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Esterline Technologies Corporation (NYSE:ESL)

F3Q09 Earnings Call

September 3, 2009 5:00 pm ET

Executives

Brian Keogh – IR

Robert Cremin – Chairman, CEO

Robert George – VP, CFO, Secretary and Treasurer

Richard Bradley Lawrence - President, COO

Analysts

Robert Spingam - Credit Suisse

John Croke - Jefferies & Co.

Troy Lahr - Stifel Nicolaus & Company, Inc.

Eric Hugel - Stephens, Inc.

Peter Jacobs - Ragen MacKenzie

Chris Denny - D. A. Davidson & Co.

Thomas Lewis - High Road Value Research

Byron Callan - Perella Weinberg Partners

Operator

Good day and welcome to the Esterline Technologies third quarter earnings conference call. (Operator Instructions)

It is now my pleasure to introduce your host, Brian Keogh. Please go ahead, sir.

Brian Keogh

Thanks, [Stacy]. Good afternoon, everybody.

Bob Cremin, Esterline's Chairman and CEO, Brad Lawrence, President and COO, and Bob George, Vice President and CFO, are with me today to discuss Esterline's fiscal 2009 third quarter performance.

A replay of this call will be available for seven days by calling the following toll-free number: 1-888-286-8010. And you'll need this passcode: 43505970. Or you can hear a replay at Esterline.com in the Investor Relations section.

You'll also find a copy of this quarter's earnings release on our website in the News & Press Center. In the release there's a paragraph regarding forward-looking statements. This paragraph covers this call as well. Essentially it says that forward-looking statements within the meaning of the Private Litigation Reform Act of 1995 are based on management's current expectations and are not guarantees of future performance. Of course, forward-looking statements always involve risks and uncertainty and we detail those risks in our public filings with the SEC.

As is our practice, when we get to the Q&A we're going to put a two-question limit on the first round, then we'll circle back for any follow up questions if time allows.

I'd like to turn the call over to Bob Cremin now. Bob?

Robert Cremin

Great. Thanks, Brian, and thanks to everybody for joining us today.

To start I think it's fair to say this was a solid quarter. Like most that have preceded it, there are a lot of moving parts. In a few minutes we'll drill down and give you some insight into the details. I'll want Bob George to go through the quarter numbers, and I'd like Brad in his role as President and Chief Operating Officer to expand on our cost controls and how we're investing in the future.

First let me give you a 30,000-foot view of how we run Esterline through the inevitable cycles we face. We've never changed our long-term focus. All cycles turn, and we've not lost sight of positioning Esterline for the long run. We continue to make significant investments for Esterline's future. We've won serious positions on all of the major new platforms. We're actively adding capacity to handle future volumes, and we continue to make selective acquisitions to broaden our capabilities.

Some comments on these items. First, on programs, the Joint Strike Fighter will be a game-changer for Esterline. Our chipset content will exceed $1 million per plane.

The T-6B, the military trainer for the U.S. Navy, that was a prime attraction in acquiring CMC. Our chipset content is now over $600,000. We're responsible for both cockpits that go into each plane. First shipments begin later this year.

On the 787, our content is about $450,000 per chipset. It's another layer of work that will come.

We're Tier 1 on the two newest international regional jets. We're sole source for all elastomer products on the Chinese ARJ21, and we're the lead for work on power distribution systems on the Sukhoi Superjet.

On the A400, over 190 planes have been sold. Our $1.1 million in chipset content will be a good return for our investment. We expect this plane to fly.

And now we're getting started on the A350, the Airbus response to the 787, by designing the engine sensors for Rolls-Royce.

We have to be ready for future volumes that we anticipate, and we're putting the pieces in place to make that happen. If you're going to add capacity, there's no better time than now to do it. We have three actions taking place in Mexico - our power systems operation is expanding its existing large plant that's already there, and we have started two smaller operations for our elastomer and our sensor businesses, and they're taking advantage of the power systems experiences.

We're coming down the home stretch on our new high-performance countermeasures factory being built in the U.K. We expect to ship product out of that facility in early 2010.

Our new site in Everett, Washington for our Avionics operation just had a ribbon-cutting a couple of days ago. With this new operation we can show customers an Esterline plant that's been lean from day one.

And we like the outlook for our Idaho medical devices company. We've initiated an expansion that will be complete there in early 2010.

One last point: We've taken aggressive action to group individual companies together over the past year into what we call growth platforms and they're going to drive real synergies. We're encouraged by the results and the spirit of entrepreneurship that is evident.

Now let's get into the quarter. Bob, how about diving down into the numbers?

Robert George

Sure, Bob. Thanks, and good afternoon, everyone.

As we indicated in our earnings release today, third quarter results were solid. Year-to-date consolidated sales continue to be reasonably strong. Gross margins are holding. Operating profit is healthy and so is cash flow.

Starting at the top, in the third quarter Esterline sales of $361.5 million were virtually on par with last year's $363.5 million.

And skipping right on down to the bottom line, earnings per share from continuing operations were $1.09 per share, and that compares to last year's $0.61.

Over the next few minutes we'll walk the path from the top line to the bottom line and highlight some of those moving parts that Bob referenced.

Sales for the quarter were led by the Avionics segment. With sales of $171 million for the quarter, up nearly 16% from last year's $148 million, Avionics and Controls benefited from the acquired sales of Racal as well as increased military sales.

Volatility in foreign exchange rates contributed to the softer sales results in our other two segments - Sensors and Systems and Advanced Materials. As many of you know from previous calls, Sensors and Systems is our most international segment and Advanced Materials has significant U.K. content as well. Sales in these segments were down 18% and 6%, respectively, from last year's third quarter. Contributing to this result were business jet market weakness and softness in countermeasure flares.

On a year-to-date basis, sales this year of $1.03 billion are 4.5% below last year's $1.08 billion. Both third quarter and year-to-date sales benefit from the acquisitions made earlier in the year of Racal Acoustics and Nylon Molding Corporation.

Organic sales declined 6.9% in the quarter and 8.9% year-to-date. A significant factor in this decline is the relative weakness of each of the major international currencies in which we trade against the dollar.

Gross margin performance is solid. On a consolidated basis for the quarter gross margin was 32.4% this year compared to 31.2% last year. And for nine months gross margin is remarkably stable - 32.2% this year compared to 32.4% last year.

Avionics and Controls segment gross margins demonstrated significant strength, up to nearly 36% in the quarter from 29% last year. Sensors and Systems margins were down to 31.3% from 35% last year, and Advanced Materials gross margins slide moderately to 28%.

Selling, general and administrative expenses were 16.5% of sales in the third quarter of this year compared to 16.8% last year. On a dollar basis SG&A expenses are down for the quarter and down year-to-date in 2009 compared to least year - a little over $1 million in the quarter and $4 million year-to-date.

Now this reduction in SG&A expenses was partially offset by increased pension costs of about $3 million in Q3. Regarding pension, I should add that on the cash side of things we do intend to fund an incremental $20 million to our defined benefit pension plan in the fourth quarter. I should also note that we haven't made a cash contribution to the plan in over 25 years, but then again, we haven't seen a market like this one in 75 years.

Now, dropping down to the research, development and engineering line, we have expenses of $14.9 million in the quarter, 4.1% of sales. During the quarter an agreement was signed between CMC and the province of Quebec. This agreement was retroactive to 2007. As a consequence, $2.2 million of retroactive assistance payments are reflected in the quarter's R&D expense. On a normalized basis, therefore, absolute spending was $17.1 million or 4.7% of sales. This level of investment is consistent with our spending over the last several quarters of around $17 to $18 million and is in line with our projections for a long-term R&D investment in the 4.5% to 5% of sales range.

Segment earnings excluding corporate expenses moved up smartly in the third quarter from $39.5 million last year to $50.2 million this year.

Third quarter operating profit margins were 13.9% of sales this year, 10.9% last year.

For the first nine months of fiscal 2009 and 2008, segment earnings were exactly the same - $130.8 million or 12.7% of sales in '09 and 12.1% of sales in '08.

By segment, operating earnings were the following:

Avionics and Controls, $27.1 million for the third quarter, $9.6 million last year; $63.2 million for nine months, $42.4 million last year.

Sensors and Systems, $7.0 million for the third quarter, $12 million last year; $27.1 million for nine months, $34.8 million last year.

And Advanced Materials, $16.1 million for the third quarter, $18 million last year; $40.4 million for nine months, $53.6 million last year.

Avionics and Controls is the clear driver of the strength behind these numbers. A nice contribution is coming from Racal Acoustics, acquired earlier this year; however, the other businesses in this segment are generating strong results as well and we have benefited particularly from a nice turnaround at CMC.

Sensors and Systems segment profit is down as they are managing through reduced sales volume but increasing investments in new facilities and new product development.

Esterline's effective tax rate in the third quarter was 8.5%. This compares to the 25.3% rate we recorded last year in the third quarter. Now, the third quarter rate this year was 17.5% prior to two discrete events - one, the reversal of prior expenses related to the application of foreign tax laws, and two, a tax benefit associated with the reconciliation of the prior year's tax returns. Our expected tax rate for the fourth quarter is 16%.

Bottom line, earnings per share for the quarter on a fully diluted basis were $1.09 from continuing operations compared to $0.61 on the same basis last year. For the first nine months comparable numbers are $2.32 per share and $2.41 per share for 2009 and 2008, respectively. Adding in the income from discontinued operations, earnings per share for the first nine months were $2.86 this year and $2.56 last year.

A few words on Esterline's cash flow and balance sheet. In one word, both are solid. I guess that's three words.

The cash flow from operations for the first nine months was $115 million compared to $94 million last year.

Capital expenditures in the first nine months were $42 million, and depreciation and amortization was $50 million.

During the quarter we repaid the balance on our U.K. pound term loan - approximately $33 million - and we do not have any significant debt repayments due prior to March 2012.

So we like our position.

Brad, over to you.

Richard Bradley Lawrence

Thanks, Bob, and good afternoon.

One question we've been getting from you guys is why haven't we seen any announcements that Esterline is cutting costs? What are you doing to adjust for the downcycle? Well, you know, over the past few months I spent a lot of time visiting our operations from L.A. to Montreal to Paris, and I can tell you we're doing plenty.

At Esterline we just don't make corporate edicts, like announcing across-the-board employment cuts or slashing R&D spending, or placing blanket restrictions on capital expenditures. We have a different model. Our cost savings activities come from the bottom up. Our operating unit presidents know how to manage the business cycle. We make prudent moves according to local circumstances and then communicate our decisions carefully to minimize disruption.

Our operations are doing a good job of minding the expense throttle. For example, total employment is down year-over-year by about 7% and SG&A spending is down year-to-date by $4 million. But these reductions have been surgical and some units have even been hiring. Engineering is one area of focus. [Talented] engineers can be hard to come by and we need to have good people in place as market conditions shift. We've been through these cycles before, and as this market turns we will be well positioned to take advantage.

Cremin mentioned that we're continuing to invest in capacity expansion to get ready for the new programs we see coming online. One way we expand capacity is through lean. Our mantra is: Lean frees up capacity. We continue to invest significantly in lean enterprise programs at all of our operations not because it's the popular thing to do but because it works.

And we're making significant capital improvements as well. In Mexico, for example, we're not just chasing low labor rates; we're embracing an expanding aerospace industry presence there. Our power systems group has been in Tijuana for 25 years and has really learned the ropes. Currently they employ approximately 300 people there, doing sophisticated electronic assembly, and we are currently in the process of expanding that facility by about a third.

With this positive experience under our belt we decided to invest further in Mexico. About a year ago we opened the doors to a new 30,000 square foot facility in Tijuana separated into two parts - one, a finishing operation for a Southern California-based elastomer business, and two, a support operation for our global Sensors group, where we are doing intricate electronic assembly.

As Cremin mentioned, our new control systems facility in Everett, Washington will be a showplace for our efforts in lean enterprise. This new operation will be a real game-changer.

For those of you who have visited us and toured the existing facility, you know what we've been working with - 200,000 square feet spread over three multi-level buildings separated by a major thoroughfare in downtown Seattle. Even with this handicap, the operation has been a perennial top performer thanks to a superb group of employees. Well, those same employees now have a state-of-the-art facility. They started with a clean sheet of paper and implemented a layout that will optimize their lean vision.

At Esterline activity continues on the R&D front, including our announced partnership with Rolls-Royce on its Trent XWB engine program. This is the sole engine available to power the new Airbus A350. To date, Airbus has booked over 500 orders for aircraft. And remember, there are two engines per plane. Esterline is one of only 12 partners who collectively account for 40% of this Rolls engine program. We will be responsible for nearly 30 separate components in the sensors package. At least 75% of these components will be produced in-house at our advanced sensors facilities.

Another important program that deserves bigger headlines is the Hawker Beech T-6B military trainer. The T-6B is the designation for the upgraded version of the T-6 aircraft that has been in use since early 2000. The most significant upgrade has to do with our advanced avionics suite, which includes, among other things, two integrated avionics computers, two upfront control panels, and six multi-function displays. The U.S. Navy will buy more than 250 T-6Bs and foreign military sale requests are adding up. Thanks to our cockpit design, it isn't a big leap for the Defense Department to configure this aircraft in an attack version.

Our avionics suite mirrors the systems and capabilities of today's frontline aircraft, including the F-16, the F-18, and the F-35 Joint Strike Fighter. Speaking of the JSF, just this week Secretary Gates emphasized the importance of this aircraft, saying - and I quote - "We cannot afford as a nation not to have this airplane." With $1 million of content per plane and counting, that's good news for Esterline. Our engineered materials are leading the way, with mission critical products such as radar-absorbing materials, thermal insulation, and vital sealing and clamping systems. We also have our share of avionics and sensors on the JSF also.

The program is currently in the LRIP stage - that's short for low rate initial production - ramping to one aircraft per day by 2018. Between the U.S. and eight international partners, production is expected to exceed 3,000 aircraft. If I've done my math right, that works out to about $3 billion in revenue for Esterline over the life of the program.

On the organizational front, over the last several quarters we've stepped up our efforts to drive for synergies, bringing more value to customers through the creation of growth platforms. Rather than our companies approaching customers individually, we are now melding several companies together to operate with one Esterline identity to leverage capabilities and services. This is one of the means by which Esterline is evolving system-level capabilities to better meet customer needs.

Our two most recent acquisitions in particular are taking advantage of the growth platform concept.

NMC, a small company focused primarily on specialized fasteners for Boeing Commercial, is now part of an industry leading line of clamps, seals, fasteners and other specialized installation components. Opportunities that weren't even visible to NMC are now opening up with access to our truly global sales organization.

And U.K.-based Racal Acoustics, an acquisition that closed in February, is already working closely with its new sister company, Palomar, our secure communications operation, to best leverage the relationship's capabilities.

Speaking of Racal, in July this operation was awarded a contract by Northrup Grumman to supply ruggedized noise-canceling headphones for the U.S. Army's new VIS-X program, a family of headset and other communication components for military tactical vehicles.

So, as Cremin said at the outset, there are a lot of moving parts at Esterline. But in these difficult market circumstances our units are right-sizing their businesses and carefully watching costs while simultaneously keeping an eye toward the future. We have not deviated one bit from our enthusiasm for lean or our pursuit of operational excellence. Despite less predictability in the marketplace, operational metrics, which include on-time delivery, quality performance, customer recognition and more continue to improve. Our research programs are on schedule; if anything, our marketing efforts have stepped up, and we feel well positioned to take action as our markets return to normal.

Bob, back to you.

Robert Cremin

Thanks, guys.

We're working really hard to position Esterline for the next upcycle. The balance sheet's solid, we continue to generate cash, we've got a growing list of opportunities throughout the organization, and we've got a solid billion dollar backlog to perform on. I like what I see ahead.

So with that, Operator, how about we open it up for some questions?

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Your first question comes from Robert Spingam - Credit Suisse.

Robert Spingam - Credit Suisse

Brad, you just went through a whole bunch of programs. I think I'm going to start there. Two questions in this area: First, anything that the U.S. Air Force is talking about cutting? You know, there's been a lot of news over the past few days C-130 AMP, some other stuff. Is there anything here that would impact Esterline?

Richard Bradley Lawrence

From the announcements that we've seen so far we haven't seen a material change in any of the major programs that we're currently working on.

Robert Spingam - Credit Suisse

Okay. Anything at all that touches you?

Richard Bradley Lawrence

Nothing that comes to mind.

Robert Spingam - Credit Suisse

And then you mentioned thermal insulation. And with the greater usage or rising usage of carbon fiber in the aerospace industry, can you talk a little bit about the tail or the pipeline for that business? How big is that Darchem business now and what would it look like five years from now, six years from now or so when we have 787 at mature production levels, one would hope, and A350 ramping up to that?

Robert Cremin

Well, as you know, we only report our financial results by segment, but I will say that Darchem has been a strong growth company for Esterline and we see continued opportunity, particularly with the Airbus account, on increased use of our insulation materials.

Interestingly, though, Darchem's strongest growth at the moment is really not coming from the aerospace sector but it's coming from our activities in the nuclear and oil and gas segment. Darchem is providing and has been a long-time supplier of insulating components for nuclear reactors as well as fire protection on petroleum sites that are located offshore.

Robert Spingam - Credit Suisse

So it's going to be a multiple, though, of what it is today?

Robert Cremin

It's growing at a double-digit compound annual growth rate.

Robert Spingam - Credit Suisse

And then just going over to Bob George for a moment, Bob, could you go back to cash flow again? I just want to review what you said. You were talking about your operating cash flow, I believe, and what your expectations are for the year.

Robert George

Well, Rob, right now the company continues to generate cash at a nice rate. As I mentioned, cash flow from operations was $115 million through the nine months; that compares to the $93 - $94 million we generated last year. We see that trend continuing through the fourth quarter and our EBITDA is similarly moving in the same direction.

The DA component is about the same as it was last year of in and around $50 million. Capital expenditures are up, as we mentioned. In the first quarter we thought this year was going to be a lot higher than it was last year, but our business units have done a really nice job of focusing on must-haves and investment areas that are providing growth for the future and restraining themselves in some areas, so we're a little bit lower than we thought. Overall, we're very, very pleased with where we are in cash flow and sitting on about $150 million right now in cash.

Robert Spingam - Credit Suisse

And then just the last thing is can you just delve into a little bit more detail on have we bottomed in margins in Sensors? How should we think about that ramping back up?

Robert George

Well, I'm going to start with that and then let Brad maybe take a crack at it as well.

You know, Sensors right now are really having the most difficult management challenge, I think, that you can face for an operating company. They've got some weakness in their sales area and they are managing, as Brad said in his prepared comments, they're managing through some significant investments. Again, going back to a point Bob made in his opening comments, we also manage the business for the long run and we haven't lost sight of that focus.

Brad, do you want to talk about some of the difficulties Sensors is having there?

Richard Bradley Lawrence

Yes. I think the question was specifically on the margins at Sensors and a lot of that is determined by aftermarket parts, which is a very difficult part of our business to predict since so much of that business does go through distributors. However, I will say that we do feel at this time that we're bouncing along the bottom, so we don't think there'll be much deterioration from this point.

Robert Cremin

Rob, let me just go back to the original question you had about how are we going to fare if a particular programs gets impacted by cuts in the defense budget.

As you know, our business model is to avoid being dependent on any one or two programs.

The second is, we've invested heavily over the recent years in expanding our businesses internationally. When you look at new programs, I like our position on drones. I like what we're doing on robots on the ground. If you look at an acquisition like NMC, heck, we're opening doors for them in Europe that they didn't even know existed.

So I think we're trying very hard to position offsets to whatever may happen.

Operator

Your next question comes from John Croke - Jefferies & Co.

John Croke - Jefferies & Co.

In your press release you reminded us that in the flare business you're somewhat at the mercy of your shipping suppliers in terms of the timing of deliveries. I was wondering if you could give us a sense for how much inventory related to those shipments you're currently carrying?

Robert Cremin

Well, let me start with why is it touch and go on whether a shipment gets out.

Very often it's the flagship of the country that we're shipping to. Our portion of the load is not usually the majority of it, so they've got to put together a scheme in which they go from port to port and pick up materials so that they build a full load and then they'll swing by and pick up our materials. And very often we're given a date when this ship's supposed to arrive but they couldn't build up enough of a shipload before they got to us and they'll cancel it. No, we don't spill into two quarters, but sometimes we can spill from one quarter to another. That's the reality of it, okay? These are very specialized ships. That's part of the answer.

Rob, you want to expand a little bit on the other?

Robert George

Yes. John - and not to give you a gratuitous compliment - but you're absolutely spot on in your inventories there, and when you look at inventories the defense technologies platform is one of the platforms where inventories have grown year-over-year.

I'm not going to get into splitting out the exact details by platform, but I will tell you that in terms of looking at the amount of excess inventory we're carrying because the ships have not sailed or they haven't come in is on the order of a couple million dollars, maybe $3 million at the outside.

Robert Cremin

Another thing that I learned a long time ago, you know, you look at any particular harbor and there's hundreds of ships. There's only a couple of dozen ships at most that are equipped to handle the type of product that we're shipping. So we're talking about 12 - 15 ships, somewhere in that range. So if it doesn't make it, you know, we're inconvenienced.

Robert George

Yes. What happens on that, John, is those ships are, as Bob pointed out, few in number and they're controlled by a few companies. And they will not, regardless of what you think your schedule is, they will tend not to bring them into port unless they know they have a full shipload to go out. And so that's really the issue, trying to make sure that the bill of lading is full. And, obviously, we don't control that.

John Croke - Jefferies & Co.

Then with respect to your guidance for the full year, if we put aside the flares and say they don't happen until fiscal 2010, is it possible for you guys to hit the top end of your guidance or do you need those flares to come in by the end of October in order to hit that number?

Robert George

Well, I'm going to fall back to the comment that Bob made in his opening remarks and that is there are a lot of moving parts. We've got things that can move up and move down. You know that very well from following the company for quite awhile.

Let me just say without you trying to pigeonhole me into top of the guidance or bottom of the guidance, we're very comfortable with the guidance range where it is. As we did say in the press release, there are some things we can't control. But we're comfortable with our position.

Robert Cremin

And, John, in terms of moving parts, hundreds, believe me, hundreds. You know, you can have a settlement of an NRE occur within a particular quarter. We were very happy during this quarter to see that the T-6B was certified as an entire plane. You know, you can't ship until you get that type of certification. But we like the way the quarter's looking.

Operator

Your next question comes from Troy Lahr - Stifel Nicolaus & Company, Inc.

Troy Lahr - Stifel Nicolaus & Company, Inc.

Could you guys give us a little more color on Avionics and Controls? You talked about military being one of the drivers but maybe kind of drill down a little bit? Very strong growth, kind of surprising for us, at least.

Robert George

We've got two things going on in the quarter. One, we have outstanding strength on its own merit and that then compares to a relatively difficult quarter that we had last year in Avionics and Controls.

To be frank, one of the benefits that we're having this year in Avionics and Controls in particular is our performance on projects - large, long-term contracts - is much improved over where it's been in the past.

Last year if you'll recall - and I'm sure you'll go back and take a look at the Q or our press release - last year we took some charges for some overruns on some of our large engineering projects. We did not have that this year. Our underlying performance in all of our businesses is quite strong, so whereas last year we had those charges, this year we didn't so we get a nice boost there.

And then I definitely have to conclude my comments with compliments to our business unit managers. As Brad pointed out, they're doing a great job in right-sizing their facilities and controlling costs in a difficult environment, and we're seeing strength across that platform.

Troy Lahr - Stifel Nicolaus & Company, Inc.

With that being said, I mean, more specifically on the revenue side - like you said, you are in a difficult environment yet you still did 15.5% - 16% growth - is the military business just doing that strong and that's clearly more than offsetting the commercial weakness?

Richard Bradley Lawrence

Yes. You're getting real close to the bottom here on the answer to this.

There's a couple of issues and certainly one of the very strong pieces is that the part of our businesses within that Controls group that works with the military are seeing very strong orders.

In addition to that, it's one of those issues where there's several business units in there and they all seem to be moving in the right direction together. So frequently we benefit from offsetting effects; in this particular quarter they're all moving in the same direction.

Robert Cremin

Troy, another dimension of this - we refer to the creation of growth platforms. We have a group called Avionics and Controls; we've put four units together. In two of them we're exporting what we've been doing in the larger firms in lean. We've been helping them move to a different pricing model. We like the way this is coming together and the numbers look pretty good.

And the other thing is that, remember, Racal has been a very pleasant surprise. It wasn't in last year's numbers. It's performing well and with the recent win, as Brad had said, on VIS-X, its outlook looks pretty good.

Troy Lahr - Stifel Nicolaus & Company, Inc.

And then lastly, is the [Daso] stop-work order, is that still in effect and any thoughts on when that might get lifted?

Robert George

It is not as definite as it was in the second quarter, but it is still in effect. So they are taking some product - very select - but they're still in the process of evaluating where their business is going.

Operator

Your next question comes from Eric Hugel - Stephens, Inc.

Eric Hugel - Stephens, Inc.

You guys have been at this for awhile in terms of the parts business and commercial aircraft. I mean, you guys have been through, your parts business has been through, several cycles. Can you talk to us about on average going through how long has this inventory destocking process lasted and are you seeing any indications of it letting up, maybe sort of a timeframe, sort of a best guess as to when we could start to see things ease?

Robert Cremin

Eric, I'll start. I think the biggest crunch from inventory reduction, inventory balancing at the customers is behind us. We still see some. And things will move according to the lead times that we show people because they don't want to get caught short. I have to tell you a story part by part. Engines, which are very long lead times, have a very different profile than some of the simpler seals that we make. Maybe cockpit items are somewhere in between.

Eric Hugel - Stephens, Inc.

I guess maybe another question would be thinking about how, in terms of broad, you know, 30,000 foot, sort of looking at Boeing and Airbus, I'd just like your view and your read of the situation in terms of where do you think production rates are headed over the next couple of years? Do you think that they can maintain production rates or do you think large commercial rates have to come down?

Robert Cremin

Well, all I can tell you is what I am reading and what people are telling me, and that is both Airbus and Boeing continue to put our production schedules that definitely affect every supplier, including us, that are holding on narrow body, and that's where all the action is. And I think they probably have it right.

Eric Hugel - Stephens, Inc.

So your internal analysis sort of says the same thing, that they can hold those rates? I assume you're not just listening to them.

Robert Cremin

Because I think, you know, the U.S. fleet still has to be modernized. There's still demand in China. Europe's a little slow. India's starting to come on. The regional jets that are coming from the Chinese and the Russians, they're not going to have an impact on the Western market for probably 7 to 10 years; they've got a lot of internal demand to satisfy. So I think there's a built-in need and I think these production schedules reflect that.

Eric Hugel - Stephens, Inc.

A part of your business that you guys don't really talk about or people don't ask a lot about but it's not a small part is the medical business. Can you sort of give us an update? I mean, you mentioned in your comments that you're putting in a new facility in Idaho. Can you give us an update as to where things are going there? I know hospitals have been cutting back in terms of large equipment expenditures. Can you give us some visibility there?

Richard Bradley Lawrence

The medical business has definitely experienced a downturn in the medical diagnostics market. That business today is off around 15% and we expect that will continue to 2010, really depending on what comes out of the announcements on the administration's efforts on new medical benefit programs.

But additionally, that business also has some significant business in other niches. They do a number of military user interface devices. And they've got a new niche coming on strong, which is gaming. As you may know, the gaming or the slot machines have really gone to video games and require electronic user interfaces, and that's a very fast-growing portion of that business in Idaho.

Eric Hugel - Stephens, Inc.

And lastly, I guess, for Bob George, last quarter when we had talked we talked about the Canadian dollar exchange rate you and you noted that your hedges are targeted in, I guess, the $0.87 - $0.88 range. And we've been sort of up above those ranges for quite awhile, in the $0.90 to $0.93. Can you talk about the impact there and what you guys are doing to manage that?

Robert George

Well, you're exactly right, Eric, and your recollection is correct.

We absorbed about $3 million worth of embedded derivative impacts in the quarter at our Canadian operation. Our hedges - and I just want to clarify that - we basically execute our hedges on an ongoing basis, so really what's starting to come through now in terms of our hedges are our more or less favorable rates, below where we're at in the $0.90 range.

What we're mostly being affected by with rates in that $0.90 range are in the embedded derivative which was in backlog and it's a relative performance of the multiple currencies we do business with.

We still feel that an exchange rate in the high $0.80 range is probably our sweet spot. We start moving up into the mid $0.90s and we will see profits constrained somewhat.

Operator

Your next question comes from Peter Jacobs - Ragen MacKenzie.

Peter Jacobs - Ragen MacKenzie

As I think about the earnings guidance that's out there for the remainder of the year, there's a spread of about $0.20. I, if anybody, understand the variability that you can see in any given quarter, but with one quarter remaining - and actually two months of that quarter remaining - Bob or Bob, if you could give me a sense of where you see the variability that might come to play in that range? And it's got to be a lot more than just the flare shipment, I would guess. I think that, if I would just do a rough calculation, that would be a very small portion of that. But help me out on that please.

Robert Cremin

Peter, you sound like a fellow of Sam Pearlstein of about three years ago that asked the same question.

You know, heck, every other day I pick up the paper and one day it's up, the next day it's down. I've never seen such turbulence like this.

Throw a rock at us, call us being conservative; I think we're being realistic. It's hard to have the visibility to narrow things definitively, so we're just trying to give you an honest shot at what we see.

Peter Jacobs - Ragen MacKenzie

But where do you think the levers are that could help you get to the high end of that earnings range versus the low end? Is it the corporate business jet market coming back? Is it making the flare shipment? Or is something else, maybe commercial airplane spare parts business just doesn't soften from here?

Robert Cremin

Peter, I've given up on the business jet market for at least the next couple of quarters. I knew a couple of CEOs that were actually picking fabrics for their planes, but they can't get it through their Boards these days. And you know us; we don't have corporate business jets.

Parts, to answer your question, if people see a glow on the horizon and they start restocking parts, that's a favorable margin mix and that could push us to the high end of the range.

Robert George

Peter, just kind of jumping in from my viewpoint, and what I'll do is I'll just use the questions that your peers have already asked.

I'll start with foreign exchange, for instance. This year - and we talk about this a lot internally and with our Board - the volatility in exchange rates this year along with everything else is a factor that doesn't get as much attention as I think it should bear.

I mean, look at the pound. In the very first quarter of this year we were trying to explain the FX losses we had as we were acquiring Racal. The pound at that point in time was approximately $1.35. During the last quarter I think it again actually touched $1.70. I mean, that kind of movement in that short a timeframe is unprecedented.

The euro, while it hasn't been quite as volatile as the pound, the delta between last year's highs and this year's lows and where it's trading right now are phenomenonal.

And the Canadian dollar. Eric just asked me, well, how's CMC going to be affected if the Canadian dollar stays at $0.90? Well, earlier this year the Canadian dollar was over parity. It then dropped down into the high 70s, and is now back into the mid-90s.

Now, we try to hedge our exposures as much as we can. But that kind of volatility is a factor that no one can project.

Spares, Bob mentioned the spares activity, that's a number that we think we're bumping along the bottom, as we've said for a couple of quarters now, but if it moves up, if we get a spike in activity, that's a good thing. If it tends to drop down - and just recently Southwest Air has announced that they're dropping some routes from their system - if we get a drop there, that can affect it.

We've talked about the countermeasure flare shipment.

So even though we're in the last quarter of the year, there are lots of moving parts.

Robert Cremin

And two other items, Peter - first, if there's a mix change in the countermeasure flares where you get more, let's say, international sales versus domestic, you can get a little margin help.

But, you know, going back to Brad's point, let's talk about burden absorption and cost control. We've been able to hold margins like in Avionics adjusting for volume changes and if you get any type of increase in flow and we can hold our expenses in line, we can get a nice pop in gross margin right from that.

So have we defined enough moving parts for you?

Peter Jacobs - Ragen MacKenzie

Lots to think about, Bob. I appreciate that.

And my last question would be, looking at the A350 and, as you're thinking about potential business that you could win on that program, would you size it in the order of magnitude of the 787 or is there something about the A350 and the design and the components that could either increase your contribution or limit it?

Richard Bradley Lawrence

As you probably know, we have a strong presence in Europe, so the A350 represents at least as big an opportunity as the Boeing 787 has for us, particularly when you think about the XWB program with Rolls-Royce.

Operator

Your next question comes from Chris Denny - D. A. Davidson & Co.

Chris Denny - D. A. Davidson & Co.

You guys mentioned that there's a $2.2 million benefit, I guess, from CMC. Are you guys expecting that R&D benefit in the fourth quarter?

Robert George

No, Chris. I apologize if I wasn't as clear as I should have been.

That contract that CMC negotiated with Investment Quebec is retroactive back to 2007. The actual benefit that we will indicate in the Q when it's released on Friday for the quarter was $2.4 million, of which $2.2 million was retroactive. And so that's the piece that I highlighted.

The ongoing piece will be in and around a couple hundred thousand dollars, plus or minus, a quarter and is inline with what CMC has projected.

Chris Denny - D. A. Davidson & Co.

As far as a percentage of sales, you're expecting R&D to be about 4.5% to 5% like you were saying?

Robert George

Yes. On an ongoing basis we maintain our position that R&D is coming down off of the peak and we're looking at the 4.5% to 5% of sales range on an ongoing basis. It's just a good rule of thumb.

Chris Denny - D. A. Davidson & Co.

You guys on the last call I believe mentioned that there's some issues possibly with suppliers for the Joint Strike Fighter and you might be able to muscle your way in and get more content on that. Has anything changed there?

Robert Cremin

No. What I said on the previous call was that the financial turmoil in the market in the last year has stretched a certain percentage of what I call undercapitalized supplies to the Joint Strike Fighter program. So we're bidding. We continue to win. We've opened some doors for our recent acquisition, NMC. And I still see a chance to build content on the plane.

Operator

Your next question comes from Thomas Lewis - High Road Value Research.

Thomas Lewis - High Road Value Research

Great to hear about your win to do the sensors for Rolls on the XWB, but in light of your comments on some of the stresses your Sensors group are going through right now I've got to ask, is the scope of work of what you're doing here, the technical challenge of doing a whole suite, is this new territory for you or is there anything you can point to in your past experience that would indicate this is just more of what you already know how to do?

Richard Bradley Lawrence

That's really a great question. There was certainly a very rigorous investigation when we were bidding this program to really determine the amount of risk, and essentially the suite of sensors on this engine are basically technologies that we have well in hand. They are variants of products that we currently make, and we're really not breaking any new ground on, let's say, extreme temperatures or pressures that we already haven't accurately measured in the past.

So other than the management, the tiering, the management of some other suppliers that are filling out the suite of sensors, this is pretty much business that we feel like we know how to do and we've got a strong success track record from the past.

Thomas Lewis - High Road Value Research

And another sort of engine question. Can you point to anything at all that would matter to an Esterline shareholder as to whether there's one or two engine programs for the Joint Strike Fighter?

Richard Bradley Lawrence

That's really a great question and I'd really have to do some more homework on that, but my initial reaction is that we have an exclusive position on the current engines for our elastomer clamps, and I would expect we would do as well with another supplier given our position and the market share in the marketplace on engine technology.

Thomas Lewis - High Road Value Research

So you really wouldn't see that as moving the needle for you? I guess we're not used to programs that really move a needle for you one way, but this Joint Strike Fighter's kind of changing all that.

Richard Bradley Lawrence

Well, you know, the fact is that the other company that's talking about providing another engine option is Rolls-Royce and, as you know, we've got a great relationship with Rolls. So I wouldn't expect we'd lose any ground.

Operator

Your next question comes from Byron Callan - Perella Weinberg Partners.

Byron Callan - Perella Weinberg Partners

I wanted to follow up on one thing that's been percolating. You talked a bit about the T-6B, but there's also been some interest out of the Air Force about attack versions of light aircraft. If I look at the AT-6, is your content pretty much the same as it on the T-6B, and just generically if you could comment where you think that light attack market may be headed?

Robert Cremin

The attack version would be a simple thing for us to roll into. We've been involved in some preliminary design concepts.

Where would this type of product be used? I've heard them talk about drug interdiction, protection of ships in case of incursions off Somalia, some Third World countries. A lot of this would be FMS supported.

So in our planning cycle we see this as a viable move and we think it's more likely than not to occur.

Byron Callan - Perella Weinberg Partners

Okay. But, again, the content, it's not like you'd have additional content on the airplane because I think there was something cited in the start of the call about the content on the T-6B.

Robert Cremin

I would say that it would be a minor addition. It would be more triggering devices for countermeasures or something of that nature. There's just so much room on the cockpit panels.

Byron Callan - Perella Weinberg Partners

And Racal in the quarter probably about a, what, $10 - $15 million contribution?

Robert George

Nice try, Byron.

Byron Callan - Perella Weinberg Partners

Why not? You know.

Robert George

It was worth a shot.

Byron Callan - Perella Weinberg Partners

Okay, okay. Well, one more if I can. I know you really haven't talked about next fiscal year in terms of guidance, but the tax rate has come in, you know, generally lower than where you've been running at. I'm just curious as we start doing preliminary thinking about next fiscal year, should I still be thinking about a tax rate with a 2 handle on it, kind of, you know, that low 20s rate or do you think you could see something in the high teens again?

Robert George

I think, Byron, our internal planning right now is we're looking at something with a 2 handle in front of it.

You've got to remember that a big part of the reason why, when we came into this year, we thought we were going to be in the low 20s, of course, at that point in time we weren't aware of the acquisitions that we had lined up and we didn't factor those into our planning. And a big part of the reason why the rate dropped from the low 20s to the high teens before our discrete adjustments is really due to some of the tax effective planning we were able to do on those acquisitions.

Operator

Your next question comes from Eric Hugel - Stephens, Inc.

Eric Hugel - Stephens, Inc.

Last quarter you guys talked about, just in terms of the top line, you thought third and fourth quarter would be sort of relatively about the same and sort of in that $360 to $380 million sales range. Should we still be thinking about that for fourth quarter? Has anything changed?

Robert Cremin

Eric, that's fair from a planning point of view.

Eric Hugel - Stephens, Inc.

In terms of biz jets, if we think about where we were last quarter versus where we are today when you put together your plan, how would you say we're sort of tracking to that plan - better, worse, about the same? I know the market is kind of very fluid.

Robert Cremin

Well, I don't have data specifically, but my sense is about the same. I haven't seen much glimmer of improvement. We reported in the prior quarter that [Daso] put a stop shipment out on any production coming in. I haven't seen many encouraging signs on the horizon.

Byron Callan - Perella Weinberg Partners

So it was awful and it's been awful?

Robert Cremin

Yes, yes.

Richard Bradley Lawrence

That's a good way to describe it, yes.

Robert George

Well put.

Byron Callan - Perella Weinberg Partners

And lastly, with regards to the Quebec, the R&D, were you expecting that to come in? Was that something you had already baked into your guidance? How should we think about that?

Robert George

Yes, CMC, had been negotiating with them for some period of time. We weren't sure whether it was going to be a third quarter event or a fourth quarter event, but it was definitely in our planning.

Operator

At this time there are no further questions.

Robert Cremin

Well, good. Thanks for dialing in. We'll look forward to chatting with you next quarter.

Operator

We thank you for your participation in today's conference. This does conclude your presentation. You may now disconnect and have a great day.

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Source: Esterline Technologies Corporation F3Q09 (Qtr End 7/31/09) Earnings Call Transcript

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