Fitch Affirms Huntington Ingalls at 'BB'; Outlook Revised to Positive

Fitch Ratings has affirmed Huntington Ingalls Industries, Inc.'s (HII) Issuer Default Rating (IDR) and senior unsecured debt ratings at 'BB'. Fitch has also affirmed HII's senior secured facilities at 'BBB-'. The Rating Outlook is revised to Positive from Stable. The ratings cover approximately $1.8 billion of outstanding debt. A full list of ratings follows at the end of this release.

KEY RATING DRIVERS

HII has adequate credit metrics for the current ratings which are also supported by a strong liquidity position, solid and improving margins, and a large backlog. As of Sept. 30, 2013, HII had liquidity of $1.5 billion, including $895 million in cash and $618 million availability under its $650 million domestic credit revolving facility, after giving effect to $32 million of outstanding letters of credit. The ratings are also supported by the strategic importance of HII's products and the company's significant role in the U.S. Navy's 30 year shipbuilding plan. HII is a sole source manufacturer of more than 70% of its revenues.

Fitch revised the Rating Outlook to Positive from Stable based on expectations that HII will continue reducing its leverage over the next several years due to improving operating results and an anticipated amortization of the senior secured term loan. The company has noticeably improved its margins in 2013 driven by an on-going restructuring at its Ingalls operation and by moving past the delivery and near completion of low margin LPD 25 and LHA-6 ships, correspondingly. Fitch expects HII's EBITDA margins will be above 10% in 2013, up from 8.4% in 2012. For the last 12 months (LTM) ending Sept. 30, 2013, the company had gross leverage of 2.7x, down from 3.2x at the end of 2012. Fitch expects the company's leverage to decline further to approximately 2.6x and 2.3x at the end of 2013 and 2014, respectively.

Fitch's rating concerns include relatively weak funds from operations (FFO) based credit metrics and an anticipated decline in free cash flow (FCF) generation in 2013 and 2014 due to higher cash taxes, sizable net working capital requirements, increased dividends, and continued high discretionary pension contributions to fund the large pension deficit. The company is exposed to risks to core defense spending after fiscal 2016 and to HII's revenue concentration with the U.S. Navy and Coast Guard. 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 company's program execution risks and the high percentage of the workforce that is unionized. In addition, Fitch is concerned with future potential cash deployment actions as the company continues refining its cash deployment strategy.

The notching up of the senior secured credit facility by two rating notches 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.

HII generated approximately $317 million of cash flow from operating activities during the LTM Sept. 30, 2013, slightly down from $322 million at the end of 2012. HII's FCF totaled $142 million during the LTM ended Sept. 30, 2013, down from $165 million at the end of 2012 primarily due to higher dividend payments. Fitch expects HII will generate lower FCF in 2013 and 2014, but Fitch also expects FCF generation to significantly improve beyond 2014. In 2014, FCF is likely to be pressured by higher capital expenditures, dividends and working capital requirements.

HII focuses its cash deployment on capital expenditures, dividends, pension contributions and share repurchases to offset dilution. The company continues to refine its cash deployment strategy and held approximately $900 million in cash. Fitch expects HII's liquidity will likely decline as the company continues refining its cash deployment strategies.

The pension funding deficit was approximately $1.3 billion (74% funded) at the end of 2012, up from $885 million (79% funded) deficit at the end of 2011. The decrease in funded status was largely due to a decline in interest rates that resulted in a $728 million actuarial loss. This, however, was offset by a $396 million (12.2%) gain on plan assets and $239 million in employer contributions. The pension benefit obligation (PBO) comprised $5 billion at the end of 2012, while other postretirement benefit obligation totaled $965 million. Fitch expects HII's pension plans' funded status will improve significantly by year-end 2013 as a result of strong asset returns, $330 million in additional discretionary contributions, and an amendment to its pension plan, as well as an uptick in interest rates.

Most of HII's revenues are derived from the defense industry and exposes the company to U.S. defense spending plans and budgets. Fitch expects 2014 to be another challenging year for U.S. defense contractors, however, the Bipartisan Budget Act of 2013 (BBA), signed into law by President Barack Obama on Dec. 26, 2013, alleviated some concerns surrounding the sequestration-driven defense spending reductions scheduled to go into effect on Jan. 15, 2014.

Fitch expects the fiscal 2015 budget request in February will provide some clarity regarding future DoD spending trends. Defense appropriations are scheduled to begin increasing again in fiscal 2015, but the sequestration cuts are expected to have a negative effect on defense contractors for the next several years because of the lag between appropriations and outlays.

Fitch believes modest declines in defense spending would not lead to negative rating actions given the strategic importance of HII's portfolio, long lead times for program execution and the amount of DOD funding HII received in the past three fiscal years. The exposure to DoD spending is also mitigated by HII's good liquidity position.

RATING SENSITIVITIES:

Fitch may consider a positive rating action if HII continues improving its operating margins and decreases its current leverage by either a reduction in debt or an anticipated increase in EBITDA. Any positive rating action will also be predicated on improvements in HII's FFO based credit metrics and FCF generation. A negative rating action is not likely in the near future, however, would be considered should the company's leverage (debt to EBITDA) increase to above approximately 3.6x-3.8x; or if defense spending cuts have more significant impact on the company's earnings and FCF than currently anticipated.

Fitch has affirmed the following ratings:

--IDR at 'BB';

--Senior secured bank facilities at 'BBB+';

--Senior unsecured debt at 'BB'.

The Rating Outlook is revised to Positive from Stable.

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

Applicable Criteria and Related Research:

--Corporate Rating Methodology: Including Short-Term Ratings and Parent and Subsidiary Linkage ', Aug. 5, 2013;

--2014 Outlook: Global Aerospace and Defense, Commercial Aerospace Flies Higher, Defense in a Stalemate', Dec. 12, 2013.

Applicable Criteria and Related Research:

Corporate Rating Methodology: Including Short-Term Ratings and Parent and Subsidiary Linkage

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=715139

2014 Outlook: Global Aerospace and Defense (Commercial Aerospace Flies Higher, Defense in a Stalemate)

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=726328

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=814810

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