Rockwell Collins, Inc. F3Q09 (Qtr End 06/30/09) Earnings Call Transcript

Rockwell Collins, Inc. (COL)

F3Q09 (Qtr End 06/30/09) Earnings Call Transcript

July 30, 2009 9:00 am ET

Executives

Dan Swenson – VP, IR

Clay Jones – Chairman, President and CEO

Patrick Allen – SVP and CFO

Analysts

Myles Walton – Oppenheimer & Co.

Cai von Rumohr – Cowen And Company

David Strauss – UBS

Noah Poponak – Goldman Sachs

Howard Rubel – Jefferies

Robert Stallard – Macquarie Capital

Robert Spingarn – Credit Suisse

Ron Epstein – BAS-ML

Joe Nadol – J.P. Morgan

Carter [ph] – Barclays Capital

Presentation

Operator

Good morning and welcome to the Rockwell Collins Third Quarter Fiscal Year 2009 Earnings Conference Call. Today's call is being recorded. For opening remarks and management introduction, I would like to turn the call over to Rockwell Collins’ Vice President of Investor Relations, Dan Swenson. Please go ahead, sir.

Dan Swenson

Thank you. Good morning, everyone. With me on the line this morning are Rockwell Collins’ Chairman, President and Chief Executive Officer, Clay Jones, and Senior Vice President and Chief Financial Officer, Patrick Allen.

Today's call is being webcast, and you can view the slides we will be presenting today on our website at www.rockwellcollins.com under the Investor Relations tab. Please note today's presentation and webcast will include certain projections and statements that are forward-looking as defined in the Private Securities Litigation Reform Act of 1995.

Actual results may differ materially from those projected as a result of certain risks and uncertainties, including but not limited to those detailed on slide two of this webcast presentation and from time-to-time in the company's Securities and Exchange Commission filings. These forward-looking statements are made as of the date hereof, and the company assumes no obligation to update any forward-looking statement.

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

Clay Jones

Thanks Dan, and good morning.

Let me begin by saying as I often do that I think our balanced business and focus on operating excellence continues to pay dividends through good times and bad. In what was surely the most difficult quarter so far this year, we generated EPS of $.91 as we earned total segment operating margins of 21.5%, even with a 9% decline in revenues to approximately $1.1 billion. These results are due largely to exceptional performance in our government systems business, which increased operating earnings by 21% on 7% revenue growth. The addition of DataPath and SEOS to our portfolio contributed just over half of the revenue increase with the balance coming from our strength in simulation and training solutions, aircraft upgrades and new development programs.

This profit performance demonstrates the strength of our shared service business model as the cost savings realized across the enterprise allowed government systems to expand its year-over-year margins by 270 basis points. On the other hand, our commercial systems business experienced a 26% revenue decline, which was in line with what we communicated earlier in the year. The factors causing this decline came from across the board. Business and regional jet OEM revenues were down dramatically due to plant shutdowns and aircraft production rate decreases. Business and regional jet aftermarket volumes declined as a result of the downward trend in utilization as takeoffs and landings decreased in the order of around 27% to 28%.

We saw a decline in air transport OEM revenues due to lower 787 related sales and post strike inventory clean up at Boeing along with impacts from deferrals and reschedules at Boeing and Airbus that led to a customer mix where we have a relatively lower share of airline selectable equipment. And the air transport aftermarket revenues continued to decline as aircraft experienced lower passenger volumes, diminished yields, and decreased profitability, all of which they are working to offset with capacity reductions and cost conservation strategies, actions which affect both services and support revenues as well as retrofit and spare sales.

In the midst of these commercial markets challenges, a highlight was our ability to generate very strong year-to-date operating cash flow of $381 million, which is a 23% increase compared to the same period last year. And that is after a voluntary $75 million contribution to our pension plan. I am particularly proud of the way our people have focused on inventory and working capital management despite an extremely volatile delivery environment and have asked Patrick to provide a little bit more detail of our improvements in his comments.

In contrast to recent earnings calls, I am very pleased to be able to reaffirm our EPS guidance, which continues to stand at $3.70 to $3.90. The fact that I can do so indicates we are starting to see some relative stabilization and a decrease in the flow of bad news in our commercial markets. Our EPS guidance still anticipates further declines in commercial system sales which we think will be down in the fourth quarter about the same percentage amount that we have experienced in the third quarter as we realized the full impact of the business jet OEM summer shut downs and a weak after market environment.

Meanwhile government systems sales are expected to remain strong as we expect fourth-quarter revenue growth in excess of 20% driven by the acquisition of DataPath and SEOS as well as a broad range of organic contributors such as the Joint Precision Approach And Landing System aircraft upgrades and network communication programs. So that is what the near term looks like for Rockwell Collins but let me also give you our perspective on market conditions as we see them over the next few months and as we prepare our fiscal year 2010 operating plan guidance which we expect to share as usual in September.

This year, business aviation has been our greatest area of uncertainty and risk. But now we may finally be seeing some early signs of stability. There is still some risk around OEM production levels for the balance of the year. The level of this risk is contingent on order activity and the level of white tailed aircraft they have on hand. One of the biggest factors that will determine how quickly these whitetails are sold and when business jet order activity turns up is the size of the used jet market. We have seen some encouraging indicators as used inventories have recently started to come down and brokers have noted an increased level of buyer interest. Hopefully, these early trends will continue to improve to at least provide a stable production base later this year.

Regardless of what happens, we will see very tough comparables in that part of our business as we move into fiscal year 2010. In the business jet aftermarket, while the year-over-year declines in takeoffs and landings is still very high, there also seems to be a sequential stabilization. This indicates that a new albeit lower floor is being established. Improved utilization along with some pickup in the used jet turnover should help create conditions for potential growth as used buyers seek to upgrade aircraft during that transfer of ownership period. While maybe a few quarters away from really seeing this take hold, it is an area of light in what was otherwise a very dark horizon.

Now while we believe we are approaching the bottom of the market for the business jet environment, I think it is far too early to say the same for air transport. To date, Boeing and Airbus have been very vocal with their intent to maintain narrow body production rates. We certainly hope they can, and have enough flexibility in our manufacturing and supply chain to deliver at those rates. However, as we look at the macro environmental factors, we can't help but be concerned that those factors could ultimately cause the OEMs to revise their production rates downward. Fortunately, based on the lead times required by other suppliers, the longer Airbus and Boeing maintain their rates, the lower the potential impact for our next fiscal year. That type of lead time gives us great flexibility in managing our production base and our supply-chain.

In the meantime, we will continue to build to their production plans and we will be watchful of any future announcements. The area that is the hardest to call at this time is the air transport aftermarket. Air travel is the key metric we're watching and we're also keeping an eye on oil prices. We are disappointed that air traffic has not improved during the traditionally strong summer season. Until aircraft yields and ultimately profitability improves, most discretionary retrofit and upgrade programs will continue to be deferred. We also need better fleet utilization and more flight hours to drive MRO revenue. If the worldwide economy improves later this year as anticipated, we may see some improving signs in the latter half of fiscal year 2010.

Now as has become a recurring theme, government systems continues to be the area of stable outlook as we think conditions remain conducive to long-term mid-single-digit organic growth despite the inevitable pressures of the defense budget – on the defense budget that will come as a result of deficits and other administration priorities. We feel that the combination of our position in the higher growth electronic segment, our success winning new programs, and the diversity of our presence across the US military and around the world gives us confidence in this outlook. Our proven ability to acquire strategic bolt on properties should only enhance our ability to grow even faster.

So with that, I will turn the call over to Patrick to take you through more specific details about our third quarter results. Pat?

Patrick Allen

Thanks Clay and good morning to everyone as well.

Let us get started by first reviewing our third quarter results. Let us start out on slides three and four. Total company sales declined 9% compared to last year, and net income decreased 17%, while earnings-per-share were $0.91 for the third quarter of 2009 versus $1.07 for 2008. Turning to slides five and six, we have our third quarter results for government systems. Total government system revenues increased 7% from $607 million to 651 million. Air borne solution sales increased 23 million with 4 million of the growth coming from the acquisition of SEOS Group Limited. The organic revenue growth of $19 million was primarily from the sales of simulation and training solutions and higher production volumes displaced for F-15 aircraft, as well as higher development revenues on the Common Range Integrated Instrumentation System program.

Surface solution sales increased $21 million. Sales from the acquisition of DataPath contributed 23 million to surplus solutions while organic sales declined 2 million as lower sales from DAGRs and GB-GRAM products were partially offset by higher revenues from the Joint Precision Approach and Landing System program. Page 6 shows the operating margins within government systems, which again were quite strong at 24.3% of sales compared to 21.6 a year ago.

This increase in margin and the associated 21% increase in earnings was due to lower employee incentive compensation costs and reduced selling, general and administrative costs relative to 2008. Moving onto page 7, our total commercial systems revenues for the third quarter decreased 26% from 587 million to 433 million. Revenues of our OEM business decreased 114 million or 35% to 211 million as a result of lower production rates at business jet OEMs, a decline in 787 program revenues, lower order volume due to Boeing's post strike inventory rationalization, and reduced sales of selectable equipment primarily due to the production rescheduling at the OEMs.

Our aftermarket revenues decreased $40 million or 17% to $199 million due to lower avionics services port revenues, the absence of avionics hardware sales to 787 simulator manufacturers that benefited 2008 and lower retrofit hardware revenues in both the air transport and business jet aftermarket. Finally, sales of wide bodied IFE products and systems were flat at $23 million.

Slide eight details operating profit margin information for commercial systems. We saw a decrease in commercial system operating margins from 23.7% in the third quarter of 2008 to 17.3% this quarter. The margin decline was due to lower sales volume which we were able to partially offset with our reductions in discretionary research and develop and expenses, lower employee incentive compensation costs, reduced headcount, and other cost saving activities.

On slide nine, we have our nine month year-to-date total company financial results for sales, EPS, net income and operating cash flow. Of note on this slide is the increase in our year-to-date cash flow from operations from $310 million in 2008 to $381 million in 2009. Contributing factors to the strong cash flow included working capital improvements related to collection on accounts receivables, advanced payments received from customers as well as lower income tax payments. There were partially offset by the voluntary $75 million contribution we made toward defined benefit pension plan and payments for employee compensation.

We also made significant strides in improving inventory management, which was matched by acquisition impacts. Excluding the $32 million of inventory from the acquisitions of SEOS and DataPath, our net inventory would have been $966 million, $4 million lower than our fiscal year end 2008 inventory, and an improvement of $60 million if you exclude pre-production engineering costs.

Slide 10 provides an overview of our capital structure at the end of the third quarter compared to fiscal year end 2008. With the new long-term debt we issued to pay down short-term debt and fund the DataPath acquisition, our total debt outstanding was 647 million as of June 30. Slide 11 details our share buyback activities in the third quarter of fiscal year 2009. We repurchased 1.4 million shares at a total cost of $55 million leaving 67 million of remaining authorization for future share repurchases. This latest activity brings our total share repurchased since January 2002 to 53.2 million representing $2.4 billion in cash returned to shareholders through repurchases.

Now on to our final slide, slide 12, where we provide updated details of our fiscal year 2009 financial guidance. Looking first at our revenue projections, we are now expecting revenues for 2009 of about $4.55 billion, roughly a 5% decrease from 2008 actual results. In commercial systems, we anticipate full fiscal year 2009 revenues to be down approximately 20% from 2008. This reflects OEM revenues being down about 22% and aftermarket revenues being down about 17% for fiscal year 2009 and roughly a 40% decline for wide bodied IFE product revenues.

In government systems, we expect full year r revenue growth of 11%, including the impact of the DataPath acquisition. With regards to the segment operating margins, we believe that the dilutive margin impact of the DataPath acquisition will result in full year total segment operating margins of 21%. As we have said before, our expectation is that the government systems will perform at a level above that average margin and commercial systems will perform at a level below it.

Including DataPath, we still expect research and development expenditures of approximately 900 million with 40% being company funded and 60% being customer funded development. Capital expenditures should be approximately $150 million. Finally looking at earnings per share, our expected range remains at $3.70 to $3.90, which incorporates an effective tax rate range of about 32%.

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

Dan Swenson

Thank you, Patrick.

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

Question-and-Answer Session

Operator

(Operator instructions). Your first question comes from the line of Myles Walton with Oppenheimer & Co.

Myles Walton – Oppenheimer & Co.

I was wondering if you could talk about the defense margins a little bit, it was obviously very strong, but at the same time it looks like DataPath in the mix, DAGR lower, C-130 lower, were kind of working against you again on mix. Obviously incentive comp was a help but were there any program adjustments in there and what is the outlook for 4Q within this business?

Patrick Allen

Myles, there were really no significant program adjustments at all in the quarter. As we have indicated, we do expect the margins to come down a little bit in the fourth quarter due to a couple of things. One is our mix of sales and secondly is – I should say, probably identify three things. One is the mix of sales, two is DataPath itself will dilute margins on the government systems side. The third thing is we have kind of run out of incentive compensation adjustments with this quarter, we are down, now down to 0% accrual, so there'll be no further adjustments in the fourth quarter.

Myles Walton – Oppenheimer & Co.

Was the year on year benefit for lower incentive comp maybe 200 basis points?

Patrick Allen

I would think more like 100.

Myles Walton – Oppenheimer & Co.

100, okay. And the only other question to honor the two question rule is can you talk about what we should be thinking about for both incentive comp and pension expense building into 2010?

Patrick Allen

Well, just to give you a little color, and we haven't, we have not completed our planning process, so the short answer is, I can't give you a whole lot of guidance. But we said about pensions is that we expect the pensions to be higher next year due really to two things. The largest contributor now is the discount rate. As we look at it, it is probably about 125 to 150 basis points lower this year as we sit today than was last year. And as we indicated, that is about $5 million of expense for every quarter point, so you are looking at a fairly significant headwind there. And then the asset performance, now our assets have returned a little bit, so I would say that it's less of an impact next year as we look at it today, but again we've still got three months to go before our measurement day. As it relates to incentive compensation, what we have said is that it is about $1 million for every percentage point of incentive compensation and last year we paid out about $120 million, this year paid out to about zero. So my suspicion is it should be somewhere between those two numbers.

Myles Walton – Oppenheimer & Co.

Okay, thanks a lot.

Operator

Your next question comes from the line of Cai von Rumohr with Cowen and Company.

Cai von Rumohr – Cowen and Company

Thank you very much. You know still with everything, the government margin looks given the mixed anonymously strong, was there any, were there any positive adjustments in the government area?

Patrick Allen

As I had indicated, the only adjustment Cai was the really the incentive compensation accrual. We reduced our incentive compensation down to zero, that had a benefit of about $9 million for the total business, so think about half of that being government.

Cai von Rumohr – Cowen and Company

Okay, thank you. And then you gave us kind of you know what commercial and air transport, could you give us some granularity, I think last time you give us some help in terms of how much was biz jet RJ OE down, how much was air transport OE down, and segment the aftermarket how much were each of the sectors, biz jet and the air transport down in the quarter?

Patrick Allen

Sure. The biggest decline on the OEM side was business jet as you could probably imagine. That was about 43%.

Cai von Rumohr – Cowen and Company

In OE?

Patrick Allen

In OE, yes. Air transport was down about 29%, it was a little more than we expected quite frankly, it was due to a few things that I think Clay noted which is the some inventory rationalization at Boeing, some customer mix issues as a result of the production rescheduling, and the absence of some 787 related revenues. And OE and regional jet OEM revenues were down about 22%. So that gives you a picture of what happened on the OEM side. On the aftermarket side really there was weakness across the board, so about 17% in total aftermarket and it was roughly split about equally between biz jet and air transport.

Cai von Rumohr – Cowen and Company

Thank you very much.

Operator

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

David Strauss – UBS

Good morning. Clay, can you just give us an update where you stand on 787 and your discussions, negotiations with Boeing?

Clay Jones

Well, we don't know where everybody else is, but I think we are the least of Boeing's problems. We do have some claims as you know for nonrecurring work that was down and that they still owe for, that are still in negotiation. We also have some cash due from equipment delivered that is not yet "flight ready" that is being changed from red label to black label. But I would tell you although all that is important to us, it is relatively immaterial in the grand scheme of either what Boeing is facing or obviously the performance of our corporation.

So we're getting that as we – we're dealing with that as we can. We would like to move that forward but we certainly understand Boeing's got its hands full right now with other bigger issues and the way I would say is our development has gone extraordinarily well. We have no outstanding issues and we're well ahead of where we need to be right now for any production deliveries on the horizon.

David Strauss – UBS

As my follow-up, thinking about 2010 and the color that you gave on the markets and then obviously pension and what is likely to be higher comp accrual, I know you don't want to give 2010 guidance, but I guess what has to happen or is there anyway that your earnings in 2010 would hold at these levels?

Clay Jones

Well, I think if you look at the headwind, that is going to be very difficult unless the market changes fairly substantially. You know what I tried to do was in my opening comments outline for you what the dynamics are in that market and the relative trends which you know you can put your own spin on, and then obviously what we don't know yet is the specific details of how much pension expense it will be and exactly where we are going to put our compensation programs and how much that is going to be. As Pat said, we are still on our planning process and we will be working that through the month of August, then we will let you know that in September. But depending on all those variables, we will see in September.

David Strauss – UBS

Okay, thanks.

Operator

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

Noah Poponak – Goldman Sachs

Hi, good morning.

Clay Jones

Good morning.

Noah Poponak – Goldman Sachs

At government systems, the top line growth number you are providing before adding DataPath is a little lower than it used to be, can you just talk about what has been a little softer than you expected?

Patrick Allen

I think it is due principally you know just some program delays, we're seeing a little bit less revenues on some of our development programs. FCS, the hold up on FCS, the cancellation of the ground vehicle was also another headwind that caused us to reduce our organic sales growth a little bit.

Noah Poponak – Goldman Sachs

And can you give us your view on how you see that playing out with FCS and whether or not it creates an opportunity for you or just your thoughts on the program?

Clay Jones

Well, yes, Noah, I think we have fairly good visibility how it is going to play out and the issue that Pat talked about is more a delay that the loss of long term r revenue. As has been fairly widely reported, in that cancellation, the DOD full well expects to reconstitute that program and to begin what they call an army brigade combat teams approach to continuing the develop the networking portion of FCS while they are restructuring portion that would deal with the vehicles.

We think most if not all of the content we had on FCS would port over to these new programs. But to do that, they have got to change the color of the money and that request is currently sitting with the committees in Congress and we're waiting for their approval for that restructuring of the money. We think that won't happened until probably mid-August timeframe and that is why we reported this delay where we are frankly not doing the work right now because we are not going to do it on our nickel until they figure out what that is going to be.

So we think things like our integrated computer system will continue forward, all the JTRS which there is over 200 radios we have developed for ground test will continue. And then ultimately we think that that the displays program, the low-cost displays program, will move from the new developmental vehicles to the legacy vehicles as they integrate this situation awareness networking platform into legacy vehicles. And that is the clear intent that we pick up from DOD.

Noah Poponak – Goldman Sachs

Okay, thanks a lot.

Clay Jones

You bet.

Operator

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

Howard Rubel – Jefferies

Well, I hate to be a guidance analyst, but I am going to – it is very unusual for you to have such a wide range for the final quarter of the year. Could you just for a moment, Patrick, elaborate on some of the extremeness to the variability?

Patrick Allen

Well, I think the only reason it is wider than what we normally do is because of the market environment, Howard. I mean here is a guy that has guided you down every time I have spoken to you since September and for once I feel pretty good about holding what I have. But I don't feel so good not to suggest there is variability in the market. As I said, we have got to wait and see how biz jets work out, and we have got this FCS thing that we're working with right now. And I think it is no more sinister, Howard, than just the market environment and the ramp uncertainty we have dealt with earlier along. So that would be my answer.

Howard Rubel – Jefferies

No, it is pretty fair. And if you look at your buyer furnished equipment business, you talked about we will call it also the volatility of that market, are you starting to see discussions with some of the non-US carriers regarding sort of their needs especially in the narrow body market? Are you seeing any change in tone or character yet?

Patrick Allen

No, we are not. And I view this buyer furnished equipment issue this quarter as an aberration. We don't expect it to be recurring in the fourth quarter and as I stated there, it is just a function of almost a Monte Carlo, think of the Monte Carlo scenario where Boeing and Airbus have as you know have been doing this wild rescheduling as they are getting cancellations, deferrals and pull ins. And literally we are all waiting around to see which customer is going to go where as we are shipping our equipment. Part of you know in the midst of all that, we saw a customer mix here that affected us. But we're not seeing any change in the end customer decisions or in the way those buying influences are going right now.

Howard Rubel – Jefferies

I mean it is not uncertainty – how shall I just ask this, just to wrap it up, is it – there is still some uncertainty but maybe the level of volatility has declined?

Patrick Allen

Are you talking about specific for BFE, Howard?

Howard Rubel – Jefferies

Yes, sir. Thank you.

Patrick Allen

No, I just – I really don't experience a change. If they are going to buy an aircraft, they are going to have BFE. If they have BFE, we there have preferred supplier agreements in which case it is ours, and all of that, or if they do a competition, and all of that is going according to form. I really don't see many market dynamics. If they are going to buy the aircraft in the way that they procure the BFE.

Howard Rubel – Jefferies

Thank you.

Patrick Allen

Yes.

Operator

Your next question comes from the line of Robert Stallard with Macquarie Capital.

Robert Stallard – Macquarie Capital

Clay, first of all, I just wondered if you could classify the comments you made with regard to government systems about good acquisition opportunities. Can we expect to see a shift maybe there in your cash deployment, less share buyback, and maybe looking for more acquisition opportunities?

Clay Jones

Well, you saw that this Rob. I wouldn't say that is a shift at all. I would say – you know our approach, that hasn't changed in seven years. We're looking for good bolt on acquisitions that make good strategic value, that can accelerate our growth. And I think that is what we are looking for. As we have said for the last several quarters, I believe conditions like this present more opportunities, and that we have seen a relatively richer pipeline than we have seen let us say a year or two ago. And I think that is a function of the smaller companies that we're going after, are seeing the ramifications of the credit markets.

I think that people are even becoming more shy of doing business with smaller companies without good capital resources. Typically that is one of the things we always see you grow a company up to $50 million or $100 million that do very well and they go after program that customers say, well, you're going to be around. And so that is even more of a pressure now. And I think as we look at the shape of the defense budget out in the future, you know some personal owners are saying now is the time. So all that is creating I think a little bit more robust pipeline and that little more robust pipeline gives me hopefully more hope and opportunity we will see some capital deployed in that area.

Now, you're not going to see a jailbreak on our side, we are not going to become a serial acquirer, we've never had been. But the good news is we have a lot of good cash flow right now, we have a very good position right now in our balance sheet that Pat and his team have positioned on this year, and we will take advantage of those opportunities using the same disciplines you have seen us do in the past.

Robert Stallard – Macquarie Capital

Okay. And secondly on the defense margins again you obviously highlighted the compensation issue (inaudible) if you look at the margin on a more structural basis, particularly looking forward, do you see any shift there, Clay, in terms of mix or potential underlying margin that makes you feel comfortable that you can sustain this kind of margin going forward?

Clay Jones

Rob, I think we are most likely to not sustain the margin as it is today. I think probably the biggest structural change we see going forward is DataPath, at least in the near term. That is going to come at very low, almost no margin, and so that is going to – and it is a relatively significant piece of the business, it is roughly 10% of the sales of our government systems business. So that is going to be a margin drag for at least the short-term.

Patrick Allen

Well, I think the other side of that question though Rob is, we don't see anything different in the kind of contract mix that we have. It enables us to have that high margins, so I feel good about that. And once the reset for DataPath happens, it actually gives us another chance to continue expanding that margin as we go into DataPath, get past this accounting period, and do the kind of work I know we can do to significantly enhance their existing margins. So it depends on which structure you're talking about, the long term structure I see no difference.

Robert Stallard – Macquarie Capital

Thanks very much.

Operator

Your next question comes from the line of Rob Spingarn with Credit Suisse

Rob Spingarn – Credit Suisse

Good morning.

Clay Jones

Good morning.

Rob Spingarn – Credit Suisse

Just a clarification question, first, when I look at your guidance change from last q quarter to this and no what is talked about this on the defense side but the 1% lower growth there but also we have 2% greater decline in commercial, so really a 3% adjustment from before but the top line ex-DataPath stays the same?

Clay Jones

Well, it is kind of a rounding thing. We are probably a little bit above 4.5 billion before – in the third quarter. As we look forward today, it is a little bit below 4.5 billion. And then you add DataPath which is roughly about 80 million, that will take it to the 4.55.

Patrick Allen

But to your – but to the – to answer your question, r the conditions think we have already highlighted, we are seeing some organic revenue weakness in both government and commercial systems highlighted by the items that we talked about, OEM on the commercial side and some of these programs delays and move outs on the military side.

Rob Spingarn – Credit Suisse

Okay. And Clay on the organic growth side and the recovery in biz jet, and you have touched on this earlier, but could you talk a little bit more about how you expect biz jet after market and OE to fold out here, maybe the lag between the two. I suspect we think that flight ops and spares would improve first and then OE after that, how do you think about that?

Clay Jones

Well, as I said in my remarks, that is a tough one to predict right now, Rob, because I just think we are right in the kind of the middle of the storm. But if it follows a predictable path, first of all, I would expect the biz jet aftermarket to recover a little faster because everything about that market happen faster. The OEM recovery happen faster, the aftermarket happens faster, and so I think as people begin to use these aircraft and realize their utility in the midst of a world that is declining, the air transport system and the number of seats available, that is I think an inevitable as people move back into that market, you will see an aftermarket increase. And I think you would see that pickup hopefully relatively soon, as soon as you've seen utilization improved.

With the air transport aftermarket, you know now we're looking at conditional events. We're looking at better economy, ultimately better employment, more people travel, more seats being used, and then you begin to see OEM revenues for MRO pickup – I mean, sorry, the aftermarket revenues for MRO pickup, and then following that, there will be sort of as they get cash generation to improve and profitability improves, some of these retrofits and spares will come back in. My uncertainty now is how long is that going to take. As we sit here today, you wonder if it is ever going to happen. I know it will, but at what pace, it is very difficult to say. And I think that is going to be the biggest uncertainty as we go into 2010 is what is exactly the pace of aftermarket improvement. As I say, I am sort of biased to the conservative side right now.

Rob Spingarn – Credit Suisse

The reason I asked the question Clay is in Paris you talked about just the very sharp and accelerated decline in biz jet relative to OEM. In fact on the large jet side of course we have seen very little in terms of changing production rates. Should we think about the biz jet cycle recovery as more condensed that the various pieces, space, retrofits, OE than commercial?

Clay Jones

Oh, yes, absolutely. Always has been, I think always will be. It's just – it goes down faster, it comes back faster relative to be big air transport items.

Rob Spingarn – Credit Suisse

Thank you.

Operator

Your next question comes from the line of Ron Epstein with BAS-ML.

Ron Epstein – BAS-ML

Yes, good morning guys.

Clay Jones

Good morning.

Ron Epstein – BAS-ML

Clay, just maybe a follow-on to one of your opening points, you mentioned that you're potentially fearful that we might see a cut in large aircraft build, do you mind elaborating on that?

Clay Jones

I do, that is a risk, I would tell you, Ron. Well, the thing is first of all, I mean I am encouraged by the fact that Boeing Airbus feel that they can maintain those rates in the near term. I will say that they have bent over backwards to try to tell us and re-explain to us why they feel like they can. And I want to believe them to my bones. And if they can do that, I will be a happy guy, you will be a happy guy. We'll all be happy guys.

All I'm doing is overlaying that to what as you are to what traditional cycles have been and look at the supply demand equation and it is hard for me to pencil that out so it ends up in the same place that the OEMs are seeing. And so that is my caution. It is not because I have any insight at all that is additional to what the OEMs are telling. I do not. But as a result of historical evolutions, we are just being cautious. As I stated in my opening remarks, it is more of a planning issue for our guidance to you than it is a running our business issue, because our supply chain and manufacturing lead times are such that we will know well before, well before, to actually change the production rate. 777 is a great example, we have known that for six months and we can now begin to think ahead and align our supply chain. So that was and there is no more difference than what I have said in the past about that, no insight, just a concern about historical relativity.

Ron Epstein – BAS-ML

Okay great. And then maybe one clarification for Patrick, when we think about defense margins for this year, for the year, maybe I missed it, but what kind of range do we think that they will end up in for the year?

Patrick Allen

We didn't talk specifically about the margin. What we said was we're going to have total operating segment margins above 21%, government systems is going to be above that. So they are running a little bit over 24 right now. I would anticipate it being somewhat less next quarter.

Ron Epstein – BAS-ML

Okay, great. Thank you.

Operator

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

Joe Nadol – J.P. Morgan

Thanks, good morning.

Clay Jones

Good morning Joe.

Joe Nadol – J.P. Morgan

On biz jets, one more for you. You did 189 million in the quarter and you say you see things kind of bottoming out, you have certainly gotten a pretty big impact on the OE side now, but even though you are down 43%, I guess there is as we see on the air transport side down well 20% I guess, well over 20%, without any real reduction in rates yet, you know, but one that I think could get worse. The question is does that 189 that you did in the quarter, do you think that is the bottom?

Clay Jones

For biz jets?

Joe Nadol – J.P. Morgan

Yes.

Clay Jones

I think it is getting close, Joe. We said that our – you can take commercial systems in our fourth quarter and it is going to be about the same amount of reduction that we saw this quarter. And so if we are not at the bottom, we're getting real close to it. And that combined with the relatively stabilizing signs we're beginning to see, which I outlined in my comments, gives us some confidence we are there. And that doesn't mean it will get better faster, but at least it will quit going down and the amount of bad news is diminishing. So yes, I think we are not at the bottom, but we're getting pretty close to it, Joe. And also let me just mention, I want to reinforce this, the OEM reductions on the air transport side were I think a lot of one-time cost events, either because of the comparability on the 787 sales we had a year ago, including the NRE sales or these things where Boeing kind of over ordered in the second quarter and how they rationalize it in the third quarter for some of our things, I believe these are transitory there. So we wouldn't take too much from that.

Joe Nadol – J.P. Morgan

Okay. And then just on the follow-up, I'm not picking on you guys at all, on the share repurchase side of things, you picked up your volume a little bit this quarter, your stock was up a bit this quarter from where it was in the calendar first quarter. I guess just wondering what's the strategy is here? I guess I take that I mean you're feeling a little more comfortable with the world and it is you're not sort of timing, trying to time your stock, but more just looking at your comfort level and as indicated by your comments here in the call you are feeling a little bit cautiously better about things.

Clay Jones

I wouldn't necessarily characterize it that way Joe. I think it is a function of cash flow which you saw was a pretty strong cash flow quarter. What we're looking at last quarter was relatively weaker cash flow plus a fairly significant acquisition for us in DataPath and so we slowed down share repurchases accordingly. This quarter we will start to generate more cash flow, so we're doing a little bit more share repurchase. It is as simple as that.

Joe Nadol – J.P. Morgan

Okay. Fine, thank you.

Operator

(Operator instructions). Your next question comes from the line of Joseph Campbell with Barclays Capital.

Carter – Barclays Capital

Good morning.

Clay Jones

Good morning Joe.

Carter – Barclays Capital

Good morning. Well, it is actually Carter [ph] and Joe. Good morning guys. Clay, I wondered if you could think a little bit or comment a little bit, I know you don't give guidance till September on 2010, but as you think about all the various pieces, I mean there is a lot of headwinds and potential negatives that you're battling against, whether it is pension or incentive comp or biz jet OE or air transport OE, are there some things that could surprise us to the upside?

Clay Jones

Well, they are harder to find right now, Carter. I think most of those are sort of macro dynamic things, example of any of the markets began to recover a little faster than we see it, that would be good news. You know we are chasing some opportunities in the government side which could end up being very interesting if those come to pass. But I wouldn't say anything that reaches either the import of the magnitude of those things you outlined.

Carter – Barclays Capital

Okay.

Joseph Campbell – Barclays Capital

Well, we're all looking for it.

Clay Jones

Thank you.

Carter – Barclays Capital

Thanks, guys.

Operator

We do have a follow up from Cai von Rumohr with Cowen and Company.

Cai von Rumohr – Cowen and Company

Yes, thank you very much. So is DataPath EPS neutral because kind of if you do the numbers of 21.5 without it, 21 with it, and the incremental 50 million of sales, it looks like it is negative. I don't know if that is rounding, so that would be part of the question. And then as you pointed out, it is going to be 200 million plus of sales. You know what is the plan, what are you doing to improve profitability, and when might you improve and when might you hit that goal and what kind of margins do you think this business ultimately can have?

Patrick Allen

Well, I think – Cai, firstly it is EPS neutral. There is no negativity in it, and numbers don't (inaudible) it is probably rounding.

Clay Jones

Yes, it is more like about 80 million of sales and which you're really getting tripped up on as well.

Cai von Rumohr – Cowen and Company

No. I'm talking about next year. You're talking about making these improvements obviously you didn't buy this business to be breakeven forever, so can you help us understand what are the intangibles, what kind of operating changes are you making so that this will become a more profitable business, and when might that profitability start to show through?

Clay Jones

Well, first thing, let me say this. It has been a long-time since we have done an acquisition and where I am more convinced we can make operating improvements. This was a very good business in terms of its market position but I would say it was a less well-managed business in terms of its just overhead SG&A that it had. They had unfortunately geared up to be a bigger company than they were at the time and as you remember they lost a contract right before we bought them and that put their profitability into a spiral.

We believe that there are some very readily available cost takeouts there as a stand-alone business. And then when you add in our shared service business model, which this business is large enough to really take advantage of it, where get synergies and consolidations of a lot of their back office stuff into a much better organization, I think just the combination of those two right there would make it a much more profitable business.

And then the third thing we hope to add to that is the revenue synergies of adding their communication capability to our total portfolio and the opportunities that we believe present themselves for improving their revenue flow. And all three of those things I think are readily available to us if we get after and I will tell you Greg Churchill is singularly focused on getting after.

Cai von Rumohr – Cowen and Company

Well, I assume a business like this, the intangibles are not going to be huge because you didn't pay that much for it, maybe I am wrong. But these cost takeouts, I would assume a quarter or two once you make the cost cuts, they are gone, so that by certainly by the second quarter of next year, I would assume this thing would start to be producing much better numbers than it is today, is that a fair assessment?

Clay Jones

We hope it is.

Cai von Rumohr – Cowen and Company

Okay, great. Thank you.

Operator

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

David Strauss – UBS

Clay, looking for positives in 2010, can you give us some maybe some color on R&D, how much room there might be in terms of moving down the discretionary side of R&D as we look into 2010?

Clay Jones

I think that there is good opportunity for moving discretionary down. The interesting just trying to look at the macro dynamics of it, in the course of this last year, there have been virtually no new starts in the commercial sector where we do most of our discretionary investments. And there are always programs that complete as you go year-to-year. And one of the reasons our discretionary gross is we have been very successful at not only winning programs, but winning market share of those programs. We will not see a lot of add on programs. The other thing is, if you look at the next two or three years, we are projecting that there is going to be less than half the number of new starts in the commercial world that they're going to be in the past three or four years. So I think that just structurally we have the opportunity to walk that discretionary R&D down. Now how much, we will wait and see.

David Strauss – UBS

As a follow-up, the Cessna Columbus, any exposure there to the program being canceled?

Clay Jones

Not at all.

David Strauss – UBS

Yes. Thank you.

Clay Jones

You bet.

Operator

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

Noah Poponak – Goldman Sachs

Yes, just one follow up, I wondered if you could talk about the DAGR program a little bit more just because you noted that it declined in the quarter but you also recently done an expansion there, what should we look for from that going forward?

Clay Jones

The way I would characterize DAGR is as you know we reached a very high level of production over the last year or so and it is a relatively stable to slightly declining production rate. Even though we had an extension of that program and that program r revenue is going to flow out for the next several years, we are not expecting the rate of growth in DAGR that we have seen in the past. So I would just say we saw a slide decline, it wasn't a large decline, but a slight decline in this last quarter, enough to be a cause. But so long as we have the up tempo that currently exists both in Iraq and Afghanistan, they're going to need that equipment. So we think that the production rate will stay at a fairly high level but not on a growth path.

Noah Poponak – Goldman Sachs

Okay. And I will maybe try to ask Joe's question on the commercial top line but about the commercial margin with regard to how close you are to the bottom there. You know we know you've got the incentive comp, maybe going higher next year and you talked about the movement in R&D and the first half revenue declines are pretty tough. You know how should we think about the shape of that margin heading into the first half of 2010 and whether it is kind of close to stabilizing versus going much lower?

Patrick Allen

I would say we're closer to the bottom than we are to the top at the moment. But you are right, you pointed out all the headwinds and the tailwind being lower R&D. I would have to say we are not prepared to really talk about margin guidance for next year at this point.

Noah Poponak – Goldman Sachs

Okay, fair enough. Thank you.

Operator

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

Howard Rubel – Jefferies

Thank you very much. To go back to the shared service model for a moment, Clay, or Patrick, how is that you have been able to sort of prevent this spill from the softness in commercial not to drag down the defense margins?

Patrick Allen

Well, I think we have seen some spillover effect, particularly in our production area with respect to impact at government margins but it is a more than offset by the cost reduction activities we have taken. So we have been able to offset a lot of the also the overhead absorption issues we have seen in the factory with other cost saving initiatives.

Howard Rubel – Jefferies

And then are you essentially done with headcount reductions or is it is there anything that we should expect from here other than maybe some minor tweaking?

Clay Jones

Well, I don't think we are done yet unfortunately. I would like to say we are. But I think as I said we're going to see weakness in the fourth quarter and what we're doing is as programs are particularly impacted, either development programs or if we production weakness, we are taking what actions we need to take in a specific location or a specific program to rationalize the headcount around that. You're not – I don't think you're going to see any massive moment from now but I would love to be able to tell you we are finished, but I think that would be premature.

Howard Rubel – Jefferies

That was helpful. Thank you.

Operator

Your next question comes from the line of Myles Walton with Oppenheimer & Co.

Myles Walton – Oppenheimer & Co.

Thanks. Just one follow up elsewhere I guess an attempt to find some good news into 2010, given your comments on incentive comp accrual this year, looking to cash flow for 2010, I guess is it – do you see a case where or do you see significant higher probability that cash flow will be up in 2010 kind of along the same lines as the prior question on earnings being up in 2010? It looks like you have a much easier bar to be set for yourself on the cash side?

Clay Jones

Well certainly we (inaudible) that out right now, Myles, and for the first time, our first quarter cash flow looks pretty good because we're not going to have an incentive compensation payment. But the other consideration as we look at cash flow is pension contributions, we're going to put up a contribution into our pension plan. We have a fairly substantial growth in our deferred engineering balance on the commercial side due to the programs we have won. So there are puts and takes but I would expect next year to be a very solid cash flow year for us.

Myles Walton – Oppenheimer & Co.

Okay, thanks.

Operator

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

Dan Swenson

We plan to file our form 10-Q including our financial statements and putting those today, so keep an eye out for that. Thank you for joining us and participating on today's call.

Operator

Thank you for participating in today's conference call. You may now disconnect.

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