Huntington Ingalls Industries, Inc. (HII) Q1 2013 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to Q1 of 2013 Huntington Ingalls Industries Earnings Conference Call. My name is Sandra, and I will be your operator today. [Operator Instructions] As a reminder, this call is being recorded for replay purposes. I'd now like to hand the call over to Dwayne Blake, VP of Investor Relations. Please go ahead.

Thank you, Sandra. Good morning, and welcome to the Huntington Ingalls Industries First Quarter 2013 Earnings Conference Call. With us today are Mike Petters, President and Chief Executive Officer; and Barb Niland, Corporate Vice President, Business Management and Chief Financial Officer. As a reminder, statements made on today's call that are not historical fact are considered forward-looking statements and are made pursuant to the Safe Harbor provisions of Federal Securities Law. Actual results may differ. Please refer to our SEC filings for a description of some of the factors that may cause actual results to vary materially from anticipated results. Also in the remarks today, Mike and Barb will refer to certain non-GAAP measures, including certain segment and adjusted financial 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 www.huntingtoningalls.com, and click on the Investor Relations link to view the presentation, as well as our earnings release. With that, I'll turn the call over to our President and CEO, Mike Petters. Mike?

Thanks, Dwayne. Good morning, everyone, and thanks for joining us on today's call. I'm pleased to report Huntington Ingalls Industries' results for the first quarter of 2013. Today, we reported sales of $1.6 billion, essentially unchanged from last year; and diluted earnings per share of $0.87, a 30% improvement over the same period last year. Pension-adjusted earnings per share was $1.17 for the quarter compared to $0.89 last year. Segment operating performance continues to improve. First quarter segment operating margin was 7.7%, up 124 basis points from 6.4% last year. The margin expansion was driven by improved operating performance at Ingalls and risk retirement at Newport News. We received $3.2 billion in new business awards during the quarter, including the refueling and complex overhaul of CVN-72 USS Abraham Lincoln, resulting in a backlog of $17.2 billion at the end of the quarter. And before I address our major programs, I will make a few comments on the defense budget and sequestration. The failure to pass the Defense Appropriations Bill for 2013 in a timely fashion delayed the start of the refueling and complex overhaul of the USS Abraham Lincoln at Newport News by 6 weeks and also delayed the award of the DDG-51 multiyear contract at Ingalls. The Congress subsequently approved and the President signed into law the 2013 Appropriations Act in late March, and the Lincoln has now arrived at Newport News, although later than we would have liked. In addition to funding the Lincoln RCOH, the 2013 Appropriations Act also includes funding for construction of CVN-79; 3 DDG-51 destroyers, which is 1 more than the Navy requested; advanced procurement funding for a second Virginia-class submarine in FY '14; and advanced procurement funding for continuation of LPD production. The Act also funds the cost to complete LHA-6, LPD-25 and the CVN-71 RCOH. Within the Homeland Security title, the act also funds construction of NSC-6 and added funding to buy long lead material for NSC-7. From HII's perspective, all of our 2013 priorities were supported by the 2013 Appropriations Act. Regarding the President's budget request for FY '14, support for our programs generally remains favorable. The budget request includes a second year of funding for CVN-79 Kennedy construction, 2 Virginia-class submarines with authorization to incrementally fund the second VCS in FY '14, allowing the Navy to fund the submarine over 2 years, 1 DDG-51, a third year of funding for the CVN-72 RCOH and full funding for construction of NSC-7. With regard to sequestration, as most of you know by now, shipbuilding is more insulated in the near term than many other defense programs due to the long-term nature of our contracts and our backlog. However, sequestration does present increased risk to our supply chain, which consists of nearly 5,000 companies in all 50 states. Long-term sequestration could benefit the shipbuilding supplier base if procurement schedules are stretched out and make the construction of ships and submarines more expensive. In an effort to support the long-term health and viability of our industrial base, we will continue to communicate this impact to our customers and elected officials. Now I will hit a few highlights of our major programs, beginning with Ingalls. LPD-25 Somerset continues to perform well at the Avondale Shipyard and successfully completed main engine light off, a key milestone that supports delivery this year. At Pascagoula, LPD-26 is in the unit construction and erection phase of production, and LPD-27 is on track for keel laying in the second quarter. LHA-6 America continues to progress through the test program and is experiencing typical first-in-class issues that put pressure on the delivery schedule. However, the team is taking the necessary steps to mitigate the impact of these issues in preparation for a successful acceptance trials and completion of the ship this year. LHA-7 Tripoli is in the early stages of construction and continues to make steady progress. In the National Security Cutter program, NSC-4 and NSC-5 are progressing well. On May 1, we were awarded the construction contract for NSC-6, with construction to begin in October. Also, the contract award for procurement of long lead time material for NSC-7 is expected this quarter. Construction at DDGs-113 and 114 continues to progress well, and we expect the Navy to announce the next DDG-51 multiyear ship award of either 9 or 10 ships split between ourselves and our competitor very soon. On the DDG-1000 destroyer program, construction of the aft PVLS modules hangar and deckhouse for the DDG-1001 is progressing well. Ingalls demonstrated considerable improvement from the first set of class products to the second set, and we plan to complete our work on DDG-1001 by the first quarter of 2014. At Avondale, although closure remains our baseline assumption, we are pursuing commercial energy infrastructure contracts and other opportunities. While we pursue alternatives, we are sending some LPD-26 and 27 units to Avondale to efficiently manage the base at both Ingalls and Avondale. However, as we have communicated previously, if we are unsuccessful in our pursuit of commercial energy infrastructure and other industrial manufacturing opportunities, we will have to close the facility. This is our least desired outcome, and we're taking reasonable steps to try to prevent this from happening. Now turning to Newport News. CVN-78 Ford has reached several significant milestones in 2013. In fact, just yesterday, NNS performed the last of 162 super lifts, which completes more than 3 years of structural erection work and makes the ship's primary whole structure 100% complete, with overall ship progress at 60%. Outfitting of the ship has included coatings application in approximately 500 tanks, voids and spaces, installation of over 4 million feet of cable and installation of a significant amount of machinery in preparation for launch this year. On Kennedy, the next carrier in the Ford class, efforts continue under our construction preparation contract to ramp up engineering design, planning, long lead time material procurement and advanced construction, and we anticipate having a construction contract in place later this year. In submarines, the final Block 2 boat, SSN-783 Minnesota, recently completed very successful alpha sea trials and remains on track to deliver this spring, 11 months ahead of schedule. We expect a Block 4 contract award this year for up to 10 additional submarines, with construction beginning in 2014. CVN-71 Roosevelt remains on track to complete its refueling and complex overhaul and redeliver midyear, and the CVN-72 Lincoln, which arrived at the shipyard on March 28, is under contract for its 44-month RCOH. CVN-65 Enterprise is expected to enter the yard later this year for inactivation and the defueling of its 8 nuclear reactors. In summary, I am very pleased with the progress that Ingalls and Newport News continue to make on our major programs. And while risk remains as we work through the test programs on LPD-25 and LHA-6, we remain confident in our ability to expand the margins at Ingalls and reach our anticipated 2015 targets. I am also very proud of the efforts of our 37,000 shipbuilders during the first quarter. In spite of the uncertainty surrounding the 2013 budget, they remain focused on the work at hand, and continue to maintain an emphasis on safety, quality, cost and schedule because they know that these areas are vitally important to our customers, our shareholders and the men and women who will be serving on these ships. Now that concludes my remarks. And I will now turn the call over to Barb Nilan for some remarks on the financials. Barb?

Thanks, Mike, and good morning to everyone on the call. I'd like to briefly review our consolidated and segment results as disclosed in the press release, then wrap up with some clarifying comments on pension. Turning to the financials on Slide 4 of the presentation. First quarter sales were flat from the same period last year and included higher sales on submarines, the NSC program and fleet support services, offset by lower sales on amphibious assault ships. GAAP operating income was $95 million. Pension-adjusted operating income was $118 million, up 22% over 2012. GAAP diluted earnings per share for the quarter was $0.87. Pension-adjusted diluted earnings per share was $1.17, up 32% over 2012, driven primarily by additional risk retirement on the VCS program at Newport News and the absence of unfavorable adjustments on the LPD program at Ingalls. Consistent with prior years, we were cash users is in the first quarter. Cash used in operating activities was $362 million, bringing our quarter end cash balance to $652 million. For the full year, we expect to be free cash flow positive. However, as I've said before, cash flows are primarily driven by timing of collections and ship deliveries, so a small ship can make a material difference in year-end reported cash balance. During the quarter, we purchased approximately 4,000 shares, for a total of 35,000 shares since we announced our $150 million share repurchase program last November. Additionally, we paid our second dividend of $0.10 per share on March 15. Capital expenditures for the quarter were $30 million, up $3 million from the first quarter last year. For the full year, we continue to expect capital expenditures to be in the mid-2% to 3% of sales range. Turning to Slide 5. Ingalls' revenue for the first quarter were $631 million, down 8.8% from the same period in 2012, driven by lower sales in amphibious assault ships following the delivery of LPD-23 and LPD-24, and lower volume on LPD-25 and LHA-6. These declines were partially offset by an increase in the NSC program from the continued construction of NSC-4 and NSC-5 and the advanced procurement contract on NSC-6. Ingalls' operating income for quarter was $26 million compared with $20 million in the same period in 2012. Ingalls' operating margin was 4.1% for the quarter, up from 2.9% last year. The increase was primarily due to the absence of unfavorable adjustments on the LPD program. Turning to Slide 6. Newport News revenues for the quarter increased $55 million or 6.1% from last year, primarily driven by higher sales on the VCS program, as well as higher fleet support services. Newport News operating income for the quarter was $94 million compared with $81 million last year, primarily due to VCS program risk retirement and the favorable resolution of outstanding contract changes also on VCS. Newport News operating margin was 9.9% for the quarter, up from 9.1% in 2012. If you'll turn to Slide 7, I would like to make a few comments on pension to give you an update from the ranges provided on our last call. After the evaluation of the recently completed Collective Bargaining Agreement negotiation at Newport News, we expect the 2013 FAS/CAS adjustment to be $85 million. We also expect our qualified pension contributions to be $301 million for the year, of which $32 million was contributed in the first quarter, with the remaining contribution planned in Q2. That wraps up my remarks. And with that, I'll turn the call over to Dwayne for Q&A.

Thanks, Barb. [Operator Instructions] Sandra, I'll turn the call over to you to manage the Q&A.

[Operator Instructions] Your first question is from Joe Nadol from JPMorgan. Joseph B. Nadol - JP Morgan Chase & Co, Research Division: Mike, just on the LHA-6, you mentioned that there's some pressure on the schedule. Could you maybe give some more specifics on what you're seeing there, and just how you're feeling about the situation with the accrual rate on the contract?

Well, in terms of what's happening on the ship, I feel really good about what's going on in the ship, and we had a really good quality launch. We're moving into the test program now. Just walked the ship myself last week, and now we're at the point where we're bringing this brand-new ship through the test program to get to builders trials and acceptance trials and we see ourselves being on track to get through all of that this year. But it's going to be, as we've said all along, we've got to sleep with one eye open on this until we get it across the finish line. So then I'll let Barb talk about accruals.

Yes. We're doing a very thoughtful approach to how we're going to deliver the ship. And at this point in time, we don't see any issues with our current booking rates. Joseph B. Nadol - JP Morgan Chase & Co, Research Division: Okay. If we look sequentially from Q4 to Q1, Ingalls' margin was down a touch. I know there's all kinds of mix shifts, and the margin was up a lot year-on-year as you guys pointed out. But Barb, could you maybe give the comparison from Q4 to Q1 at Ingalls?

Yes. Sequentially, what happened in Q4 is we had several favorable adjustments, none of which were individually significant. But the types of adjustments -- we had since small risk retirement on NSC-4. We had some risk retirement on LHD-8 for some material. We also closed out some old contracts on DDG-51. So that helped us get to the 5.3% in Q4. And then in Q1, we actually had some downward pressures related to overhead rates and the EPA indices going down on our contracts. Again, it affected multiple contracts but none of which were individually significant.

Your next question, this one's is from Noah Poponak from Goldman Sachs.

This is Omear in for Noah. A couple of quick ones for me. Mike, just following up on your comments regarding the new business development issue that you guys have. You had mentioned previously that some newly announced energy projects in Louisiana and Texas were specifically creating some demand for your workforce with some incoming requests. Any updates or any progress there specifically? And also when should we be expecting some sort of news one way or the other from you guys on whether this is a viable endeavor for you or you guys will not be pursuing it further?

Well, I don't know that -- first of all, the news is the same. I mean, the projects are moving along and the phone keeps ringing in terms of are there ways that we can work with you or with your facility or with your workforce. And so we're being fairly deliberate here, because we've got some scars around trying to do things that we've never done before, and so we're trying to find the right arrangement with the right partner that takes full advantage of what we do. In terms of -- I've resisted the challenge of what's the drop-dead date on this. The clock that's ticking is that the workforce continues to -- as we finish LPD-25, the workforce will continue to drawdown. And at some point, if there's no workforce there, then the conversation that we start to have with the industry becomes very different. We mentioned that we've actually -- to balance the workload at Ingalls, to support the work we're doing on LPD-26 and 27 there, we're actually doing some unit work at Pascagoula -- I mean, I'm sorry, at Avondale, and that unit work is actually helping us maintain the workforce a little bit longer than we would have otherwise with just the drawdown of LPD-25. But we're -- the workforce basically draws down pretty fast over the next 12 months. And so that's kind of the window that we're in right now. And if we get to the point where there's no workforce left, I guess my view is that we still have an asset and we just move to a different phase of discussion with that industry.

Sure. That's helpful. Just last one for me, a high-level margin question. It seems like you guys are obviously making reasonable progress here towards the 9% goal for 2015. If you look at beyond that, do you see any upside to margins above and beyond there? And if so, what would the drivers of that upside be potentially?

Well, I think I've said before that this kind of business operates normally in the band of between 9% and 10% over a period of time. And I think you get high in the band when your projects are very mature and you're in serious production, and you're low in the band when you're doing lead ships and doing a lot of engineering and trying to start programs up. And so I would expect that we would stay in that band going forward. A lot of that will depend on how the workload plays through in terms of sequestration and what happens with ship procurements and the on-time procurement of things, particularly -- as I've said before, I think that the carrier schedule, the submarine schedule and the destroyer schedule is a pretty good schedule, and I feel pretty good about that. I -- we're putting a lot of energy right now into shoring up the amphibs schedule, because I think that's where the challenge will be in the 3- to 5-year time frame.

Your next question is from Robert Spingarn from Crédit Suisse. Robert Spingarn - Crédit Suisse AG, Research Division: Mike, on the margin, long-term margin outlook, just following up on the last question, I think you and Barb have consistently said 9-plus percent across the company for 2015. And Barb, I think you've clarified that, that is a full year number in the past.

Correct.

That's right. Robert Spingarn - Crédit Suisse AG, Research Division: How do we think about the mix between the 2 businesses in that margin? I -- clearly, it depends on what you just talked about, the maturity of programs in 2015, so are we in a situation where we're at parity between the 2 yards? Or should we think of one being -- maybe Newport News is higher and Ingalls is still sub-9? How do we think about that?

I think our objective is to be at parity. I mean I -- we believe that to attract capital to this business and to attract talent to this business, whether it's a nuclear business or a non-nuclear business, you've got to have that kind of a return. And so that's our objective, is to get both of these businesses up above that threshold. And I feel really confident about that. As I've said, beyond that, we've got to go shore up the amphib base. But I feel very confident that both of these businesses will be operating in that range.

And Rob, it's important to look at it on an annual basis because you'll have -- quarter-over-quarter, you'll have tick-ups for risk retirement, so you have different things going on. So it's very important, like you said, to look at it for the year. Quarter-over-quarter isn't really a way to a to look at our business because you'll have risk retirement at different periods during the year. Robert Spingarn - Crédit Suisse AG, Research Division: Barb, on that note, how does the risk retirement look in the early stages here on some of the newer programs that are moving through Ingalls, so moving the focus away from Somerset and LHA-6, et cetera, to the newer ships?

Yes. I would just look at it across all programs. We look at a lot of different things. We look at how we're forecasting overhead, what our actual labor rates are on each program and then we have events that occur, and it could be percent complete while we're meeting our performance criteria, it could be launch, it could be we achieved different incentives in the contract, like on submarines, it can be threshold [ph] complete. Of course, at delivery, you've retired a lot of the risk, but you still have to go through warranty periods and things like that. So there's various stages of testing. So we look at a lot of different things across all the programs.

And what I would say, Rob, is that 2 years ago, we said that we needed 5 contracts, and we talked about not only did we get all 5 contracts, we got 6. We got an extra NSC contract in there that wasn't on our first list. All of those contracts, at the early stages, are performing in the range of where we want them to perform to support our long-term objectives. Every single one of those programs is where we want it to be. Robert Spingarn - Crédit Suisse AG, Research Division: And just as a final question, on sequester and to the extent that you have some maintenance exposure or short-cycle exposures here and there in the business, if we end up with this $41 billion coming home, so to speak, we're -- and at what magnitude might you see some impact in '13 and '14?

If there is any impact, it's going to be in our AMSE business, I believe, or maybe a little bit of Continental in San Diego. But in the grand scheme of things, we expect that to be relatively minor to the overall size of the business. Robert Spingarn - Crédit Suisse AG, Research Division: And is that next year, because you're largely booked through in those businesses for this year?

I think it's still -- it's mostly next year, because we don't know where next year is going right now. I think there's still decisions to be made about this year. So I feel pretty good about where we are this year, and I think that we may have a nick here or there. But I think that it's -- again, this is such a small piece of our overall business that, at the macro level, it's not something that is driving us at this point.

Your next question comes from Doug Harned from Sanford Bernstein. Douglas S. Harned - Sanford C. Bernstein & Co., LLC., Research Division: I wanted to see if we could we get a better understanding of this -- of the amphib outlook and there's -- and once you get past LPD-27, how are you thinking about this portion of the business? I know that we're looking -- at least in the current shipbuilding plant that I've seen, we're looking at LX off in the future and no more LPDs. What do you see happening here? And now does that affect the way you manage that business?

Well, we're advocating that -- and first of all, I think you're looking at exactly the same things we are. There's LXR program out there that's fairly far away. And there's LHA-8, which is a follow-on to LHA-7, which is very important to us. But our view is that there are ways to be creative here that can actually be more efficient for the taxpayers, the Navy and the Marine Corps and also support our objectives. So trying to move those programs around or bridge from the program that we have, the LPD program that we have to a future LX program, is something that we're advocating very loudly. We've been proposing that you could use the LPD haul [ph] for a variety of missions besides just LPDs, and so we're taking that case forward. And if you go and look at the Appropriations Bill, there was money set aside in the '13 budget to go down that path. Whether it's a transition ship or a bridge ship from an LPD program to an LX program, we've got the kind of work our way through that. But the Congress believes that you can't just stop building amphibs and then restart it. That's what the law says. So we're engaged in that process in a very robust way. I'm not sure -- because of the way we're pushing on this, I'm not sure I can actually predict exactly how it's going to turn out. But I do feel pretty good about the reception that we're getting and the traction that we're getting because I think everybody now understand that when you stop a shipbuilding production line, it becomes very expensive to restart it. And so folks are trying to find a way to -- in this environment, it's not easy, but to try to find a way to get us from where we are today to where we want to be the future. Douglas S. Harned - Sanford C. Bernstein & Co., LLC., Research Division: And if you overlay the budget situation, sequestration and the potential for future automatic cuts on this, I mean, right now, you've got a lot -- you did well, I would say, in the '13 budget. You've got a lot of contracts in place for shipbuilding. But when you look out, if we have a next year of, say, automatic cuts, are you looking at some risk there on the construction side of the business, not deplete [ph] support?

I think it's really just about timing, Doug. I mean, once we have the contract, I don't believe there's any -- there's not going to be any movement to go back in and try to adjust the contract based on anything that happened. So it's a matter of what's the timing of the ships and what's the timing of the contracts. I've described to some folks that, as I've said before, I believe carrier submarines and destroyers are pretty solid. I mean, those are the Navy's priorities, the Navy has a really good understanding of the symbiotic relationship between those high-performance platforms and the industrial base required to support that. And I believe the Congress does, too. And in fact, the Navy went forward and -- to the Congress, and the Congress has expressed their desire to add a destroyer and add a submarine to what the Navy requested. So I think those programs are going to continue along on the path, basically, that's been laid out. But I think when you drop below those 3 programs and -- let's set ORP off to the side here, because I think ORP ends up in that -- it becomes the fourth of those programs. But you set the rest of those -- you take the rest of the Navy programs and the amount of money the Navy has, I think there's going to be, I've called it a scrum, for lack of any other word, but it's going to be a scrum to try to figure out how do you sort through this so that you get the most capability of -- at sea the dollars that you have. We believe that you're going to be going into that decision with mature designs, not new designs, and we believe that volume at sea is going to be an important discriminator. So that's why we've been pushing hard on the LPD haul [ph] form as a mature design with an opportunity for putting volume at sea to support a variety of missions. And we're getting good reception with that. I'm not sure how the scrum all plays out, but it is something that we're very focused on.

Your next question comes, this one comes from Pete Skibitski from Drexel Hamilton.

Guys, I wanted just to follow up again on the 9% margin rate goal by 2015. I'm just wondering, with the 2 problem ships delivering later this year, or expected 2, why wouldn't you be able to hit the 9% goal in 2014? Is it an extra volume issue? Or is there something else? Can you just add a little color there?

Yes. I mean, we've said this before that what we have to do is, when we have new programs, we put all of the risk that we are aware of in the risk register, and then as the program matures, we retire that risk. The new programs that we signed after we spun 2 years ago won't be mature enough in 2014 to get us to the point where -- and we just need the time to let those programs mature to the point where we can get Ingalls up into the band in 2015. It's that simple, really.

Okay. Understood, understood. And then in the quarter, on the Virginia risk retirement and the contract change, can you quantify us -- for us the cum catch-up on the VCS in the quarter, and then maybe give us the net cum catch-up for the quarter also?

Okay. We don't break it down individually by program. But when I look at gross favorable adjustments for the quarter, it was $45 million, and it was primarily risk retirement on Virginia class, as well as contract adjudication of a bunch of changes. But there was also some CVN-71 risk retirement as we're winding down on that ship. So that was the primary drivers in the $45 million. And then we had $15 million of cumulative unfavorable adjustments, and that was kind of across-the-board, and it was all related to downward pressure on overhead rates, as well as the change in the escalation indices. So nothing individually significant, just all across-the-board, both at Ingalls and Newport News. And that's $3 million favorable adjustments.

Okay, got it. And then last one, Mike, the Navy going to Congress and asked for an increase in cost of the Ford, I think, a 9% increase. Any expectations in terms of Congress not approving that? And is that sort of in line with your expectations and planning?

Well, I'm not going to try to predict what the Congress will do. They will certainly want to understand the issue, and we're prepared to walk through all of it with the Navy. This is, as we've talked about before, the Ford is a lead ship and we're going through. While I still insist that this is the best lead ship I've seen come together, there are going to be -- we're going to be taking it to launch. We don't want to launch it until it's ready to be launched just to make sure that we retire as much risk and do this as efficiently as we possibly can. I do expect that ultimately, that the request will be honored and that we'll move ahead, and that's certainly a part of our financial plan going forward, and frankly, what it will take to get that ship delivered. So it's part of the process. It's a healthy process. I believe the Congress will give it a full review. And after they've given it a full review, they'll come to the same conclusions that we have.

Your next question comes from Jason Gursky from Citibank.

It's Jon Raviv for Jason. Just following up on Pete's question about Newport News margins. Mike, you talk about the business being 9% to 10%. Clearly, 9.9% is your best first quarter there in a while. Can we get a little -- just a little more detail on how you expect those to trend maybe throughout the year and then going forward, in terms of the new business coming in and how we could see margins trend in '13 and then sort of going forward from there?

So I'll start, and then I'll let Mike weigh in on my comments. First of all, I'd say 9.9% isn't really sustainable. We had some ships -- some submarines come out of warranty, we had favorable rate performance, we have a couple of different things going on in VCS program that allowed us to make the favorable adjustment this quarter. And all along, we usually have -- if you look last quarter and you look first quarter 2012, we had favorable adjustments on VCS, and it's really just as we hit certain milestones in the program, we retire risk. So we won't see it every single quarter, but you'll see it on and off, which drives that high rate. Overall, we're at the mix that Mike talks about, new contracts as well as more mature contracts and the process at Newport News, which allows us to have that blended rate of 9%.

Right. Well, over time, you'll see that the Ford is a cost-type contract. We expect that we'll move to a -- some kind of fixed-price incentive contract on the Kennedy, which means we'll start that work. And as that work starts to ramp up, the -- we'll have our eyes on all of that risk so the booking rates will be fairly low. And then as they mature, we'll -- they'll become part of the blended rate. But that's our expectation. And so that's why I always think that the best place for this business to be and the best way to think about a shipbuilding business is that it's in the range of a 9% to 10% business because you need to have a blend of fully mature programs plus new programs so that you can't sustain that over a period of time. That's certainly what our objective is, and that drives our overall Navy strategy.

Okay. And a quick follow-up on Avondale. It sounds like you're being a little more active in terms of pursuing projects, but also actively keeping the shipyard alive. How was that impacting your discussions with the government in terms of what you expect to be able to recover or the timing of that recovery or if it's going to happen at all?

Well, our discussions with both the Navy and the State of Louisiana continue to be very positive. The Navy is very supportive of our effort to redeploy, as opposed to close the facility. And obviously, the State of Louisiana is working very, very closely with us to find the right opportunity that makes sense for -- first of all, makes sense for Avondale. But that would also make sense for them. And so we maintain a very, very, I'd say, high-bandwidth of communication with both parties to make sure that everybody understands what we're doing, and we're very comfortable with the way that this is playing forward so far. Whether you want to talk about the incentives that the state has put on the plate -- on the table or the restructuring that we have in front of the Navy, we're very comfortable with the way this is working right now.

Your next question comes from George Shapiro from Shapiro Research.

One point of clarification. The way I read in your release, favorable resolution of outstanding contract changes, that strikes me as more onetime than the general risk retirement that you wind up seeing quarter-to-quarter. Am I correct in that, or...

You are correct. When we're -- when we file the -- adjudicate all the changes and everything, you get the fee on top of the cost and your change in your targets, and so you can recognize all that at the point you finalize. So that's onetime.

Okay. And then just to -- a follow-up question. If I back out what seems to be maybe 20% or so of 0 margin programs this quarter, the margin at Ingalls is a little bit over 5%. Now Mike, historically, I mean, would you expect to get a -- like a 400-basis-point increase in 2 years for retiring some risk on some of these newer programs?

Well, remember where we are is that the new programs have to mature. They've got to come through their -- the keel events, the start of fabrication, the first few phases of construction. But yes, I could see that.

I mean, is that historically kind of a normal kind of sequence that you would expect to see, or is there more...

I think it's -- to be frank, George, it's a little bit hard to talk about the history here. I mean, the operating system that we're using at Ingalls is fundamentally not something that we've used at Ingalls, and we started this just a few years ago. So we don't really have the track record of what that provides to us. On the other hand, the -- it does look a lot like the system that was in place back 15 years ago. And in -- 15 years ago, if you took an individual ship program and you looked at how it matures over its life, a ship that takes 4 to 6 years to build, and you're going to talk about what do you do with the booking rates when you go from year 2 or 3 to year 5 or 6, yes, 400 basis points is certainly within the range of reason.

Your next question comes from Myles Walton from Deutsche Bank.

Barb, could you maybe start on free cash flow? I think you mentioned it will be positive, but I guess I'm looking to flesh that out a bit. Because when I think about your S-curve chart for working capital, I think about the pension. Year-on-year is a bit of a headwind but after tax, not much, and net income, cash earnings rising. What am I missing that free cash flow in '13 isn't as good or better than '12?

So what happens with, say, the delivery of LPD-25, you have to think of deliveries have -- when you think about S-curve, the reason why you're on the upside is because you're delivering the underperforming ship. So you no longer have -- you collect the retentions with the exception of a little bit related to the warranty period and everything that they hold back, but that's usually a big number, $50 million, $60 million. And also, you can bill 100% of your cost so you're not dealing with this lower cost or progress when you get to delivery. So you got a pickup there also. So you have a big cash bump with deliveries, and that creates that reversal on that S-curve.

Yes. So -- but you are planning some deliveries for this year, so...

We are planning the LPD-25 delivery, and we haven't given up on LHA-6 getting out of here. We just know that there's pressure and we're going to do it in a very thoughtful, methodical way to do it the most efficient and cost-effective way to make that delivery. So there could be some pressure on that, that's why I said, "Hey, the lumpiness at year end on the cash balance is related to the timing of collections, as well as timing of deliveries."

Okay. All right. Mike, the other question I have for you is on supply chain. You mentioned it in kind of your opening remarks with respect to sequester and your conversations with the Navy customer about that being probably more of the concern to the health. I'm curious from a financial perspective, how protected you are within your contract structures against the suppliers, the weakness under sequestration? Is this more of a customer heads-up that this could cause an issue to you? Or is this also a self-protection against your own contracts?

Well, gosh, with 5,000 suppliers in all 50 states, I'd say the answer to your question is just probably all over the map. There are some suppliers that are probably in a place where they are -- they have their substitutes if there was problems from their standpoint. I think that they're looking at the same kind of thing that we've been looking at. It just -- we look at it in a -- at a very broad level. They have a very narrow perspective. They have to decide whether they want to invest in the workforce or the tooling to support a program that they don't know exactly when that program is coming. However they make that decision, it's possible that, that could lead to some inefficiency in the supply chain, could cause some people to decide not to make the investment and not to stay as part of the team, depending on whether programs get delayed are not. We take each case in our supply chain, both at Newport News and at Ingalls, we handle each one of these as an individual case. We evaluate how critical the technology is, how critical the supplier is, what's the risk to the program, what -- how important are they to the schedule, and we factor that all into the way that we put a purchase order in place with them. We go so far as, in some places, we put our own people in their plants to make sure that we are helping them retire risk to support our schedules. And so we believe that we do this really well. It's one of the core competencies that we have. But because we do it well, we have a lot of contact with these guys, and we know that if there's a lot of restlessness out there in the supply chains today because they can't really figure out exactly when the next level of procurement is going to come, and when's the next ship going to happen. And that uncertainty is really creating some chaff in the supply chain, if you will, in a supply chain that over the last -- in my opinion, over the last 10 years has already been thinned out because we've done so many lead ships. We're -- I believe in the submarine program, we're 80% sole-source. We will probably be, I bet, at least 60% sole-source on the Kennedy. And so you start to see that they're just -- it's -- this is becoming a very important part of our business to manage. So I think it's -- there is not one-size-fits-all answer here, Myles, but it's kind of all over the map. But we do feel good that we -- this is something we do know how to go manage.

Yes, I mean -- and I don't want to diminish it, but it seems like your business would have some of the best visibility and certainly -- your programs having the best visibility, and if you get the 51 in VCS multiyear this year and maybe the CVN-79 this year or next year, I mean, it's hard for me to see what the supplier -- I could see if their business were touching other elements of the defense complex, but within your subsegments, visibility the is probably better than it's ever been.

Yes, I agree with that. I think that even though that we're 80% sole-source in submarines, we have been able -- because that has been a very -- has become a very predictable business, we've been able to manage that supply chain in a very efficient way because we have sustained demand there and the suppliers know that. They can invest against it and be very efficient to it. I think this is more of a problem for the non-nuclear side of the business, where the -- it's a bit more dynamic. When is the next amphib coming? What's the story? Is there going to be a follow-on to LPD-27? The National Security Cutter, we basically have proposed that if we really want to save some money, we should do multi years on National Security Cutter. We've not had any commitment to that from the Congress, and so those are one ship at a time. And so if you're a supplier in those programs, you're living a little bit closer to the edge than you might be if you're a, say, in a submarine program or the destroyer program, where you can kind of see the horizon a little bit better.

We have a question from George Shapiro from Shapiro Research.

Mike, how do you manage the fact that you had mentioned you're going to move some work from Pascagoula back to Avondale on the LPD-26 and 27? I mean, how do you manage that efficiently? And then on the LHA-6, you've kind of raised the question here about potential delay and delivery and stuff. At what point would we -- would you be confident about that? And at that point, would that necessarily mean another charge or not?

Well, let's take the 6 first. I don't see this as being a charge to get the ship to delivery. I think this is really a matter of sequence. And the task for the team is, as we sit here and we're walking through the sequence to get to completion and then delivery, we feel very confident that the ship will be completed this year. The question is, can you get beyond the acceptance trials and get the closeout done in time before December runs out? And I think that's really all we're up against. And the one thing that we're going to make sure that we do is we do this as efficiently as possible. If it delivers in December, that'll be great. If the efficient way to do this is to deliver it in January, that'll be great, too. And so that's kind of the way we're looking at it right now. We're pretty transparent about all of this. The team is doing some pretty incredible things to get that ship ready to go to sea, and I'm very proud of what's going on there. It's just that the calendar and the schedule are intersecting a little bit at the end of the year, that's all. Relative to the movement of units or the construction of units at Avondale, this is a pretty fluid process relative to -- we can build units at Avondale and transport them pretty efficiently. We've done that in the past. Frankly, we actually had folks that we outsourced these units to in the past, so we've kind of brought them in to do ourselves. And we can look at this in terms of what are the skilled trades that we're going to potentially need for a redeployed Avondale and align that. The haul guys and the piping guys are folks that we really are going to need if we're successful in redeploying Avondale and that lines up with this work. And so this is a very low-risk way to buy some time on the clock, and that's kind of the approach that we're taking. But don't get me wrong, I mean, it's not going to buy us 2 years. It's going to buy us months.

I'd now like to call -- hand the call over to you, Mike Petters, for closing remarks.

Okay. Well, thanks to everybody for joining us this morning. Again, we had a good, solid first quarter. We're right on track to retiring the risk that we said we needed to retire by the end of this year. We feel really good about that. And we continue to be on track to obtain our objectives for 2015. We are very, very engaged in the process in Washington relative to the strategic issues around shipbuilding schedules, and the best way to buy these ships and how does that match with other priorities. And so if you stick your head up and look around, you'll see advertisements from us, you'll see program stuff, and most of that is really going to be about how do we transition the amphib production lines that are warm to the future amphib lines that we need. So with that, thank you all for joining us, and we'll be talking to you.

Thank you for joining today's conference call. Ladies and gentlemen, that concludes the presentation. You may now disconnect, and enjoy the rest of your day.