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Goodrich Corporation (NYSE:GR)

Q2 2009 Earnings Call

July 23 2009 10:00 am ET

Executives

Paul Gifford - Vice President of Investor Relations

Marshall Larsen – Chairman, President and Chief Executive Officer

Scott Kuechle – Chief Financial Officer

Analysts

Robert Spingarn - Credit Suisse

Heidi Wood – Morgan Stanley

George Shapiro – Access 342

Troy Lahr – Stifel Nicolaus & Company

David Strauss – UBS

Peter Arment - Broadpoint Amtech

Joseph Nadol - J.P. Morgan

Ronald Epstein - Merrill Lynch

Robert Stallard – Macquarie Bank

Myles Walton – Oppenheimer

Ted Wheeler – Buckingham Research

Cai von Rumohr - Cowen and Company

Noah Poponak - Goldman Sachs

Sam Pearlstein - Wells Fargo Securities Llc

Carter Leake - Davenport & Company Llc

Howard Rubel - Jefferies & Company

Operator

Good day everyone and welcome to the Goodrich second quarter 2009 results conference call. Today’s call is being recorded. The press has been invited to participate in today’s conference in a listen-only mode.

At this time for opening remarks and introductions I would like to turn the call over to Vice President of Investor Relations, Mr. Paul Gifford.

Paul Gifford

Thank you, and thank you for joining us today as we discuss our second quarter 2009 results. Joining us today are Marshall Larsen, our Chairman, President, and CEO and Scott Kuechle, our CFO. We will start with brief prepared remarks followed by Q&A. A presentation is available at our website, www.goodrich.com, which together with our press release provides the basis for most of our remarks.

Before we start, let me remind you that today’s remarks include forward-looking statements that involve certain risks and uncertainties and actual results could differ materially from those projected in the forward-looking statements. The risks and uncertainties are detailed from time to time in our reports filed with the Securities and Exchange Commission, including our annual report on Form 10-K and quarterly reports on form 10-Q. They are also detailed in today’s earnings press release. I urge you to read them carefully.

This conference call is being webcast and replays will be available at our internet site beginning this afternoon.

Now I’ll turn the call over to Marshall, who will provide you with an overview of our second quarter 2009 results and our updated full year 2009 outlook.

Marshall Larsen

Thanks, Paul. I assume you’ve all had the opportunity to review today’s earnings release and the related presentation. Today I’ll describe the key factors that led to our performance during the second quarter 2009 and our updated outlook for full year 2009.

Despite the economic downturn, our second quarter results demonstrate the strength of our company. While our sales were down slightly, most of the decline was due to the impact of foreign exchange and the formation of the Rolls Royce Joint Venture in late 2008. We continue to benefit from our balanced sales mix.

About 28% of our sales are to the defense and space markets around the world and the growth of these sales has helped us partially offset weaker commercial aerospace sales during the first half of 2009.

For the last several years we’ve been awarded key positions on new commercial and military platforms and have gained market share as a result of these awards. When the world economies recover and these new platforms enter service, we believe Goodrich is poised to enjoy sustained significant long term revenue growth.

Last year when it became evident that our customers and the world were entering a time period of severe economic stress, we implemented proactive cost containment initiatives throughout our company. We limited the hiring of new employees which has saved a significant amount of money and also allowed us to minimize layoffs of existing employees.

Additionally, we dramatically cut discretionary spending throughout Goodrich. Every employee has had a role in these efforts which have enabled us to sustain our margins despite more difficult commercial and market conditions. These actions should enable us to leverage our lower cost base as the economic recovery commences and progresses and to grow earnings significantly over the long term.

In the second quarter 2009 we achieved segment operating income margins of 16.0% compared to 17.1% in the second quarter of 2008. These margins were achieved despite increased tension expense of about 1.2% of sales during the quarter.

Our second quarter 2009 net income was $177 million or $1.40 per diluted share compared to net income of $187 million or $1.45 per diluted share during the second quarter of 2008. These results for the second quarter 2009 included pre-tax expense of $42 million or $0.21 per diluted share related to worldwide pension plan expense compared to pretax pension expense of $21 million or $0.10 per diluted share recorded during the second quarter 2008 as well as after tax income from discontinued operations totaling $31 million or $0.25 per diluted share, primarily associated with the resolution of a past environmental claim.

Long term contract revisions for the second quarter 2009 were about the same as they were for second quarter 2008 and our effective tax rate of 27% in the second quarter 2009 was consistent with the rate we reported for the second quarter 2008.

Our second quarter 2009 sales compared to the second quarter 2008 decreased by about 8% or $149 million primarily due to unfavorable foreign currency exchange rate impacts on sales of about $62 million, lower engine control sales of about $29 million that resulted from the formation of the engine controls joint venture with Rolls Royce, and the impact of current economic conditions on the sales in our commercial airplane market channels.

Our large commercial airplane original equipment market channel experienced a sales decrease of 7% and our regional business in general aviation original equipment sales decreased by about 32% during the quarter. Sales in our commercial aftermarket channel decreased 16% in the second quarter 2009 compared to the second quarter 2008. Sequentially, aftermarket sales declined 5% from the first quarter 2009.

Our defense and space market channel continues to show strong growth with an increase in second quarter 2009 sales of 11% compared to the second quarter 2008. For second quarter 2009, we generated net cash provided by operating activities minus capital expenditures of $69 million compared to $107 million during the second quarter of 2008. The decrease was primarily attributable to higher worldwide pension plan contributions totaling $152 million during the second quarter of this year compared to contributions totaling $12 million during the second quarter 2008, partially offset by lower growth and working capital.

During the second quarter we had several significant accomplishments. We acquired Cloud Cap Technology, Inc., a leading provider of proprietary end to end avionic solutions for small unmanned aerial vehicles and sensors for manned vehicles. This acquisition will strengthen our presence in the fast-growing UAV market and enhance our ISR capabilities. We were selected by Airbus to supply the external video system for its A350 XWB airplane. It is expected that the award will generate more than $1 billion in original equipment and aftermarket revenue over the life of the program.

Also during the second quarter, we were selected by Airbus to provide advanced cabin attendant seats for the A350 XWB airplane. This selection is expected to generate $100 million in original equipment and aftermarket revenue over the life of the program.

We were selected by Bombardier to provide several systems including our next-generation SmartProbe air data system and ice detection system for Bombardier's new CSeries family of aircraft. This selection is expected to generate more than $200 million in revenue over the life of the program.

We opened a new facility in China's Tianjin Airport Industrial Park to support nacelle and thrust reverser original equipment, as well as maintenance, repair and overhaul activities. The facility will perform nacelle and thrust reverser MRO work for customers in the region and it will support engine buildup and podding work for the new Airbus A320 Family aircraft final assembly line in Tianjin.

As I am sure you are aware, market conditions for 2009 continue to be very challenging, but there are some indicators that we have seen the most significant impacts on our company and our industry.

The IMF outlook for global GDP has softened very slightly in 2009 but they increased their 2010 estimate from worldwide growth of 1.9% to growth expectations of 2.5%.

Our expectations for large commercial production rates for 2009 have not changed since our prior outlook. We continue to expect Boeing and Aircbus to deliver a total of 960 to 970 airplanes this year.

We continue to expect available seat miles, ASMs, to contract by about 5% to 8% in 2009. While we believe this reflects the announced cuts for later this year in international capacity, further announcements incremental capacity reduction could impact this expectation.

Within our own businesses, half of our SBUs experienced sequential increases in commercial aftermarket sales compared to the first quarter 2009. Additionally, landings for airplanes with our wheels and brakes are down for the year-to-date in 2009 compared to 2009 but appear to have stabilized in the last few months.

ASMs do not include traffic and cycles related to the freight market or to business jets where the decline in activity has been significantly worse than for commercial airlines although both freighter and business jet markets show signs of stabilization.

The number of newer generation parked aircraft has remained about the same as it was at the end of the first quarter and includes about 172 parked A320s and 737MGs. While timing is uncertain, these will be the first aircraft to return to service when the airline markets start recovering.

Freight traffic continues to be very weak but the May IATA results for international freight showed marked improvement over the traffic results for the earlier months of 2009.

The business jet market still remains very weak. This is not a large part of our sales with business jet original equipment and aftermarket sales during the second quarter representing about 3% of total sales.

The market for our defense and space products remains very strong. Our second quarter defense and space sales grew faster than previously expected, leading us to increase our expectations for 2009 sales for a growth rate of 12%, most by organic growth.

Today’s release also contains an update to our outlook for 2009. We believe this outlook realistically portrays our expectations for performance in the current market environment. We continue to expect full year sales in 2009 to be about $6.9 billion, a small sales decline from our 2008 sales.

The 2009 sales expectations compared to 2008 include unfavorable sales impacts of approximately $163 million or 2% of sales related to the stronger US dollar and lower sales of approximately $125 million or 2% of sales related to the formation of the Rolls Royce Engine Controls Joint Venture. Excluding the impact of these two non-operational sales adjustments, our expected sales would show a slight growth in 2009 compared to 2008.

Our sales growth expectations for each of our major market channels are as follows: large commercial airplane original equipment sales are expected to increase slightly in 2009 compared to 2008. This expectation is based on the latest 2009 delivery estimates from Boeing and Airbus of about 480 deliveries each.

Regional, business, and general aviation airplane original equipment sales are expected to decrease by around 25%. Regional airplane original equipment sales are expected to decrease by 15% to 20% and business and general aviation original equipment sales are expected to decrease by more than 40%.

Large commercial, regional, business, and general aviation airplane aftermarket sales are expected to decrease by 8% to 10%. We believe our aftermarket sales in each of the third and fourth quarters of 2009 will be higher than we experienced in the second quarter of 2009.

These expectations include double-digit decreases in sales in support of freighters and regional, business and general aviation airplanes. Defense and space sales of both original equipment and aftermarket products and services are expected to increase by about 12% in 2009 compared to 2008 driven by growth in Intelligence, Surveillance, and Reconnaissance products, helicopter products, and landing gear products. All three of our segments are expecting significant growth in their defense and space sales this year.

Our outlook for net income has been revised to $4.60 to $4.75 from our previous outlook of $4.50 to $4.75. We expect that the income decrease related to lower commercial aftermarket and regional business and general aviation original equipment sales expectations will be largely offset by income from higher defense and space sales, the continued success of our cost containment initiatives, and the combined benefit of slightly lower tax rate compared to the previous estimate, and higher income related to the resolution of a past environmental claim.

Our 2009 outlook range includes among other factors higher pre-tax pension expense of $101 million or $0.51 per diluted share compared to per diluted share compared to 2008, after-tax income from discontinued operations totaling $32 million or $0.25 per diluted share primarily associated with resolution of a past environmental claim. Our prior outlook issued April 23, 2009 included $0.10 to $0.15 per diluted share associated with this environmental resolution.

Restructuring charges totaled about $0.09 per diluted share. About one-half of the expected charges were incurred during the first half of 2009. A full year 2009 effective tax rate of 29% to 30%.

For 2009 we continue to expect net cash provided by operating activities minus capital expenditures to exceed 75% of net income. We now expect capital expenditures for 2009 to be in a range of $200 million to $220 million compared to our prior outlook of $220 million to $240 million. During 2009 we still expect to contribute between $150 million and $200 million to our worldwide pension plans, including our year-to-date contributions of $160 million.

Clearly we continue to operate in an extremely uncertain global economic environment. Our balanced business mix with a focus on flight critical systems with a non-discretionary aftermarket, our concentration of sales on newer large commercial aircraft, and our defense and space business positions us very well to weather a difficult market environment.

Operationally we have performed very well this year. Our focus on cost control has enabled us to deliver strong margins in the face of higher pension costs and lower aftermarket sales. As the commercial markets recover, we are poised to grow our earnings as we leverage our lower cost base and focus on continuous improvement and lean initiatives. We expect that this will allow us to sustain our good performance and will complement our expectations for solid long term sales growth for our company.

Now I’ll be glad to open it up for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Robert Spingarn - Credit Suisse.

Robert Spingarn - Credit Suisse

Marshall, could you give us some specifics on how the A320 and 737 aftermarket flowed in the quarter and particularly relative to the first quarter? I think in Q1 you were up a little bit.

Marshall Larsen

Yes, we were in some areas flat with it but also down a little bit in our aerostructures business from Q1 to Q2. We’ve seen as I said in my opening comments about 170 to both the A320 and the 737MG temporarily parked. About two-thirds of those are A320s and what typically happens, they park them when they get close to a maintenance cycle. So probably some of the older aircraft in it. As we looked at our sequential aftermarket sales, as I said, we had four different business units out of nine had sequential upward movement in aftermarket sales and for instance, actuation is one of them and actuation is not on Boeing aircraft, they’re on primarily A320 family, and they were up sequentially. So it’s a little bit mixed but there were some signs of stabilization and improvement.

Robert Spingarn - Credit Suisse

Are these signs to some extent attributable to seasonality with these narrow bodies just coming in for the summer or are you concerned at all that they go back out in the fall?

Marshall Larsen

It doesn’t appear so. When we look at our landings data in wheels and brakes, June was up and that’s the first uptick we’ve seen and we’re taking into account seasonality.

Robert Spingarn - Credit Suisse

Just to close the topic, from an OE perspective you talked about being fairly well prepared should Airbus and Boeing take down narrow body rates. Can you talk about that a little bit, either you or Scott, with regard to absorption and how you would see that work? We know it’s a lower margin business but at some point absorption has to be an issue.

Marshall Larsen

I’ll start it off and I’ll turn it over to Scott. We have been very, very focused on controlling what we call discretionary costs. I’m speaking to that and I’ll have Scott speak to the absorption, but all of our business units have done a great job in really,,, Things like office supplies. Mundane kinds of cost cutting have saved us a lot and if you think about our margin for the quarter being down about one point from last year, well, we had over a one point headwind in pension expense, so we had to take costs out in order to maintain that 16% margin and we expect to continue taking costs out in the rest of the year.

We’ve had between 2% and 2.5% of our workforce laid off. That does not include open requisitions that we had this last year that we chose not to fill except in key technical areas, but we had a lot of contract employees that we have been able to take out first which are much less expensive to reduce in the short term, so all of our businesses including landing gear which would be the most affected have been working very hard on that cost base and Scott, do you want to talk a little bit about the absorption?

Scott Kuechle

On the absorption side, as you know, those are fairly big volume programs that run through our operations and touch most of our different businesses. So the key to managing the absorption in a down rate scenario is obviously getting enough notice so that you can manage towards that change and both Boeing and Airbus have indicated that they would give suppliers significant notice if they do elect to make any changes there.

So with an appropriate amount of notice, you can manage down in terms of both the labor and the inflow of materials as well and work with your suppliers to offset some of that cost. So we think it’s manageable and I think if you point back to what happened during the Boeing strike which affected us in Q4 of last year and Q1 of this year, we were able to hold margins at a pretty robust level even while Boeing was effectively shut down for essentially a quarter during that time period, and our plants were affected as a result of that, so with some amount of notice and some good planning, we think we can weather that pretty well.

Robert Spingarn - Credit Suisse

Should we think about this as a fairly high variable cost business?

Marshall Larsen

If you think about our total mix of business, I think you can think of it as more variable than very high fixed. I mean, if you’re just talking about landing gear, that’s pretty fixed. But think about what takes place with our wheel and brake business should one of those OEs drop their production rates. All of a sudden we’re giving less free of charge hardware to Boeing and Airbus, margins actually increase in the short term for wheels and brakes, so that offsets some of that absorption issue.

Robert Spingarn - Credit Suisse

I think what most of us focus on, I guess Marshall, is the cell business and thrust reversers over in France.

Marshall Larsen

Certainly those are great businesses for us, but just remember that OE business is lower margin compared to aftermarket. So yes, you have to work on the absorption issue, but what we’ve been able to do in the engine build up facility in [Taloose] in particular has become extremely productive there. We haven’t had to hire a bunch of people there.

Scott Kuechle

I’ll just add on maybe one other comment. We do believe that production rates are stable at least to the middle part of 2010 and Boeing and Airbus have kind of indicated that. By that point, you’re going to see some good growth in the aftermarket based on everything that we can tell from the global economic situation and how it’s progressing and just understanding how the fleet is going to grow over the next year with additional narrow body aircraft coming into the point where they’re generating more service hours so the aftermarket growth is going to be there well before, in my opinion, before we see any kind of change on the production side.

Marshall Larsen

Yes, so you see the cycles decoupling a little bit here.

Operator

Your next question comes from George Shapiro – Access 342.

George Shapiro – Access 342

Marshall, just pursue a little bit more, I mean, it looks like to meet your guidance in aftermarket, the second half aftermarket has to only be down about 5% versus the declines we’ve seen in the first half. I was just wondering, given that we still see weak traffic numbers through the summer and normally airlines take out more capacity in the fall after the summer season, where do you get the confidence to think that you actually will see set sequential kind of improvements?

Marshall Larsen

As I said before, we’re starting to see signs of stabilization and maybe even some uptick in some of our businesses. We also see the China market growing more than we originally expected. We think we’re nearing the capacity reductions here in the US so we also have seen a few more major spare sales coming out of our nacelle and aftermarket business which gives us some hope that we’re going to do better. You look at our outlook for the year and you can obviously very quickly deduct that it’s only about $1.25 in EPS for the next two quarters and if we get any upturn in that aftermarket, we believe we can beat that.

George Shapiro – Access 342

Because the history has been that you’ve seen the spares recovery lag somewhat even improving traffic as opposed to what you’re implying is more coincidence, even if it does happen which isn’t all that clear yet.

Marshall Larsen

You also have airlines for quite a while now trying to get by with a lot less inventory and stretching the maintenance cycle as much as they can so I think we’re getting at a point where we’re going to start seeing more of that kind of MRO activity start to bump upward. Is it going to be a huge increase between now and year end? No, but when I listen to the Fed and I listen to a lot of economists around, everyone is expecting some recovery by the fourth quarter in our US economy so we’re counting on some of that and we’re also counting on some recovery in Asia.

George Shapiro – Access 342

On the positive side, given how much aftermarket was down, the ability to pretty much hold the margins ex the pension was pretty impressive. Now did that suggest that the aftermarket doesn’t have the same kind of leverage for your earnings as it had before or how would you analyze that?

Marshall Larsen

Not at all. I think it has the leverage. I think we’ve just been very successful in containing enough cost and having positioned our business to do a lot more military side in the right growth areas like helicopters and ISR so when we do see a recovery in the airlines, I think we’re going to see that upward leverage.

Operator

Your next question comes from Troy Lahr – Stifel Nicolaus & Company.

Troy Lahr – Stifel Nicolaus & Company

Just so I’m clear, is your guidance assuming that airlines pull more capacity out in the third and fourth quarter or you’re just kind of assuming that it’s kind of even flow from this point on?

Marshall Larsen

All the announced cuts that we’ve seen so far are assumed in that guidance. We said in my opening remarks that if someone comes off with some more capacity coming out, we’ll have to see what that is, but remember that most airlines are taking out older aircraft and we’re much better positioned on the A320s, the 737MGs, the 330s, and the 777s, which are all the newer in production aircraft and more efficient, so could we see more aircraft being taken out? Yes, but they’re more likely to be the older aircraft.

Troy Lahr – Stifel Nicolaus & Company

I haven’t seen the chart in a while. Can you maybe just break down how much of your sales are from in production aircraft versus out of production?

Marshall Larsen

I’m going from memory here, but those four aircraft that I gave you I think are about 60% of our sales.

Troy Lahr – Stifel Nicolaus & Company

So what’s the outlook for the other 40%?

Marshall Larsen

You’re going to see our overall those out of production aircraft like the MD80s, the DC9s, some of the older 737 classics were probably less than 8% I think it was as I recall of our total sales.

Scott Kuechle

And they’re declining in terms of utilization at double digit kind of rates right now because as Marshall says, that’s where most of the pressure is coming from in terms of reduction of capacity. It’s coming into very old aircraft and a lot of the aircraft that are used on the international routes as well.

Marshall Larsen

We’re watching the freighter market very carefully because that has been down even moreso than the passenger traffic and if you strip that out of our results, our overall aftermarket sales were down less than double digit, so I think if what we hear from the freighter world out there is I think they’re stabilizing hit bottom, that’s good news.

Troy Lahr – Stifel Nicolaus & Company

But just so I’m clear, when you say 40% out of production, not all of that is the stuff that’s getting retired, you think maybe like 8% to 10% of the stuff that’s actually getting pulled and parked, is that right?

Marshall Larsen

That’s right.

Operator

Your next question comes from David Strauss – UBS.

David Strauss – UBS

One of your major landing gear suppliers talked about seeing de-stocking and the results kind of reflected that. Could you just comment, are you in fact de-stocking them, are you producing below Boeing’s rate right now on the landing gear side?

Marshall Larsen

No. Obviously the 737 is slipping along at the normal pace but 777, they’ve already announced taking down the 777 by mid next year so you have long lead time items on that. We’re not going to order any more inventory on that than we have to.

David Strauss – UBS

So you’re just kind of building out to where the 777 is going to go, but on the 737 you’re right in line with what Boeing’s building at?

Marshall Larsen

That’s right and now if you get that particular supplier was supplying us on A380, I’m not surprised at all because we’ve had a lot of… It takes 24 months to get forgings and so we’ve got plenty of inventory to meet the reduced schedule that Airbus gave on their A380.

David Strauss – UBS

Then just on the aftermarket again, the 16% decline in the quarter is pretty tough to reconcile to even assuming freighters down 20% or 25%, business shift down 25% or 30%. If I understand kind of your aftermarket breakout where I think 78% to 80% is non-freighters and non-business jet related, it’s still tough to get to down 16%. Am I right first of all, and second of all, is the difference just de-stocking on the aftermarket side and did that pick up in the quarter relative to what you had seen in the first quarter?

Scott Kuechle

Let me try to circle that for you in a couple different ways. I would look a little bit more sequentially than year-over-year because we know the impacts year-over-year are pretty significant and some of that may just be timing, but if you look sequentially, what we saw is continued significant pressure on the business GA aftermarket where we’re down between 20% and 30% sequentially. When you look at the regional and large commercial markets, sequentially we were only down in the 3% to 4% range sequentially.

A part of that large commercial reduction was due to freighter again, and if you look at our full year expectations for 2009 in the aftermarket where we’ve guided to 8% to 10% down, we’re looking at big decreases in the regional and GA side of the market on the order of 20% with large commercial only being down in the 3% to 4% range excluding freighter. So there’s clearly some subtext going on here below the broad category of aftermarket. It’s very much pressured on business GA and the freighter market first of all, to a lesser extent on regional, and our large commercial is actually tending to hold up pretty well because of the positions that we have on the newer aircraft there. So the broad themes that we’ve talked to you about before are still holding in there and they’re pretty reflective.

David Strauss – UBS

Scott, on the preproduction excess over average side, it ticked up by a bigger amount then w hat we’ve seen recently. Was there anything special going on there?

Scott Kuechle

Nothing unusual there. I think we were up about $50 million in the quarter, about $80 million year-to-date, so that’s consistent with what our expectations were. We were expecting around $200 million in growth for the full year so we’re actually running pretty close to that.

Operator

Your next question comes from Peter Arment - Broadpoint Amtech.

Peter Arment - Broadpoint Amtech

Marshall, can you talk about military and space growth, 12% in ’09/ I think your prior guidance was closer to 8. I know you mentioned that helicopters are not ISR driven but how should we think about this, not that we’re going to give out 2010 guidance here, but how should we think about just the volumes here going into 2010? Is this potentially a double digit growth segment?

Marshall Larsen

I think it is. I don’t know what the ’10 is going to be yet because we haven’t given the guidance on it but the kind of growth we’re getting is coming out of the areas of the budget that are being funded. The Intelligence, Surveillance, and Reconnaissance areas of the budget, helicopters are being funded, and some of the replacement MRO kinds of things that you happen to refurbish the platforms that are out there.

So as we look at that 12% growth, probably over two-thirds of it is organic and we’ve made several small military acquisitions in the last couple of years, two of which are adding to revenues this year. We had one that is in second quarter last year but we just did Cloud Cap Technologies and prior to that we did Recon Optical and those are in the ISR arena in the growth areas where funding is available. So even though we’re losing a little bit probably because of the F22 production reduction over time, we’re very well positioned on the F35. So where we’re positioned I think is where the money is going to flow.

Peter Arment - Broadpoint Amtech

That’s very helpful and then just quickly, Scott, on your guidance you kept greater than 75% on the cash flow side of net income, but how should we think about that as we get into 2010? I guess a lot of it is depending on the OE side of the business.

Scott Kuechle

A lot will depend on the OE side but if you paint this scenario where OE production rates are flat for a couple of years and we continue to get growth in the aftermarket and military and space side of our businesses, those are not real large working capital users so my expectation would be working capital is not as significant as a drain as it has been the last few years which will help us.

Capital expenditure requirements have already come down this year so that will help us as we go forward to generate more cash flow as well. So in my view we would continue to edge up towards that 100% number over the next couple of years, painting the environment as roughly flat on the OE side of the equation. We still have some [Iron D] programs that are midstream or late stream that we need to finish up over the next year or two. 787, as it finishes up, A350 is kind of midstream, and then a couple of the big regional jets are early stages. So we’ve got a lot of development costs still in front of us but we should continue to edge up that cash conversion like we did in the current quarter.

Operator

Your next question comes from Joseph Nadol - J.P. Morgan.

Joseph Nadol - J.P. Morgan

I was wondering if you could characterize pricing a little bit? Sales down 8% in the quarter. Is there any way to break that down companywide in terms of volume versus pricing? Then I guess added on to that, what are you hearing from customers, particularly in the aftermarket with all the financial pressures on your airline customers?

Marshall Larsen

That 8%, remember, you’ve got FX in there and you have the 50% of the Rolls Royce Joint Venture which is our large engine control business that we consummated in December of last year, so really we only had a 3% drop and clearly more of that is volume related than pricing.

Joseph Nadol - J.P. Morgan

So no pressure? You would imagine in this kind of environment with raw materials picking up but still way off where they were and the airlines gasping for breath in terms of their finances, at some point you’d imagine they’re going to be coming and asking for reductions. We see it in every company, strong margins and weaker sales. I just wonder if you’re seeing any of that.

Marshall Larsen

Certainly we’re dealing with the airlines on a daily basis and where we can make a win-win situation, that’s what we’re working to do.

Joseph Nadol - J.P. Morgan

What are you doing right now in your factories for the 787 just given the delays and you noted that the preproduction picked up a little bit but it was along the line of expectations. Are you keeping all your employees there, are you putting them in other areas, what exactly are you doing?

Marshall Larsen

We’re kind of waiting to see what happens with Boeing when they come out sometime during the quarter and say how long the delay is. So I really can’t answer that at this point in time. I could see if it’s a longer delay than we expect, we may have to shift employees. In some of our businesses we’re sitting on a fair amount of inventory for 787 that we can’t ship at this point in time so depending on how many months of shipments that is and whenever their new schedule comes out, we may or may not have to adjust our employee totals.

Joseph Nadol - J.P. Morgan

Any indication that the nacelle is going to be impacted by any changes on the win?

Marshall Larsen

Not that I know of.

Joseph Nadol - J.P. Morgan

Then finally on currency, the Euro has been ticking back up relative to the dollar or actually the dollar’s been ticking down relative to everything again. Scott, where are you looking into the next couple years in terms of hedging and headwind, tailwind?

Scott Kuechle

We took advantage of the stronger dollar environment earlier this year and moved up our hedge position pretty dramatically. So certainly for ‘09 we’re more than 95% hedged and in 2010 we’re almost 90% hedged at reasonably good rates, so in 2010 we should see about a $14 million or $15 million year-over-year benefit as a result of those hedges based on where the currencies are currently trading, and in ’11 we’re about 65% hedged and again based on current rates, that should give us another incremental $19 million or $20 million uplift in ’11 versus ’10. Then in ’12 we’re already 50% hedged as well so I think we’ve got a good track in front of us here where FX should be a help to us as opposed to the negative it’s been the last several years.

Operator

Your next question comes from Ronald Epstein - Merrill Lynch.

Ronald Epstein - Merrill Lynch

Just to follow up on the defense questions, Marshall, when you stand back and look at your defense business, we visited the ISR business I guess a month or two ago and it’s pretty impressive. When you think about the portfolio of businesses you have and you look out say 5 years, where would you like to see that business be?

Marshall Larsen

It’s definitely a very good growth business for us so we certainly have plans to continue that growth and take advantage of government funding for one, and two, where we have to, we’ll supplement some of the funding if we can accelerate a program occasionally. For instance, our DB-110, rather than wait for government funding from either our own government or an allied government, sometimes we’re better off to spend $5 million to $10 million on inventory and put it in there and then we can get it on faster.

We are really accelerating our health utilization and monitoring systems, our HUMS business, going on the Black Hawk helicopters. That’s been a very, very good business for us and continues to be so as we not only do OE and [sakorsky] but retrofit and the military. You’ve seen what we’ve done on recent acquisitions. We’re trying to cover the spectrum from space all the way down to just above the war fighter, working very hard to bring solutions to that war fighter in dealing with the various departments and DOD and the armed forces on that. So we see that as a continued area of investment on our part.

Ronald Epstein - Merrill Lynch

Then just a follow up on you mentioned containing costs. When things do turn around, how much of the costs that are contained will come back? How much leverage do you have to the costs that you’ve taken out?

Marshall Larsen

I think it’s very interesting you should ask that because when we get our ten business unit or nine business unit OE units and our aftermarket sales and service unit together and talk to those presidents, I think there’s going to be a pretty good chunk of that stuff that will continue on because we’ve learned how to do things more efficiently and it’s kind of the whole lean process. So will we end up with more costs in travel or some of those kinds of things where you need to spend more time with the customer, yes. But I think we’ve learned internally how to be more efficient in doing business with ourselves where we can really reduce that. I’m very optimistic that when we do see that aftermarket uptick that we will leverage that to the bottom line.

Operator

Your next question comes from Robert Stallard – Macquarie Bank.

Robert Stallard – Macquarie Bank

Just a follow up on Ron’s question about the cost situation. Marshall, how far do you think you’re through on this process of taking out costs and efficiency? We’ve certainly seen the impact over the last two quarters. Can we expect to see further upside in this area over the next 6 to 12 months?

Marshall Larsen

I do believe we’ll at least be able to sustain it during the course of the year but we continue to find ways of taking costs out. It’s just one of those things where like one of our business units spends about $10 million a year on materials and direct supplies, not that necessarily go in the product, and we’re taking out over 20% of it, and I think they’re going to learn how to live with that as time goes on. So those are the kinds of things that are taking place.

So all of us, including the corporate headquarters, are continually looking for ways to take more costs out and we really do have those SBU presidents aligned on the enterprise. Half of their annual incentive comes about because of how the total company does, not just how their business units do, and they get a much greater percentage of their long term incentive is obviously tied to the entire enterprise in restricted stock units and options.

Robert Stallard – Macquarie Bank

Proportionally, would you say you save 20% through this process or 80% through this process? Does it get much more difficult going forward because of easy things like travel being [attacked]?

Marshall Larsen

I don’t know, I think we’re still in the early stages of learning on it. I would say on the continuous improvement, the lean process, we’re quite advanced in some areas in our factories, not so much in others. We’re really starting to gain traction in the offices. The other thing that we’re finding out is we’re about 60% through putting SAP in and that is really giving us some cost effective measures across the company that we didn’t have before. We’re starting to see that in our businesses.

Robert Stallard – Macquarie Bank

Just a quick follow up on the defense side. You saw 12% growth in the quarter. It may be tough to parcel this out, but how much of this do you think is related to ongoing military operations and how much to the core budget?

Marshall Larsen

I don’t think a lot. Certainly the helicopters are going to be needed whether we wind down in Iraq or not, and a lot of them will have to be refurbished. So the HUMS kinds of business is going to continue. We have on the ISR side a lot of the things we’re working on are looking forward beyond the war, so I think it’s got a pretty good chance of continuing a reasonable growth rate.

Operator

Your next question comes from Myles Walton – Oppenheimer.

Myles Walton – Oppenheimer

A couple of questions, first on the pension, can you give us an update Scott on where the plan performance is relative to the plan expectations for the year?

Scott Kuechle

Probably to no one’s surprise, we’ve got returns that are not very robust so far halfway through the year. We’re about 2.5% negative return for the year-to-date through June. Obviously we’ve seen some improvement since June and interest rates are about the same today as where we left the year or started the current year so we’ve got a ways to go for the last six months of the year but today it would be a drag.

Myles Walton – Oppenheimer

Marshall, on the Cap Ex, was that more of a proactive cost control measure or was that the result of [inaudible] delays in some of the work you’re doing?

Marshall Larsen

That was more a result of not bringing capacity on before we need it. So we’re just being cautious from that standpoint. We’ll eventually when the market comes back revisit some of that spending.

Operator

Your next question comes from Ted Wheeler – Buckingham Research.

Ted Wheeler – Buckingham Research

I just went from two to one. I’ll do my best. On the pension, if you ended the year where we are now, just roughly, what would the decrement be?

Scott Kuechle

It would be fairly significant. Again, probably on the order of $50 million roughly in terms of pension expense, but again, you don’t set that until you get to the end of the year so that number changes literally on a weekly basis as you go through the year with the volatility in the marketplace.

Ted Wheeler – Buckingham Research

That $50 million would compare with what, $100 some million this year, correct?

Scott Kuechle

Relative to our total pension expense of $180 million roughly this year.

Marshall Larsen

Are you talking about for next year?

Ted Wheeler – Buckingham Research

Yes.

Scott Kuechle

We had growth this year of 101. Year-over-year change was 101 2009 versus 2008 and if you ended the year today you’d see a further degradation in 2010 but again a long way to go in terms of where interest rates go and where do returns go.

Ted Wheeler – Buckingham Research

If you look at the relationship of aftermarket to ASMs, obviously there’s a lot of moving parts this year, but do you think that your ability to [over list] three or four years deliver a premium to ASMs will return in 2010?

Marshall Larsen

I think we’ll see growth return in 2010 and I do believe that if we’ve got positive ASMs we’ll be able to grow faster than that.

Scott Kuechle

The positions that we’ve got on the newer aircraft have got a drive of favorable mix effect for us because so much of our aftermarket is centered on the in-production aircraft and as those age and drive into their maintenance cycles, we will get better than market growth in that channel.

Ted Wheeler – Buckingham Research

This year particularly up to date, you’ve talked about, I think there’s been some inventory reduction with customers.

Operator

Your next question comes from Cai von Rumohr - Cowen and Company.

Cai von Rumohr - Cowen and Company

You did 15.8% in electronics. You didn’t mention any kind of non-recurring adjustments and if I look at your guidance for the year, it looks like you’re assuming something like a 15% margin for the company in the second half which would be down from the second and yet the sales should be better, FX should be better, you’re talking about aftermarket maybe bottoming. Help us understand that and if you could give us any help in terms of the ranges we might be looking for, for each of the three business units.

Scott Kuechle

In terms of electronics, we did have a really good margin order in the current quarter at 15.8%. I think you’re right that the balance of the year and the full year we think probably comes in right around 15%. That’s good growth over a year ago because again we’re absorbing 1 point to 1.5 points degradation from pension expense so it’s excellent growth year-over-year. I think the reason Q2 was a little higher than what we think the rest of the year will be is they did have a very good mix in the quarter relative to aftermarket sales in particular and so when we see that softening a little bit in the second half, this business is a little bit more exposes to the business GA market than the rest of our portfolio so a little bit of an impact there but I think they should be able to sustain margins in that 15% range which is excellent, particularly when you look over the last couple of years they’ve made great progress there.

Cai von Rumohr - Cowen and Company

What about the other sectors? If the aftermarket which was awful in this quarter isn’t worse, can the margins… It looks like actuation or nacelles have to be lower in the second half to kind of get us to where your guidance for the year seems to be for the company.

Marshall Larsen

We would expect actuation and landings systems margins to hang in somewhere near where they were in the second quarter. I wouldn’t expect a lot of change for the rest of the year versus where they finish the second quarter and generally the same for nacelles and interiors. They should be fairly similar for the rest of the year versus where they finished the second quarter.

Operator

Your next question comes from Noah Poponak - Goldman Sachs.

Noah Poponak - Goldman Sachs

Just wanted to ask a couple more questions on the aftermarket. There’s this discussion of your ability to outpace passenger ASMs because you’re all over new aircraft and the reported total aftermarket numbers do not because that’s because they include a lot of non-passenger things. Did your first half non-freight large commercial passenger aftermarket outpace what ASMs were in the first half of the year?

Scott Kuechle

I think it was pretty similar, if you exclude freighter, business, and all the things that aren’t part of the ASMs, it was fairly similar.

Noah Poponak - Goldman Sachs

Is that because the 737, A320 parking surprised you a little bit?

Scott Kuechle

That and maintenance practices that I think the airlines have adapted during the first half of the year in particular where they have done things like parked airplanes just prior to C&D checks which generally drive a fair amount of aftermarket support. They’ve reduced the scope of a lot of repair work that they do so in previous months, previous quarters, years, etc., when they send in spare parts for repair, they would do more than was just required to get the parts back into service so they’ve cut down the scope of those repairs. They’ve also tended to transfer inventory to us and then hold the repair order until just before they actually need it for service so those things, people generally talk about those as de-stocking effects and that’s what we’re seeing and as those start to turn around, because they can’t continue on the same trend forever, we should see some pick up going forward.

Noah Poponak - Goldman Sachs

To that point, I think you alluded to 20% declines on the regional and general side in the second half and given what the full year guidance is, that would appear to shake out to some second half growth in the again non-freight large commercial aftermarket side. Is that fair?

Marshall Larsen

I was speaking of those declines for the full year.

Noah Poponak - Goldman Sachs

And one other question, you talked about growth in the second half of 2010, but your presentation also discusses the full year of 2010 being flat, so that would seem to imply you expect the first half of ’10 down again even though you’ll be coming up against pretty easy comparisons. Am I reading that incorrectly or how are we thinking about the shape of next year?

Marshall Larsen

We’re having a hard time following the question.

Noah Poponak - Goldman Sachs

So you talked about growth in the aftermarket in the second half of 2010 earlier on the call. But then your presentation talks about the full year sort of being close to flat and so does that mean that you expect the first half to show continued declines even though you have very easy comparisons?

Scott Kuechle

We’re not sure, number one, what 2010 is going to do with respect to ASMs. Flat or slightly up, one of the charts in our presentation says flattish. We said slightly up a little. We’re just going to have to wait and see. I don’t know that we would know right now what the trend by quarter is. Certainly it should be better than this year and this year steps up for some pretty easy comparison we hope.

Operator

Your next question comes from Sam Pearlstein - Wells Fargo Securities.

Sam Pearlstein - Wells Fargo Securities

I actually wanted to try to follow up, maybe you guys don’t want to talk about it yet, but I guess I was trying to think about how you see the pace of recovery? You talked about a bunch of parked A320s, 737 next gens that are kind of bumping up against maintenance cycles, do you see those starting to come back and help you later this year or is that really a 2010 event and I guess I was trying to figure out how do you have growth if you have flattish ASMs next year other than price?

Marshall Larsen

We’re not counting on much of those getting back this year, Sam. I think it’s more a phenomenon for next year. I think if you look at trying to predict the next quarter to I think it’s harder than trying to predict next year because I think everything indicates that we’re going to…. We may have a jobless recovery so we may have some uptick in our markets and I think that we may have hit the bottom in terms of capacity reductions in the US. I think we’ll still have sluggish results in Europe and greater growth in Asia driven by China. I don’t see a huge jump back in the premium market, the upfront market where the airlines make most of their money, but when I just look at where we are now compared to where I think we’ll be by midyear next year it just kind of indicates based on our own revenues in the next year of sequential either up or flat sales in our business units that we’re probably going to see some uptick next year. We’re also going to have obviously easier comps.

Sam Pearlstein - Wells Fargo Securities

That’s true and then just kind of separately, on the discretionary costs that you’ve been cutting, just in terms of how you’re thinking about the business, does some of those start to come back later this year in terms of the requests for travel to go see customers to do that, or is that something also that pushes out into next year when you see some of those costs come back in?

Marshall Larsen

We have no plans of letting those costs drift back in this year. We have not limited our business units for essential travel to see customers where they’ve deemed it necessary. What we’re doing instead of sending a couple of people on a trip, maybe one person goes. You try to be a lot more efficient about what you’re doing so I don’t see those costs drifting back in.

Operator

Your next question comes from Carter Leake - Davenport & Company Llc.

Carter Leake - Davenport & Company Llc

We’re all still trying to guess what ultimately will happen with Boeing and Airbus and narrow body production rates and you made a comment earlier which is in line with common thinking that due to lead times, any production cuts are likely now to be no earlier than mid 2010. You also threw out a comment with regards to landing gear forging lead times being possibly as long as 24 months. Given commentary that Boeing and Airbus are sensitive to the impact that any cuts might have on Tier 2 and 3 suppliers, do you think that we’re shaping up for no cuts prior to 2011 or put differently, do you think an 18 month number is a better lead time we might use, meaning sort of 12 months has been contractual, 24 months is just a one data point but somewhere between 16 and 18, can you give some commentary on that?

Marshall Larsen

Every meeting I had with either of the large OEs at our recent Parish airshow indicated that they’re going to do everything possible to maintain their rates for the foreseeable future, and I got the impression through next year especially on the narrow body. We should also understand that the narrow body lead time is not a 24 month forging. That’s with a very large A380s and some of the 777 forgings but on 737 our lead times are much, much less. We could react under six months on those.

Carter Leake - Davenport & Company Llc

Also earlier in the week there was an upstream supplier that mentioned that some of the suppliers appeared to be already anticipating a rate cut which may talk to some of the de-stocking we’ve had. Do you think that there’s a possibility that if Boeing does not cut production in 2010 that the supply chain could get caught short?

Marshall Larsen

I have to tell you that I don’t know the answer to that question but I can tell you how we deal with suppliers. We’ve been spending a lot of time helping suppliers go from some of them as little as 50% on time delivery to 90% on time delivery through going into their factories and helping them on lean and also where we’re very concerned we have gotten price reductions from the supplier in order to get them cash sooner because the small suppliers out there can’t sit a long time without cash. I mean, we don’t like doing it, that’s for sure, as a Tier 1 supplier, but we have to make sure that these suppliers remain viable and I don’t think as long as we’re working with our suppliers that way that they will do that, but I think there’s going to have to be a lot more communication about what the rates are going to be as we go forward.

Carter Leake - Davenport & Company Llc

Very helpful. Just on more, on the 24 month lead time on wide bodies, do you think we could conclude that on wide body production, that the lead times would be closer to that 24 month number?

Marshall Larsen

They’re only that when landing here because of forgings. Anything else does not have near that kind of a lead time. If Airbus cuts the production of an A380 like they’ve done in the last 6 months, now we’ve got forgings in the pipeline that means we’re going to have more inventory than we need. It’s too late to change them, so we’ve got to understand where they’re going in terms of future productions so we don’t over order when the next production change comes. We’re in constant talks with them on it. We don’t have nearly the issues I said on the narrow bodies.

Operator

Your next question comes from Howard Rubel - Jefferies & Company.

Howard Rubel - Jefferies & Company

Just two things very quickly. First, on taxes, Scott, not sure I heard exactly why this is better, and how sustainable do you think you can be with that?

Scott Kuechle

On the tax rate, Howard. When we go into the year, we typically look at opportunities in terms of audit settlements and things like that, that we might expect to occur during the year. We budget those in into the overall annual rate. The question though, is the timing of those settlements. What we’ve seen so far this year is slightly better than what we expected for the year, but all being realized in the first quarter and the second quarter.

We’ve got very good tax rates in the first half of the year, not as good in the second half. The full year rate is down about a percentage point better than what we anticipated. It’s just delivering the things that we anticipated when we started the forecast year, which is getting those audit settlements done, doing some good work on the tax planning sides. That’s all that’s achieving. Sustainability going forward – we think the rates for the next several years, you know, may be a little bit higher than what we’re seeing this year, but not dramatically.

Howard Rubel - Jefferies & Company

On the other hand, you’ll get the rest of the benefit of the domestic manufacturing tax credit going forward, I think next year. If you’re being conservative, you probably have a little bit of room, don’t you?

Scott Kuechle

We continue to get the benefit of R&D tax credits, as we put a lot of R&D in the systems, supporting these new platforms and programs where we won a lot of market share, so that is also a good driver for the tax rate.

Howard Rubel - Jefferies & Company

And then the last thing, just very briefly. You know both receivables and inventory were up, and it’s sort of surprising given that volumes are down and you talk about lean. Can you sort of square that for me?

Scott Kuechle

Yes, actually if you look second quarter versus where we finished the first quarter, we had reductions in inventory and receivables, so they were a source of cash in the second quarter versus the first quarter. Also, on the accounts payable side, we actually put a lot of money into the supply base during the quarter in terms of flushing payments through the system. Overall working capital was very good on both inventory and receivables. We paid a lot of supplier payments on the quarter as well.

Howard Rubel - Jefferies & Company

[inaudible]

Yes, you probably are how we’re looking at inventory including our non product investments which is a part of the aerostructures contract accounting. That continues to be $50 million a quarter roughly run rate in terms of investments that we put on the balance sheet capitalizing the inventory. The actual product inventory has turned very nicely.

Operator

This concludes today’s question and answer session. I would now like to turn the call back over to Mr. Paul Gifford.

Paul Gifford

Thank you and thank you for joining us today. Sorry we went a little long. We wanted to make sure we got all the questions in. I look forward to talking to you guys throughout the rest of the day and then the upcoming weeks.

Operator

This concludes today’s conference. Thank you for your participation.

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Source: Goodrich Corporation Q2 2009 Earnings Call Transcript
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