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Executives

Robert F. Weber - Vice Chairman, Chief Financial Officer, Principal Accounting Officer and Treasurer

Thomas A. Gendron - Chairman, Chief Executive Officer, President and Chairman of Executive Committee

Analysts

Julie Yates - Crédit Suisse AG, Research Division

Tyler Hojo - Sidoti & Company, LLC

Peter J. Skibitski - Drexel Hamilton, LLC, Research Division

William D. Bremer - Maxim Group LLC, Research Division

Peter Lisnic - Robert W. Baird & Co. Incorporated, Research Division

Sheila Kahyaoglu - Jefferies & Company, Inc., Research Division

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

Peter J. Skibitski - SunTrust Robinson Humphrey, Inc., Research Division

Woodward (WWD) Q2 2013 Earnings Call April 22, 2013 4:30 PM ET

Operator

Good day, ladies and gentlemen, and welcome to your Second Quarter 2013 Earnings Call. [Operator Instructions] And as a reminder, today's conference is being recorded. And now I would like introduce your host for today, Bob Weber.

Robert F. Weber

Thank you, operator. We would like to welcome all of you to Woodward's Second Quarter Fiscal Year 2013 Earnings Call.

In a minute, I'll cover the financial highlights of our second quarter, and Tom will comment on our strategies and markets. I will then comment on today's earnings release. And at the end of our presentation, we will take questions. For those who have not yet seen today's earnings release, you can find it on our website at woodward.com. And as noted in today's earnings release, we've included some presentation materials to go along with today's call that are also accessible on our website. An audio replay of this call will be available through April 27, 2013, and the phone number for the audio replay is on the press release announcing this call and will be repeated by the operator at the end of the call. In addition, a replay of this call will be accessible on our website for 14 days.

Before we begin, I'd like to summarize our cautionary statement, as shown on Slide 3. In the course of this call, when we present information and answer questions, any statements we make, other than actual results or business facts, may contain forward-looking statements. Such statements involve risks and uncertainties, and actual results may differ materially from those we currently anticipate.

Factors that might cause a material difference include, but are not limited to, future sales, earnings, business performance and economic conditions that would impact demand in the Aerospace and Energy markets. We caution investors not to place undue reliance on these forward-looking statements as predictive of future results. In addition, the company disclaims any obligation to update the forward-looking statements made herein.

For more information on risks and uncertainties facing Woodward, we encourage you to consult the earnings release and our public filings with the Securities and Exchange Commission, including our Form 10-K for fiscal 2012 and Form 10-Q for the quarter ended March 31, 2013, which we expect to file shortly.

Segment earnings, EBIT, EBITDA and free cash flow are non-U.S. GAAP operating measures that we use in the earnings release and during this call. The description of these measures and a reconciliation of each to the most comparable U.S. GAAP measure is included in the appendix to our slide presentation and in our earnings release and related schedules, all of which are posted on our website. Management uses this information in monitoring and evaluating the ongoing performance of Woodward and each business segment.

Turning to the quarter, sales for the quarter were $486 million compared to $469 million for the same quarter last year. Earnings per diluted share were $0.61 in the second quarter of 2013 compared to $0.55 for the second quarter of last year. Free cash flow for the first half of 2013 was $46 million, an increase of $64 million from a negative free cash flow of $18 million in the first half of the prior year.

Now I will turn the call over to Tom to comment on the results, strategies and markets.

Thomas A. Gendron

Thank you, Bob, and welcome to those joining us today. I'll start with some highlights for the quarter. Operating performance and market share were solid this quarter, reflecting that our lean initiatives are working. Continuing customer concerns regarding future economic strength have affected our first half sales. Airline demand for improved fuel efficiency is driving strong aircraft build rates and increasing revenue passenger miles for the solid aftermarket business. The market for industrial engines that burn compressed natural gas continues to be strong but was more than offset by a dramatic drop in the wind market.

Turning to Aerospace, commercial aircraft delivery showed strong growth in the quarter. Business jets continued to show signs of a slow recovery and rotorcraft and regional jets were stable. Commercial aftermarket sales in the quarter were up sequentially, although down from a strong comparable in 2012.

Our Duarte acquisition integration is proceeding as planned. The acquisition is targeted to help our overall strategy integrate the propulsion systems with the leading OEMs in the industry. Despite government budget uncertainty, including sequestration, military market segments were solid, notably military aftermarket.

Turning to our Energy markets. Compressed natural gas systems, predominately in Asia, continue to be a bright spot in our Energy business. The need for a significant natural gas infrastructure investment in the U.S. and elsewhere remain robust but the anticipated order growth has been slow to develop. We believe this is still -- represents a significant future opportunity for us.

The Wind business remains very challenging. In addition to the volatility related to inconsistent U.S. energy policies, we are seeing project delays and inventory management as a result of global economic uncertainty. More broadly speaking, our Energy market segments are being impacted by the stagnant global economy. Having said that though, we are seeing some positive indications across our Energy business for the latter part of this year.

In summary, we continue to invest in technologies and programs that we believe will grow our market share and provide enhanced customer and shareholder value. The global economy presented a challenging first half for Woodward. However, we are beginning to see improved order volumes and other positive signs that we believe hold potential for a significantly stronger second half.

Now let me turn it back to Bob for the financials.

Robert F. Weber

Thank you, Tom. This quarter I would like to modify our approach somewhat on providing financial information and focus more on key items of interest as opposed to largely reciting the press release. I will address my comments as they relate to our 2 segments, Aerospace and Energy, and then address some Woodward items in total.

Our Aerospace segment's sales for the second quarter of fiscal 2013 were favorably impacted by growth in commercial OEM sales and military aftermarket, including the $35 million impact of the Duarte acquisition. Organic sales increased 5% in the second quarter of 2013 compared to the prior year.

Aerospace earnings as a percent of segment sales were 15% this quarter, comparable to the same quarter a year ago. Segment earnings this quarter were positively impacted by the higher sales volumes and lower investments in research and development. Excluding Duarte acquisition, segment earnings as a percent of sales would have been 17% this quarter. The Duarte business is performing in line with expectations and was slightly accretive in the current quarter.

In our Energy segment, strong sales of compressed natural gas systems in the quarter were offset by a significant decrease of $30 million in wind turbine converter sales. Of this decrease, a portion relates to the impact of the anticipated expiration of U.S. production tax credit in calendar year 2012. The balance of this decline was unanticipated and reflects general uncertainty with respect to investments in large wind projects.

Additionally, softness continued in our reciprocating engine and industrial Turbine Systems sales. As Tom mentioned, we do see some positive signs for the second half.

Energy earnings as a percent of segment sales were 11% this quarter compared to 14% in the same quarter a year ago. Segment earnings were primarily impacted by the substantially decreased wind turbine converter sales volume and loss of related operating leverage. This was partially offset by increased pricing and favorable product mix.

Now I'd like to focus on certain specific elements of our consolidated financial statements. Gross margin, defined as net sales less cost of goods sold, was 28.3% of sales in the second quarter of 2013 compared to 31.2% for the second quarter of 2012. Gross margin percent decreased, primarily due to the loss in operating leverage associated with the wind turbine converter sales decline.

Selling, general and administrative expenses were $37 million or 7.6% of net sales this quarter compared to $41 million or 8.7% of net sales in the same period of 2012, primarily related to the favorable impacts of foreign exchange rates.

Research and development costs increased, primarily due to the completion of certain programs and lower related material purchases.

Our effective tax rate for the second quarter of 2013 was 15.7% compared to 28.3% for the same quarter last year. After removing the impact of the fiscal 2012 portion of the retroactive R&E credit restatement, the effective tax rate was approximately 26%. Last year's effective tax rate included a reduction related to a repatriation assumption change with respect to China. We expect the full year effective tax rate to be approximately 27%, which is largely consistent with the prior year.

Looking at the balance sheet and cash flows. Free cash flow for the first half of 2013 was $46 million, a significant increase from the prior year when we experienced negative free cash flow of $18 million for the first half. We generated $93 million of cash flow from operations for the first half of 2013 compared to $12 million for the prior year, related to higher collection accounts receivable and lean operational improvements but lowered inventory purchase requirements.

Capital expenditures increased to almost $48 million for the first half of 2013 compared to $31 million for the prior year period. We continue to believe capital expenditures for the full year will be about $150 million but subject to variability, as to the timing of major facilities expenditures that can be affected by weather and other factors. We now expect full year 2013 free cash flow will be approximately $75 million. We had $17 million of share repurchases for the first half of 2013 compared to $14 million in the same period of the prior year.

In the first half of 2013, we borrowed an additional $200 million related to the Duarte acquisition and used some of our strong cash flow to repay $40 million of term loan debt during this quarter, prior to maturity without penalty.

Lastly, let me turn to our outlook. As Tom mentioned, our first half was challenging and the global economy remains uncertain. Given this backdrop, we now believe fiscal 2013 sales will be between $1.9 billion and $2.0 billion and earnings per share will be between $2.22 and $2.35 per share for fiscal 2013.

This concludes our comments on the business and results for the second quarter of fiscal 2013 and our full year 2013 outlook.

Operator, we are now ready to open the call to questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first is coming from Julie Yates Stewart from Credit Suisse.

Julie Yates - Crédit Suisse AG, Research Division

So on the outlook, I'm a little surprised that the sales guidance range did not come down after the first 2 quarters were disappointed, especially in Energy. Is there an offset elsewhere? And then can you update us on your growth expectations by segment?

Robert F. Weber

On the -- so on the sales outlook, if you recall in the first quarter, when we added Duarte into the mix, I think the comment was made, "Well, that must mean you're a little bit less bullish on the other parts of Woodward." I think that was true and that's kind of where we're at again at this quarter. The first half, as we said, has been overall challenging. We mentioned there are some potential bright spots that we're seeing in the second half. And if you look at the mix of the first half to the second half, there's a significant improvement in the second half, which is largely in line with our historical patterns. So not a lot of change from historical pattern standpoint. We have some -- Wind is obviously been the biggest issue for the first half. And you can tell that $40 million for the first half, $30 million of which were in the second quarter, so a substantial impact there. There are some potential bright spots that may cause that to come back a little bit. We talked a little bit about the extension of the production tax credit might allow some fourth quarter impacts there, and we're hopeful for that. And a lot of the other areas, I think the Aerospace side of the equation has been growing largely in line in most areas. Commercial aftermarket, we saw strength in prior quarters. That has modified a bit but we're seeing good strong aftermarket sales in the military side of the equation. In the Energy side, outside of Wind, we've seen kind of a delay, a pause, the infrastructure growth is a little bit slower than maybe originally anticipated, but we do see that coming on a little bit stronger in the second half. So hopefully that gives you some color there.

Julie Yates - Crédit Suisse AG, Research Division

Bob, can you quantify how much the commercial aftermarket was down in the quarter and maybe update us on your outlook for the year just specifically for that market?

Robert F. Weber

Yes. Overall, just if we looked at the total, so commercial aero year-over-year was up roughly to 9%. I think we've called out a number similar to that in the past. And overall, we're at a 3% growth in commercial side of Aerospace. So you can kind of work from there the math on being slightly down, low single digits sort of range on commercial aftermarket.

Operator

And our next question is coming from Tyler Hojo from Sidoti & Company.

Tyler Hojo - Sidoti & Company, LLC

I just wanted to follow up to Julie's question. Maybe I can ask you like this: I mean, basically over the last couple of days, we've heard from GE, who lowered their outlook for large gas turbine. Caterpillar lowered their outlook, predicated on mining. And Textron lowered their business jet outlook. And they're all customers of you. So I guess, what I'm wondering is how do we think about that? Were you just being a little bit more conservative? Any comments you could provide would be helpful.

Thomas A. Gendron

Tyler, this is Tom. You did see the reports, and obviously those are 3 of our big customers. I think we have to look at it as we have factored that type of data into our outlook. And as always, you got to break it down by the market then by application. I think what you maybe can pick up from our customers' announcements as well as ours, the first half of our fiscal year, so the fourth quarter last year and this first calendar quarter, the economy didn't really follow the economic model that we use, and we saw pullbacks. And I think our customer base did, too. And you see a lot of comments that it was pulled back strong -- more than anticipated, and I think that, that was the case. We saw hesitancy that started in the fourth calendar quarter, and I think it was due to fiscal policy, uncertainty around the world, China changing governments, our election in this country, tax policy. Yes, we just saw people pull back and it kind of rolled into the first quarter. The Wind market, we knew was going to be down but it's down more than we thought, and we're still continuing. There may be some chance for the end of this year, a pickup, but it was down more than we anticipated. So you can combine those, we weren't the only ones that, should I say, were surprised by the severity or the pullback, but I think there was a lot of non-normal business cycle type things that were occurring. Going forward, we're seeing -- we still see some pressure on our reciprocating engine business. Now we have pockets of bright spots. As Bob highlighted, the compressed natural gas area is doing well. But we serve those mining industries and others, and those are down. The marine market is still down. And if you're tracking global logistics and the marine freight market, you'll see that it's down, so we're feeling that. So those ones came in, But -- and then on the Energy side, it's a kind of couple of things, power generation was down some but you see kind of oil and gas was flat. And we expect -- as we said in our prepared remarks, we expect to start seeing that order volume, which we are starting to get the orders, picking up in the second half of the year and going into '14. The Aerospace side, which was interesting, the OEM side was strong and it's really driven by good programs we're on and increasing line rates. We saw some pullback in the aftermarket -- and I wouldn't call it pullback, I would call it airlines being conservative on when they were spending their maintenance and repair budgets. We did get impacted by some of the new aircraft and delays of getting into service. So our initial provisioning sales were down, below our plan. Those didn't disappear. They're just pushed out as the aircraft start to be delivered. We expect those initial provision sales to materialize. So that's why we're starting to see the second half pickup. So the Aerospace side, we feel it's in strong shape. The Energy side, the orders are starting to come in. It will be at the latter half of the second half, more like fourth quarter, and into '14, as we start seeing these orders coming back.

Tyler Hojo - Sidoti & Company, LLC

Okay. Yes, that's very helpful, Tom. Just 2 quick follow-up questions. In regards to wind inverters, I think you said in the prepared remarks, down $30 million in the first half.

Thomas A. Gendron

$30 million in the quarter, $40 million in the half.

Tyler Hojo - Sidoti & Company, LLC

Okay. And I thought we were talking about down $50 million for the year that I think...

Thomas A. Gendron

We were, and we're expecting maybe now somewhere closer to $80 million down. So that's a substantial change. And it's just along with the pullback because of, if you want to say, the acceleration of orders last year to catch the PTC, the lack of orders and getting things online. And then as things dried up, customers are burning off their inventory or they're resisting to take any inventory. So it's a timing effect. But in our fiscal year, we're getting the brunt of it beyond. I think if you want to say, "Where's the surprise?" We knew the production tax credit was going away. We knew we were going to be down. The surprise was the pullback in inventory and how much inventory was spread around the world with some of our customers that they've actually just backed down on that. So it won't be until the production goes up that we're -- we'll start seeing orders, and that -- as Bob said, we're really thinking fourth quarter and into next year.

Tyler Hojo - Sidoti & Company, LLC

Okay, very helpful. And just lastly for me, I'm just curious if you could give a quick update on the conversion of locomotives that you guys have talked about quite a bit over the last 6 to 12 months. There was some press in the journal about BNSF running a pilot program. Just curious, do you play on that? And have you gotten more optimistic over the last several months?

Thomas A. Gendron

Well, we play in all those applications. So we will be present as those materialize. The case for going to LNG locomotive is really compelling. The amount of savings per year for the railroads is huge and the emission reduction is huge. So they have a very compelling case to go this way. The big issue for them is, I think, the technology is coming along, the ability to show that the locomotives can be converted is being proven. And -- but there's a lot of regulatory issues the industry still needs to work through, and they're working through it quickly. So we're active in that market. We're going to participate and it's going to be how quick they can get through all the regulatory issues. And then the major OEMs are going to be -- are preparing for that, and I would expect to start seeing it next year.

Operator

And we'll take our next question coming from Peter Skibitski from Drexel Hamilton.

Peter J. Skibitski - Drexel Hamilton, LLC, Research Division

Just on Energy again, in the second half of the year, are you expecting it down again in the second half of the year, just maybe low single digits instead of high single digits? What's your thoughts there?

Robert F. Weber

Yes. But on a more moderated scale. So you're right. It won't be down as significantly as in the first half. We are expecting some uptick from this level but possibly still down from the prior year. We had a very strong fourth quarter last year, and that is our pattern. And so we're going to be hopeful for that same strong fourth quarter but we'll see how that goes.

Peter J. Skibitski - Drexel Hamilton, LLC, Research Division

Okay. And I guess, it sounds like Wind doesn't really help you in the second half at all. So I guess, what you're seeing is a little bit of incremental order flow from the other end markets, maybe you see power gen coming back a little bit and mining a little bit. Is that the way to think about it?

Robert F. Weber

That's true. We are kind of holding out hope that Wind may actually show some signs of life in the fourth quarter but that would be a wildcard. So otherwise, I think you're accurate.

Peter J. Skibitski - Drexel Hamilton, LLC, Research Division

Okay. And then I guess I want to ask you about, you'd previously stuck with like a 14% margin rate guidance for the year in Energy. Is that still the expectation? Or is that kind of pulled in here?

Robert F. Weber

Yes, that would be pulled in a bit. So you can see where we ended up for the year-to-date and the quarter now. We do anticipate an improvement from there. And I would like to point out that when you take out the impact of the Wind decline and the, I'll call it, reverse leverage that, that's giving us, there's some nice pockets of profit improvement going on in the rest of the business. So we do anticipate that, that will come back a little bit, and we won't be that far off of that target by the time we get to the end of the year.

Peter J. Skibitski - Drexel Hamilton, LLC, Research Division

Okay. So pretty close to 14% for the full year -- not for the full year but for the second half of the year?

Robert F. Weber

No, for the full year, pretty close to that number.

Peter J. Skibitski - Drexel Hamilton, LLC, Research Division

Okay, got it. And then guys, the other thing I want to ask about, we had this military sequestration that's happened now for fiscal '13. It sounds like you're not feeling it at all as of yet. Do you get any indications at all that you may be impacted in the second half of the year from sequestration? And maybe you can give us a sense of what your expectations are for growth in military in H2?

Thomas A. Gendron

Yes. I don't think you're going to see a huge impact. It will probably be relatively flat. But it may surprise everyone on the call, but overall for the year, we'll probably be up low single digits year-over-year. A lot of that is, it's how the budgets are put in place, the repair and overhaul, the fleet that's going on, those type of things that are still coming through. Our long-term belief is that Military will be hovering around flat, as we look out over the next number of years. And it could go plus or minus a little bit over flat, a couple of points, but that's our expectation with the portfolio we have and what we see in the defense budgets and the activities that we participate in. So I think you just kind of plan for that. This year, yes, a little up this year but basically flat going into the next couple of years.

Peter J. Skibitski - Drexel Hamilton, LLC, Research Division

Tom, is Precision guidance in maybe both U.S. and international, has that been a big pocket of strength for you kind of this quarter and going forward?

Thomas A. Gendron

That's been good still. But I have to tell you, one of the biggest areas for us was military aftermarket. And when we say that, what that really means is getting -- especially rotorcraft, they had heavy use in the wars that are still going on, and that's been probably the biggest pocket of strength.

Operator

And our next question is from William Bremer from Maxim Group.

William D. Bremer - Maxim Group LLC, Research Division

Most of my questions have been already answered. You've provided some very good color. You mentioned increased pricing across both segments. Can you elaborate on that? Where are you seeing some pricing now?

Thomas A. Gendron

Well, Bill, when we can get price realization, we try to accomplish that. At the same time, there's a lot of pressure from customers trying to work you in the opposite direction. So it's a combination of just working value and ensuring that where we can get price, we get it. So it's kind of that general. So we do what we can, and we did accomplish some in the first half.

William D. Bremer - Maxim Group LLC, Research Division

And what type of look-through do you have in terms of the -- your Energy segment right now? How far out are you starting to see some things percolate? You mentioned the back half of this year, but how does '14 look?

Thomas A. Gendron

My belief is that you'll see our Energy segment improving through the second half of this year, and then continuing to improve as we go into '14.

Operator

And our next question is from Peter Lisnic from Robert W. Baird.

Peter Lisnic - Robert W. Baird & Co. Incorporated, Research Division

I guess, first question on Energy. If I look at the op margin, at least on a sequential basis, revenue up but margin down. So can we ascribe all that to the kind of the Wind absorption hit? Is that right? Or is there something else there in the mix? I would have thought that maybe margin would have been a little bit stronger if it was just Wind and the mix from Wind is negative.

Robert F. Weber

No, the -- I think we've said from time to time that the Wind mix isn't as negative as I think from time to time has been ascribed to it. So it is -- largely that's the impact. But as I mentioned, I think from the rest of the business, we've actually seen some profit improvement. I'm not going to use grandiose terms but some nice movement in profits in both the industrial turbine side and the reciprocating engine side, but that was totally offset by the Wind.

Peter Lisnic - Robert W. Baird & Co. Incorporated, Research Division

Okay, all right. And then, as you look to the back half, and I may have missed this, but it sounded like you said that around that 14% margin is maybe not going to be there but kind of close, but that would require a pretty significant step-up in the face of another $40 million volume headwind that you've got in the back half of the year from Wind. So how do we reconcile the margin acceleration off of the first half into the back half with still another big hit from Wind in the back half?

Robert F. Weber

So a lot of the efforts, and we've been talking about them from time to time, you heard us last year talking about a lot of investments in manufacturing and lean and everything else. Obviously, those are gaining strengths. So as we saw some impact in the first half and largely in the second quarter, we expect that to continue now and see more benefit relative to the first half in the second half. So we also, as Tom mentioned, there's a couple of areas where we hope for some increased natural gas infrastructure sales, et cetera, and so that may counteract some of that Wind decline.

Peter Lisnic - Robert W. Baird & Co. Incorporated, Research Division

Okay, all right. And then if I could switch to Aero. On the biz jet side, it sounded like the commentary there was modestly positive signs of recovery, I guess. Can you give us a little bit more flavor as to where that is occurring?

Thomas A. Gendron

Yes, and Pete, I'll just highlight, one of the things to recognize is we are on substantially all the major large biz jets and large -- the large cabin biz jets are doing okay. And then you start going in the super midsize, and they're recovering. It's really the light jet market, the light and -- they're called light, small and then the mid are under the most pressure, and so it's again, the split of the market. So if you get super midsize and above, the market's doing and recovering. Below that, midsize are still under a lot of pressure. And the small and light are really under pressure still. And so that's the mix. And so we have good representation, and that's where we're starting to see some recovery.

Peter Lisnic - Robert W. Baird & Co. Incorporated, Research Division

Got it. Okay, that's helpful there. And then I'm sorry, last one, going back to Energy. I understand that [indiscernible] maybe picking up or signs that '14 is going to look better or the back half is going to look better. But can you give us a little bit of color or flavor as to what's happening in the backlog? Are you seeing -- I'm just wondering if you're seeing any sorts of things get pushed out, any sorts of significant cancellations? Just kind of the quality of the backlog. If there's any commentary you could give along those lines, I think, would be helpful.

Thomas A. Gendron

Sure. When I look at why I feel -- why we feel that way on the book of business and also it ties to the margin, as we're starting to see -- on our turbomachinery business, we're starting to see orders picking up and those have a long lead time, but we're getting the orders coming in. We see some very large projects that some have been announced, some are going to be announced shortly that have good -- real good content for us, good potential. So we start seeing that pick up. And those will kick in towards the latter part of this year and roll into next year. We're starting to see some improvement in our large reciprocating engine business. We had quite a drop-off in the first half of the year that we talked about, some beyond our expectations. We are starting to see some of the orders come in. We'll use our faster-cycle businesses, are starting to see orders pick up, and so that's a good indication of how the longer-cycle businesses follow. So we do believe the outlook for '14 in our mind has changed a little bit and it's actually improving. So in some ways, as we said the -- some of the issues in the economy occurred earlier than people had planned, earlier than we had planned, and now we're starting to see things coming back. And the order book -- you're asking backlog, but the order book is supporting the increase. The one that's the most volatile is the renewable business. And that one, we're being very cautious on looking forward. But I do expect going into '14 that to pick up as well. But that one's been very volatile, as you all know.

Peter Lisnic - Robert W. Baird & Co. Incorporated, Research Division

Okay. And then what about the electrical business within Energy?

Thomas A. Gendron

Electrical was also down. The power management controls were a little soft in the first half. We're starting to see orders increasing there as well. So it's kind of following the same pattern that I just discussed. And it was down, below our expectations first half, starting to get the orders, filling in. I would anticipate that those will continue and ramp into '14.

Operator

And our next question is from Sheila Kahyaoglu from Jefferies.

Sheila Kahyaoglu - Jefferies & Company, Inc., Research Division

Can you provide an update on the Duarte acquisition and maybe where you are in finalizing the content per aircraft there?

Thomas A. Gendron

Sure. We're actually very happy with where we are at this stage. We've had -- we've owned it for maybe 105, 110 days. It's on plan. The integration is progressing. We talked about the significant narrow-body orders of the future that we have with those programs. We're getting our arms around the development efforts and some of the activities there. The final configurations are still being worked out. But what I will do is we'll commit to you that at our December Investor Meeting, we will provide dollar content per application for all the narrow-body programs, the new ones and the new aircraft. So I think at that point, we -- I think things will be a little more stable in the development programs and we're going to have some confidence to give those numbers to you, so we will be providing. But right now, what I can tell you is that programs are going well. Development, we're really heavy in development right now in all the narrow-body but -- as well as in Duarte. Integration is progressing well. So far, we're on the plan we laid out when we bought it, so we're feeling good after 100 -- a little over 100 days. So we still got a lot to do but it's progressing well.

Sheila Kahyaoglu - Jefferies & Company, Inc., Research Division

Got it. And then I might have missed this, but in terms of -- your revenues grew 4% in the quarter but COGS grew 8%. What drove that increase?

Robert F. Weber

Well a lot of that is that the impact of that reverse leverage. So the big -- if you kind of take a, I'll call it, a standard flow-through on that $40 million and kind of assume all -- most of that all takes place at the gross margin level, you kind of will find, and I think we commented on this, that it's largely in line. There really isn't that big a difference in the overall gross margin percentage when you back out that impact. That really was almost entirely related to that.

Sheila Kahyaoglu - Jefferies & Company, Inc., Research Division

Okay, got it. And then my last one for me is aftermarket utilization within Energy, can you maybe provide some color on what you saw there? And just any geographic color would be great, too.

Thomas A. Gendron

Well, I would say on that, the big -- I think if you want to say the aftermarket driver has been a large increase in the utilization of the installed natural gas turbines and natural gas engine fleet, so they put more hours on it. We are seeing more spare parts being ordered and we are seeing some replacements. So definitely a higher utilization of the installed base, and that's been a positive. But I'd have to say that's one of those pockets of bright spots that we had. So -- and I anticipate that's still going to continue with the price of natural gas. You're seeing a high -- much higher utilization, a higher percent of the total power generation markets, so we are seeing that flow through in parts.

Operator

And our next question is from Michael Ciarmoli from KeyBanc Capital.

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

Just to maybe follow up on the Duarte. I think you said x the acquisition, margins were at 17%. How should we think about the Aerospace margins? I mean, is that a function of just digesting some of the purchase accounting and step-up still? Or are we looking at kind of margins in and around this 15% range going forward?

Thomas A. Gendron

One comment I would make and I'll turn it back to Bob, I just want to highlight that for the last couple of years, we talked about improved margins occurring in our Airframe Systems business. Okay, if you set aside the acquisition and we had a lot of step-ups and other things that occurred in the second quarter, but if you take a look at it, we are seeing improvements. Airframe Systems is continuing to improve its profitability and our turbine group is continuing to manage a huge R&D load while keeping profits up. And so we anticipate this to continue as we go forward, and we still support our higher, longer-term target of 20% for the -- for this segment. So what I'd say is that's the progress occurring. Obviously, having Duarte in the quarter and the like in the first quarter, as you're working through all the accounting impact that's there, but it looks like a solid contributor to our Airframe -- our Aerospace segment.

Robert F. Weber

Yes, we didn't -- as Tom mentioned, we did have the inventory step-up issue that you always have in the first quarter. It was not anywhere near as significant as some of the past, so we chose not to highlight it. But it did absorb that and it was still accretive in the quarter. So now that's a good sign and portends [ph] well for the remainder of the year for us.

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

If -- I'm just looking at that back half guidance and the margin assumptions at the corporate level. I mean, if Energy stays kind of pressured, it seems like Aerospace should be able to get into the 16.5% range fourth quarter. I mean, is that kind of the right way to think about this?

Robert F. Weber

Yes, without commenting specifically on the number, it will improve, yes. That's true.

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

Fair enough, perfect. And then Bob, just maybe on the tax rate, was the -- I guess, you had been looking for 28%, 29% for the year. Now you're at 27%. Was that just a function of the R&D tax credit being a little bit better than anticipated? Or is there anything else going on there with taxes?

Robert F. Weber

Largely, that is true. There's always a U.S., non-U.S., where is the income earned kind of impacts to those things, and that's what causes it to move around a bit. But we're really trying to highlight that when you took out that retroactive impact, we're largely in line with where we are most of the years here. So it's pretty consistent from that standpoint.

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

Okay, perfect. And then just one last one on the aftermarket, Tom. Looking at some of the trends that surfaced at the MRO Americas conference last week, the influx of surplus parts from all these aircraft retirements seem to be putting some pressure on aftermarket activity at the new part level. I mean, how do you -- how are you guys looking at that? You've got a lot of content on the engines. What would be considered some of the high-valued, resellable content that comes off those retired aircraft? Is that creating headwinds in your business, creating more difficulties forecasting the business?

Thomas A. Gendron

Well, it definitely will have a little impact on forecasting, especially -- probably the fleet that we're most closely monitoring and watching is the 737 classics. It's a very large fleet. We derive good revenue from that fleet. They are starting to park in part some of those but not in great numbers yet. So as we move forward, not compared to like if you're looking at the old McDonnell Douglas aircraft or like the MD-80s and the like. So we're monitoring that very closely and watching and trying to build that into our forecast. What I would tell you is our incoming repair and overhaul pipeline, the volume of incoming units has been increasing in the last month. And moving forward, we're forecasting good aftermarket -- or repair and overhaul incoming. We've had some pressure -- just going on in the aftermarket, some pressure and I want to highlight. So the initial provisioning, as there has been some difficulty with 787, the 47, A380. Those aircraft are going to get into service. They are going to need their initial provision spares. It's just they have -- airlines aren't spending the money until they really have those aircraft in their fleet. So that's been a little bit of pressure as well. But we have to really watch that classic -- 737 classic fleet. That's where we'll see potential problems with parting out an aircraft and what that will do to our aftermarket, but we're monitoring it.

Operator

[Operator Instructions] So we will take our next question from Peter Skibitski from Drexel Hamilton.

Peter J. Skibitski - Drexel Hamilton, LLC, Research Division

Just a few short follow-ups. On Duarte, the $35 million in revenue for the quarter, is that kind of a run rate for this firm? Is it kind of a $140 million business? Or I feel like I've been up and down in terms of what the level of that business should be.

Robert F. Weber

Yes. We, I think, had a little confusion over the 3 quarters of the year that will be included this year for us. So yes, the annual is roughly that $140 million, not to hold that too tight. And I think -- and everybody kind of focused on, okay, $110 million would be included in our fiscal year this year and roughly $35 million in the quarter. So you can see subject to normal quarterly variability, it's largely on track with that.

Peter J. Skibitski - Drexel Hamilton, LLC, Research Division

I see, okay. And then the SG&A and the R&D spend down for this quarter. Was that deliberate -- just trying to be disciplined on those 2 fronts? Or was it all what you said in SG&A? I think you mentioned some FX...

Robert F. Weber

Yes, FX. Clearly, no, we have talked about initiatives to watch obviously the spending. When you're not delivering the same level of sales that you originally anticipated, you're kind of watching how things go towards that. So that was an element of it, but the foreign exchange also an element there. We will continue that as we go into the second half. On the R&D, conscious from the standpoint of programs do fall off from time to time. And a lot of times, there's material purchases that go into those programs but you're also not purchasing anymore. And so the cost comes down a bit. So nothing that we anticipate will be a continuing trend. I think we're still within a reasonable range of where we targeted for the full year, so more quarterly variation than anything.

Peter J. Skibitski - Drexel Hamilton, LLC, Research Division

Okay, got it. Got it. And then as the last one, Bob, did you say you bought back about $17 million worth of shares this quarter. Did I hear you right?

Robert F. Weber

Yes, I did.

Peter J. Skibitski - SunTrust Robinson Humphrey, Inc., Research Division

Okay. And shall we see share count then declining in the third quarter? Or is that just offsetting options creep [ph]?

Robert F. Weber

Yes, very hard to say. We do not have a kind of a formal standard program, so it's more opportunistic. So we'll kind of watch the way the market plays out and go from there. So impossible to say at this point.

Operator

Mr. Gendron, there are no further questions at this time. I would now turn the conference back to you.

Thomas A. Gendron

Okay, thank you. Well, appreciate everybody joining us today and appreciate your questions. Look forward to seeing you over the next quarter. Thank you.

Operator

Ladies and gentlemen, that concludes our conference call today. If you would like to listen to a rebroadcast of this conference call, it will be available today at 7:30 p.m. Eastern Daylight Time by dialing 1 (888) 266-2081 for a U.S. call or 1 (703) 925-2533 for a non-U.S. call and by entering the access code, 1609981. A rebroadcast will also be available at the company's website, www.woodward.com, for 14 days. We thank you for your participation in today's conference call and ask that you please disconnect your lines.

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