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Rockwell Collins, Inc. (COL)

F2Q09 (Qtr End 03/31/09) Earnings Call Transcript

April 28, 2009 9:00 am ET

Executives

Dan Swenson – VP, IR

Clay Jones – Chairman, President and CEO

Patrick Allen – SVP and CFO

Analysts

Robert Spingarn – Credit Suisse

Howard Rubel – Jefferies & Company

Noah Poponak – Goldman Sachs

Cai von Rumohr – Cowen & Company

David Strauss – UBS

Joe Nadol – J.P. Morgan

Joseph Campbell – Barclays Capital

Ron Epstein – Bank of America Securities

Myles Walton – Oppenheimer

Operator

Good morning and welcome to the Rockwell Collins second 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, Lindsay. 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 detailed on slide two of this webcast presentation and from time-to-time in 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.

With that, I'll now turn the call over to Clay.

Clay Jones

Thanks, Dan. And good morning, everybody. As I reflect on the fiscal year that we are now halfway through, Charles Dickens couldn’t have written a better script about the markets we are dealing with. It’s the best of times and it’s the worst of times. On the one hand, our government market has been predictable and our business is generating the highest margins in its history by any standard world-class.

We’ve seen the capture of new business almost completely offset about $50 million of early year program delays and cancellations as we anticipate even stronger sales growth over the second half of the year for Government Systems. And we feel very good about how our company will fair in fiscal year 2010 and beyond, as we analyze the impact of Secretary Gates’ recent budget recommendations and a strategy that guided these pronouncements.

Finally, we have been able to find valuable new acquisitions such as Athena Technologies and SEOS to supplement our high growth areas and look forward to the closing of the latest deal for DataPath, which will make a key contribution to further strengthen our capacities in pursuit of network communications growth.

On the other hand, our efforts to anticipate the dynamics of a declining commercial aviation market have been extraordinarily challenging, as this market has been whipsawed by the global economic crisis, credit availability, customer strikes and production delays, and even populist demagoguery. Despite these conditions, which are out of our control, I am very pleased with the performance of our Commercial Systems business and the share of services that support them with a very quick and aggressive way as they responded to these rapidly changing conditions.

Indicative of that is commercial systems performance in the second quarter. Despite a 14% decline in revenue, they were able to turn in an operating margin of 21%, a bit lower than 2008, but better than almost any other commercial aerospace business can generate in the best of market conditions. And it should come as no surprise to anyone on this call that commercial market conditions have weakened further since our last call in February.

Cargo traffic is down and air transport passenger traffic has declined more than the 3% we predicted at that time. While fleet reductions attract actually fairly closely to our expectations, we see now a new phenomenon of reduced utilization of those aircraft that remain in service as airlines adjust to this slower traffic volume. But the most dramatic impact we have seen recently is in the business jet markets. By some measures, take-off and landings are down 30% from a year ago and every OEM has made significant reductions to their bill rates, which are being quickly implemented.

In February, we anticipated something of this nature happening and had established a $50 million sales discount in hopes that that would cover. Well, we were wrong and by a lot. Given our current view of the next two quarters, we have not only used up that reserve, but we also believe we will see another $200 million of sales erosion from our last projections, about two-thirds of which will be related to business jet OEMs and a third for the other commercial market conditions. This will result in commercial systems being down about $440 million or 18% from FY 2008 to 2009. But even as we deal with these extraordinary conditions impacting our tale of two markets, there is still plenty to feel good about.

First, just as it did after our spinout in 2001, our balanced business and shared service model is proving its value under battlefield conditions. Government Systems, which now makes up 57% of our revenue is proving a very meaningful counterweight to commercial market weakness. Specifically in the second quarter, Government Systems grew operating profit by 26% on revenue growth of 6%. Their operating margin of almost 24% was a testament to outstanding management performance and significant efficiencies generated across the shares services.

Second, our focus on containing cost has buffered some of the negative leverage you would expect from such a large reduction in commercial sales. Although our new guidance suggests overall company revenues declining about $250 million or 5% in FY 2009 compared with 2008, we expect to be able to deliver total segment operating margins of about 21.5% for a less than 50 basis point decrease from last year.

Third, we stepped on the brakes quickly to align our supply chain to market reality. Given that dynamic way this fiscal year has unfolded, this is no small task. Our inventory levels have declined $33 million since last quarter-end. And I’m particularly pleased with the way our people have managed finished goods. Over the second half, we should see additional progress in WIP and production stock as we work ourselves upstream in the supply chain.

We have already seen these actions help to deliver $137 million in operating cash flow in the first six months, and that’s after a $75 million voluntary pinch in contribution. For the full year we believe we will generate operating cash flow of between $625 million and $675 million, which should have us at or above 100% of net income.

Finally, we continue to make progress pursuing our business strategies. During the quarter, our simulation and training business continued its first quarter advances, growing at a double-digit pace. We negotiated an extension of our DAGR contract that will take this important program out to 2016.

Airbus has recognized us for the third consecutive year as their number one external supplier for quality and on-time delivery performance. And we have maintained our very high win rates of BFE equipment at those airlines that continue to take new aircraft. Clearly, these are difficult times in our commercial markets and a great deal of uncertainty remains about just how we will play out over the next few quarters. But in the midst of this turbulence, we will continue to manage those things we can control and put our company in a strong position with inevitable recovery.

With that, I will turn the call over to Pat to take you through the more specific details of our second quarter results. Pat?

Patrick Allen

Thanks, Clay. And good morning to everyone as well. So let’s get started by first reviewing our second quarter results that start out on slides three and four. Total company’s sales declined 4% compared to last year and net income decreased 2%, while earnings per share remained at the same $1.03 due to the beneficial impact of our share repurchase program.

Of note, our net income as a percentage of sales increased slightly from the 14.2% in the second quarter of fiscal year 2008 to 14.4% during the second quarter of this year. This improvement came despite the lower effective tax rate of 27.6% during 2008’s second quarter compared to 31.7% this quarter and provides context for the effectiveness of our cost reduction activities.

Turning to slides five and six, we have our second quarter results for Government Systems. Total Government Systems revenues increased 6% compared to last year from $576 million to $613 million. Airborne solutions sales increased $32 million, with $10 million of this growth coming from the acquisitions of Athena Technologies and SEOS Group Ltd.

The organic revenue growth of $22 million was primarily from higher sales of simulation and training solutions, higher production volumes on the Eurofighter program, as well as higher development revenues on the Common Range Integrated Instrumentation System program. Surface solutions sales increased $5 million, as higher sales from our work on Future Combat Systems and the Joint Precision Approach and Landing System were offset by lower data link systems revenues.

Page six shows the operating margins within Government Systems, which were again quite strong at 23.7% of sales compared to 20% a year ago. This increase in margin and the associated 26% increase in earnings was due to higher sales volume, cost reductions, and lower employee incentive compensation cost relative to 2008.

Moving on to page seven, our total Commercial Systems revenues for the second quarter decreased 14% from $610 million to $525 million. Revenues in our OEM business decreased $33 million, or 10%, to $295 million, as a result of Boeing’s gradual return to full production rates during the quarter and the decline in sales to our business jet OEM customers due to their initial cuts in production rates.

Our aftermarket revenues decreased $34 million, or 14%, to $213 million due to the absence of hardware sales to 787 simulator manufacturers that benefited 2008 and due to lower service and hardware revenues in both air transport and business jet aftermarket. You should note that the second quarter of 2008 was the last quarter in which we had meaningful hardware sales for 787 simulators. So that will no longer be a comparative factor as we move forward in the year. Finally, sales of wide-body IFE products and systems declined from $35 million to $17 million, as we experienced the anticipated decline in that product area.

Slide eight details operating profit and margin information for Commercial Systems. We saw a decrease in Commercial Systems operating margins from 23% in the second quarter of 2008 to 21% this quarter. The margin decline was due to lower sales volume and the absence of royalty revenue that benefited the second quarter of 2008, which we were able to partially offset with our reduction in discretionary research and development expenses, lower employee incentive compensation costs, and other cost reductions.

On slide nine, we have our six-month year-to-date total company financial results for sales, EPS, net income, and operating cash flow. Of note on this slide is the increase in cash flow from operations to $137 million. (inaudible) strong cash flow included working capital improvements related to inventory and collections on accounts receivable, as well as lower income tax payments, which were partially offset by the voluntary $75 million contribution we made to our defined benefit pension plan, lower advanced payments in accounts payable, and payments for employee compensation.

Our efforts to improve inventory management were evidenced by the $31 million reduction in finished goods inventory as of March 31, 2009 compared to September 30, 2008 and, as Clay mentioned, the $33 million reduction in overall inventory from the end of our first quarter to the end of the second quarter.

Slide ten provides an overview of our capital structure as of the end of the second quarter compared to fiscal year end 2008. We paid down $56 million in debt during the second quarter so that our total debt outstanding was $618 million as of March 31.

Now on to our final slide, slide 11 that will provide updated details of our fiscal year 2009 financial guidance. Looking first at our revenue projections, we are now expecting revenues for 2009 of about $4.5 billion, roughly a 5% decrease from 2008 actual results.

In Commercial Systems, we anticipate full fiscal year 2009 revenues to be down approximately 18% from 2008. This reflects OEM revenues being down 20% and aftermarkets being down in the low-teens for fiscal year 2009 versus our prior assumption of high-single digit declines in both markets. Our forecast of a 44% decline for wide-body IFE product revenues is relatively unchanged. In Government Systems, we continue to expect full year revenue growth of 8%, which does not include any potential impact of the DataPath acquisition.

With regards to segment operating margins, we believe the business has now reached an inflection point where we will start to see incremental pressure on Commercial Systems margins. This pressure will result in full year combined segment operating margins of about 21.5%. Given the margins we have realized through this point in the year, we expect to see margins of between 20% and 21% over the remainder of the year to arrive at that full year result.

As we have said before, our expectation is that Government Systems will perform at a level above that average margin and Commercial Systems will perform at a level below. Part of the reason we will see incremental impact on margins is that we have decided to maintain our currently projected research and development expenditures of approximately $900 million, which will now represent about 20% of sales.

Looking at earnings per share, our expected range is now $3.70 to $3.90, which incorporates an effective tax rate of between 31.5% and 32.5%. Finally, given the reduction in net income, we now expect the full year operating cash flow will be between $625 million and $675 million.

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

Dan Swenson

Thank you, Patrick. In order to give everyone the opportunity to ask questions, we ask that you limit your first round of questions to two per caller. You may ask further questions by reinserting yourself into the queue and we will answer those additional questions as time permits. Operator, we are now ready to open the lines.

Question-and-Answer Session

Operator

Thank you. (Operator instructions) Your first question comes from the line of Robert Spingarn with Credit Suisse.

Robert Spingarn – Credit Suisse

Good morning.

Clay Jones

Hi, Rob.

Robert Spingarn – Credit Suisse

Clay, Patrick, I’m not sure how much detail you can give us here. But with the various adjustments in guidance since last summer and now two-thirds of the $200 million revenue drop coming from biz jet OE, could you size that business for us at this point so that we have some context for where it has come from and where it’s going to?

Clay Jones

Let’s take a look at this a second. While they are doing that, Rob, if you kind of look at it, we are a little bit of victim of our fiscal year because as we go into September time frame, October where we normally give the first guidance, it was before the real full brunt of the economic impact that’s come to bear on that market. And we were seeing really no reductions.

In fact, a relative increase year-over-year in business rate production because of those very strong backlogs that we all remember so fondly. Since that time – literally in that five-month period, we’ve seen the full brunt of those conditions I outlined in my opening statement there relative to the economy and even (inaudible) of the business jet in some of our public officials. And that has caused that rapid decline that we believe will see the full burnout in the second half of this year. And so it is a gradual over the course of the year decline that probably has that OEM market down about 25% as that –

Patrick Allen

Let me give you a little color around that. Our entire business in regional business is going to be down about 18% year-over-year. That’s about 27% on the OEM side. And just to put that in context to give you a flavor as to how bad the second half is going to be, our first six months is only about 5%. So we are going to see a precipitous decline in the second half of the year in the OEM area. Aftermarket is going to be down about 11% for the full year.

Robert Spingarn – Credit Suisse

Okay. But if I look back, for example, the ’08 results, and I look at I guess about $1.15 billion in business in regional, if I have those figures correct based on your filings –?

Clay Jones

Yes, that’s right.

Robert Spingarn – Credit Suisse

How should we think about that? And Clay, maybe to your point, maybe there is peak run rate, annual run rate that we want to talk about and then a trough run rate that you are contemplating at this point to take the fiscal year out of the discussion. And so if we look at that, is business jet OE $0.5 billion a year at peak and $300 million per year at trough? How should we think about that?

Clay Jones

Well, here is my thinking. And again, this is a fast-moving train. But my stance is that the biz jet OE guys are rapidly decelerating their production rate to meet these market conditions. And I think they will be at about a de minimus run rate by the end of our fiscal year. So I think they are moving over the next six months to size their inventory levels with the reality of the market, the reality of the used aircraft situation that we all know to get down to a run rate that I think will be at a trough, if you will, we hope by the end of our fiscal year. So think of it around September.

I think we’ve seen the brunt very rapidly approaching the trough in the aftermarket, because that was able to adjust much faster. You have already seen and you particularly have cataloged the utility of these aircraft down to the point I think you cited around 30%. And I think we are about at those levels and we see some maybe stabilization in the aftermarket, but not at the OE level. So I hope that most of the adjustments will be made within this fiscal year and then next year we will be dealing with some comparability because of the first half of the year, but at a relatively stable revenue level for business aviation. Does that answer your question?

Operator

The next question comes from the line of Howard Rubel with Jefferies & Company.

Howard Rubel – Jefferies & Company

Thank you very much. Clay, you were pretty good at getting ahead in terms of doing some reductions in employment early. Are there still some additional headcount reductions that you are contemplating or you are in the middle of taking on right now?

Clay Jones

I think you can pretty much assume, Howard, that if more volume comes out of our factories, which you can presume by this guidance change that’s likely the case that we will have to size it a little bit lower than it is right now, but I can’t give you a number on that.

Howard Rubel – Jefferies & Company

And then just a follow-up. The DataPath acquisition, if we look at the number of employees there and size it relative to what your productivity, your employees is, is that sort of fair that this is sort of a $150 million to $180 million annual revenue contribution?

Clay Jones

Well, right now we are not in a position where we can disclose their revenues, because obviously we have to close the deal and we have to be sensitive to the agreement from both parties. So I really can’t confirm that right now, Howard.

Operator

The next question comes from the line of Noah Poponak with Goldman Sachs.

Noah Poponak – Goldman Sachs

Hi, good morning.

Clay Jones

Good morning.

Noah Poponak – Goldman Sachs

I was wondering if you could give us a little more color on the margins. You had said that the commercial margin that 2Q would look a little worse and the second half would get stronger as you thought about the lag in the cost-cutting impact. And clearly the larger revenue decline hits you on operating leverage, but can you give us a little more color on how much deterioration you see in the back half in commercial? And then on the government side, you had said 1Q wasn’t sustainable, but you got pretty close there. Maybe a little color on what you see in the back half.

Patrick Allen

Yes. What I would say is we are going to see relative reductions in the Commercial Systems margins. And think about it as being the leverage on that the lower business jet OEM sales largely – I'm not sure I want to peg a number exactly, but suffice to say it would be below 20%. The Government Systems margins will continue to be strong, not quite as strong as they were in the first half as we see a transition from more hardware volume to more development revenues. And therefore we are going to see a little bit of mix pressure on the Government Systems side, but you will still see very strong margins on the Government Systems side, I’d say probably north of 21%.

Noah Poponak – Goldman Sachs

That’s very helpful. And as a follow-up on capital deployment, last quarter you talked about paying off some debt and you did that in the quarter. But you also didn’t buy back any stock compared to buying back a meaningful amount in the year-ago period. And you also seem to have a little increased focus on M&A here. So how do we think about the capital deployment in the next couple of quarters?

Patrick Allen

As we look at the second quarter, we had a couple of things going. We had a pension contribution of about $75 million. We had the DataPath acquisition that we are in the midst of negotiating. And quite frankly, the cash flow for the quarter surprised us on the upside a little bit for the second quarter. So I was not anticipating in the second quarter having significant share repurchases. Now as we look at the back half of the year, I would anticipate us to continue to be in the market for share repurchases, but we really don’t disclose the relative level of those share repurchases.

Operator

The next question comes from the line of Cai von Rumohr with Cowen & Company.

Cai von Rumohr – Cowen & Company

Yes, thank you very much. Clay, you mentioned that we will see sequential drop-off in biz jet. Two questions. First, is any of this because of excess inventory at the manufacturer’s level so that your production rate will go to a rate below what they are actually producing at? And secondly, could you give us – normally you don’t comment about quarters, but given this dynamic of a sequential drop-off, should we expect the commercial margins in the fourth quarter to be substantially different from the third?

Clay Jones

Well, the first part of your question is, obviously the business jet OEMs are struggling with inventory as they are – again, as they – because it’s such a rapid decline in the market, just their ability to size down their supply chain and operations obviously with all the moving parts they had is challenge. And so my sense is, yes, they are building inventory and they are rapidly, as they historically do, are moving to adjust to the proper inventories. And that is having a ripple effect into us. I wouldn’t say that our production rate will drop below what theirs are, but we are in constant contact with them as they make these changes in the good fortune that electronics company has is that we can stop our supply chain and our production rates a lot faster than they can.

So we are in the process of adjusting that. My sense is the bigger impact of these production rate adjustments will be in the third quarter and will get to a sustainable rate and then move into the fourth quarter. My sense also is that you will not see a big disparity in Commercial Systems margins in the third or the fourth quarter. It will be about level once we get down to this lower production rate. But you will see a very large drop-off from second to third quarter as a result of this phenomenon.

Cai von Rumohr – Cowen & Company

Thank you. And you kept your overall R&D flat and yet you mentioned that there was some bit less discretionary R&D in the second half. Is that going to be caught up in the second half? And is your $900 million of R&D the same mix or is there more government and less commercial?

Patrick Allen

The mix hasn’t changed much, Cai. We are anticipating I think slightly lower R&D for the second half, but not significant.

Clay Jones

A lot of the reductions that we took early in the year, Cai, will feather in over the year. So what’s really happened is that the sales have dropped below expectations, but we are not at a point we can bring R&D down much. We sort of telegraphed that at the last call by saying most of the discretion has been removed. And now we are at that point where we have customer commitments. Now we are in discussions with these customers and many of them are re-looking at a few of the development programs that might get some amount of relief. But what we are projecting now is what we think we know.

Patrick Allen

And one thing we are going to see, Cai, is we are going to see a shift in company funded research and development from Commercial Systems to Government Systems a little bit. So there will be a little bit of a shift from Commercial to Government.

Operator

The next question comes from the line of David Strauss with UBS.

David Strauss – UBS

Clay and Patrick, you talked about the business jets and why it was down [ph], business jets and RJs, but they were down in the first half when you are looking at the second half. Can you give us the same kind of numbers on the air transport on the large aircraft side? Why was it down in the first half and what do you expect in the second half?

Clay Jones

I’ll give you a color while Pat is looking at the numbers. You know, this is really a juxtaposition of these two markets because the majority of the air transport OE was down in the first half largely as a result of the Boeing strike. I think you all know that Boeing and Airbus have made whatever announcements they need to have announced at this point, the majority of which is not going to affect us greatly in this fiscal year. So most of the OE impact has already been felt, and what we are going to see in the balance of the year is just the continuous erosion and a little bit of the aftermarket as we see that utilization rate, which was a little surprise to us.

We are actually seeing that the airlines are not taking more aircraft out of service, but they are using the aircraft that they have in service less frequently. And they are flying them fewer hours so they – I would guess, so they can maintain those routes. And also I think they are having hard time finding the place to park them if they wanted to. But that utilization rate is obviously affecting a little bit of our MRO service and support, and then we are continuing to see an erosion in some of the discretionary retrofits and upgrades, which as you know are the most unpredictable thing we do as this passenger traffic has remained soft. We think a lot of that will come back. That’s the sort of pent-up demand part. But we will expect that to decline further.

Patrick Allen

And David, just to give you a few numbers, we’re looking at air transport OEM revenues being down 17% for the full year. Now, the first six months it was down about 26%. So you are going to see, say, roughly about a 10% decline year-over-year in the second half. The aftermarket, down about 14% for the year, which is about what we are seeing year-to-date. So I think the aftermarket is going to be pretty steady – a steady decline of about 14% in the second half of the year.

David Strauss – UBS

Okay, thanks. It’s great color. Second question, on the margin side, best I can tell, it looks like you are applying about a 17% to 18% margin for commercial in the back half of the year. It looks like from a revenue side you are back to like a 2006 run rate from a revenue standpoint and back then you were doing 20% kind of margin in commercial. So I guess – maybe correct me if I’m wrong there, and with the lower margin stages be attributable to just the giant drop-off that you are seeing.

Patrick Allen

First of all, I think you got the numbers pretty close there, David. And the way I’d describe it is we’ve got a much larger R&D build this year than we did in 2006. And that’s affecting margins, particularly in the back half of the year. We're not stepping away from those commitments. So, certainly as the drop-off is happening pretty precipitously, it does take a while to adjust cost structure as well.

Operator

The next question comes from the line of Joe Nadol with J.P. Morgan.

Joe Nadol – J.P. Morgan

Thanks. Good morning.

Clay Jones

Good morning, Joe.

Joe Nadol – J.P. Morgan

First question is actually on the government side. You had I think some good news in the quarter both on the supplemental side, the DAGR contract and JTRS made it through better than maybe some thoughts through the Gates review. Just wondering, Clay, if you can give a bit of an update on – big picture on how government looks the next couple of years, what the risk items are?

Clay Jones

Well, as I alluded to in my opening statement, Joe, we actually feel pretty good about at least the big directions that were set by Secretary Gates. The first thing I’d say out of that, the only real disappointment we had was the CSRX [ph] being canceled because we are on two of the three teams, and we felt pretty good about our chances of adding that, the portfolio that now going to go away. But as usually the case, with the ubiquity that we find ourselves on these programs, we think we have two real distinct opportunities that we are waiting to see how they may manifest themselves over the next year or two.

One is the aftermath of CSRX cancellation where we think there are going to be more opportunities for upgrades of the H-60s and the H-47s that will still be doing that mission, but if they are going to keep those helicopters around longer, it’s now much more likely that we will be involved in some margin upgrades to them. The other real nice opportunity is the cancellation of the presidential helicopter, the VH-71, which we did not have a major position on. We had some communications product. We now believe that there will likely be upgrades to the VH-3s, which were not going to be upgraded. There are about 11 of those similar to the upgrades we are already doing with the VH-60s. So this is going to sort of create opportunity.

And then the other things that – I guess the third thing I would say is it looks like a KCX competition is back on. And as you know, we are a fairly large partner with the Boeing team on that. And then as we all have been watching how that goes, at least that creates another opportunity. And then the last thing I would say is relative to what you were saying. We were very pleased that they revalidated the import of JTRS and networking, and even the FCS changes, although they were some vehicle reductions. Secretary Gates reiterated the importance of the networking part. And so, as you know, our integrated computer system as well as the communications part, we think, will still be used in good stead for the foreseeable future. So we think these were all the positives, with maybe a few negatives like CSR being in the middle of that.

Joe Nadol – J.P. Morgan

And then secondly, for Patrick, the employee incentive comp expense, you noted as a sort of margin supporter for both segments and for the corporate, and corporate expense down a lot. Just wondering if you could give an update on I guess the outlook here, quantify what’s going on year-over-year, and then perhaps more importantly, some sense of the mechanics here and how this is really generated so we can think about what it might look like for FY ’10.

Patrick Allen

Sure. We – the way I think about it, Joe, is we have an incentive compensation plan that goes throughout the company. And the payouts can range anywhere from 0% up to 200%. And it’s about $1 million a point. So last year we paid out, I believe, about 121%. So, about $121 million was accrued throughout the course of last year. This year, we are paying it about 20%. So you are seeing about $100 million reduction in the overall accrual. That accrual occurs ratably. But as we lower our forecast, we have to do sort of a cumulative catch-up adjustment for those reductions. So what you saw in the first quarter was we reduced it, I want to say, to about 43%. And then in the second quarter we reduced it now down to 20%. So we are now accrued down at the 20% level. And we had the benefit in the second quarter of the first quarter catch-up. Hopefully that was clear.

Operator

The next question comes from the line of Joseph Campbell of Barclays Capital.

Joseph Campbell – Barclays Capital

Good morning.

Clay Jones

Good morning, Joe.

Joseph Campbell – Barclays Capital

This is just an easy one. This 787 simulator sales that was cited as part of the aftermarket decline, we don’t tend to think of that as an ongoing thing. Maybe I’m wrong, but is – so in the second half of the year, I presume in the air transport business, the compares against the 787 are different, but there is something else that I guess you answered in an earlier question that will be eroding. I mean, we’ve just seen – as we listen to the various transport commentary, we’ve had some people down. I mean, Hamilton Standard was just way down. Other people have been up. What’s going on in your – I mean, in your air transport sales in the second half, do you still have the 787 stuff?

Clay Jones

No. Joe, there is no 787 sales in any of our forecasts for fiscal year ’09. None, zero.

Joseph Campbell – Barclays Capital

No, I meant the lack – I guess it's the comparative item where you shipped simulators –

Clay Jones

Simulators specifically, yes. We think that this quarter will sort of be the peak comparable. And if you recall back to when the 787 began to start slipping, and that was cause of why we are providing the simulator hardware, by the end of this year it drops off significantly I believe. By the end of this year, you will see very little comparable on that one. Is that right –?

Joseph Campbell – Barclays Capital

Right, just right.

Patrick Allen

And Joe, I think what we are seeing in kind of the back half of the year is a lot of the discretionary aftermarket initiatives in air transport are going away as the traffic comes down, as the airlines feel the cash flow pinch. A lot of the anticipated aftermarket initiatives, discretionary retrofits aren’t coming through as we had expected.

Joseph Campbell – Barclays Capital

And then on the military, I guess it was mentioned, the DAGR win and JTRS, can you explain for us what happened – the Secretary has decided I guess not to build all these FCS vehicles, at least not right away. How does the JTRS program, which at one point was pretty aligned with FCS, proceed given the Secretary’s decision on the vehicles? Is there a linkage or if they have been separated in a way that JTRS will proceed even without the vehicles, or what should we think of that?

Clay Jones

Yes. Well, it was actually separated some time ago, Joe, relatively, whereas they were indeed aligned to go onto the new FCS vehicles. But they were also directed to make them adaptable to the existing legacy vehicles as well. And as Secretary Gates continues to move investment into more near-term operability, things like the ICS, which had already been structured and accelerated to align itself within a development window to be applicable to the existing strikers and Humvees and everything else that we have today, so will JTRS. And the great thing about the networking continuing, it can be retrofitted and placed on those vehicles as well as the new FCS vehicles that are too calm [ph], as I understand they are going to restructure that program. So that sort of philosophy, Joe, has been in place for sometime within the DOD.

Operator

Your next question comes from the line of Ron Epstein with Bank of America Securities.

Ron Epstein – Bank of America Securities

Yes, good morning, guys. The simulation business appears to have done very well in the quarter. Clay, can you give us a little more color on that?

Clay Jones

Well, yes. A little bit of that, as you remember, about a year ago when we were saying a lot of delayed programs and that was hurting simulation business, a lot of that is coming back in. And so we are just seeing that big one as the catch-up part of it. Second, we’ve been very successful at capturing new programs, E-2D, most specifically, that we won a few quarters ago, and that development is beginning to ramp up. And then the third thing I would say is, in addition to sales growth, the profitability of that piece of our business, now that we’ve put the full brunt of the Rockwell Collins’ processes in place and begun the lean it out, it’s beginning to make a meaningful contribution. So I think it’s a combination of those three things. And we think it will continue in that area as we begin, we believe, to move troops out of the four battle area in Iraq and move them back to the United States. We have always felt the simulation is a more efficient way to train. And in fact, that’s the sort of the macro trend we expect that is happening and will continue to happen.

Ron Epstein – Bank of America Securities

Okay, super. And then you guys have brought up a couple of times that you’re continuing to invest in R&D and actually it is very good. On the CSeries program, can you give us a feel for how big a commitment that is for the company maybe in broad strokes and how that’s going?

Clay Jones

Well, I can’t give you a specific. We never give a color on any specific program or how much we are investing in that. Notably, the 787 and A350, we don’t provide that color either. But what I can say about the CSeries is it is not in the realm of an A350 or a 787 by any means. And number two, because they have selected Pro Line Fusion type derivatives, a lot of that investment, the initial investment will have already been put in place by the time we really ramp up the CSeries. So it’s an important program. It is something we’ve spent meaningful dollars on, but it is not in the realm of a brand new airplane like one of the big air transport aircraft because we are applying a lot of the existing technology that will go on some of those other aircraft.

Ron Epstein – Bank of America Securities

Super. Thanks.

Clay Jones

You bet.

Operator

(Operator instructions) Your next question comes from the line of Myles Walton from Oppenheimer.

Myles Walton – Oppenheimer

Good morning. A question for you, maybe Pat first, on pension. Is it fair to say at this point, into the next year, if you were to market today, maybe be a $38 million or $40 million headwind?

Patrick Allen

I think there would be some headwind. I didn’t speculate as to how much, because it changes by the day depending upon where asset performance is. I think we would see some moderate headwind, maybe $10 million to $15 million as it relates to the discount rate And then we would see some incremental asset headwind, but I’d hate to project how much.

Myles Walton – Oppenheimer

Okay. And then I understand the R&D commentary in terms of the projects that are ongoing and obviously commitment to maintain and gain share there. But I’m just curious as the timing rolls into 2010 and the manufacturers kind of slow down some of their R&D efforts perhaps, should we expect a benefit – significant benefits on your margin line as a result of reduced R&D? Or do you think that actually won’t happen in 2010?

Clay Jones

Well, I think one of the sort of trend things you can assume, especially since a lot of the discretionary R&D, the majority of it goes to the Commercial Systems business. There are not a lot of new programs that have been generated by any of the OEMs this year. And therefore, the additional programs that typically get added in year-to-year have been far less just because of market conditions. And then as we work off some of the programs and they are incremental over the next several years, you should see a general trending down in the overall R&D rate. But I wouldn’t say it’s an extraordinary rate, but the general direction should be less discretionary R&D rather than more just because of the market conditions.

Myles Walton – Oppenheimer

Okay. Trough R&D as a percent of sales has been 7% in the past. Is that kind of a benchmark to think about in terms of maintaining the discipline to spend at least at that rate?

Patrick Allen

I think that would be a floor, but certainly it would be too early to predict that what is going to be next year, but mainly because you’ve got to cash that against a lot of variables between now and then and the sales right next year [ph].

Operator

Your next question comes from the line of Howard Rubel with Jefferies & Company.

Howard Rubel – Jefferies & Company

Just wanted to go back to your – you used a word, Clay, you said de minimus production for business jets. So if you could characterize a little bit more on how you see this market playing out? Is it just going to go quiet at 60% of – excuse me, down 60% of the rate that we experienced at the peak, or do you see something that can change that any time soon?

Clay Jones

Well, Howard, it’s real hard to answer that question since I can’t get it right quarter-to-quarter. I’m hesitant to predict in that particular case. But I will say that historically at least that business aviation tracks the economy. And right now the economy is not in a very good shape and neither is the business aviation market. I think the biggest indicator of improvement in business aircraft will be when the economy recovers. And there are a lot of variables in there of the used market and pricing that are being looked at relative to how they sell these airplanes. But in terms of exactly selecting where that level of production is going to be, it would be hard for me to do. I guess I would stand by what I said earlier. And that is, we are hopeful that by the time we get to the end of this fiscal year, they will be down to a sustainable rate of production.

Howard Rubel – Jefferies & Company

Thank you.

Operator

The next question comes from the line of David Strauss with UBS.

David Strauss – UBS

That’s allocated between commercial and government?

Clay Jones

Could you say that again, you were cut off, Dave?

David Strauss – UBS

Sorry. The comp accrual that Joe was asking about, how was that allocated between Commercial Systems and Government Systems?

Patrick Allen

I would say it’s roughly 40% government, 40% commercial, and 20% general corporate net.

David Strauss – UBS

And then, Clay, in terms of thinking about beyond 2009 into 2010, I know you won’t give guidance. But just in terms of thinking about the headwinds, you are obviously going to have a very tough comp on business jets in the first half of next year. You’ve got pension, but you’re going to benefit because you had the Boeing strike this year. How to think about 2010, if you could give any color at all at this point?

Clay Jones

Obviously I don’t want to give guidance, but directionally, I think our government business will continue to be very strong. And I think you can count on performance in the general area of where you’ve seen this year. I see no reason why that performance will be any less good than what we’re seeing right now. The interesting thing in commercial obviously, that’s the big variable that we are all wondering about, However, all I would say directionally here is this additional weakness that we are experiencing this year actually I think helps moving into next year. Because rather than a very slow and gradual decline over the next year or so, I think when you have (inaudible) like this that drags the business down this quick, especially in one market, you tend to get it down and get it over with.

I would cite the 9/11 aftermath as more indicative of what we saw. And assuming we don’t have a swine flu and assuming we don’t have another war and all the things we experienced in 2003, by the time we got to 2003 we were seeing gradual improvement. And so I actually feel that this sort of bloodletting in this fiscal year makes the relative impact in future years somewhat more digestible. The other thing I think we are all watching is what are the big OEMs are going to do, Boeing and Airbus? I’m actually encouraged by the statements that have been said so far. Again, we don’t know how it’s going to break in the long-term, but I think many of us would have thought that they would have brought production rates down as they look into the future years and align their supply base before even now. And so there must be some strength underlying that that perhaps gives one optimism, but we will have to wait and see that as well.

David Strauss – UBS

Okay, thanks.

Operator

This concludes the question-and-answer session. I’d now like to turn the call over to Dan Swenson for any closing remarks.

Dan Swenson

Thank you. We plan to file our Form 10-Q, including our financial statements and footnotes today. So keep an eye out for that. Thank you for joining us and participating on today’s conference call.

Operator

This concludes today’s conference call. You may now disconnect.

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Source: Rockwell Collins, Inc. F2Q09 (Qtr End 03/31/09) Earnings Call Transcript
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