Esterline Technologies Management Discusses Q3 2013 Results - Earnings Call Transcript

Aug.29.13 | About: Esterline Technologies (ESL)

Esterline Technologies (NYSE:ESL)

Q3 2013 Earnings Call

August 29, 2013 5:00 pm ET

Executives

Brian Keogh

Richard Bradley Lawrence - Chairman, Chief Executive Officer, President and Chairman of Executive Committee

Robert D. George - Chief Financial Officer, Vice President of Corporate Development and Secretary

Analysts

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

Samuel J. Pearlstein - Wells Fargo Securities, LLC, Research Division

Julie Yates - Crédit Suisse AG, Research Division

Howard A. Rubel - Jefferies LLC, Research Division

Omear Khalid - Goldman Sachs Group Inc., Research Division

Operator

Good afternoon, and welcome, ladies and gentlemen, to Esterline Technologies Third Quarter 2013 Earnings Conference Call. At this time, I would like to inform you that this conference is being recorded. [Operator Instructions] Also, a replay of today's call will be available for 1 week by calling this toll free number 1 (888) 286-8010. You'll need the following PIN 57697395. At the request of the company, we will open the conference up for questions and answers after the presentation. [Operator Instructions] I would now like to turn the conference over to Mr. Brian Keogh. Please go ahead, sir.

Brian Keogh

Thank you, operator, and good afternoon, everyone. Brad Lawrence, Esterline's Chairman, President and CEO; and Bob George, our Chief Financial Officer, are here today to discuss Esterline's fiscal year-to-date and third quarter 2013 performance. In addition to the number just given, you can also visit esterline.com in the Investor Relations section to access a webcast replay of this call.

As always, I need to remind you that our call today contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are based on management's current expectations and are not guarantees of future performance. As you know, forward-looking statements always involve risk and uncertainty, which we detailed in our public filings with the SEC.

Thank you again for joining us. I'll now turn the call over to Brad.

Richard Bradley Lawrence

Thank you, Brian, and welcome, everyone, and thanks for joining us to discuss our third quarter results. We're pleased to report relative to our expectations and the environment, a solid performance for the quarter. As anticipated, we had a tailwind from our tax rate, but importantly, operating profitability was right in line with our expectations. And as anticipated when we announced our initial guidance, we continue to see a strong fourth quarter finish to the year, a typical earnings pattern for Esterline over the past several years. Our commercial aerospace markets remain a major source of strength, with continued solid OEM build rates, particularly for single-aisle jets and a generally stable aftermarket. Defense markets, however, continue to be impacted by budget uncertainty. Still, there are number of bright spots in our defense business that give us confidence not only in a solid fourth quarter but position us well with a good mix of programs going forward.

In general, our view of the business, both in the quarter just reported and for the immediate future, remains largely unchanged. We're right where we expected to be. In each of our segments, we're working hard to take full advantage of our revenue opportunities, and at the same time we are laser focused on operating efficiency, maintaining discipline on lean techniques, developing better processes, while keeping a sharp eye on cost control.

In our Sensors & Systems segment, each of our major business platforms, Advanced Sensors, Connection Technologies and Power Systems, are well positioned with good order trends and a solid backlog. We have a number of very constructive meetings at the Paris Air Show this past quarter, and we're encouraged by our relationships with the major OEMs. We're also identifying new partnership opportunities across an increasingly wide range of customers. We're excited about our progress with Rolls-Royce on the XWB engines for the A350. And Airbus has begun low rate initial production for A400M at one aircraft per month. This is an important platform for this segment, and we're leveraging a very efficient facility in Morocco for a good portion of that work.

Also this quarter, Sukhoi began delivering its Superjet 100 to their first Western customer in Mexico. We have about $750,000 of content per copy on this aircraft, which we believe has a strong market position. The aftermarket for this segment is shaping up to be stable. But frankly, it's still not where we had anticipated. Ironically, increasing durability of our sensors is causing some of the pressure we're experiencing. But we expect this to be offset over time by the sheer number of aircraft flying with the popular CFM56 engine.

Meanwhile, helping our Connection Technologies business are early signs of improving industrial market conditions in the Eurozone. Our Avionics & Controls segment is where we are experiencing the greatest impact from defense market pressures. T-6B production at Beechcraft continues at the lower rate of 42 per year. Our signal intelligence receiver business remains in limbo, pending political decisions surrounding the Global Hawk Block 30 program. And program changes for global military land-based vehicles and soldier modernization have impacted our Racal Acoustics Headset business prompting a further $3.5 million goodwill impairment.

Despite these issues, Avionics & Controls is the segment of our business that holds the most potential for growth. We are working diligently on a number of significant opportunities for both new and retrofit cockpits. And we continue hitting the singles and doubles that built our reputation, providing the best quality, highly-engineered components for the world's cockpits.

Recent developments along those lines include performing well and ahead of schedule to deliver cockpit solutions for 20 aircraft in Peru's trainer fleet and award 1 with KAI earlier this year. Making production deliveries to supply avionics systems for 2 international customers on 80 Pilatus P-21 turboprop trainer aircraft, continuing to support Beechcraft's pursuits of the AT-6 and the T6C opportunities around the globe, and we're particularly pleased with the progress we're making, developing a strong growing relationship with Embraer on multiple platforms.

In addition, significant retrofit opportunities continue to exist across the global market for both upgrades needed to maintain aging fleets of trainers and helicopters and for modernization to meet regulatory requirements for transport aircraft. In all cases, we are well positioned to meet these demands.

Regarding the second tranche of C-130 cockpit modernization orders for our Middle Eastern customer, we continue to receive positive indication that this project remains alive. While we're certainly aware of the variability created by the long sales cycle surrounding retrofits, we remain confident that our cockpits present the most attractive solution for a wide range of customers in terms of technology and proven ability to deliver.

Turning to our Advanced Materials segment, Engineered Materials had a strong third quarter, is operating with good visibility particularly on the F-35 program and is positioned well both in its commercial aerospace and industrial markets. Our Defense Technologies platform has a particularly strong order book and backlog heading into the fourth quarter. And the focus here is on execution. We were very pleased to see our margins up sharply in this segment versus both last year and last quarter, and we're confident this segment will continue to outperform.

With that, I'd like now to turn the call over to Bob for a more detailed discussion of our third quarter results.

Robert D. George

Thanks, Brad. Good afternoon, everyone. As you have seen in today's release and as Brad has discussed, Esterline's operating results in the third quarter were consistent with our expectations and prior guidance. Sales of $478 million in the quarter, strong gross margin performance, continued focus on expense control and discrete tax items previously discussed all contributed to solid operating performance and earnings per share of $1.65, excluding the effects of 2 nonoperating items. And as we explained in the press release, we booked a $3.5 million charge against goodwill at our Racal Acoustics unit and $10 million for an estimated charge related to a pending compliance matter with the State Department's Directorate of Defense Trade Controls or DDTC. Collectively, these 2 discrete items reduced earnings per share by $0.42 in the quarter.

In the case of Racal, the effects of the global defense spending pullback have been a bit more challenging than we anticipated. Racal have continued to see programs delayed and purchases deferred, which, as Brad noted in his remarks, caused us to take the noncash goodwill charge in the quarter.

With regard to the DDTC matter, as we disclosed last quarter, Esterline is subject to U.S. export laws and regulations that restrict export of defense-related products, data and services. Esterline has been engaged in discussions with the DDTC through its Office of Defense Trade Controls Compliance, which is responsible for compliance enforcement since May 22, to reach agreement regarding Esterline's voluntary disclosures and other aspects of certain compliance matters. Based on these discussions, we estimated and recorded a $10 million charge in the third quarter in accordance with U.S. GAAP. As our discussions with the DDTC are ongoing, this accrual is our best estimate of a settlement at this time. Excluding these items, the strong operating results in the third quarter are keeping us on track to hit our existing $5.30 to $5.50 per share full year guidance.

So let's get into some of the operating details. Third quarter sales of $478 million and 9-month sales of $1.44 billion were in line with our expectations discussed at the end of the second quarter. As we stated in today's release, we are seeing the drivers you would expect right now, strong commercial aerospace, stable aftermarket and soft defense spending leading to a challenging sales environment.

Drilling down into the numbers, you see much of the current top line challenges centered in the Avionics & Controls segment. This is consistent with our previous communications and guidance. Specifically, the single-largest impact in the quarter was reduced demand for our signal intercept receivers for the Global Hawk.

On a consolidated basis, sales were down about 2% in both the quarter and year-to-date compared with last year. I reported last quarter that this slow growth sales environment has put the challenge in the hands of our platform leadership, and they are responding well. Clear indications of these efforts are the results we are posting in gross margin, expense control and the drop through to free cash flow.

Starting with gross margin. Third quarter results came in at 37.4%, 200 basis points above last year's 35.4%. A large part of the increase is attributable to the operational excellence programs and cost control activities implemented by our business unit leaders. On a year-to-date basis, gross margin this year is 36.3% compared with 35.2% for the same period last year.

From a segment perspective, Advanced Materials led the way in the quarter on strong performance from the Engineered Materials platform. Contributing factors here were operational improvements at one of our California operations, strong results from a U.K. business and sales of defense products. For the first 9 months, both Sensors & Systems and Advanced Materials gross margins are advancing nicely.

Selling, general and administrative expenses are similarly being held in check. SG&A expenses through the third quarter and 9 months this year are $101.8 million and $299 million, respectively, compared with $91.9 million and $285 million last year. The increases this year are driven by compliance and regulatory initiatives, including the DDTC matter at the corporate level.

Research and development expenses are tracking in accord with our 5% guide. We anticipate R&D expenses for the full year to be at or near the 5% level. Segment earnings for the quarter, excluding nonoperating charges for both years, were 15.4% of sales this year or $73.8 million compared with 12.8% of sales last year or $62.2 million. Nine months results are 14.1% of sales this year compared with 12.4% of sales last year.

Results at the income tax line were as we have projected in previous calls and guidance. Esterline benefited from 2 discrete tax benefits in the third quarter in the amount of $8.7 million, resulting in a tax rate of 2.8%. The 2 benefits were $4.3 million from the release of reserves due to the expiration of a statute of limitations and $3.8 million related to deferred tax liabilities from the reduction of the U.K. statutory tax rate. You may recall from prior discussions, we were able to quantify the reserve release but were a little fuzzy on the U.K. rate change. The $8.7 million benefit we recorded this quarter however is within the range we identified earlier.

Bottom line, for the third quarter of 2013, net earnings from continuing operations were $52.7 million or $1.65 per share, excluding the discrete charges of $13.5 million or $0.42 per share. Last year's third quarter numbers, excluding discrete charges, were $35.1 million or $1.14 per share. Year-to-date 2013 earnings from continuing operations were $113.3 million or $3.58 per share compared with $103 million or $3.30 per share last year. Both sets of results are adjusted to exclude the effects of discrete charges as discussed earlier in my remarks.

Wrapping up before turning back to Brad, a few statistics: Free cash flow through 9 months, $159 million, and by the way, this would be a record for a full year; capital expenditures, $37.8 million to date; depreciation and amortization, $88 million; backlog of $1.3 billion supports our expectations of another strong finish to the year.

Brad, back to you.

Richard Bradley Lawrence

Thank you, Bob. The bottom line is we're confident that we're on track to achieve our objectives for the full year, including our adjusted EPS guidance of $5.30 to $5.50 per share. But even beyond our short-term focus on execution, we have a broader commitment across the entire organization to push for a continual profitability improvements. Our corporate culture encourage decision-making close to the customer and the independent thinking of our talented business leaders. We call this earned autonomy. There's a lot of value in this approach. It fosters innovation, as well as accountability and is particularly valuable in building strong, lasting customer relationships. This, in combination with better integration within the organization, including shared services, resources and best practices, we believe we can create better value for our customers. We have market leadership positions in many of our major businesses, and it's in our DNA to extend the full advantages of these positions throughout our global organization.

As we speak, we're in the midst of our planning process, and it is very focused on developing specific strategies to better integrate our platforms, streamline our infrastructure, leverage our critical mass, all the while ensuring our ever-present commitment to customer service and operational excellence.

Thank you. Operator, we're ready to take some questions.

Question-and-Answer Session

Operator

[Operator Instructions] And your first question comes from the line of Michael Ciarmoli with KeyBanc.

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

Brad, maybe just on the aftermarket, you mentioned that maybe better on wing performance of some of your sensors, creating some weakness, I know, I guess, you're expecting -- or as of last quarter, you were expecting sort of flat growth for the year. Are you seeing any change? I know Souriau was a big customer of yours. They indicated that some of those CFM shop visits were coming in. Are you seeing anything in the ordering trends or anything out there that might signify some improvement?

Richard Bradley Lawrence

No, the -- I had indicated a few weeks ago when we were visiting, Mike, that I saw some better signs. But now when we look at the 90 days smoothing average in the rearview mirror here, those sales are pretty flat year-over-year.

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

Okay, okay, that's helpful. And then just in terms of the other specific programs out there, I guess, kind of maybe 2 parts to this one. You mentioned some pressure on the Global Hawk, and I think the acquisition you guys made a couple of years back of Eclipse had some key defense content in there. How's that acquisition performing? And I'm just asking that in relation to what's happened with Racal over the past couple of months here.

Richard Bradley Lawrence

Yes, so let me take that in a couple of parts. First off, the performance from a technology standpoint is going very well. We are developing a new line of receivers that are lighter and more powerful and are the best in the world for radio signal interception. And we're getting great market acceptance on those, and I'm pleased to say those programs are within budget and on time in the R&D process. The prospects for that business I believe remain quite bright. It's just a matter of where the U.S. government is going to deploy their signal intelligence systems. So the holdup on the Global Hawk then just is delaying the deployment of those radio signal receivers, so there's other platforms out there that if the Global Hawk Block 30 does not go forward, there are other platforms out there that will be receiving those receivers, but it does represent interruption of shipments.

Operator

Your next question comes from the line of Sam Pearlstein with Wells Fargo.

Samuel J. Pearlstein - Wells Fargo Securities, LLC, Research Division

I want to just go back to your comment about the $159 million in free cash. Can you just talk about is there anything unusual that is driving that just because if I look at the balance sheet, it looks like you might have gotten a little bit of a benefit from the accrued liabilities? But it doesn't seem like there is much that's really quarter-over-quarter changing that would drive the free cash as high as it is.

Robert D. George

Yes, Sam, this is Bob. We -- one of the strong points there is the very, very strong fourth quarter that we had last year resulted in a significant amount of working capital improvement in the first quarter. And then, we're just tracking -- we're tracking to continue the strong free cash flow as we have been over the last several years as you know through the balance of the year. But really it's -- the year kicked off exceptionally strong in Q1.

Samuel J. Pearlstein - Wells Fargo Securities, LLC, Research Division

Okay. And then just looking at the fourth quarter, if you do about $2 billion in sales, that would imply $80 million more than you did this quarter. So I'm trying to just think about what are the moving pieces that would drive you there, and related on the cash flow statement, should we see this buildup in inventory that's been happening all year also reverse?

Richard Bradley Lawrence

So on the Q4 strength, Sam, is we do agree with your math on improving in -- quarter-over-quarter in the fourth quarter if we do hit that sales number. There are a number of variables. Even though they were close to the end of the year here and have backlog to support our sales forecast, there's still a number of things that are a bit uncertain. There's always execution risks, customer pushouts, we've got a number of customers assertions in the forecast and finally, product mix. So we think that the guidance -- we're staying with the guidance, we think, that captures that range of possibilities.

Robert D. George

Yes, and Sam, I'll just jump in just to kind of comment on the inventory levels question -- portion of your question. When you look at fiscal '12 and fiscal '13, it's an amazing how similar those 2 years have been playing out. We saw the same exact trend last year as we ramped up from, give or take, $450 million early in the year to nearly $550 million that we did in the fourth quarter of last year for, I think if I remember correctly, we did about $1.99 billion last year. This year, as we said last December, we were looking at a pattern that is virtually identical to last year's. The inventory loads that you're seeing, we've been checking with our platform guys and everything else. We're noticing that as well. And it's leading up to a $560-ish million fourth quarter.

Operator

Your next question comes from the line of Julie Stewart with Crédit Suisse.

Julie Yates - Crédit Suisse AG, Research Division

Just on Advanced Materials margins, so 23% is the best in history, it looks like. So Bob, can you just talk about the sustainability? And then, if we think about what Brad said of having the strongest order book for F Q4, can we expect further improvement from this level?

Robert D. George

Yes, Julie, I'll kick off, and I'm sure that -- and Brad might have a few comments. We're awfully pleased with the results of Advanced Materials. Let me first say that I think that just speaking personally that what we're seeing here in Advanced Materials has been a couple of years in coming. As you may recall, the Engineered Materials platform there is one of the platforms where we've been consolidating facilities. We closed down a couple of operations, moved production from the East Coast and also in California to other operations in California and our Tijuana facility. And quite frankly, we paid a price for that for a period of time as we're working through getting those products requalified with our customers, resetting our sales and operating planning performance in a couple of our units and struggled. And what we're now seeing, however, is the benefit of that. And we see that very strongly as I called that in my comments. Engineered Materials margins are really strong. We benefited, quite frankly, from a nice product mix as well. So we had the improved operating performance at one of our facilities there. We also benefited from strength in our U.K. facility. But I don't want to leave out the performance that our Defense Technologies business is also generating. We've -- recently, our platform leadership team there added a new technology officer. And he has demonstrated some great results already and improving the efficiency in our flares operation in Arkansas. And our flow-through there is really, really strong. And even though that business is struggling in a very, very difficult sales environment and as we've talked before, our sales have been declining in a controlled fashion in that platform for a period of time, our margins are actually remaining very strong and moving up in some cases.

Richard Bradley Lawrence

Yes, Julie, to directly answer your question, I believe those margins are at these volume levels. And there is some positive mix, as Bob indicated. I believe these margins are sustainable going forward.

Julie Yates - Crédit Suisse AG, Research Division

Okay, great. And then Bob, what about the tax rate for the fourth quarter? Is that going to be about 21.5% what you guys have guided to before to discrete benefit?

Robert D. George

You are exactly right, Julie. The actual number we're looking at right now is 22%.

Operator

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

Howard A. Rubel - Jefferies LLC, Research Division

Brad, it sounds as if you're changing a little bit of strategic focus and raising the bar in terms of operating performance at your various platform levels. And there's 2 parts to this. One is, is that fair? And I mean, some of the language in your call sort of points to that. And then related to that is you have an item of discontinued ops in the quarter. And is this an example of you're setting a bar where you either perform or we sell you, trade you or close you?

Richard Bradley Lawrence

Yes, so let me take the first part of that question, Howard, is that for some time, we've been talking about and taking action towards the -- accelerating the integration in our segments amongst our platforms. Bob just alluded to a very successful case -- well, the results have been successful. Let's say it was painful. We've learned a lot about working with customers to requalify parts in a different manufacturing location. There's more opportunity for that without doubt in Esterline, and we are going to execute on, take advantage of those. It takes time, but we are focused on doing that. And on the discontinued ops question is really, this is a legacy environmental issue, and it doesn't reflect pruning the portfolio for companies that haven't measured up, although probably not a bad idea.

Howard A. Rubel - Jefferies LLC, Research Division

Well that's pretty neat because it sounds like, as I said, this platform responsibility, I think, is the word you used, sort of says there's some measurements that are ongoing with respect to the people that you have let run businesses. And then just to turn the cash flow for 0.5 seconds. What -- at the end of the second quarter, you had an $80 million target for CapEx, and I think you said, Bob, you spent a little over $37 million for the 9 months. And then, related to that is some -- also, some of the legal costs, my bet, are included in these reserves, so there's some nonrecurring items in there. Could you want to outline the CapEx, and then second, eliminate -- can you parse the legal issues a little bit finer for us?

Robert D. George

Yes, Howard, this is Bob. Both are good questions. I might be remiss here, and if I am, I apologize. I think you're absolutely correct. We were at $80 million capital expenditures for our initial guide. I think we reduced that to $65 million. If not, that's where we're at now, okay? We have some large expenditures coming through in the fourth quarter from a U.K. facility that we have been doing some fairly major work on, as well as some other flows coming through. But our current expectation is $65 million, and that is in the Q. With respect to the reserve, and I think you're probably -- you're referring to the DDTC matter, if I ask that question?

Howard A. Rubel - Jefferies LLC, Research Division

Yes, sir.

Robert D. George

Okay, no, that is strictly for the expected -- or estimated is probably a better word, estimated settlement with the DDTC. Legal expenses are incurred as -- or expensed as incurred.

Howard A. Rubel - Jefferies LLC, Research Division

At some point they'll go away.

Robert D. George

Yes, they will, absolutely, and we hope soon.

Operator

[Operator Instructions] Your next question comes from the line Omear Khalid with Goldman Sachs.

Omear Khalid - Goldman Sachs Group Inc., Research Division

This is Omear for Noah. Brad, I just wanted to turn towards the retrofit business for a second. You've talked previously about the military -- a potential military aircraft retrofit cycle due to some new commercial airspace regulations. Can you dive a little bit deeper into that potentially and add some color to the potential size of the market and scope of the retrofit work there?

Richard Bradley Lawrence

Sure, so the market drivers, as I indicated, is the next gen and the requirements for these older military aircraft, which are now not going to be replaced because the slashing of defense budgets globally. These aircraft, in order to fly in commercial airspace, need to be equipped with compatible avionics. And so we see that there will be a -- coming strong demand to upgrade these military fleets. As you know, we've done some of that work. We believe we're very cost competitive and very efficient in turning around those cockpit retrofits. The market extends not just in the military fleets but also into the air freight companies that fly a lot of older aircraft, among them are A300s and DC-10s. So the size of the market, I'm reluctant to even mention it, it's a big number, and it starts with a B.

Omear Khalid - Goldman Sachs Group Inc., Research Division

That's fair. Just as a follow-up to that, you previously also talked about how the military -- the retrofit business is more leveraged towards military retrofit than commercial. And you guys do a pretty good job pursuing a niche market for smaller orders, where Collins and Honeywell don't really play because it's not feasible for them from a cost perspective. But are you at all concerned now about how Collins and Honeywell potentially trying to move down into that space because also some of the pressures that they're facing in their other businesses?

Richard Bradley Lawrence

Well, they're -- both Collins and Honeywell are good customers of ours. And there's certainly areas, gray areas where the fleets get large enough to attract their attention, and they're still within our scope of capabilities. So no doubt, we competed in the past, and we will compete in the future. We think we're in a good position with the right technology to do well in that market.

Operator

We have a follow-up question from the line of Julie Stewart with Crédit Suisse.

Julie Yates - Crédit Suisse AG, Research Division

One housekeeping, and then I have another sort of longer-term question. Bob, can you just give us the gross margin by segment?

Robert D. George

By segment, I'll see if I have it handy here, Julie. I do not have it by hand. Actually I do, sorry, I apologize. By segment, gross margins for the third quarter, Avionics & Controls, 39.4%; Sensors & Systems, 36.4%; and Advanced Materials, 36.1%.

Julie Yates - Crédit Suisse AG, Research Division

Okay, great. And then I recognize you guys are in the midst of your financial planning and that you won't give formal guidance until December, but is there any initial color you can offer on FY '14?

Richard Bradley Lawrence

As you know, we're not going to give our guidance there for '14, and we're still -- the big issue here is for us to analyzing the military budgets and how we anticipate these programs to be supported. So the initial look I will tell you is that I think '14 should be a better year, but by how much will depend on how we see the defense budgets playing out.

Julie Yates - Crédit Suisse AG, Research Division

Okay, okay. And then just back to the margins, I mean, Avionics & Controls showed nice improvement even on lower volumes. Are you starting to see some improvements maybe at Control Systems, or what are some of the drivers there?

Robert D. George

Julie, once again you've kind of put your finger on it. Well done. Control Systems is an important part of that segment for sure. And the 2 large units in that platform are performing nicely and recovering from a relatively lower trend performance. The 2 smaller units are still struggling with some issues there. But I need to mention that CMC had a very strong performance in the quarter. A lot of their performance earlier in the year was buffeted by some of the changes in the flow of the T-6 production rates. Now that, that is stabilized and they're moving forward there, that's been fine. And Interface Technologies is beginning to perform nicely as well. So we've had reasonable performance across that segment.

Julie Yates - Crédit Suisse AG, Research Division

Okay, and then on Sensors & Systems, I would imagine that you're going to need a little bit more of a recovery in the aftermarket with the CFM56 to see much margin improvement there. Is that fair? Or are there other kind of system drivers that are -- that will cause an inflection?

Robert D. George

I think it's really, really important that if we're going to step up a few basis points from where we are right now, we're going to have to see stronger performance in the aftermarket, particularly for Advanced Sensors.

Richard Bradley Lawrence

I would add to that, we've made a -- considerably, we've got a very strong position in the A350 XWB. And when that A350 gets into production, we'll give a boost to the Sensors & Systems group also.

Operator

We have a follow-up question from the line of Michael Ciarmoli with KeyBanc.

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

Just to stay on that margin theme, can you just give us some color, as you're starting to obviously ramp up the rates on the 787, how should we think about the overhead cockpit panel? Is that a little bit dilutive to Avionics & Control margins at this point, or anything you could say about that program specifically?

Robert D. George

Yes, Michael, I'll start. Brad may want to jump in. Let's just -- I mean, that is a great question by the way, and one of the reasons why it's such an excellent question is you may recall that we built a brand new facility up in Everett a number of years ago, not specifically designed for the 87 production but with the 87 overhead panel in mind. The overhead panel for that program is one of the largest physical pieces of equipment that we produced in our Avionics group. And as we were designing that facility and sizing it, that was clearly a big factor. And as you can imagine, and as we have discussed at times here, that has largely been a fairly quiet production line for a long time. So as the 87 ramps up, we are beginning to see -- and this ties back to part of my answer to Julie's last question, we're beginning to see nice drop-through in that facility from the volume increases, and we're starting to make, obviously, more productive use of that facility. With that being said, I don't want to go -- want us to go off tip toeing through the tulips, as you would imagine and as you implied as an OEM product, our margins are a little bit lower than certainly from the aftermarket retrofit. What we have been able to demonstrate, however, over the years, particularly in that operation, that's our Control Systems operation in Everett, we have been able to use our operational excellence, our lean focus, we've got a great team there, and we're already beginning to see improvements and efficiencies in fabricating the overhead panel. So we don't really see it as -- certainly as regards our guidance going forward and our impact in terms of what we're looking at, we don't see it as a drag to margins.

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

Okay, that's helpful, and then...

Richard Bradley Lawrence

So Michael, let me, if I may expand upon that, just to talk about the really big picture, that overhead panels brought to us. And you may have heard me mention before that we have uncovered a strong market for overhead panel integration in business jets, as well as air transports. And we are quite busy now at that facility in executing on a number of programs. I believe the number is 5, it could be 6 on overhead panels. And that's going to have a very positive influence on that business in the future. In the meantime, however, we are experiencing higher than usual R&D rates in that unit. So that's a very, very busy factory there, both in the engineering and the production phases, and the impact of that 787 overhead panel is going to be -- have a very long and lasting effect.

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

Okay, great. That's extremely helpful. And then just one other housekeeping, I just want to make sure I heard you. The strong margins in Advanced Materials, you guys think that's sustainable not only into the fourth quarter but beyond. Should we be thinking about that rate going forward into '14 at sort of at these levels now?

Richard Bradley Lawrence

I need to qualify that, and there's a product mix. There's no reason to believe at this point that, that product mix will not continue. And if it does, we should expect those types of margins going forward.

Operator

At this time, there are no additional audio questions in queue. I would now like to turn the call back over to Mr. Brad Lawrence for closing remarks.

Richard Bradley Lawrence

Thanks, operator. Before we sign off, I'd like to say that I believe the overall health and strength of Esterline is apparent. We could see it in the drop-through to free cash flow, a record $159 million through 9 months, and our ability to maintain a rock-solid balance sheet are 2 keys to continuing our long-term growth strategy.

With that, I'd like to say thanks for joining us today, and we look forward to seeing you all soon at our Investor Day in Boston on September 19.

Operator

Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may now disconnect. Have a great day.

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