Fitch Ratings has upgraded Huntington Ingalls Industries Inc.'s (HII) Long-Term Issuer Default Rating (IDR) to 'BBB' from 'BBB-' and Short-Term IDR to 'F2' from 'F3'.

Fitch has also upgraded HII's long-term ratings on its senior unsecured notes, revolver and term loan to 'BBB' from 'BBB-', and short-term CP rating to 'F2' and 'F3'. The Rating Outlook is Stable.

The upgrade was driven by HII's executed debt reduction plan, which resulted in EBITDA leverage sustained around 2.0x. HII's ratings are further supported by the company's $48 billion backlog and more than 70% of shipbuilding revenue under contract through 2027. Additionally, the U.S. Navy's funded 30-year shipbuilding plan reduces cash flow risk, and systematically improves diversification.

The company also holds a strategically important position as the sole U.S. industrial designer, builder, inactivator and refueler of nuclear-powered aircraft carriers and one of only two companies capable of designing and building nuclear-powered submarines for the U.S. Navy.

Rating concerns include execution risk, program concentration, and potential cash flow variability related to the timing of revenue generation and program development costs. Changes in Department of Defense (DoD) fleet planning needs could become a concern over time; however, Fitch does not expect material deviation over the next several years.

Key Rating Drivers

EBITDA Leverage Below 2.0x: Fitch projects HII's EBITDA leverage will remain below 2.0x over the next several years following more than $1 billion of debt reduction between 2021 and YE 2024, in conjunction with improving profitability at Mission Technologies and Newport News.

Fitch believes the company's leverage of around 2.0x is consistent with defense contractors in the mid-to-high 'BBB' category. HII's exposure to program execution risks have historically constrained the company's credit ratings. The company has required stronger-than-average credit metrics and financial flexibility compared with similarly rated aerospace & defense companies in order to sustain an investment grade rating. However, increasing program, revenue and cash flow diversification and visibility help moderate these risks and lessens the company's sensitivity to future program development costs.

Diversification Improving: Fitch believes HII's diversification has improved over the past several years to a level where Mission Technologies and sustainment work helps mitigate individual program and operational risks. Fitch expects HII will continue to diversify by capitalizing on new revenue streams, such as C5ISR, cybersecurity, and electronic warfare, which became part of HII's product portfolio through the Alion acquisition in 2021, and should experience increasing demand over the next decade.

Long-term Revenue Visibility Supports >2% FCF: Fitch considers HII's backlog of $48 billion (4x revenue) a strong supportive factor of HII's positive rating momentum and FCF growth. The agency views HII's backlog as more defensible and less susceptible to budget cuts than average defense contracts, particularly with more than 70% of shipbuilding revenue under contract through 2027. Revenue visibility supports margin stability and growth as the company is better-able to manage working capital fluctuations and supply chain schedules, despite potential lumpiness of final delivery.

The majority of the company's products have a significant role in the U.S. Navy's 30-year shipbuilding plan and should remain key components of both the DoD and Department of Homeland Security's national defense initiatives over the foreseeable future. Fitch does not expect a material reduction in defense spending in our forecasts, particularly in areas such as shipbuilding where HII is a market leader.

HII could be modestly vulnerable to changes in plans regarding the fleet needs of the DoD and the Department of Homeland Security over the longer term. However, the company's programs have long lead-times and are often funded several years in advance, which would allow it to adjust its cost structure in a timely manner if the U.S. Navy's 30-year shipbuilding plan changes significantly and unexpectedly. There generally is also bipartisan support for military spending, though program-specific allocations can shift.

Shipbuilding Strategic Importance: Fitch views HII's position as one of the two main shipbuilders for the U.S. defense industry as a key supporting factor for the company's ratings. Switching costs between contractors are very high, and there are significant barriers to new entrants, including development costs, technological capabilities, infrastructure, and program length. HII's Newport News operations in particular are strategically important to U.S. security policy and defense infrastructure, as the only contractor capable of producing the Gerald R. Ford-class aircraft carrier.

Long-term International Opportunities: HII was selected as a partner on one of the first collaborations under the trilateral AUKUS agreement between Australia, United Kingdom and United States to establish and support Australia's conventionally armed nuclear-powered submarine program. Under the agreement the U.S. will sell Australia up to five Virginia-class submarines starting in the 2030s, while Australia builds a new derivative class over the following decade.

Although Fitch expects HII's revenue generation will remain heavily skewed towards the U.S., it believes this agreement will provide some modest diversification, particularly as HII assists in training international workforce and supply chain over the next few years.

Derivation Summary

HII does not have a like-sized peer with a similar operating profile, but with limited-but-improving customer, geographic and product diversification compared to peers. General Dynamics Inc. (not rated by Fitch) is the only other company with comparable shipbuilding operations for the U.S. Navy, but it cannot be directly compared to HII due to its size, broader product line-up, and vastly different financial profile.

The lack of diversification has historically been a constraint on HII's ratings but was mitigated by solid leverage metrics, which have been stronger than those of its peers rated in the 'BBB' category. HII's diversification has moderately improved following the acquisition of Alion and growth in the Mission Technologies segment over the past few years.

HII's peers differ from the company for significant reasons; as an example, L3Harris Technologies (LHX; BBB+/Negative), BAE Systems (BBB+/Stable) and Northrop Grumman (NOC; BBB+/Stable) are each more diversified than HII but have weaker leverage metrics, with each contractor having EBITDA leverage greater than 0.5x higher than HII pro forma for 2024.

LHX generates significantly stronger FCF margins, regularly greater than 5% per year, though its revenues are somewhat less predictable due to the shorter-cycle nature of many of its IDIQ contracts. NOC is a large prime contractor, which has similar EBITDA margins in the low double digits and weaker leverage metrics but greater diversification by product offering and stronger financial flexibility.

Key Assumptions

Flattish revenue in 2024, followed by low-to-mid-single-digit annual revenue growth through 2026; low-to mid-single digit revenue growth in each the Mission Technologies and shipbuilding segments through 2026;

Revenue could be lumpier than projections depending on project completion and delivery;

EBITDA margins trending around 10% over the forecasted horizon as margins modestly expand in both Mission Technologies and Newport News; offset by flattish margins at Ingalls;

Company refinances most maturities after 2024, while allocating a modest amount to share repurchases and dividends over the forecasted horizon;

Annual capex elevated above 3% through 2026, trending towards 2.5% over the next few years;

No material shift in long-term DoD budget plans.

RATING SENSITIVITIES

Factors that Could, Individually or Collectively, Lead to Positive Rating Action/Upgrade

Financial and capital allocation policy and EBITDA growth that supports sustained EBITDA leverage below 1.75x;

Further improved product diversification and backlog visibility that would lessen the cash flow sensitivity to potential future program development costs or execution risks.

Factors that Could, Individually or Collectively, Lead to Negative Rating Action/Downgrade

Deviation from stated financial policy with EBITDA leverage sustained above 2.25x in conjunction with deterioration to the company's operational profile;

Operational deterioration could occur from either weakened program diversification, cost overruns or loss of contracts heightening the cash flow risk profile.

Liquidity and Debt Structure

Fitch believes HII's liquidity is adequate to cover the company's working capital fluctuations, capex spending plans, and debt servicing. Fitch estimates total liquidity will remain around $1.5 billion to $2 billion over the rating horizon, comprised of between $1.25 billion and $1.5 billion of revolver availability along with greater than $150 million of cash. The company's capital structure consists of senior unsecured notes and revolver.

Issuer Profile

Huntington Ingalls is the nation's sole industrial designer, builder, and refueler of nuclear-powered aircraft carriers and one of only two companies capable of designing and building nuclear-powered submarines for the U.S. Navy.

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG Considerations

The highest level of ESG credit relevance is a score of '3', unless otherwise disclosed in this section. A score of '3' means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. Fitch's ESG Relevance Scores are not inputs in the rating process; they are an observation on the relevance and materiality of ESG factors in the rating decision. For more information on Fitch's ESG Relevance Scores, visit https://www.fitchratings.com/topics/esg/products#esg-relevance-scores.

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