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Rockwell Collins (NYSE:COL)

Q1 2013 Earnings Call

January 18, 2013 9:00 am ET

Executives

Steve Buesing - Vice President of Investor Relations

Clayton M. Jones - Chairman, Chief Executive Officer and Member of Executive Committee

Patrick E. Allen - Chief Financial Officer and Senior Vice President

Analysts

Carter Copeland - Barclays Capital, Research Division

David E. Strauss - UBS Investment Bank, Research Division

Robert Spingarn - Crédit Suisse AG, Research Division

Michael F. Ciarmoli - KeyBanc Capital Markets Inc., Research Division

Robert Stallard - RBC Capital Markets, LLC, Research Division

Noah Poponak - Goldman Sachs Group Inc., Research Division

Richard Tobie Safran - The Buckingham Research Group Incorporated

Jason M. Gursky - Citigroup Inc, Research Division

Yair Reiner - Oppenheimer & Co. Inc., Research Division

Samuel J. Pearlstein - Wells Fargo Securities, LLC, Research Division

George Shapiro

Joseph B. Nadol - JP Morgan Chase & Co, Research Division

Myles A. Walton - Deutsche Bank AG, Research Division

Howard A. Rubel - Jefferies & Company, Inc., Research Division

Peter J. Arment - Sterne Agee & Leach Inc., Research Division

Kenneth Herbert - Imperial Capital, LLC, Research Division

F. Carter Leake - BB&T Capital Markets, Research Division

Kristine T. Liwag - BofA Merrill Lynch, Research Division

Cai Von Rumohr - Cowen and Company, LLC, Research Division

Operator

Good morning, and welcome to the Rockwell Collins First Quarter Fiscal Year 2013 Earnings Conference Call. Today's call is being recorded. For opening remarks and management introduction, I would like to turn the call over to Rockwell Collins' Vice President of Investor Relations, Steve Buesing. Please go ahead, sir.

Steve Buesing

Thank you, Bonnie, and good morning, everyone. With me on the line this morning are Rockwell Collins' Chairman and Chief Executive Officer, Clay Jones; and Senior Vice President and Chief Financial Officer, Patrick Allen. Today's call is being webcast, and you can view the slides we will be presenting today on our website at www.rockwellcollins.com under the Investor Relations tab.

Please note today's presentation and webcast will include certain projections and statements that are forward-looking. Actual results may differ materially from those projected as a result of certain risks and uncertainties, including, but not limited to, those detailed on Slide 2 of this webcast presentation and from time to time, in the Securities and Exchange Commission filings. These forward-looking statements are made as of today, and the company assumes no obligation to update any forward-looking statements.

So with that, I'll turn the call over to Clay.

Clayton M. Jones

Thanks, Steve, and good morning. Everyone who does business with the U.S. Department of Defense has, over the last year, been waiting for the resolution to one of the worst pieces of legislation that I have seen in my adult life, sequestration. And most of you on this call who follow this sector were hoping, if not planning, for the issue to be resolved as part of the fiscal cliff negotiations as 2012 drew to a close. Well, we all know now that didn't happen. And as a result, the shadow that has hung over defense markets persists and, if anything, has gotten darker.

Fortunately, we anticipated this in our initial guidance last September and factored in the impact of sequestration as we believed it could be. As a result, we've already taken numerous actions and are well prepared for whatever happens in the next round of Congressional negotiations.

Now, uncertainly like -- uncertainty like this, which has persisted over the past 4 years and been a prominent part of the markets we serve, both defense and commercial, makes it challenging to both forecast performance and execute to those forecasts, so it should come as no surprise that I'm extremely pleased with the performance in our first fiscal quarter. Despite an expected decline in revenue, we exceeded our internal expectations for EPS, operating margins and cash flow. We were able to do this largely because of the laser focus of our people on the things we can control even as the uncertainty of the market swirls around us. These controllable items include our operating costs, capital deployment, investments and customer relationships.

For example, our operating margins improved year-over-year by 20 basis points and almost 100 basis points above our guidance targets as a result of early restructuring benefits and an exemplary job of our shared services controlling costs. We generated $63 million of positive cash flow in the first quarter, again, ahead of our expectations.

The strong start for cash generation was aided by lower incentive payouts in the period, which was expected. However, we received an equivalent benefit from better working capital management through improvements in areas such as production inventory and advanced customer payments. And with our strong balance sheet and ability to generate predictable cash flow, we once again used those financial assets to return value to shareholders by repurchasing 4% of our stock in the quarter. This brings the share reduction we've achieved just over the past 15 months to 11% as we've taken advantage of what we believe to be a relatively undervalued stock price.

Finally, our investments in new products and technology, along with the strong performance we've demonstrated delivering those products to our customers, has yielded additional success winning programs that will add to our long-term growth prospects.

In the commercial market, we announced a landmark win at Boeing to provide the display systems for their new 737 MAX. And we broadened our international reach by winning a program to install Pro Line Fusion in the cockpit of the AgustaWestland's 609 tilt rotor aircraft.

We were also able to land 2 significant U.S. government awards that will fuel growth over the next several years. The Air Force awarded us the first production lot of the E-6B aircraft upgrade program, and we also received orders for Low Rate Initial Production of the JTRS HMS Manpack program. HMS production ramp-up is underway, and we've already begun delivery of full function radios to the Army.

These programs add to the formidable existing list of development programs that we have won and have in various stages of development.

As I look out beyond this year of transition in 2013, I expect continued strength in commercial and greater visibility across our defense market. While I can't predict the outcome, I do expect the domestic defense budget outlook to eventually stabilize, creating a much more manageable environment. Increased clarity in those defense markets, coupled with growth in our commercial markets from new platforms like the CSeries, the A350, the Embraer Legacy 500 and Bombardier's Lear 85, all of which are expected to enter service next year, should set us up well for accelerating growth over the next several years.

So with a plan accommodating many of the identified risk in the balance of this year, I am increasingly confident in our ability to achieve continued performance improvements across our business and meet or exceed the financial targets we've set for the year.

So with that, let me hand the call over to Patrick.

Patrick E. Allen

Thanks, Clay, and good morning to everyone as well. I'd now like to walk you through today's presentation slides and summarize our results for the first quarter of 2013. I'll begin on Slide 3 where we highlight our total company first quarter sales, EPS, net income and operating cash flow.

Total company sales for the quarter decreased $32 million or 3% compared to last year's sales, while net income increased 2%. The increase in earnings was primarily driven by a lower effective tax rate, which went down from 33% to 30%, driven by the implementation of some tax strategies in the U.K. that allowed us to recognize some previously reserved net operating losses. While net income increased by 2%, earnings per share grew by 9% driven by our continued focus on returning capital to shareowners through share repurchases. In the first quarter, we deployed $333 million, reducing the share cap by 4%.

Looking next to our operating cash flow for the first quarter, we generated $63 million of cash compared to a use of $64 million last year. The increased cash generation resulted from improved working capital management, as well as lower employee incentive compensation payments, as we traditionally pay the prior year's incentive compensation payments in the first quarter of the following year.

Turning to Slide 4. We have the first quarter results of Commercial Systems, which achieved revenue of $516 million in 2013, up 1% from $511 million in 2012. Sales related to aircraft OEMs increased $17 million or 6% to $282 million, primarily resulting from increased deliveries for the Bombardier Global and Boeing 787 aircraft.

Meanwhile, aftermarket sales decreased $14 million to $207 million due to the large sales of spares last year related to air transport aircraft deliveries, special mission military aircraft programs and Chinese regional jets, which did not recur this year.

Commercial Systems operating earnings increased 5% to $106 million in 2013, with operating margins expanding from 19.8% to 20.5%. The increase in operating earnings and margin was primarily due to lower company-funded R&D expense as we shifted our development resources to preproduction engineering programs such as the Boeing 737 MAX and Bombardier CSeries and Global 7000/8000 programs.

Moving on to Slide 5. Government Systems revenue decreased by 6% to $546 million in 2013, driven by the completion of development programs, some of which are expected to transition to production, and the anticipated reduction in GPS product sales. These headwinds were partially offset by increased sales in areas such as tanker aircraft avionics, network communications and targeting systems.

Looking specifically at our product categories. Sales of Avionics decreased $9 million or 3% as headwinds from development programs transition into production were partially offset by increased sales on tanker aircraft programs.

Communication Products sales declined $11 million or 8%, primarily due to fewer deliveries of legacy airborne and satellite communication products, partially offset by increased deliveries of ground networking radios.

Surface Solutions sales decreased $10 million or 17% from the impact of completing multiple development programs, partially offset by increased international sales of FireStorm targeting systems.

Finally, sales of Navigation Products declined by $7 million or 13%, resulting from fewer deliveries of our handheld GPS receivers.

Government Systems' first quarter operating earnings decreased $10 million to $107 million, and operating margin of 19.6% compared to 20.1% last year. The decreased operating earnings and margins resulted from lower sales volume, which was partially offset by lower company-funded research and development, as well as some benefit from cost reduction actions taken over the past year.

Moving to Slide 6. We show the status of our capital structure as of the end of the first quarter compared to the end of last year. In addition to $573 million of long-term debt, we had $549 million of short-term debt outstanding at the end of the quarter. The increase in short-term debt came from the issuance of commercial paper to fund share repurchases, as well as the reclassification of long-term debt that is due within the next 12 months.

Now we ended the quarter with a debt-to-total capital ratio of 51%, which is higher than we just have historically operated. We have traditionally used debt-to-total capital as a metric to assess our financial health, both internally and with investors. We believe this metric is a bit misleading, as equity is abnormally reduced by a large pension adjustment, thus overinflating the percentage. If you normalize debt to total capital for the pension-related adjustment, as we do for our lenders, the metric would be about 30%.

I believe a better metric of the health of our financial structure is debt to EBITDA, as it's not affected by this adjustment equity. At the end of 2012, we had debt to EBITDA of approximately 0.7. With the issuance of commercial paper in the first quarter, we're currently about 1.1. I feel that this level of debt still provides us the necessary cost effective access to fund our capital needs. I expect this ratio to come down over the balance of the year as a larger portion of our cash flow traditionally comes later in the year, and we'll pay down a portion of that short-term debt.

Slide 7 provides us an update of the total R&D investment through the first quarter of the year. Total spend remained consistent at 21.4% of sales for the first quarter. Customer and company-funded R&D expense declined as we completed certain development programs and redirected the resources to preproduction engineering programs, predominantly in the commercial markets. Looking to the full year, we still expect to spend approximately $1 billion in total R&D.

The updated status of our share repurchase program as of the end of the first quarter is detailed on Slide 8. During the first quarter, we repurchased 6 million shares at an average cost of $55.22 per share, reducing the outstanding share cap by 4% since the beginning of the year and reducing it by 7% compared to the same period last year. This brings our total repurchase activity since 2002 to about 82 million shares or $4 billion returned to shareowners through maintaining an active share repurchase program. Our repurchase authority remaining at the end of the quarter was $147 million.

Now on to our final slide, Slide 9, where we provide the details of our fiscal year 2013 financial guidance.

The American Taxpayers Relief Act of 2012 was signed into law in early January, resulting in the retroactive application and extension of the Federal Research and Development Tax Credit through December 31, 2013. The effect of this credit will reduce our full year tax rate from 32% to about 27%. The change creates about a 30% improvement to the earnings per share, of which about half of that benefit will go to fund increased employee incentive compensation costs. That will result in a net $0.15 increase to earnings per share guidance, resulting in a full year target range between $4.45 and $4.65 per share.

Now the second quarter tax rate will include 5 quarters of benefit related to the final 3 years of our fiscal year '12 and the first 2 years of our -- or first 2 quarters of our fiscal year '13. As a result, I expect the second quarter tax rate to be about 18% and to recognize about 75% of the $0.15 full year EPS increase in Q2. Said a different way, we should see lower taxes in the second quarter than we previously expected, but also a corresponding increase to incentive compensation costs, which will result in a reduction to our operating margins.

Just as a reminder, our second quarter tax rate last year was also abnormally low at 24% due to the favorable adjustment stemming from the completion of prior year tax audits. Excluding the impact of this tax change, all other aspects of our financial guidance remain unchanged.

That completes my review of the financial results and projections. So Steve, back to you to kick off the Q&A session.

Steve Buesing

Thank you, Patrick. [Operator Instructions]. Operator, we're ready to open the line.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Carter Copeland of Barclays.

Carter Copeland - Barclays Capital, Research Division

A quick one on the incentive comp and tax comment you just made, Patrick. Can you tell me exactly how the structure of that works? So the -- is the incentive comp payment based on EPS targets? Because the -- you said -- I think you said $0.15 of the $0.30 benefit was going to get eaten up by higher incentive comp payments, that sounded like what you said. So can you clarify how -- what the structure of those payments are?

Patrick E. Allen

Sure, let me just kind of review the bedding. When we set up the incentive compensation program for this year, we actually set it up at 75% of the target. Usually, we set it at about 100%. And that target's based upon really 4 factors: sales, EPS, cash flow, and I'll say, a board evaluation of our strategic goals. The 2 factors that this R&D tax credit impacts positively are EPS and cash flow. And although we haven't changed our cash flow guidance, we've provided for that improvement in that $0.15. So what you're seeing is actually an increase of our incentive compensation payment from that 75% level closer to actually to the more normal 100%, and that'll be booked predominantly in our second quarter.

Clayton M. Jones

But let me add to that, Carter, also, when we structured those 4 components, we weight each one of them and the heaviest weighting that we put on each of those factors is predominantly EPS and cash flow, consistent with our view of the turbulence in the market, that these are things we can more likely control and that our people control through their actions as opposed to the sales volume, which obviously is not factored into this. So that's why you get an apparent disproportionate share with this tax windfall that we've received.

Operator

Our next question comes from David Strauss of USB (sic) [UBS].

David E. Strauss - UBS Investment Bank, Research Division

Clay, in Government Systems, the business -- when you look back 2, 3 years ago, it looks like the business is down about 25% or so when you look at top line and you look at the operating income side. Can you give us a sense on the cost-cutting side how much you've taken headcount down in that business and what else you think you can do in that business to take the cost structure down if we see additional pressure even beyond what we expect of sequestration?

Clayton M. Jones

David, I don't think I have at my command right now the exact number of personnel changes over that period of time, so I can't give you that number. But what I can say that the major point -- components of reductions have been personnel. They've also been reductions of research and development, which we've been very open about as we've not sort of needed that. And then -- and I guess the third case is some restructuring actions that get to at least a contribution to the part of the reductions, which are some facility reductions and some consolidations that we're doing most notably in our European operations, a lot of which goes into Government Systems. So I'd say those are the 3 big levers that we've used in the past. And we've been able to both quickly and I'd say proportionately reduce that in Government Systems, and more effectively in Government Systems because a great deal of those revenues are nonrecurring engineering or development costs that goes into the customer-funded R&D line, which is also booked, as you know, as sales and some profitability. So if you look back over the last 2 years, I think your number in reduction is about right, but a great deal of that has been the elimination of development programs. I think we've had 8 or 9 programs canceled, the majority of which of those have been development programs, and therefore, you're able to both anticipate the stoppage by the government and then make your headcount adjustments attendant to that. Second part of your question is how much more of that can we do. I think we've got a good bit more of that on the personnel side if we have to. A lot of that has already been anticipated in the restructuring action that we took in the fourth quarter of last year. And if, in fact, what comes out of the Congressional negotiation is even deeper than what was accommodated in sequestration, we certainly show an ability to make that move and we'll do what we have to do to balance that business to the realities of the world.

Operator

Our next question comes from Robert Spingarn of Crédit Suisse.

Robert Spingarn - Crédit Suisse AG, Research Division

Okay, Patrick, on the margin, you did better in the margin in the quarter at slightly over 20% than we were anticipating based on comments that you all made about a month or so into the quarter. So can you talk about -- a little bit about what improved in December and why we don't see higher margins overall in the guidance? Does this not continue? Is it just front-ended a little bit? And -- or is it just explained by the puts and takes with the incentive comp? And then lastly, the further cadence on the buyback.

Patrick E. Allen

Sure. As it relates to the margin and how -- why it's exceeded our expectations in the quarter, I'd say it was really just the actions that were taken with our shared services controlling spending, as well as, I would say, slightly a quicker benefit from the restructuring actions we took at the end of the fourth quarter. I think both of those things surprised us to the positive and resulted in increased margin for the quarter. Now do those benefits carry forward for the full year? Yes. But you pointed out that margins are also going to be suppressed by that incremental incentive compensation, particularly in the second quarter. So on balance, we're sticking to our margin guidance. But those 2 are going to be -- are going to offset each other, and actually I'd say the incentive compensation will be a little bit higher. As it relates to share repurchases, we obviously did a lot of share repurchases in the first quarter. We viewed our stock as being attractively priced. Obviously, the cost of debt is very low. We're going to continue doing share repurchases throughout the year, probably not at the same pace you saw in the first quarter, but we'll still be in the market through all 4 quarters of the year.

Robert Spingarn - Crédit Suisse AG, Research Division

Is it fair to say that the balance between the quarters will be different then than last year?

Patrick E. Allen

I would say, I really don't want to comment on our quarterly plans.

Operator

Our next question comes from Michael Ciarmoli of KeyBanc Capital Markets.

Michael F. Ciarmoli - KeyBanc Capital Markets Inc., Research Division

Clay, just to maybe follow up on the Government Systems and how you've effectively planned for sequestration, I guess, we're hearing more of that under sort of the recent measures to try and cut cost that some of the IDIQ contracts, indefinite-delivery indefinite-quantity, could really be on the chopping block since there's no termination liability. Can you sort of quantify your exposure there and maybe how you've sort of calibrated that into your plans this year? I mean, are you more exposed to some of those contracts?

Clayton M. Jones

No, we're not. We do have some. A lot of those IDIQs are related to some of the OPTEMPO OCO work that's still being done in Afghanistan. I'd say our total OCO exposure right now is less than $50 million out of the whole portfolio, so I don't think that's a big one. The other area, I think, a lot of people are looking at is service and support contracts, which have the same kind of criteria around them that you suggest there. Again, we have some exposure there, but it's fairly modest, I would say, in those areas. But again, what we try to do in the accommodation for sequestration is apply what the legislation says to the reductions that we think will be made to unobligated balances should the law go into effect. And again, we think that should give us enough headroom regardless to how they figure that out. About the only thing that would happen that could maybe significantly change our estimates is if all of a sudden Congress decides to cut the same amount but give specific program leeway and the government goes in and maybe starts canceling whole programs that may be inordinately affecting us. I think that's a lot to do in the time we have left, and again, we still have -- in fact, we've specified it, we have $120 million of sequestration impact baked into the back half of our year. So we think we've planned as prudently as you can in this environment. And I think we're ready for whatever is in front of us. The difficulty is we're right where we were 4, 5 months ago as nobody in the world knows how it's going to end, but we think we're prepared. And aren't we glad we made this assumption and took this action, and we'll see how it goes.

Operator

Our next question comes from Robert Stallard of Royal Bank of Canada.

Robert Stallard - RBC Capital Markets, LLC, Research Division

Clay, I thought we'd kick off looking at maybe the aerospace aftermarket. You mentioned you're increasingly confident about your ability to meet the financial expectations for the year. I was wondering if your confidence about this shorter cycle end market had perhaps improved over the last 3 months.

Clayton M. Jones

What I would say is the aftermarket is rolling out about like we thought it would. If you remember, we pretty much forecasted this quarter that we would see some weakness, specifically relative to spare part comparables almost across both markets. And that really is the predominant causal for why our aftermarket is down in the first quarter. I would just, for historical reference, relate to everybody what happened last year. Last year, we had 3 strong quarters and 1 weak quarter, if you remember, it was third quarter, where everybody kind of got all crazy because we thought that the music had stopped. The fact of the matter is this aftermarket is very lumpy. There are a lot of different things that move in there that are short-term focused. We have some visibility, but others, we just have to see how it goes. And I would just advise everybody not to judge the aftermarket on the basis of 1 quarter. And as we look forward for the rest of the year, we see 3 big drivers. We see the mandates that are coming in that we've talked about, mostly European-based for collision avoidance and datalink requirements that we've already talked to our customers about doing. We see improving comparables on spares as we had a weak second half and expect strength in that going forward. And then we have a number of retrofits that we're already marketing out there. We have a lot of this new technology that's going to go into especially business aviation, because as that market stays weak, we're seeing customers want to upgrade their existing aircraft. So I wouldn't say we have perfect visibility, but we have pretty good visibility of what's going to drive the aftermarket for the balance of the year, and we still see it proceeding according to as we had planned it.

Robert Stallard - RBC Capital Markets, LLC, Research Division

And as a quick follow-up, you mentioned business jet there. Has there been any change in your view on in-production business jets versus what you said before?

Clayton M. Jones

I would say not a lot of change, Rob. We went into the year not expecting any big recovery or any significant improvement, and that's exactly how I see it today. I don't think that there's a big order buildup. I'd say still that the high end of the market is much stronger than the low end. If I were to make any editorial comment of something that I may be watching more closely is that again, the low end of the business jet market. It has always been the most fragile. I think it stays the most fragile. And so we'll be watching, waiting and working with our customers to see how those order fills are going, but right now there's nothing that is encouraging.

Operator

Our next question comes from Noah Poponak of Goldman Sachs.

Noah Poponak - Goldman Sachs Group Inc., Research Division

Clay, you had the inter-quarter presentation that went into some detail on some of your thoughts longer term. I wanted to ask you specifically where you were talking about government growing again by 2015, and then that growth rate accelerating beyond that. The basic question is just sort of how do you know or how do you have that confidence? What is it about the business that allows you to overcome all of the uncertainty about future defense spending, how difficult this business has been to predict that allows you to have the confidence to sort of put out those reasonably official longer-term targets on government?

Clayton M. Jones

Well, Noah, what I've learned is predicting the future is very difficult, and -- but that's what you expect us to do and that's what our job is. So I would say that's not a Pollyanna, pie-in-the-sky, gee, I wish it was like that. I think that's based on historical reference and some of our personal thinking that combines 2 things. Number one, what we believe the direction will be once this grand drama finally gets over with, and we all hope it'll get over with in the government of deciding what defense spending is going to be going into the future. And is there uncertainty to that? There's extraordinary uncertainty into that. But my view is based on nothing goes down forever. Actually, if sequestration were to go into effect, that would give me greater confidence that those projections I put out will happen because that means we'll not scab off, we'll let it bleed a little while and then we'll reset it and go ahead. If there's some accommodation of that, that could bring into question whether we get quite back to flat by 2015, but I don't think I'm going to be off by 5% or 6%. It's going to be in that neighborhood. But the other side of the equation are the core programs that we have and the core business that we're planning to have. It's kind of like a race to the bottom to reset. We're sizing and shaping our defense business to be able to come out of this with the kind of core capabilities that we believe are right for the market at that time, and we stated those very clearly. If you're not buying new airplanes, you're going to fix the one you have. And our Avionics portfolio, which is more than half of our business, is going to be well positioned with a world of new commercial technologies to apply to governments that don't have much money, and that applies here in the United States and beyond. We know that as we soon as we get the DAGR comparable over in GPS products, we're going to have a Modernized User Equipment. The satellites are already up in the air, and they're going to have to start cutting that in. Our communication portfolio is inherently strong with legacy. And hopefully, if HMS stays alive, we'll be good for that. And then we're still focusing on international. Our international business in defense grew 6% last year. And so all those things that we control that we're positioning for is the other side of equation that gives me some confidence that we'll get back to that level. Now could it be wrong? Yes. And are we all worried about the way it's going to go? Sure. But I don't think that is an unreasonable assumption based on what core products we have, the programs we're on and what we hope the evolution of Congressional funding is going to be. So we still stand by that.

Noah Poponak - Goldman Sachs Group Inc., Research Division

Okay, that's very helpful color. Just on the international portion of that, specifically, are there larger programs you can identify yet to be won that we can watch for? Or is it a lot of smaller to medium-sized items going into that forecast?

Clayton M. Jones

I'd say they're both of them. I think, things like aircraft retrofits and communication sales of our Talon or ARC-210 and other HF products are in the small -- we're working them a point at a time. But there are larger programs that we are chasing in these developing markets. Brazil has got some very large investment programs in both communication and homeland defense they're working on. The Middle East, there are a number of large programs we're looking at. India and some of the areas that they're looking at could potentially be large in the longer term. So I'd say it's a mix of both.

Operator

Our next question comes from Richard Safran of Buckingham Research.

Richard Tobie Safran - The Buckingham Research Group Incorporated

Clay, on your comments on international defense sales, I wanted to know if this pursuit is going to drive you to pursue more joint ventures. Maybe if you can, assuming you are, you could discuss how that might impact your business there.

Clayton M. Jones

I think almost certainly it will require us to partner and even up to define joint ventures with partner companies just because of the way business is done in some of these countries. And so we've been working very hard internally to improve our capabilities in that area because that's not a big way of doing business in the United States, but it is a much bigger way to do it over there. For example, we have a joint venture with Talus on a software-defined radio that we're jointly developing and taking across the world. We've announced a joint venture work that we're doing with Tata in India. We're realizing that partnerships in the Middle East are a must to make sure that there is value that's brought into that. So I think, yes, that's the way of doing business internationally.

Operator

Our next question comes from Jason Gursky of Citi Investment Research.

Jason M. Gursky - Citigroup Inc, Research Division

Clay, you've guided to Government Systems being down 10% for the year. You just did negative 6%. Can you explain to us what has to happen in order for you to actually hit down 10%?

Clayton M. Jones

Well, yes, sequestration has to happen. Remember, that's part of that. We suggested that roughly half of the decline is going to be a result to -- of either sequestration or a full year continuing resolution. I'd say either one of those would get us probably pretty close to that level. As I said before, Jason, hell, we don't know what's going to happen. We're all over the place on this thing. But something is going to happen, isn't it? And one of those things is going to impact us in the balance of the year. It's very difficult to predict on a program-by-program basis like we normally like to plan. So we think whatever that is, that's going to go that way. I think a couple of pieces of color here. One of the reasons we weren't down more in the first quarter, honestly, is because our Government Systems business did a grand job of going out there and trying to secure as many orders as they could before the music stops. And so I think there was both a willingness on the Department of Defense to entertain those discussions, and our folks worked real hard to bring some of those orders in that would normally have come in subsequent quarters. So remember, we're still waiting and seeing there. I think you're going to begin to see some of the impacts that we predicted in things like transition programs. Two of the biggest avionics programs we have, which are the E-6 and the E-2 development programs, will really be hit hard the next couple of quarters as we go through that transition from development into production. I would expect, as an example, our largest business, Avionics, to be down 8% to 10% next quarter as a result of just those 2 programs almost alone. So again, we have some visibility, I'd say half of it. The other half we're planning for, and that's what we factored into that overall 10% down. Believe me, I hope I'm wrong. I hope it's better than that. But at this point in time, it would be imprudent to plan or suggest that to be the case.

Operator

Our next question comes from Yair Reiner of Oppenheimer.

Yair Reiner - Oppenheimer & Co. Inc., Research Division

Business jet, part of the business -- the existing Hawker Beechcraft fleet is a pretty important source of aftermarket demand for you, I imagine. I'm just wondering to what extent the bankruptcy has changed customers' appetite for continuing to invest and upgrade that orphan brand and how we should think about the value of that fleet for you guys at this point.

Clayton M. Jones

I think it's probably too early to tell, Yair, the long-term impact of that. What I would tell you is, I think, where there maybe some risks there, there's also opportunity, and you've seen that in the company Nextant taking a lot of the old Hawker 200 fleet and retrofitting it with our Pro Line cockpits and being very successful reselling that very good residual airplane with new electronics and updating it. And so that's a very interesting example of how that has taken place. If you look at the King Airs, there's just a world of King Airs that are already out there, and that's a terrific airplane for a lot of missions that are being used, and you can't imagine the number of electronic and avionics configurations that exist out there that can improve the ability to fly that airplane but still retain the residual value in it. And the Beechcraft company, as they come out, is going to make a special push to make sure those retrofits and upgrades are available, and we're going to be helping them do that. And so on the face of it, if it's a good airplane and it's existing out there in the fleet, somebody's going to take care of it, and we believe there's going to be retrofit opportunities as a result.

Operator

Our next question comes from Sam Pearlstein of Wells Fargo.

Samuel J. Pearlstein - Wells Fargo Securities, LLC, Research Division

One quick question is, on Slide 4, you talk about the year-over-year on Commercial Systems and you highlight the increased 787 production rates. Have you come off the 4 per month? Or is that just a year ago, you were at a lower rate?

Clayton M. Jones

The latter. Remember the -- remember, we dropped down actually to 2 per month toward the latter part of last year, or actually, the beginning of last year, and then we raised it up to the current 4 per month, and we're still at 4 per month. So it's just a comparable.

Samuel J. Pearlstein - Wells Fargo Securities, LLC, Research Division

Okay. And then, somewhat related is in the aftermarket, I know that you had a lot of 787 initial provisioning a year ago. If you were to x out initial provisioning from both years, what would the commercial aftermarket growth rate look like? Is it positive, is it negative? Can you talk a little bit about that?

Patrick E. Allen

Are you talking about for the quarter or for the year?

Samuel J. Pearlstein - Wells Fargo Securities, LLC, Research Division

For the quarter.

Patrick E. Allen

I would say that it would probably be negative.

Clayton M. Jones

Because there were -- Sam, what I would say is although there were a lot of 787 spares in that, there were a lot of other airplanes that were being introduced from both Airbus and Boeing that also generate, frankly, a higher volume of spares just for the numbers that went out there. So that's sort of an across-the-board spares comparable.

Patrick E. Allen

And the other thing I'd mention is there was quite a bit of sparing on the business jet side related to some Chinese regional aircraft, as well as some special missions aircraft, and that would also be a negative.

Samuel J. Pearlstein - Wells Fargo Securities, LLC, Research Division

Okay. Then if I can ask one last question. $147 million of remaining authorization, given the pace where you were in the first quarter, is that something that you think can get you through the remainder of the year? Or is that something we should expect to see an extension of that?

Patrick E. Allen

I would expect to see an extension at some point during the year.

Operator

Our next question comes from George Shapiro of Shapiro Research.

George Shapiro

Clay, just wanted to pursue the aftermarket a little bit more. I mean, to effectively get to your double-digit growth for the year, I mean, the rest of the year has got to average 15% or something. I mean, so are you comfortable that, that's going to happen?

Clayton M. Jones

That's what I said.

George Shapiro

Okay. And then just a quick follow-up, Patrick. On the cash flow question that Sam asked, would you expect the same rate of buyback to occur the rest of the year, or you're going to buy back less as you want the debt number to come down somewhat?

Patrick E. Allen

Well, as I indicated, I think what you're going to see is you're going to see continued buybacks, but probably not at the pace that we saw in the first quarter.

Operator

Our next question comes from Joe Nadol of JPMorgan.

Joseph B. Nadol - JP Morgan Chase & Co, Research Division

Clay, you termed to the win on the 737 MAX display as a landmark win. I was wondering if you could give us any details you're willing to share on the business case, how big the ship set value is perhaps on then -- if not for the displays, then maybe for the aircraft overall at this point. Any -- it looks like you're going to be capitalizing the R&D. Is this a new product, or is this an extension of an existing product line? Any other thoughts you have on that win?

Clayton M. Jones

Well, as is our custom, Joe, we don't give ship set values on that. But we have disclosed, and I'll remind you that we talked about just the initial win with the service and support over the life of, at least, the numbers of airplanes that we suggest in there. I think we planned on about 4,500 airplanes. We may be off a little bit on that, actually, may be light according to Boeing's projections. But we're looking at about a $1.6 billion value for this program over its life with the service included. Now I think the significance of the airplane, you have to look at that display system, which takes our market share on standard equipment, SFE equipment, from 15, 1-5, percent to about 50, 5-0, percent of the share that we'll have on that standard equipment, and add to that our existing win rates on the airline selectable equipment or the BFE. And when you combine those together, we're looking at a value of this airplane of about $3.5 billion to $4 billion. And so that makes it at or slightly above what the value we see over time of the 787. And when you combine those 2 together, that's pretty formidable. Then you add the 350 to that, that's a great legacy that these programs are going to leave for this company for years to come. Relative to the investments, you're correct. We have put that into the deferred engineering amount. Most of what we're doing here is reapplication, not invention of the technology that will be going onto there. That obviously is derived from the 787, extended on the KC-46 and the FedEx modification program of the 767s. So it's yet one more product extension we've got into that initial development, so it won't be near as high as the initial development, but it'll be significant enough that we'll have a little work to do.

Joseph B. Nadol - JP Morgan Chase & Co, Research Division

And those market share numbers that you gave, the 15% to the 50% on the SFE, that's the way you look at your share of the addressable market on that platform?

Clayton M. Jones

That's correct.

Operator

Our next question comes from Myles Walton of Deutsche Bank.

Myles A. Walton - Deutsche Bank AG, Research Division

Probably following in that line on R&D, is it still expected to be up on an expense basis in fiscal '13? Obviously, trending a little light here in the first quarter. And then secondly, on preproduction, I think, you had previously talked about peaking kind of in fiscal '14 given the wins. Does that push it out?

Clayton M. Jones

Well, on the first question, if we look at the expense line, it's going to be, I'd say, roughly flat for the year. It may be down just a very few million dollars, but just flattish to modestly down. The big increase in R&D this year is coming out of the deferred, which is going from roughly $120 million up to about $200 million. That's the big upper in terms of the way we account for that. We'll probably see a little bit of decline from customer funded, I'd say, maybe $15 million to $20 million of decline there just as the -- mainly from military, U.S. DOD funding reductions. But overall, for the year, as we've said before, while our revenues are going to be down for the year, our total R&D is measured by all 3 of those components, so it's actually going to be up.

Myles A. Walton - Deutsche Bank AG, Research Division

Okay. So I read though, for the rest of the year, it looks like it's flat to slightly up for the remaining 3 quarters. And then preproduction for fiscal '14, does that still peak? Or because of the wins, you're looking that extending out a period of time?

Clayton M. Jones

I'll let Pat...

Patrick E. Allen

I think you're going to continue to see the balance on the balance sheet grow for the next few years, and then come down probably toward the end of our planning period, which is 5 years. But you're going to see it increasing at a decreasing rate. So it'll begin to be a cash flow tailwind for us really starting next year.

Clayton M. Jones

Yes. Depending on what peak you're talking about, it is at least our belief that this year, FY '13, will be the peak annual amount. And as Pat said, we'll see a declining amount of annual deferred added next year, which is going to help us improve our cash flow.

Myles A. Walton - Deutsche Bank AG, Research Division

Okay. But sorry, just to clarify, it won't be a tailwind to cash flow. It'll still be a significant headwind to cash flow [indiscernible].

Patrick E. Allen

Well, yes, year-over-year, it'll be a benefit.

Operator

Our next question comes from Howard Rubel of Jefferies.

Howard A. Rubel - Jefferies & Company, Inc., Research Division

Clay, I can't ever recall seeing you talk about the A330 in your press release as being a big contributor to business. Was there that and some other BFE wins that help the numbers? And could you sort of talk about some of your successes in the BFE market of late?

Clayton M. Jones

Well, I think that was probably just the mix this quarter. We were citing it as a causal just because there was a favorable mix of customers that the A330 was delivered to. And relative to successes, we announced that GOL down in Brazil selected us, so we had that one, which is a new one in those area. China Southern selected us this year, and that wasn't A330. So our commercial systems folks have just done an absolutely over-the-top job of maintaining strong customer relationships. That's that component I talked about in our overview to continue our very high win rate of BFE. And because they're typically one program at a time and a few airplanes at a time, they may not be as incrementally noticeable as the 737 MAX, but they sure are feeding the bulldog around here, and I continue to be very pleased with the success we've had around the world on BFE.

Operator

Our next question comes from Peter Arment of Sterne Agee & Leach.

Peter J. Arment - Sterne Agee & Leach Inc., Research Division

Clay, a lot of questions have been asked. Can you talk a little bit about in particular, I guess, the Chinese market and the narrow-body? A lot of discussion about their intent to field HUDs for their narrow-bodies, and whether that's kind of a potential opportunity for you in calendar 2013, or is this more '14? How do you see that developing? And any color you could give us, that'd be great.

Clayton M. Jones

Well, first, I think it's much more of an opportunity beyond '13. To me, it's part of that opportunity beyond this transition year that we're going to get just because it's going to take a while for both the airlines themselves and the government that's defined this sort of HUD mandate to initiate it, get it operable, just some work to be done, to sell it and to install them. But in terms of an opportunity, we stand by the fact that we think it's an exceptionally good opportunity now, and I think that opportunity could even get better. As you know, we are the only HUD operable on all the Boeing airplanes, the narrow-bodies. We're not currently operable at Airbus, and that's something we're working very hard to try to remedy and make sure that we get that opportunity in the future. But we think the directive will probably go in place toward the latter -- I'd say, mandate will be the latter part of this decade, so it's going to take them a few years that they build toward that. But over that, I'd say the next 5 to 8 years, we think, it's going to be an excellent opportunity to expand our footprint, our volume and improve revenue there.

Operator

Our next question comes from Ken Herbert of Imperial Capital.

Kenneth Herbert - Imperial Capital, LLC, Research Division

Just wanted to follow up with a question on the aftermarket. I can appreciate that the spares business would be pretty lumpy and you don't have necessarily great visibility there. But can you comment on the backlog within the repair and overhaul side of that business? And what -- any trends you saw in the quarter and how the outlook looks specifically for that part of the aftermarket?

Clayton M. Jones

Well, the MRO part, which is just slightly over half of our aftermarket piece, it is remarkably predictable. And typically, it tracks pretty much toward flight hours flown. I would say in this quarter, it was down a little bit because flight hours were down. However, our projections and IATA's projections for the full year are traffic growth at around 5%, and so we've laid in budgets that suggest that the basic service revenue is going to grow, I'd say, relatively consistent with that passenger growth.

Kenneth Herbert - Imperial Capital, LLC, Research Division

Great, that's helpful. And just finally, did you see any strengthening of that as you went through the fourth quarter? Or is that -- you typically don't see much volatility in that because of what you said, the predictability and the correlation with flight hours?

Clayton M. Jones

I'd say the latter. It is a much more predicable component of the aftermarket compared to spares and retrofits. And so I would say it operated according to its seasonal norms. There is a little seasonality to it as they take airplanes in and out of service for these peak times. But again, we have very good parametric models that our folks have come up with that allow us to predict that fairly accurately.

Operator

Our next question comes from Carter Leake of BB&T Capital Markets.

F. Carter Leake - BB&T Capital Markets, Research Division

Can you update us on how you're synced up on the 787 shipments? It's been a while since we've got an update. How correlated are you to their production rates?

Patrick E. Allen

We are running under their production rates right now. As we said earlier, we have stayed at 4 per month. We are currently at 4 per month shipsets delivery. And that synchronization, we have always suggested, is going to happen in the second half of the year. We haven't gotten to the point right now where we -- or I can call it exactly. But if I were sort of projecting where I think it's going to happen, it's probably going to happen right around the beginning of our fourth quarter, plus or minus maybe a month or so, where we get the opportunity to accelerate.

F. Carter Leake - BB&T Capital Markets, Research Division

And so is that synchronization in 4Q, obviously, that's in your estimates?

Clayton M. Jones

That's correct.

F. Carter Leake - BB&T Capital Markets, Research Division

Okay. And one more is -- maybe you've answered this. Is it possible that the large-format displays on the MAX, is there any contemplation that, that could be a retrofit option, or is that not possible?

Clayton M. Jones

It's very possible.

F. Carter Leake - BB&T Capital Markets, Research Division

For a 73 -- so it is very possible. Any color on that timing?

Clayton M. Jones

Nothing right now, but the fact that we have now secured this win on the MAX gives us the opportunity to start some planning, not only ourselves but along with Boeing, to be able to offer a product at some point in the future that would make that retrofit available. And I think it's one of those things you got to get the baseline in play first. So the first efforts are going to be putting it on the MAX. But then, very quickly, making that operable in the aftermarket once people see the advantages of those large-format displays and the reliability improvements and the cost improvements and the ability to be more flexible in a NextGen-type air traffic environment, I think, over time, is going to make that very attractive.

F. Carter Leake - BB&T Capital Markets, Research Division

And the -- but the retrofit would definitely have -- it would come after the MAX, is that right?

Clayton M. Jones

Most probably.

F. Carter Leake - BB&T Capital Markets, Research Division

It could not come before. Okay.

Clayton M. Jones

Nothing's impossible, but I think it's logical to assume that the market demand will follow after you get the initial equipment installed.

Operator

Our next question comes from Ronald Epstein of Bank of America Merrill Lynch.

Kristine T. Liwag - BofA Merrill Lynch, Research Division

Kristine Liwag calling in for Ron. The last time Government Systems margins fell below 20% was in 2008. So I was wondering, how much of that margin contraction is attributed to the higher overhead because of lower sales versus pricing pressure from the customer?

Clayton M. Jones

I'd say, none of it is pricing pressure for the customer. I think the contraction we saw this year is purely as a result of the volume reductions, 6% volume reductions, and the fact that the full impact of our restructuring actions have not yet been felt, and we'll see that improve through the year.

Kristine T. Liwag - BofA Merrill Lynch, Research Division

Sure. And I guess another one for me. So Garmin has been winning platforms in the light and business jet avionics market, but your R&D spend is declining, Commercial Systems. Are you still planning to compete in this segment of the market? Are you focusing on the large cabin and air transport wins like the 737 MAX you just did?

Clayton M. Jones

Okay. About everything you said except for Garmin winning some market share is wrong. First of all, our Commercial Systems R&D is increasing dramatically if you include the deferred, as well as the currently expensed. Second thing, we absolutely are going to continue to compete at all phases of the business jet market. In fact, I would contend we're the only avionics company that has positioned itself to do that. And with our new Pro Line Fusion EDS, the Embedded Display System, we, in fact, have already had a competition, and we won that competition head to head against Garmin. So we're going to be there, and I expect them to be there as well. So if nothing else, it will be a good fight.

Operator

Our last question comes from Cai Von Rumohr of Cowen and Company.

Cai Von Rumohr - Cowen and Company, LLC, Research Division

So Patrick, you indicated that incentive comp would now be $100 million. By my math, the change from $75 million is about a $0.12 drag, and yet the benefit of a 5-point drop in the tax rate is a $0.33 plus. You only raised your guidance by $0.15. What happened to the other $0.06? Is business -- are there really other things you have to overcome, or is that just caution?

Patrick E. Allen

Well, what I would say is that, I think, you've overstated the benefit of the R&D tax credit slightly and understated the benefit of the incentive compensation. The way I look at it is it's about $0.30 -- if you want to get down to the penny, it's about $0.32 impact of the R&D tax credit offset by about $0.16 of incentive compensation when you factor in the cash flow impact, and so we're talking about $0.16 versus $0.15.

Cai Von Rumohr - Cowen and Company, LLC, Research Division

But it's like $25 million.

Patrick E. Allen

Well, I didn't -- I think you may have misinterpreted. I said we're getting to be around 100%. I was -- we're getting to our payout to be around 100%. So it's not exactly $25 million.

Cai Von Rumohr - Cowen and Company, LLC, Research Division

It's more than $25 million is what you're saying?

Patrick E. Allen

A little bit more, yes.

Cai Von Rumohr - Cowen and Company, LLC, Research Division

And so you also mentioned, there would be catch-up in the second quarter. I assume the first quarter must have been $17 million, $18 million since you do it ratably by as a percent of sales. Help us understand a little bit better how you're going to -- are we going to have a full catch-ups in the second quarter?

Patrick E. Allen

Yes, the way we're going to account for it is if you think about the value of the R&D tax credit, it's 7 quarters of benefit, 5 related to, I'll say, a cumulative catch-up through the second quarter. So we're going to record 5/7 of the catch-up on the incentive compensation during that -- during the second quarter.

Cai Von Rumohr - Cowen and Company, LLC, Research Division

Actually, the question was on the incentive comp, because you're going to 100%-plus is you get -- I assume, the first quarter was at the lower of the $75 million run rate, and so we really get a bigger step-up in the second quarter on the incentive comp.

Patrick E. Allen

Yes. I'm sorry if I misspoke. We're going to record 5/7 of the incentive compensation charge in the second quarter as well, the catch-up.

Cai Von Rumohr - Cowen and Company, LLC, Research Division

5/7 of the catch-up? Okay.

Patrick E. Allen

Yes.

Cai Von Rumohr - Cowen and Company, LLC, Research Division

So the full year catch-up or just kind of true you up to where you would be for...

Patrick E. Allen

I would describe it as the full year catch-up.

Cai Von Rumohr - Cowen and Company, LLC, Research Division

Okay, very good. And just one last one. Your wide-body IFE was up. Why was it up? And what should we expect for the year?

Clayton M. Jones

The second part, you say expected to decline for the year and it was up because of a onetime sale of last time spare parts to one of our customers that's operating that IFE system. So basically, we gave them a onetime buy of spares that they'll need to operate the system until they take it off wing.

Operator

This concludes the question-and-answer session. I'd now like to turn the call back over to Steve Buesing for any closing remarks.

Steve Buesing

Thank you, Bonnie. We plan to file our Form 10-Q later today, so please review that document for additional disclosures. I want to thank everybody for joining us and participating on today's conference call.

Operator

Thank you. This concludes today's conference call. You may now disconnect.

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