vary depending on how material and labor costs align with the quarter close. Looking at our shipbuilding results, we had expected 2020 to reach about $8 billion, but a strong fourth quarter led us to finish at $8.25 billion. This represented nearly a 6% increase from the previous year. Certain materials arrived earlier than anticipated. The trend we have shows figures of $7.8 billion and $8.2 billion. Last year, we highlighted a medium to long-term growth rate of 3%, but some adjustments shrunk our projections for 2021 by a couple of hundred million dollars. We experienced pressures at the end of 2021 due to both the Delta and Omicron variants. Newport News showed a slight growth of about $50 million in sales, while Ingalls increased by approximately $150 million, influenced by planning and labor pressures. For 2021, shipbuilding was adjusted to $8.191 billion, which is $50 million less than 2020. Regarding our guidance range of $8.2 billion to $8.5 billion, we're currently observing a decline in case rates from the virus at the start of this year. If this trend continues and we have a stable year, we believe shipbuilding could reach $8.5 billion, marking a clean increase of over 3.5%. However, should COVID persist throughout the year or if another variant emerges, we might see a flat year instead. Labor pressures from 2021 into 2022 could also affect this. We have plans in place for hiring and recognize our workforce as our most valuable asset. We've successfully developed our labor strategies, and we remain optimistic for this year. While Q1 is traditionally a low quarter and may be affected by labor issues, we anticipate recovery. It's important to note that revenues can fluctuate significantly from quarter to quarter. If we consider 2017 as our base year for shipbuilding at $6.6 billion, the compound annual growth rate over the past four years is 5.5%. Using 2018 as a base gives a CAGR of 3.7%. Even when considering the unique circumstances of 2020 and the stagnation in 2021 due to COVID, we still see a CAGR of 2.4%. We aim to be transparent about our expectations, and while we believe we can achieve long-term growth of 3%, we have slightly adjusted our guidance to a range of $8.2 billion to $8.5 billion.

Regarding the timing, you mentioned 2021 and how performance on the Virginia class contributed to improved margins in Newport News. Now that you are transitioning from Block 4 to Block 5, General Dynamics has indicated there are delays in modules and some supply chain challenges. Looking ahead to 2022, are you experiencing any issues with this overall program and the transition from Block 4 to Block 5?

Yes. No. Doug, this is Chris. Actually, it's pretty encouraging from a module standpoint in Newport News last year. They met their commitment on module, so they're getting some stability in the manufacturing organization in Newport News. So it's pretty stable. Missed the milestones at the end of the year related to Montana and New Jersey but those will happen here momentarily. But they're pressing toward getting back to a 2-tier cadence; the team is very focused on it.

Okay. Okay, great. Thank you.

And the next question will be from Ron Epstein with Bank of America. Please go ahead.

Yes. Good morning, guys. Thanks for the time. Could you walk through the growth in Technical Services? Because it looks like if you look at the guide that you guys are implying, it implies organic growth in the core. If you pick out a line, it was actually pretty darn good. I mean it seems like we had organic growth that might have been mid-teens or higher in the business without Alion. And how do we think about that? And what are the growth drivers for that business as we go into '22?

So Ron, it's Tom here. According to the notes I shared, the organic growth year-over-year was flat. We can discuss this in more detail if you notice something different. We did encounter some challenges in unmanned, yet we remain optimistic about that sector, which we believe will see growth despite the current smaller budget. We anticipate that this will be a rapidly growing area in the Navy budget. We experienced delays in appropriations and awards, which we had anticipated would push out to the summer of 2022, affecting the organic aspect of TSD. However, Alion had a remarkable year last year, achieving a 23% increase from 2020 to 2021. Historically, from 2018 to 2020, their growth was in the teens. This growth has been factored into our $1 billion TSD business forecast. For the overall $2.6 billion, we are confident in our growth projections of 7% to 9% for at least 2024. As I mentioned earlier, the run rates for Q3 and Q4 have been consistent and align with our expectations. With actuals at $507 million, we need about 11% growth to reach the $1.6 billion target within the $2.6 billion for the TSD division in 2022. We are quite comfortable with Alion so far, though success will depend on securing future bids. Additionally, Andy Green has restructured his business and aligned his leadership team, which should create synergies with the organic TSD. We are closely monitoring the unmanned sector to assess its growth potential.

Ron, from a market standpoint, I mentioned some significant opportunities that we have bid on and will bid on in the first part of the year. I don't want to comment on the specific items because they're competitive but there — it's broadly across ISR, advanced training, cyber-intel. And then we have unmanned opportunities that were delayed from last year that will come out this year. So it's pretty broad within growth markets that Alion and the legacy TSD are engaged in.

Got it. Got it. And then maybe just as a follow-on. Can you speak a little bit to the CapEx investment you're making? Is that prepped for maybe more Virginia class? Or I mean, how do we think about that?

Yes. In previous quarters, we indicated that there was a possibility for a change, noting that our capital expenditure has decreased from 3.6% in 2020 to 3.3% last year. We are now guiding towards approximately 2.5%. Recently, we have been reviewing both the current and anticipated future requirements for submarines, including discussions about the Columbia class follow-on with our Navy customer. Additional investments are needed for submarine industrial rates, particularly in infrastructure and tooling. We are willing to partner with the Navy for this investment. With capital incentives, we plan to moderately increase our CapEx to a forecasted range of 2.5% to 3%, which will extend over the next several years. We will proceed only with customer support and only if the investment is sensible and promises an appropriate return. This adjustment is minor but has been factored into our $3.2 billion free cash flow forecast through 2024 that we have revalidated.

Yes. Ron, it's also consistent with the 2 per year plus the next phase of the Columbia class. If they were to accelerate to 3, then there'd be initial investment that would be required.

And my congratulations on the transition. For Doug's remark, it's been nice working with you over the years.

Thank you. And the next question will come from Robert Spingarn with Melius Research. Please go ahead.

Hi, good morning. Mike and Chris, congrats. It has been an excellent run working with you, Mike. I'd like to ask Chris if you could talk a little bit about labor. What do you expect net headcount to be or growth to be in '22, the pieces of that, so departures, additions and how we think about cost within that and how the new collective bargaining agreement might affect that.

Yes, that's a good question. There are some positive indicators related to Omicron that make us cautiously optimistic. Earlier this week, we only had 20 cases in Newport News and attendance is improving, which is crucial. Restoring stable attendance provides us with a reliable labor force to execute our program, which is ideal for a shipbuilder. However, we need to hire over 5,000 people. I won't go into details about attrition or break it down by shipyards, but we have established strong relationships with our apprentice schools, community colleges, and high schools. We believe we can meet that hiring commitment. It will be a challenge, but we are confident we can build the workforce needed to achieve our sales guidance.

Okay. And then just a quick one for Tom. If you could run through the details on EACs in the quarter.

Sure. So for Q4, we saw a net of $10 million favorability, $45 million favorable and $35 million unfavorable. And the net debt of the $10 million was basically attributable to a split between Ingalls and TSD.

And the next question will come from Mike Maugeri with Wolfe Research. Please go ahead.

Hey, good morning. Thank you, guys. And Mike and Chris, congratulations to both of you. Chris, following on Doug's question, can you add a little bit more color around the transition between Virginia Class Block IV and Block V as you close out the year, risk items you're keeping an eye on that happened to Block IV, where you're sort of expecting for Block V and whether there could be upside there?

Yes. We did incur a charge on Block IV, so there might be some potential for improvement in Block V. The team is focused on early module fabrication, and we met our commitments this year in that area. The positive momentum in the VCS program is that we are training a team to deliver one afloat each year. That team will seamlessly transition to Block V. If we can achieve consistent performance, that’s the ideal situation for shipbuilding in serial production. We just need to maintain the positive momentum.

Got it. And then a related follow-up. How does the mix between Block IV and Block V trend over the next 3, 4 years, 3 years, probably?

We don't have that specific information for you. We don't really provide guidance at that level. But deliveries on Block IV happen one a year for the next 3 years after we get through Montana, and then we'll transition. So it will slowly evolve into more Block V revenue.

The next question will come from Seth Seifman with JPMorgan. Please go ahead.

Thanks very much and good morning, and congratulations to Mike and Chris. Just wanted to start off asking a little bit about the cash flow bridge and just kind of understanding the piece that's in '23, I think, the $200 million of shipbuilding growth at working capital. Just when we think about shipbuilding growth and we think about a 3% top line with a shipbuilding margin type drop-through after tax, that would imply that the vast, vast majority of that $200 million is working capital. So, I just want to confirm that that's kind of the right thing about it. And then when we think about what drives the growth from '23 to '24, is it a similar dynamic where there's that level of underlying EBITDA growth from the shipyards on that kind of 3% and then anything else is kind of working capital as you go to '24?

Thank you for the question. It's Tom here. From a working capital perspective, you're correct that the bar shows $200 million, indicating an increase from both volume and the expected returns from the $7.7 billion decline we mentioned for shipbuilding. This leads to a quick calculation of about 1/4 of that amount, with the remainder in working capital, which constitutes the majority. Although capital expenditures are projected to be on the lower end at 2.5% to 3%, there is a slight upward push reflected in our chart moving forward. I see a drag on working capital transitioning from 2021 to 2022 of about $100 million in additional working capital, which then reverses to over $300 million. This is affected by both the existing contracts and trade working capital. Overall, there is a significant improvement from 2022 to 2023, with projections moving from the upper end of the 6% to 8% range in 2022. Including cap incentives, we expect to drop below the bottom end of that 6% range in 2023, with a slight improvement anticipated for 2024.

I wanted to ask about the hiring of 5,000 people. How does that number compare to recent years in terms of gross additions? It seems like a high percentage of the shipbuilding workforce, around 14%.

Seth, we're quite proficient at hiring. We brought on a similar number last year and plan to exceed that this year. So yes, we're skilled in this area; my boss sees it as a key strength, and I agree.

Great. Okay. Thanks very much, guys.

The next question will come from David Strauss with Barclays. Please go ahead.

Great, thanks. And let me echo my congratulations to you both as well.

Thanks, David.

I would like to inquire about the shipbuilding margin profile. You're anticipating an improvement of around 40 to 50 basis points. Could you provide some insight into how this improvement might be distributed among the shipyards? We've observed that Newport News has been increasing while Ingalls has been declining. What does this look like for 2022 and the further progress you're expecting beyond that?

Yes. So to date, we give our outlook against the enterprises, so we don't kind of break that up between both Ingalls or Newport News. As I kind of mentioned earlier a little bit, it is the ships that we have in the contract, working them through the EAP processes, the registers burning down risk. As we get deeper into the build cycle, the additional progress, payments clause allows us to have more collections. And with the bringing down on risk, we'll have high booking rates as we get into more deliveries in the out years. So I mean, that's the essence of it.

Yes. I will say, David, just I agree with Tom that it's really the maturity of the ships that Newport News are going to drive a lot of that earnings growth.

Okay, got it. And Chris, maybe if you could touch on the unmanned portfolio. I think you highlighted it as a bit of a risk item last quarter. And I guess you also highlighted in the release today, the drag on TS margin, just an update on what you're seeing there.

Yes, we've made some progress with small and medium, which we expect will be awarded in late Q1 or early Q2, once the budget is finalized. We should have more information once those awards are made. We're also advancing with XL, having shipped our first modules to Boeing. It's crucial for Boeing to get that boat in the water to start showcasing its capabilities. Overall, we're making reasonable progress in the unmanned segment, and we anticipate learning a lot more this year.

The next question will come from Pete Skibitski with Alembic Global. Please go ahead.

Yes, good morning, guys. And I'll reiterate, Mike, best of luck, and Chris, congrats. I want to talk about aircraft carriers. It looks like work on the Ford elevators is finally finished up and ships getting closer to deployment. And I just saw on your slides the statement of work, I think, on the Kennedy is now done. Can you talk about maybe what you've learned about the technical risk on the Ford class and how that's going to apply to the Kennedy? And do you have that contract mod yet on the Kennedy? That's it.

Yes. We do have the mod on the Kennedy. I got an old aircraft carrier program manager here that hasn't answered a question, so I'm curious if he wants to jump in here on the aircraft carriers, then I'll jump in after.

Thanks. It's Chris. So I think the first part of your question is what do we learn from Ford that's going to go through the rest of the class. And I think, over time, we've talked about it, we've pointed out that the first ship in our production run is also a prototype where we have to test out the manning plans, the design, the supply chains, the construction plans, all those things get tested. We then came off of that, just to kind of set you on how we did this. We came off of that with a plan to invest capital. We invested about $250 million in capital. We reduced the price of the Kennedy by about $1 billion based on that, and that was really driven by learning curves. We went to the government and said, okay. We have now figured out how to efficiently build this ship, understanding the supply chains and understanding the manning and the technology and all that sort of stuff and the learning curves. The next thing we need to do is we need to buy these things smarter. And so the government worked with us, and we came up with a 2-ship buy for 80 and 81. I think that where we are right now is the weapons elevators on Ford are behind us. The ship is accelerating towards delivery from its last availability with us post-shock trials and it's accelerating towards its first deployment. I think you're going to see the ship out there carrying the flag and doing great things. In the meantime, we've got the modification for Kennedy to go forward. We've taken all of the lessons that we've learned from Ford. We've invested against those lessons to drive success on Kennedy. And as I think Chris pointed out, the fabrication and work that we're already doing on the Enterprise after that and then Doris Miller after that, I mean, you're talking about a 4-ship program here that's going to be very mature and hot and running really well. And I think it's going to put our customer in a place where they can think seriously about how do we extend this program and move forward. My focus would be at this point is how do we take all of this in a package and start talking about 82 and 83. I think that's where we need to be going with the program. I think it's positioned very well to do that. We're through the growing pains now and we're ready to accelerate into efficient production. I'm excited about the future of the program, and it is a tremendous ship.

That's great. Thanks very much.

The next question will be from Gautam Khanna with Cowen. Please go ahead.

Hey, good morning, guys. And congratulations, Mike and Chris.

Thanks, Gautam.

By the way, it's sad now we are. Anyways, I just wanted to…

You'll be okay. I'm sure.

I just wanted to ask about the guidance on shipbuilding margin, first of all. I mean, it seems extraordinarily precise, 8% to 8.1%. It's a tighter range than you've given in the past. And I was curious what informs that conviction around a 10 basis point swing? And given the soft Q1 start, I mean, is there any weighting you could tell us? Like Q4 has got a ton of human catch-ups or risk retirement opportunities or what have you. Like just if you could kind of give us a sense for why the precision. And when do we get those lumpy human catch-up opportunities later in the year?

Sure. It is a more precise range than we provided last year. Last year, we started with a range of 7% to 8% and then narrowed it in Q3 to 7.5% to 8%, ultimately landing at 7.7%. While that range was likely conservative, we knew there was a possibility of reaching the top end. We wanted to wait and see how things played out with COVID before making any adjustments. For 2022, we aimed to provide a more specific outlook without presenting a wide range. We feel confident that, given our exit point at 7.7% for shipbuilding and the ongoing work and backlog, we are on solid ground. Although the upcoming work won't significantly impact 2022, we are encouraged by the serial production and lessons learned that Mike and Chris have mentioned. While COVID may affect revenue, we are optimistic about our current cost efficiency and operations, believing it will result in positive outcomes. We have indicated a plan for gradual improvement, which we still see as achievable. The changes in our portfolio mix related to DCS may slow our recovery, but we still expect to progress beyond our initial projections. As we progress through the year and manage risks, we expect to see positive results. Specifically, we anticipate more deliveries in 2022, 2023, and 2024 compared to 2018, 2019, and 2020, benefitting from lessons learned in serial production. Some ships, such as DDG-125, have unique contracts with enhanced incentives, which we believe will contribute to higher margins than usual. We are confident about this outlook of reaching between 8% and 8.1%.

And your point is it sequentially builds through the year. So Q4 is greater than Q3, greater than Q2, etcetera, in terms of margin.

We didn't provide that guidance. I would tell you, it's pretty flat. I mean, I think, obviously, Q1 is going to be light. And then from there, we'll see how it plays out. But after we get out of Q1, it's not a significant driver from quarter to quarter there.

Thank you. The next question will come from George Shapiro with Shapiro Research. Please go ahead.

Yes. Could you comment on where the learning curve has been on the Kennedy that you're 89% done? I remember in the beginning, there was this big issue that you were going to have twice the learning curve that they may be in suggesting.

We currently do not have a specific learning curve for Kennedy. We have extended the schedule for the single-phase delivery. The team is deeply engaged in the volume work on the ship and has made significant progress in some systems. I feel confident about their financial position, but I can't provide a specific learning curve at this time, George.

Okay. And then maybe one quick one for Tom. Given that New Jersey and Montana didn't meet the milestones in Q4, are they expected to meet them in Q1? And if so, why wouldn't the margin be a little better than the 7%?

They were scheduled for last year. However, as we near the finish line, some milestones don't immediately impact margins. Depending on our quarter-end results, we conduct an Estimate at Completion and a review, which could affect the subsequent fourth quarter. Although they will contribute some revenue to the portfolio, you may not see a significant boost in one specific quarter. It provides a slight increase, which should be beneficial overall. The 7.7% from last year, without these contributing this year, strengthens our outlook and suggests that the target of 8% to 8.1% looks promising.

Remember, George, those are Block IV boats and we did take a charge on those. So the opportunity for risk retirement is reduced.

Okay, thanks. And congratulations, Chris. And lots of luck to you, Mike.

Thanks, George.

Thanks, George.

Thank you. I am not showing any further questions at this time. I would like to hand the conference back over to Mr. Petters for any closing remarks.

This is my last earnings call. I just want to take the opportunity to say thank you, again, to all of the folks that I've had the opportunity to work alongside the last 35 years. It's been a privilege for me to serve as CEO of this company for so many years and I frankly have enjoyed working with each and every one of you in the financial community, in the business, in our customer set. And I do appreciate your research and thoughtful questions, even if I didn't say so at the time. I've learned a lot. I would hope that maybe you've learned a little along the way. But as we look forward and as you can tell by today's call, our company is in very good hands with Chris and the senior leadership team. I am confident that HII has a very bright, bright future. Thanks for joining us on today's call. I hope that you and your families continue to stay safe and healthy. We appreciate your time and your continuing interest in our company. Thank you very much.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.