Fitch Affirms Huntington Ingalls Industries at 'BB+'; Outlook Stable

NEW YORK--()--Fitch Ratings has affirmed Huntington Ingalls Inc.'s (HII) Issuer Default Rating (IDR) at 'BB+', senior secured facilities at 'BBB-/RR1', and senior unsecured notes at 'BB+/RR4'. Fitch's ratings currently cover approximately $1.3 billion of long-term debt. The Rating Outlook is Stable. A full list of rating actions appears at the end of this release.

KEY RATING DRIVERS

The ratings are supported by HII's strong operating performance and cash generation over the past several years; solid liquidity; large and highly visible backlog; and strong credit metrics for the current ratings, which mitigates the company's nearly 100% exposure to the U.S. government's military spending. The company has the financial strength to withstand significant revenue and profit pressures. The company's Newport News operations are strategically important to the U.S.'s security policy and defense infrastructure, and the majority of the company's products have a significant role in the U.S. Navy's 30-year shipbuilding plan.

The company had gross leverage of 1.3x at the end of 2015, down from 1.9x and 2.3x at the end of 2014 and 2013, respectively. HII significantly improved its leverage metrics in 2015 due to higher EBITDA (as calculated by Fitch) margins and the repayment of outstanding senior secured term loans. Fitch expects the company's leverage will remain stable over the next several years. HII's EBITDA margins have improved annually over the past four years and reached 15.1% in 2015, up from 13.2% and 11.3% in 2014 and 2013, respectively. The company's operating margins were partially aided by the settlement of the Aon litigation in 2015, and Fitch expects HII's EBITDA margins will stabilize going forward and will remain in the range of 13% to 14% over the rating horizon.

HII generated $828 million of cash from operating activities (CFO) and $559 million of free cash flow (FCF: CFO less capex and dividends) in 2015, up from $716 million and $502 million at the end of 2014, respectively. Fitch expects HII's will generate $200 million to $250 million of FCF in 2016, down from 2015 levels mostly due to higher net working capital requirements and an anticipated increase in capital expenditures (CapEx).

HII focuses its cash deployment on distributions towards shareholders in the form of share repurchases and dividends (net $313 million in 2015), CapEx ($188 million) and qualified pension contributions ($99 million). The company announced a plan to significantly increase its CapEx, and Fitch anticipates that HII's annual CapEx will be higher than $300 million in both 2016 and 2017. Fitch expects annual distributions towards shareholders will be stable over the next several years, remaining in the range of $300 million to $350 million. The company has set a policy of returning most its pre-dividend FCF to shareholders over the next few years, including annually raising the dividend by at least 10%. Fitch expects the company's qualified pension contributions will remain steady in the range of $125 million to $175 million over the rating horizon.

Rating concerns include HII's significant exposure to program execution risk as evidenced by the underperformance of its Ingalls segment in 2011 and 2012 due to troubles with LPD and LHA ships; large annual net working capital swings; significant annual cash flow fluctuations related to the timing of pension cost reimbursements from the U.S. government; and program concentration. HII generates nearly all of its revenues from the U.S. government, exposing the company to changes in plans regarding the fleet needs of the Department of Defense (DoD) and the Department of Homeland Security.

Fitch is also concerned by the large underfunded status of the company's defined benefit pension plans. At the end of 2015, HII's pension plans were underfunded by approximately $1 billion (approximately 82% funded), a slight deterioration from $940 million deficit (83% funded) deficit at the end of 2014. The deterioration is largely due to the negative return on the plan's assets, which more than offset HII's $99 million contribution to the qualified plans. The pension benefit obligation (PBO) was $5.6 billion at the end of 2015, while the other postretirement benefit obligation was $566 million. While HII is not required to make minimum contributions in 2016, it plans to make a $173 million discretionary contribution to its qualified pension plans.

The pension deficit and required contributions are mitigated by expected reimbursements from the U.S. government which treats most of HII's pension costs as allowable and reimbursable. The company estimates that its cash contributions will be fully offset by the CAS recovery, and the company will have $88 million net cash inflow related to its pension funding and other post-retirement benefits contributions in 2016.

The notching up of the senior secured credit facility by one rating level from the IDR of 'BB+' to 'BBB-' is supported by the coverage provided by HII's tangible assets and operating EBITDA compared to the fully drawn facility. The collateral for the facility includes substantially all of HII's assets with the exception of the Avondale shipyard and a few other exclusions.

KEY ASSUMPTIONS

Fitch's key assumptions within its rating case for HII include:

--Flat revenues over the next two years with a modest increase in 2018;

--EBITDA margins in the range of 13% to 14%;

--Combined net share repurchases and dividend payments over the next several years will be consistent with 2015;

--Capital expenditures will be in the range of 3.5% to 4.5% of revenues;

--Debt levels will remain steady;

--HII will not make acquisitions in the near future;

--Pension contributions will be a small portion of the company's cash deployment and will be less than 20% of funds from operations (FFO).

RATING SENSITIVITIES

Fitch may consider a positive rating action if the company's leverage and FFO adjusted leverage remain in the range of 1.25x-1.5x and 2x-2.5x for a sustained period of time, respectively. A positive rating action would also depend on clarity of the company's future financial policies and its commitment to maintaining investment grade ratings.

Given low diversification and exposure to project execution risks, Fitch expects the company would need to maintain stronger than average credit metrics and financial flexibility in order to obtain investment-grade ratings.

A negative rating action is not likely in the near future; however, it would be considered should the company's leverage and FFO adjusted leverage increase and remain above 2.5x and 3.5x, respectively. Fitch may also consider a negative rating action if the company engages in significant debt funded acquisitions or experiences significant losses due to operating challenges on its programs.

LIQUIDITY

The company has a strong liquidity position. As of Dec. 31, 2015, HII had liquidity of $2.1 billion, including $894 million in cash and $1.2 billion of availability under its revolver. In 2015, HII restated and amended its senior secured revolving credit facility and increased its size from $650 million to $1.25 billion. The revolver includes a LoC sublimit of $500 million and the majority of the facility's covenants remained the same as the original 2011 agreement. The company has a favorable maturity schedule with no material maturities until 2021 when $600 million senior unsecured notes become due.

FULL LIST OF RATING ACTIONS

Fitch has affirmed the following ratings:

Huntington Ingalls Industries, Inc.

--IDR at 'BB+';

--Senior secured credit facilities at 'BBB-/RR1';

--Senior unsecured notes at 'BB+/RR4'.

The Rating Outlook is Stable.

Summary of Financial Statement Adjustments:

Fitch has made no material adjustments that are not disclosed within the company's public filings.

Date of Relevant Rating Committee: April 14, 2016.

Additional information is available at 'www.fitchratings.com'.

Applicable Criteria

Corporate Rating Methodology - Including Short-Term Ratings and Parent and Subsidiary Linkage (pub. 17 Aug 2015)

https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=869362

Recovery Ratings and Notching Criteria for Non-Financial Corporate Issuers (pub. 05 Apr 2016)

https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=879564

Additional Disclosures

Dodd-Frank Rating Information Disclosure Form

https://www.fitchratings.com/creditdesk/press_releases/content/ridf_frame.cfm?pr_id=1002585

Solicitation Status

https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=1002585

Endorsement Policy

https://www.fitchratings.com/jsp/creditdesk/PolicyRegulation.faces?context=2&detail=31

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Contacts

Fitch Ratings
Primary Analyst
David Petu, CFA
Director
+1-212-908-0280
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
Craig Fraser
Managing Director
+1-212-908-0310
or
Committee Chairperson
Steven Marks
Managing Director
+1-212-908-9161
or
Media Relations:
Alyssa Castelli, New York, +1 212-908-0540
Email: alyssa.castelli@fitchratings.com

Contacts

Fitch Ratings
Primary Analyst
David Petu, CFA
Director
+1-212-908-0280
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
Craig Fraser
Managing Director
+1-212-908-0310
or
Committee Chairperson
Steven Marks
Managing Director
+1-212-908-9161
or
Media Relations:
Alyssa Castelli, New York, +1 212-908-0540
Email: alyssa.castelli@fitchratings.com