Executives
Dan Swenson - Investor Relations
Clayton M. Jones - Chairman, President and Chief Executive Officer
Patrick E. Allen - Senior Vice President and Chief Financial Officer
Analysts
Alex Hamilton - Jesup & Lamont Securities Corporation
Heidi Wood - Morgan Stanley
Joseph Campbell - Barclays Capital
Richard Safran - Goldman Sachs
Myles Walton - Oppenheimer & Co.
Joseph Nadol - JPMorgan
Robert Stallard - Macquarie Research Equities
Ronald Epstein - Merrill Lynch
David Strauss - UBS
Robert Spingarn - Credit Suisse
Rockwell Collins, Inc. (COL) F1Q09 (Qtr End 12/31/08) Earnings Call February 3, 2009 9:00 AM ET
Operator
Good morning and welcome to the Rockwell Collins First Quarter Fiscal Year 2009 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, Dan Swenson; please go ahead, sir.
Dan Swenson
Thank you, and good morning everyone. With me on the line this morning are Rockwell Collins Chairman, President 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 as defined in the Private Securities Litigation Reform Act of 1995.
Actual results may differ materially from those projected as a result of certain risks and uncertainties, including but not limited to those details on slide 2 of this webcast presentation, and from time-to-time the company's Securities and Exchange Commission filings. These forward-looking statements are made as of the date hereof, and the company assumes no obligation to update any forward-looking statement.
And with that, I'll now turn the call over to Clay.
Clayton M. Jones
Thanks Dan.
Let me begin my comments this morning with a very brief summary of our first quarter FY 2009 results. This quarter we realized earnings per share of $0.95 compared to $0.93 a year ago.
Our EPS growth despite the decline in revenue came on mix results across our businesses. Government Systems performed exceptionally well with operating profit growth of almost 22% to $140 million as operating margins expanded from 21% to 24% on sales growth of 5%.
However, Commercial Systems revenues declined 14%. Due to the previously anticipated impacts on the prolong strike and other production issues at Boeing. As well as the decline in air transport aftermarket and wide-body IFE product sales.
Despite the significant revenue impact, it's important to note that Commercial Systems was able to maintain operating margins at 20%. Even though the full benefit of the actions we announced in November, had yet to be realized.
As a result of these items, total company revenues decreased by 5% to $1.06 billion. The net income came in at $151 million. Due to the actions we took as changes in our commercial markets were unfolding, we were able to deliver an expansion of return on sales from 13.8% last year to 14.3% this year.
Now, let me address the current market conditions and what we see going forward. I think you'd agree with me that these are anything, but normal times; and predicting the future direction of this market is extraordinarily challenging as we have learned already this year. But so far, 80% of our business is tracking to expectations, and we believe will continue to do so.
Our Government Systems business is operating in environment of relative funding stability for 2009. This stability and support for related defense budget is due to several conditions that being widely reported in the recent days. Problems of record are in place for 2009.
The global warm terror continues as our military turns its attention from Iraq to Afghanistan and other regions of instability. And DoD funding priorities have not been reset as preservation of high value jobs has appropriately been a key focus of the new Obama administration.
And thankfully, the procurement environment has also stabilized with no additional material delays or cancellations of programs since our last earnings call. And we are seeing several areas of strength such as simulation programs and growth from new programs including the common range, integrated instrumentation system, the joint precision approach in landing system, and our work in Germany on the Eurofighter.
Now turning to the air transports OEM sector; now that we are past the strike and hopefully most production issues of Boeing. We anticipate a more stable market through the end of our fiscal year 2009. As unfortunate as it was for all of us in the supply chain, Boeing slow down in production did serve as a relief to reduce supply ahead of the economic downturn.
To-date Boeing and Airbus seem to have maintained their record backlog. And while there have been some deferrals of orders, they have managed to fill these slots with customer demand.
Regarding the air transport aftermarket; we had previously announced that our expectations that air traffic would be relatively flat for 2009. Given what we've seen happened with consumer confidence and the GDP, it now appears that traffic will be down about in the order of 3%.
Unfortunately... I should say fortunately, the airlines by virtue of their fleet capacity reduction actions seemed to be well positioned to adjust to this reduction in air travel. At the beginning of the year, we expected the airlines to reduce capacity by about 1,200 to 1,400 aircrafts or 7 to 8% of global fleet. To-date, we estimate that they've set down about 500 of these aircrafts and that the remainder will come out over the next three to four quarters.
In addition to managing their operating cost with fleet reductions, the airlines have also benefited from the falling cost of fuels, which should remain a tailwind for them in 2009. And because we've already anticipated the fleet reduction actions, we remain fairly comfortable with our air transport aftermarket revenue forecast.
However, since November, we have seen a significant deterioration in the business aviation environment since economic conditions impacted global demand. Data from the FAA shows that 19% reduction in business jet utilization during the month of December, and indicated utilization was down 12% for last year.
The inventory of used aircraft for sales stood at about 16% of the worldwide fleet as of December, and it's quickly approaching the 17% peak of late 2002. A particular concern is that 39% of those used aircraft for sale are less than 10 years old as compared to an average of about 20% to 25% over the past few years.
As result of these conditions, many business jet OEMs have begun downsizing their businesses and revising their production build rates. So what's the impact of all these conditions on Rockwell Collins? Well, the good news is that we are increasing our growth expectations for Government Systems from 6% to 8% as results of the stability in the defense market. And our recently completed acquisition of SEOS Group, a visual displays company serving the simulation and training market.
However, we are taking a $250 million reduction in our Commercial Systems revenue forecast that can be categorized into three separate buckets: First, about $20 million of this is from Boeing production issues, the impact of which we disclosed midway through last quarter.
Second: based on our analysis of the business jet market, we are lowering our revenue expectations in this segment by $180 million. 150 million of that reduction is due to lower OEM production rates and the balance or about $30 million is related to aftermarket revenues from fewer modifications and retrofits.
Finally, we think there is more risk out there on the horizon in our commercial markets. And while I can't tell you exactly where it will come from, we are taking an additional $50 million of revenue out of our plant. And as a result of these adjustments, we now expect Commercial Systems, in total, will be down about 10% from 2008 to 2009.
So as you might expect, we're taking aggressive actions to appropriately size our business and preserve shareowner value. First, we are lowering our research and development forecast to about $900 million. A little over half of the reduction from our prior guidance of 925 to $975 million is on the customer funded side as a result of rolling in last quarter's announcement delays of problems such as the KCX, CSRX and others.
On the company funded side, we're cutting at some discretionary programs related to future opportunities largely in business aviation that we expect will be delayed due to market conditions. I would emphasize here that we are not cutting any areas of R&D, where we're made customer commitment.
Even with these cuts, our investment spending will be leveled with last year or about 19% of sales, indicating our commitments to maintaining one of the highest levels of R&D spending in our industry.
In addition, over the next few weeks, we'll be reducing our work force by an additional 600 positions in order to size the business to market conditions. To keep layoffs at a minimum, we will also freeze salaries at 2008 levels for all executives and other non-production employees.
These and other actions should allow us to maintain operating margins at about 22.5%, despite a year-over-year reduction in revenues. Government Systems will realize benefits as a result of savings from the cost cutting efforts in our shared services as you saw in Q1.
Commercial Systems results will improve later in the year as the full impact of expense and headcount reductions gain traction. Overall, we expect 2009 revenues to be about $4.7 billion or just slightly less than where we ended in 2008. However, with the actions we are taking, we should able to deliver earnings per share in the range of $4.10 to $4.30.
Let me leave you with these take takeaways. We are operating in a very challenging environment, especially in our commercial markets. However, I believe we've crafted a realistic response to these dynamic market conditions.
This response will demonstrate the inherent strengths of our business with its balance portfolio and experienced and highly capable management team. And the shared service business model that gives us the insight to identify areas for expense reduction and the ability to lever those reductions across the enterprise.
So with that, I'll turn the call over to Pat to take you through the specific details of the 2009 first quarter results. Pat?
Patrick E. Allen
Thanks Clay, and good morning to everyone.
Let's get started by first reviewing our results for the total company that are shown on slides 3 and 4. Sales decreased by $54 million or 5% to 1.58 billion. And our reported net income declined by $3 million to 151 million.
However, earnings per share increased by $0.02 to $0.95 in the first quarter of 2009 as compared to $0.93 in the first quarter of 2008 due to the lower share count resulting from our share repurchase program. Our total company profitability metrics continue to remain high as we compare with our sales to after tax profits at a rate of 14.3%.
Looking at our cash flow results for the quarter, a what is normally our slowest cash flow generate quarter for the year, our operating cash flow came in at $21 million, $11 million lower than last year. The main drivers here were the timing of payments on accounts payable and compensation, partially offset by collections on receivables and the receipt of an income tax refund related to the renewal of the federal research development tax credit.
Turning to slide 5 and 6, we take a look at the first quarter results of our Government Systems business, which achieved a revenue increase of 5%. Airborne solutions revenue grew by 7% with 2 percentage points of that growth coming from the acquisitions income of both Athena Technologies and the SEOS Group.
The raining growth came from higher sales of simulation and training solutions and additional revenues and programs such as the Eurofighter Tranche 2 and the Common Range Integrated Instrumentation System.
Surface solutions were relatively flat as work on new program such as the Joint Precision Approach and Landing System offset lower revenue from data links terminals and lowing (ph) revenues on JTRS Ground Mobile Radios as the GMR program moves from development into field testing.
Government Systems operating earnings improved 22% and operating margin improved 340 basis points to a little over 24%. The increase in margin was due to favorable mix shift towards higher margin hardware sales as well as lower R&D, incremental margin on the higher sales, and lower employee compensation costs.
Turning to Commercial Systems, overall revenues were down 14% as OEM revenues declined 14% as well. Primarily due to the labor strike at Boeing and their prolonged efforts to ramp back up to pre-strike production levels while OEM growth related revenues in the business and regional jet market were relatively flat.
Aftermarket revenues declined 9%, driven by another quarter of tough compatibles for equipment sales to 787 stimulator manufacturers as well as lower revenues from service and support activities in the air transport aftermarket. And again aftermarket related revenues in the business and regional jet market were relatively flat compared with the same period last year. Finally, wide-body IFE revenues were down 49% due to our previously announced decision to cease investing in this area.
Looking at Commercial Systems operating earnings and margins, earnings decreased 29% and operating margins were 20%. The decrease in earnings was from lower sales volume in the absence of a favorable contract option exercise that helped last year's period. Now I believe that it was more partially offset by the reductions we made in R&D expenditures and the lower employee compensation costs.
Moving to slide 9, where 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 235 million of long-term fit, we have $441 million of short-term commercial paper and international borrowings outstanding at the end of the quarter.
These borrowing were used to fund our acquisition of sales, share repurchases, and other general corporate needs and increased our debt to total capital ratio to 31%. We are planning to pay off a good portion of the CPO (ph) for the balance of the year and move some of it to long-term debt in the coming quarters.
The updated status of the share repurchase program as of the end of the first quarter is detailed of slide 10. During the first quarter, we repurchased a total of 1.2 million shares at an average cost of $35.15 per share. This brings our total share repurchase activity to about 52 million shares or $2.3 billion return to shareowners through maintaining an active share repurchase program since 2002.
Now on to our final slide, slide 11, which contains the updated picture of our financial guidance for the full fiscal year. First as Clay outlined, we now expect total Rockwell Collins revenues for fiscal year 2009 to be about 4.7 billion. This incorporates an expected year-over-year revenue growth rate of 8% for Government Systems and a 10% decline for Commercial Systems. As such, Government Systems sales are expected to represent a bit more than half of our total revenues.
Second, our guidance for total segment operating margins is about 22.5% at the lower end of our earlier 22.5 to 23% range and reflective of our plans to resize the organization to market conditions.
Government Systems is going to be the margin leader for the company this year as the cost savings we implemented are leveraged across the organization. While we don't expect Government Systems to continue positive margins quite good as they were this quarter, we are looking at a number of... a number higher than we realized in fiscal year 2008.
And of course given the sales reduction in Commercial Systems and the timing for implementing our cost saving actions, we expect Commercial Systems margins to be down relative to 2008. It should be noted the second quarter will be a tough comparable for Commercial Systems as we recover from the Boeing production issues, tough aftermarket comparables; and due to severance expenses, we will be incurring in connection with some of our cost reduction activities. Therefore, we expect operating margin to come in about where it was this quarter for Commercial Systems.
As a result of the decrease to our sales expectations, we now expect EPS to be in the range of 4.10 to 4.30. This EPS range continues to incorporate a projected effective income tax rate in the range of 31.5 to 32.5%. We've also reduced our cash flow from operating activities guidance to be in the range of 675 to 725 million. This range includes the $75 million discretionary contribution we made in January to our defined benefit pension plan. We have also lowered our expected capital expenditures from about $170 million to about $150 million.
And with respect to our total R&D expenditure guidance of about 900 million, this is roughly... with respect to fiscal year 2008. However, it will see an incremental shift in mix towards customer funded as a result of our reductions in company funded discretionary R&D.
That concludes my comments on the financial results and updated full year financial guidance. So with that, I will turn the call back over to Dan.
Dan Swenson
Thank you Patrick.
We'll now go to Q&A. And in order to give everyone the opportunity to ask questions, we ask you to limit your first set of questions to two per caller. Now, you'll have the opportunity to ask additional questions and if you should have further ones, simply reinsert yourself into the queue, and we will come back to those questions as time permits.
Operator, we're now ready to open the lines.
Question-and-Answer Session
Operator
Thank you. (Operator Instructions). We will go first to Alex Hamilton with Jesup & Lamont.
Alex Hamilton - Jesup & Lamont Securities Corporation
Hi good morning.
Clayton Jones
Good morning.
Alex Hamilton - Jesup & Lamont Securities Corporation
Thank you for the color that you provided on the call. I guess the first question that I think is a lot of on... on a lot of minds of investors; can you talk about the weakness that you've seen in business jet? And I know you made a great reduction in your guidance there. Can you get us comfortable that there is not going to be a lot more headwinds on the business jet side?
Clayton Jones
Well, first relative to a color around it, I think it's been a fairly wide or reported mainly by the OEMs that have had public discussions early since about mid November that there was a precipitous shift, I think, as the economy worsen to the some... (ph) and I'll say worldwide relative to demand for business aviation. And you've seen OEMs be much more descriptive than I could to take actions relative to their workforce and relative to their production rates.
I would say from my perspective, we've seen a lot more impact at the lower end of the business jet market than the higher end. This is not a typical from previous cycles. And it is not unusual given the stresses that are on people, who typically buy mid to lower end business aviation versus the relative wealth of people that are able to buy the higher end. And so I think that trend is generally what we see.
Relative to the second part of your question, I would say I am not sure anybody can give you the ultimate assurance you need that in any part of this economy the headwinds are not going to get stronger. All I can say is that in the discussions we've had with all of our business jet OEMs, we've pretty much taken to heart as we all do... always do their forecast. We've added what is now become the infamous Kentucky vintage of our own feeling about where they're going to be. And then I would say in our guidance, and this is unique to us alone, and I think it's something we've not done in the past.
We put that additional $50 million of cushion in there, and our expectation of potential more bad news to come. Let me be quick to say that's not based on any insight information. I am not trying to suggest that is going to get that bad or that we've had any discussions with OEMs that would give us that impression. But clearly from the time I talked to you in November, where we were thinking 10 to $20 million cushion is enough, now you see what we've done and taken $180 million out. Who could have guess that? I doubt anybody could have.
Alex Hamilton - Jesup & Lamont Securities Corporation
Maybe I guess when you have a competitive or an OE coming out and say they've seen unprecedented deferrals. How can one... I guess what are the lead times there? So you see deferrals now. When should that impact your business or when do you account for that in your business?
Clayton Jones
Well, I think for most of the ones that they're talked about, we already have. And they're laced into this significant reduction we've taken for business aviation. So those that are saying, they are seeing those deferrals; and those that are seeing that impact already to their production rates, we've accommodated it in this base of $180 million reduction. And will it be more? It could be; absolutely, it could be. And that's why we've taken that additional $50 million reductions to accommodate that. And if you ask me do I think that's enough right now, today? I think that's enough.
Alex Hamilton - Jesup & Lamont Securities Corporation
Okay. And then the second part of my question more for Patrick. Corporate interest and tax rate, should we use this quarter's run rate going forward in the model?
Patrick Allen
I would say the tax rate came in right about, where... right in the middle of the range. It came in at 32%. So I think that's pretty good indication where we'll be for the full year now. There are going to be some ups and downs over the course of the quarters. It does get a little lumpy, but I think that's a pretty good rate to model with.
As it relates to interest, as I mentioned in my script where we planned on going up for long-term debt, so I wouldn't be surprised the back half of the year. We will see a little bit of an uptick in interest expense as a result of the higher rates on longer term into the curve.
Alex Hamilton - Jesup & Lamont Securities Corporation
Okay. Thank you.
Operator
We'll go next to Heidi Wood with Morgan Stanley.
Heidi Wood - Morgan Stanley
Good morning.
Clayton Jones
Good morning, Heidi.
Heidi Wood - Morgan Stanley
Clay, I want to a better understand some of the color... get a little color on the interplay between business jets and regional jet activity in the first quarter when you talked about flat revenues. The business jet you talked about the take off the land (ph) has been down 19% December. We have the full 4Q data. So did you see regional jet strength that offset the softness in business jet in the first quarter?
Clayton Jones
Well, we... I would at it if I had to characterize the two, because as you know regional jet is a much smaller proportion of that whole business in regional segment that we have there. But I'd say regional jets have been up a little bit, and business aviations were down a little bit, and I am talking, maybe, 1 to 2%.
So it's a relative balance in there, yes. But remember, there is a lagging effect. If you just imagine takeoff some landings, that doesn't necessarily relate to production rates. And for the quarter, production rate wind down really didn't have that greater than effect. We see most of that going forward in the year.
Heidi Wood - Morgan Stanley
Okay. So that is it fair to understand that $180 million you took out is more for, I mean, aftermarket than OE or how does that split between OE and aftermarket?
Clayton Jones
No. To reiterate what I said, Hidey, of the 180 million, about 150 is OE.
Heidi Wood - Morgan Stanley
Okay.
Clayton Jones
And about 30 is aftermarket as things that we had in the plan, which would be, I'd say more major retrofits and upgrades, which are probably going to be now more discretionary in nature with the tightness of the financial conditions won't be done? So the ratio is much, much more focused on the OE than it is the aftermarket, and most of that relative reduction in sales will come over the balance of the year.
Heidi Wood - Morgan Stanley
Okay, great. And then second question: can you talk to us, Clay, about your visibility into the large commercial aftermarket? I mean discuss between the retrofit equipment sales and the service spares and solutions. Where are you more concerned? Where do you feel more secure? And give us a sense as to why you feel anchored in your assumptions there.
Clayton Jones
You're talking about the air transport segment, airlines, everything.
Heidi Wood - Morgan Stanley
Yeah.
Clayton Jones
Well, I think it's hard for me to break out specifically the major retrofits versus just the MRO. But we have already with the estimates that we made earlier in the year of those numbers of fleet reductions that I talked about in my opening script. We've already significantly haircutted the aftermarket for the air transport sector. And to date, we are tracking very well to that both in the MRO side and also in the major retrofit side.
So, I can't give you an exact proportion of the two, Heidi; just because I don't have it in my fingertips here. But what I would say is the position we took about a quarter ago when we began to see the economy play out, and the airlines announce these reductions, we've actually been quite pleased to the way our forecast are tracking to the, I'll say, actuals for this first quarter and in the discussions we've had with the airlines.
I mean I read just this morning on Newswire that American Airlines said that despite the fact that their forward bookings are little weak, they have no plans to reduce their fleet team in further. And I think that's attendant to the fact that they are getting enough cushion from their operating cost and the price of fuel that they can afford a slight reduction in load factors. I mean airplanes are still fairly robustly full, even though the fleet capacity is reduced. And so even though if the economy continues to weaken, the airlines can most likely absorb that weakness because of the advantages they're getting in oil even as they unwind all these hedges that they made on higher level fuel.
Heidi Wood - Morgan Stanley
All right. Great, Clay. Thanks very much.
Clayton Jones
You're welcome.
Operator
We'll go next to Joseph Campbell with Barclays Capital.
Joseph Campbell - Barclays Capital
Good morning Clay, Pat, and Dan.
Clayton Jones
Good morning, Joe.
Joseph Campbell - Barclays Capital
Clay, maybe we can get some Tennessee vintage on the... what Boeing and Airbus might be up to on the transport OE side. You've said, you thought that traffic, I think this is now getting to be a consensus down 3%. I mean that would be a 9/11 kind of decline. And I guess the forecast rather than being as they were after 9/11 focused on the U.S. This is a sort of broad based global decline. We've never had Boeing and Airbus have... not cut their deliveries. How are you thinking about... Boeing said, well, for now our plans are flat, but we will be watching it.
Clayton Jones
Yeah.
Joseph Campbell - Barclays Capital
Air is the similar kind of comment. How do you... I don't know I mean, of course, this is probably more next year than this year. But how do you think about what that will do to Rockwell Collins?
Clayton Jones
Well, first thing, Joe, we are watching it as closely as you are. And I would say we don't know any more than you do. Boeing, Airbus will tell us exactly the same thing that they are telling you in the public as you would expect. My personal feeling is that, I believe, they can and will manage the roll rates to the level that they have suggested to the balance of 2009. And I think there is a lot of things that bode for that; I mentioned some of it. Some of the capacity relief has already happened as a result of Boeing strike, which we wouldn't have expected, but it's helped.
Joseph Campbell - Barclays Capital
I'm thinking more about just changing the firing order for as we go forward and how that might affect sort of future business rather...
Clayton Jones
Well, yeah, I was getting into that is that right now I'd say I am flying comfortable with our firing order for 2009. I would say I am uncomfortable for the firing order for 2010. And so, I believe if there is an ultimate impact that you suggested to this downturn that's going to affect those two major OEMs, I think we are much more likely to see it as we roll into... and I'll say our fiscal year 2010. So that would begin fourth quarter of this calendar year is where you are most likely to see those impact. So you've got these long lead items, you've got big deposits down. You do have some modernization happening around the world even as bad as it is. And I think that will sustain us in our fiscal '09. I think '10 is another story, and we're very watchful of that. I'd certainly give them the volatility wouldn't call it today, Joe, but that would certainly be on my mind.
Joseph Campbell - Barclays Capital
On the margins for the balance of the year, the commercial margins, where as expected, given the volumes, weak in the first quarter; and you talked about some actions that you are going to take. What we should we be thinking for the balance of the year? I mean they have to be very, very strong in order to make the year. Is it more that the military is going to be able to sustain these new higher margins or the military might go back to more normal kind of numbers, and the commercial guys give them the cuts you've taken will also get back up to more normal members? Kind of what's the mix up the two?
Clayton Jones
I'll let... let me let Patrick maybe give some more color on this. But let me give you general direction there, Joe. First of all, I think this quarter will be the highpoint for government, because we had a very stable mix, and they realize most of the full benefit of some of the actions that we took in the first quarter. But I think they'll still be consistently above last year.
So you'll see kind of a high water mark in first quarter, and then slight decline through the year, but still very robust margins. And the reason for that is quite simple. They're getting the full benefit of the shared service model we have, where we're reducing the operating expenses across the board. So we reduced operations expenses in our factory or in human resources or in IT. They get the full benefit of that, just having less overhead G&A.
For commercial margins, it's going to be a significant different story. But as most of the actions we're taking there have a very much a lag effect, because we are talking mainly about personnel reductions. And as an example, in this second quarter, we are going to pay the piper and a lot of those cost of those reductions plus we are going to see some impact of the first quarter roll into second quarter, where our inventory cost is that lower inventory ripples through the way we account for that into the second quarter. And so, we're not going to have the stellar second quarter for commercial.
But once that take us through the python, we think they're going to have a very strong third and fourth quarter that will now see the traction of all these cost reduction initiatives coming home to them. So, if you will, strengthening margins in the back half of the year for commercial, slight reductions in margins in government, but the shared service model still allows us if anybody is keeping book in a declining revenue scenario to increase our total segment operating margins by a few basis points.
Joseph Campbell - Barclays Capital
Terrific. Thanks very much.
Clayton Jones
You bet.
Operator
We'll go next to Richard Safran with Goldman Sachs.
Richard Safran - Goldman Sachs
Good morning.
Clayton Jones
Hi, Rich.
Richard Safran - Goldman Sachs
Just wanted to talk about defense for a second; I think last quarter you talked a bit about the draw down effect that you would have in Iraq. And I just want to know that given the ramp up of forces in Afghanistan; are there opportunities as there was... that arise as a result of that build up?
Clayton Jones
Rich, I don't think we're going to see anything significance there. As we... as you look at the operations there, it's primarily manifesting itself in the supplementals. Our expectation actually is that in net-net, over the next couple of years, we'll see supplemental decline in general. And as we said in the past, we only get really two benefits out of supplementals: one is our DAGRs and others ARC-210. And I wouldn't expect any enhancement to those funding levels in the supplemental as a result of the shifting of forces. Most of them that go over there are going to take the DAGRs and the ARC-210s that we've already acquired with them. So no, I don't expect benefits there.
Richard Safran - Goldman Sachs
Okay. And just lastly, just want to know if you could just give us a bit more in the specifics, maybe quantify segment margin guidance... what you are expecting for government and commercial?
Patrick Allen
What I'd say, Richard, is if we take 22.5% as the total segment operating margins, government will be a little bit above that, commercial will be a little bit below that. And the commercial margins will probably be the most volatile of the two. As Clay said, the second quarter is going to be down roughly where it was in the first quarter, and then we'll see improving margins in the third and fourth.
Richard Safran - Goldman Sachs
Okay. Thank you very much.
Clayton Jones
You're welcome.
Operator
We'll go next to Myles Walton with Oppenheimer.
Myles Walton - Oppenheimer & Co.
Thanks good morning.
Clayton Jones
Good morning, Myles.
Myles Walton - Oppenheimer & Co.
Clay, I was wondering if you could comment on some of the outlook for the defense side, particularly the defense communication phase. And some of the developments over there of course of the following to the winter on TTNT versus the MAVL (ph) and also kind of your outlook for both JTRS and MIDS. I know I am turning a lot of acronyms out there, but I think it's very important space to you for longer terms; just kind of wanted your update thoughts on defense comp general.
Clayton Jones
Yeah, I'll glad to, Myles. First let me say globally that we still feel good about defense comp for a lot of reasons. Number one is the continuity we are seeing in Department of Defense gives us some encouragement, because people like Secretary, Gates, and others have already reviewed these programs specifically JTRS here within last six months. And both they... the civilian leadership and the military leadership have come out strongly, endorsing the direction for network communication in general and JTRS as a primary function of enabling that specifically. So that sort of policy direction makes us feel good so far. Now could the new administration come in and review that? I think very likely to happen, but we believe that there is institutional acceptance of that.
Number two: the programs are tracking very well. I mean since our earlier problems with GMR, the Ground Mobile Radio of JTRS two, three years ago; that program is progressing very nicely. As I mentioned or the pattern I mentioned, it's moving into fuel testing. That fuel testing is going very well. Some of the earlier problems with the wideband network waveform have been resolved, and we are getting very good performance out of it.
And so long as those programs stay healthy and tend to progress, we feel good about them. And then the other issues you say of certain waveforms like TTNT and others. They're still works in progress. They are still very much in development as they make decisions of where to put them in and how to put them in. And that's relatively small in terms of the materiality of it, but important in terms of its future capability.
So overall, I feel good about that. And I think data links will still be the way the military operates in the future. And it's fundamental to the belief that network communication and enhancing the soldiers' situation awareness through bringing more the forces together as you do in your office, and as people are doing via the Internet. I think that's a clear wave of the future, and one that will be sustained, and we're in the middle of it.
Myles Walton - Oppenheimer & Co.
And Patrick, could you comment on general corporate expense? Looks like you had a nice improvement in the quarter and sort of the part the efforts that are ongoing to maintain margins here. But what's your outlook for the full year? I think it was $53 million in fiscal '08, and obviously you're tracking well below that.
Patrick Allen
Yeah, I would say the trend that we... you saw in the first quarter will continue, Myles. It's a combination of both, as you mentioned, of the cost reduction actions that we're taking as well as slower employee incentive compensation costs. Both of those are leading to lower general corporate net. And I think the first quarter's indication of where it will go for the balance of the year.
Myles Walton - Oppenheimer & Co.
You could have 25 to $30 million general corporate unallocated?
Patrick Allen
Yeah, I would say probably close to the 30.
Myles Walton - Oppenheimer & Co.
That's great. Okay, thank you.
Operator
We'll go next to Joe Nadol with JPMorgan.
Joseph Nadol - JPMorgan
Thanks good morning.
Clayton Jones
Good morning, Joe.
Joseph Nadol - JPMorgan
Clay, on the COGS, as you look at your business, I mean obviously you've been doing a good job, I think ratcheting down G&A and CapEx, and looking at all these more discretionary areas. I'm wondering if you could talk about just the business, the operating cost and I guess the cost of goods sold line more specifically. And how flexible is the company? How scalable is it down in certain areas more than others? I'm just thinking certainly your product areas are going to have demand reductions of 50% or more. Others are doing much, much better than that. How can you move people around and how can you maintain your productivity?
Patrick Allen
Joe, this is Patrick. What I would say is that we've... I think we've demonstrated the flexibility in prior cycles to be able to move production, move engineering talent across the organization. We're doing that right now to help contain cost and get focused, give as many folks to play as we can. So we'll continue to do that.
As it relates to cost of goods sold, and I'll say the margin pressures I've seen with falling demand. You can sort of see what's happening right now. We are seeing margin pressure as volumes comedown. We're going to continue to see that margin pressure, and we'll continue to try to offset that as best we can by reducing the infrastructure size and et cetera. But there is point, which I'd say we've reached that point at Commercial Systems, where we're going to continue to see margin pressure as sales decline. So at the end of the day, based upon what we've seen to-date, we are able to maintain margins, but have declines 50% as you suggest, there will be continued margin pressure.
Joseph Nadol - JPMorgan
Yeah. I mean I am just thinking back to last cycle. Your commercial margins dropped quite a bit and there were some IFE issues in there that really kind of marred or mucked it up a little bit in terms of evaluating it. But I guess thinking through here, we're still... your average incremental margins in those 40s... in the high 40s is kind of what we would expect. Is there a tipping point at which the sales declined just a lot more than you're thinking? We have what happened last cycle. Or do you still have a lot of confidence you can keep things to more moderate declines in margins?
Patrick Allen
I think the margin decline will be more moderate this time around. And I point to two things that occurred last cycle that are going to occur or at least haven't surfaced yet. One is the IFE decline, and I think in 2002 it was somewhere in the order of about $40 million of margin pressure associated with IFE; that's not occurring this cycle. We'll continue to maintain profitability in our in-flight entertainment business.
The second thing is pension headwind. We had a significant pension headwind in 2002. Now, we are not seeing that this year. That's one that may where it's head in 2010, however. As we missed both the decline and the discount rate and a lot of the asset performance, because we had September 30th measurement date. But at least as you really get into balance of 2009, those two headwinds are there.
Joseph Nadol - JPMorgan
Okay. And then for second question just on the balance sheet and on the cash flow or the use of cash outlook, you've been... adding a little bit of debt. And as you mentioned, Patrick, you're going to term some of that out here go longer term. Just wondering are we seeing the beginning of an evolution here in the capital structure of the company, which is for a long time really been very little to know net debt. In that context, how are you thinking about share purchase?
Patrick Allen
Well, I think we still have share repurchases as an element of our capital employment strategy. I think we are still going to maintain an investment grade rating. Well, our debt pickup from virtually nothing to little bit I think the answer is yes, you've already seen that. I think the total amount of the debt isn't likely to change the whole lot, maybe come down a little bit over the course year, but the compensation, as you mention will change.
Clayton Jones
Yeah, let me add to that, Joe, because I think that's an important point. A lot of semi cash issues that lot of companies are facing now, we are fortunate not to be having to deal with. We have an investment grade rating, the highest in the aerospace industry, which gives us plenty of access to capital. We have already frozen the high end benefit pension plans. So much of that issue is behind us even though we still have to service the one we have now at least the amount of drag as Patrick talked about has gone.
And as many people have sort of actually criticized from time to time having an under leverage of balance sheet, it's serving us very well now. It will allow us to continue to take advantage of the share price now and keep the share repurchase program active, which we will do, and to still be able to go out and do these very important acquisitions, which we talked about, we did two of them here in the last year. So I think we are in really great shape financially. We are not constrained like a lot of companies. I think we are feeling right now to go out and position ourselves for the growth that we inevitably will get when we come out of this sort of weak period.
Joseph Nadol - JPMorgan
Okay, thank you.
Clayton Jones
You bet.
Operator
We will go next to Robert Stallard with Macquarie.
Robert Stallard - Macquarie Research Equities
Good morning.
Clayton Jones
Hi Rob.
Robert Stallard - Macquarie Research Equities
Hi Clay. I'd just like to briefly go back to the business jet area. Looking at OEM and aftermarket, I was thinking if you could give us a little bit more color as to what exactly you are projecting for OEM and aftermarket to be down this year?
Clayton Jones
Let me see if I can find that, Rob. I think we're probably looking at for the year, and you're talking about specifically for the business and regional part?
Robert Stallard - Macquarie Research Equities
I guess right, yeah.
Clayton Jones
I think we're probably looking at a business jet OEM for the year being down in the order of high single digits, and the after market about the same.
Robert Stallard - Macquarie Research Equities
Because you noted that's the business jet utilization have been very weak in Q4 to have your aftermarket only down high single digit. I know there is a regional jet element there. That would seem relatively optimistic given the recent trends in activity?
Patrick Allen
Well, the one thing I'd say, Rob, is we've started to see that weakness in the back half of last year, double-digit declines in the regional jet... I'm sorry, business jet take-offs and landing. And so I think the comparables are getting a little bit more favorable, especially during the back half of the year.
Clayton Jones
Yeah. The other thing I'd say is remember, we're flat in the first quarter. And I gave you a full year impact. So if you're sort of looking at it, the... so let's look at what happened. Flat this first quarter, increasing maybe into double-digits for the back half of the year, but keep taking advantage of a little bit better comparable, especially in the after market. So rest of the year, it might look worse, but this is flat period in the first quarter sort of balances that out to give that high single digit number.
Robert Stallard - Macquarie Research Equities
Okay. And secondly, you noted in the past that the helicopter market on the defense side has been pretty healthy. Has there been any development there? Have you seen any programs slipping to the right or any other problems?
Clayton Jones
In the... which market, Rob?
Robert Stallard - Macquarie Research Equities
In the helicopter upgrade market.
Clayton Jones
In military?
Robert Stallard - Macquarie Research Equities
Yeah.
Clayton Jones
No. Actually, that's stayed fairly robust. So no, we haven't seen any decline in that at all. It's been very study and that cash cockpit of ours that open systems architecture has been very well received. The only thing we've seen that has been a relative decline in that are those programs that have been cancelled that I talked about in the first quarter. We had the ARH cancel, so we run that. We had the CH-53 modification upgrade canceled.
Patrick Allen
CSRX.
Clayton Jones
CSRX has now been delayed, and we're waiting on that to happen. So except for those sort of new programs that have changed that we've already disclosed, we've seen no subsequent impact of that, and the stronger programs that we're already on are proceeding the pace.
Robert Stallard - Macquarie Research Equities
Okay. Thanks very much.
Operator
We will go next to Ronald Epstein with Merrill Lynch.
Ronald Epstein - Merrill Lynch
Good morning.
Clayton Jones
Good morning Ron.
Ronald Epstein - Merrill Lynch
Clay, you mentioned your renewed focus on M&A and the two acquisitions you made this year. Can you elaborate some more on what you're thinking about M&A and your strategy going forward, particularly with some of the opportunities that could arise given the market conditions?
Clayton Jones
Yeah. Well, first thing I wouldn't say it's a renewed focus on M&A, it's the same focus on M&A. I mean you know what we've done over the course of our history. We like these small bolt-on type acquisitions that many of them are private companies that add capability. And the two that we recently did are perfect example. Athena gave us a great controlled capability to add to our communication and navigations position for UAVs, which is as everybody knows a hot market.
And then SEOS really kind of completes our capability for simulation. They have a world leading display capability to go with our visual systems and our ability to put a full similarly together. And by the way, this isn't aside. I... again mentioned that was an area of strength. We all remember those deferrals of stimulator programs over the last year-to-year and a half. All the deferrals are coming in now as the military has seen the advantages of using a lower cost simulation capability that we always talk was true, and we solved that in space first quarter.
So those are great examples what we are looking for, Ron. And I think to the basis of your question, in times like this, where small companies are going to be particularly finding difficult times in credits and then growth, we think there are going to be enhanced opportunities to add more of those kind of companies to our portfolio.
Ronald Epstein - Merrill Lynch
Okay, great. One quick question for Patrick: when we think about the evolution of the cash flows through the year, how should we think about that?
Patrick Allen
As you probably noted, Ron, we tend to be very seasonal on cash flow; light in the first quarter, and accelerating through the back half of the year; and I would continue to expect that to be the case this year.
Ronald Epstein - Merrill Lynch
Okay, great. Thanks.
Operator
We'll go next to David Strauss with UBS.
David Strauss - UBS
Good morning.
Clayton Jones
Good morning, Dave.
David Strauss - UBS
Clay, did I hear you say on business jet OE that it's going to be high down single digits?
Clayton Jones
That's correct.
David Strauss - UBS
Okay. So if I do the math on that, 150 million, you've taken out the OE side. So you had previously been forecasting that business jet OE was going to be up high single digits?
Clayton Jones
That's correct.
David Strauss - UBS
Okay.
Clayton Jones
Yeah, that's absolutely right. So that's the kind of reversal we've seen.
David Strauss - UBS
Okay. 77, can you give us an update there as far as payments from Boeing? And then what are you thinking about as far as a ramp up on year end is Boeing... If Boeing is able to actually meet its newest schedule, where they are calling about first delivery early next calendar year, when would you start seeing the benefit of that?
Clayton Jones
Assuming Boeing is able to keep that schedule, we probably see the benefit of that in the first quarter of 2010, our fiscal year, must be the fourth quarter of this calendar year, remembering. We have already produced quite a few units already. It has been shipped to Boeing for the first few aircrafts. And so the ramp, we really kind of began for the production units that a little bit further down the road, maybe unit 10, 15, 20, something like that. So I would expect to see that probably at the beginning of next fiscal year.
David Strauss - UBS
Okay. And then an update on payment from Boeing?
Clayton Jones
How shall I say, going slow?
Patrick Allen
We have got to paid a little bit for some of the hardware deliveries, but we are still working, what we call our NRE assertions, the engineering change orders, we are still working that. And there are still quite a bit of hardware, we have to get paid for.
David Strauss - UBS
Okay. So is that upside to you cash flow forecast at this point?
Patrick Allen
I wouldn't care on it. I mean, I think it's potentially, there maybe a little bit of upside.
Clayton Jones
Both brings internal, Dave. We've been talking about that for how long... a year and a half?
David Strauss - UBS
Right, right.
Clayton Jones
So, we are still it working with them. We are not going to do anything stupid, but we certainly would like to see that come when it comes. And as you know, right now Boeing has put out a policy, which we appreciate that says as soon as we take the items that we symptom and put them in black label form, they are incrementally paying us in advance of the aircraft delivery. So we appreciate that, but that's kind of a slow going process.
Patrick Allen
With any indication, we reclassified our Boeing receivables from short term back to long term this quarter, so...
Clayton Jones
That gives you a sense
Patrick Allen
Yeah.
David Strauss - UBS
Okay. Thanks guys.
Clayton Jones
You bet.
Operator
We'll go next to Robert Spingarn with Credit Suisse.
Robert Spingarn - Credit Suisse
Good morning guys.
Clayton Jones
Good morning, Rob
Robert Spingarn - Credit Suisse
Going back to biz jet for a moment here, you've already talked, Clay, about the idea that on air transport if there's going be weakness, it's likely a fiscal tandem event. And with that in mind, can you talk about the velocity of the downturn in biz jet?
You touched on that the first quarter was flattish. We are going to see more at the back end of the year, but where I am going with this is at least on the OE side, which seems to me, it's going to get incrementally worse as we go through this year and into next year. And if we have the same problem in commercial air transport, can you offset both of those things on the OE side with some kind of recovery in... on the spare side and aftermarket or in military?
Clayton Jones
Well, we're going to have to wait and see what that velocity is. Rob, I would not argue with you directionally. I think it depends on how the economy continues to weaken or recover, but we're fully watching and anticipating that we could see this weakness extend, I would say, into 2010, and we're having to deal with that.
Couple of interesting things here; first of all, as compared to 9/11, where it just all happened at once, and we could do sort of the big bang theory in terms of taken actions, it's not happening all at once here, it's extending out. And so unfortunately, that's why you've seen us having to do some incremental adjustments to our forecasts and to the actions that we're taking. Because I would not have taken these actions in November, because none of our costumers were saying that they are going to reduce their production rates at that time, and you can't take these six months ahead of time or 12 months ahead of times and still meet the commitments you have made.
However, given that we have time to look at it, to answer your first question, I full well anticipate that the proven track record of this company to make the adjustments necessary to size our infrastructure and find where the cost is using the shared service infrastructure we have to get down to levels if we have to get down there, I have full confidence this company can do that. You've seen us do it to date. You saw us do it back in 2002, 2003, and I believe we can do it again.
And do we have opportunities? We absolutely have the opportunities. 54% of our business this year will be military. We think that will stay strong into 2010, and we are well positioned across a diverse portfolio of the defense products. So we are not going to die, because one program gets cancelled.
And as you said, historically what we see in downturns like this is when the OE rate bottoms, like we are seeing it. Ultimately you see a pick up in the aftermarket, because you've taken all the airplanes, we are continuing to fly on and have to keep them safe and maintain. They can defer a little ways, but they can't defer it forever. And mark my words right now, when we began to come out of this, and we will someday, the first accelerator of that is my old phased recovery, which we'll begin the see it in the aftermath. So yeah, I think those are opportunities. I agreed with what you said.
Robert Spingarn - Credit Suisse
So, if I'm correct, we're interpreting your response to my question, we could see and you're ahead of the idea that revenues could be down in fiscal '10 from fiscal '09, but you should be ahead of that on the cost side, or at least you're going to try to be.
Clayton Jones
Exactly. I mean, and again all I can show you is what we've done in the past. We can go back, and in fact, we'll be talking later this week again about what we did historically in 2002, 2003, and look what we're doing now. I mean we are seeing a negative revenue flow for the year, and we are maintaining our operating margins, the segment operating margins.
And to me, I can't control the market, folks. Everybody knows that. There is nothing I can do. It's going to go where it's going to go. I can try to run my company as efficiently as I know how. And fortunately for me, I've got some extraordinarily talented and experienced executives and a great workforce that's turning to on that. And indicative of that is as we're forecasting 22.5% operating margins for the year.
If I can continue to do that, that's... I hope that's what you expect on me, and I hope that will be the better measure of the strength of this company. Because when we come out of this, folks, we are going to come out with guns blazing just like we did last time. We've got great market share. We've got great products across the board. We've got a great diversity of capability, and so that's how we are positioning this company in a nutshell.
Robert Spingarn - Credit Suisse
Okay. And just quickly, two quick things: is Boeing taking product at full rate now for the core legacy production lines? And then to Patrick: what is in the inventory increase? Is that Boeing products from last quarter, is that 787?
Clayton Jones
To answer your first question, the Boeing is taking product at the rate that they're building airplanes now. So, we're not seeing any, I would say, anticipated reductions in production rate that that's in essence to your question.
Robert Spingarn - Credit Suisse
While it was the recovery from the strike, are they backup to the pre-strike level with you?
Patrick Allen
What we're going to see in the second quarter, Rob, is still a little bit of weakness in Boeing, particularly as it relates to these production issues that they had toward the end of the last quarter. But they should be back to normal run rate probably mid quarter.
Robert Spingarn - Credit Suisse
And then the inventories.
Patrick Allen
And as it relates to inventories, first of all, I think buried in inventory increase is actually some good news. We were able to reduce finished goods pretty significantly, particularly the affect that first quarter we typically have fairly significant inventory build. So we were able to reduce that inventory build. And we did have the increases in both our production stock and our work in process. That was related, I think, largely to production, the Boeing production issues and the commercial decline. We are going to work that up over the course of the balance of the year.
Robert Spingarn - Credit Suisse
All right, thank you very much.
Clayton Jones
Rob, thanks for the question.
Operator: I think that that concludes our call with the kind of we are allowed here. So again everyone thank you for your participation on today's call. We plan to file our Form 10-Q shortly. And again thanks for joining.
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