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Hexcel Corporation (NYSE:HXL)

Q3 2009 Earnings Call

October 27, 2009 10:00 am ET

Executives

Wayne Pensky - SVP and CFO

Dave Berges - Chairman and CEO

Analysts

Howard Rubel - Jefferies & Co

Al Kaschalk - Wedbush Securities

Noah Poponak - Goldman Sachs

Nigel Coe - Deutsche Bank

Steve Levenson - Stifel Nicolaus

Michael Lew - ThinkEquity

Cristina Fernandez - UBS

Avinash Kant - DA Davidson

Operator

Good day everyone, and welcome to this Hexcel Corporation third quarter 2009 earnings release conference call. As a reminder, today's conference is being recorded.

For opening remarks and introductions, I will now turn the call over to Wayne Pensky, Chief Financial Officer. Please go ahead, sir.

Wayne Pensky

Thank you. Good morning, everyone. Welcome to Hexcel Corporation's 2009 third quarter earnings conference call on October 27, 2009.

Before beginning, let me cover the formalities. First I want to remind everyone about the Safe Harbor provisions related to any forward-looking statements we may make during the course of the call. Certain statements contained in this call may constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. They involve estimates, assumptions, judgments and uncertainties caused by a variety of factors that could cause future actual results or outcomes to differ materially from our forward-looking statements today. Such factors are detailed in the company's SEC filings including our 2008 10-K, last night's press release, and the filing of the third quarter 10-Q.

Lastly, this call is being recorded by Hexcel Corporation and is copyrighted material. It cannot be recorded or rebroadcast without our express permission. Your participation on this call constitutes your consent to that request.

With me today are Dave Berges, Hexcel's Chairman and CEO, and Michael Bacal, our Communications and Investors Relations Manager. The purpose of the call is to review our 2009 third quarter results detailed in our press release issued last night. First, Dave will cover the markets, then I will cover the financials, then we'll turn it over for questions.

Dave Berges

Thanks, Wayne. Third quarter revenues of $257 million were down $74 million, or 22.4% lower than last year, with only space and defense holding at comparable levels. The magnitude of this sales decline in two of our three core markets overwhelmed our efforts to improved operations and further tightened costs, and resulted in an adjusted operating margin of 7%.

We did, however, take advantage of the lower sales volume to further tighten our capital spending plan and focus on all elements of cash, resulting in another $36 million of free cash flow for the quarter. Year-to-date we've now delivered $58 million of positive free cash flow, $140 million better than last year.

Given the demand outlook, we're again reducing our capital expenditure plan to below $90 million for this year and below $100 million next year. As usual, I'll cover our markets in constant dollars to describe sales trends. The dollar, you may have noted, has lost an additional ground to the Euro and to the pound in the third quarter, putting us back almost to last year's record low levels.

Commercial aerospace sales were about $127 million for the quarter, down 27% in constant currency. Despite limited aircraft build rate changes announced by the large OEMs, there has been a continuation of the across-the-board management of inventories by our customers, particularly with respect to Airbus sales. As a result of Boeing's strike, which began in September of last year, the decline for Boeing-related sales was less pronounced.

Our other commercial aerospace submarket, which includes regional and business jet customers, had sales drop more than 50% versus last year. Over the past two quarters this submarket, which last year represented 28% of our commercial aerospace sales, is running at $100 million run rate, down dramatically from last year's $200 million level. We hope that we have found the right run rate for this business, but because this decline for Hexcel only began in April, we have two more quarters of tough comparisons ahead of us.

On large aircraft, both Boeing and Airbus have recently reaffirmed 2010 build rates, and we expect some modest pickup in sales once the inventory lag is exhausted. Revenues from new programs were slightly higher than last year's levels and were essentially flat sequentially as sales of materials for the A350 and the 747-8 offset the 787 delay impact.

New program sales remained less than 15% of our commercial aerospace sales, but are expected to contribute to accelerated growth once in production. Sales to space and defense markets were $74.5 million for the quarter, essentially flat with last year's results.

Sales to rotorcraft programs, including the V22, constituted about half of our space and defense for the quarter. We expect the growth in rotorcraft to ramp up with the Joint Strike Fighter and the new A400M transport to more than offset the potential wind-down of the F22 program and eventually the C17, though a timing mismatch could cause a temporary sales decline.

Sales for our industrial markets of $55.1 million were down nearly 28% versus the third quarter of 2008 on a constant currency basis as the impact of the declines in the wind market between became truly evident. In August, we stopped shipping premium grade carbon fiber for the American Centrifuge Program, while USEC works to obtain program funding. We began sales to this $100 million contract last December, but have only shipped about $16 million to date. So we're anxious to see this program restored.

Our glass prepreg sales for wind turbine blades to-date have been predominantly in Europe and were down more than 25% in constant currency for the quarter. Wind farm financing issues have resulted in a significant inventory correction as short-term growth projections were revised downwards. For Hexcel, year-to-date sales to wind are now down double digits versus 2008 despite a very strong first quarter.

This summer's clarification of the American Recovery and Reinvestment Act of 2009 offers generous grants to new wind farms in the U.S. We hope that will stimulate a restart of growth in this region later next year. We've made good progress on our wind plant in Colorado, had our first sales of qualified material in the quarter.

I think it's worth noting that our sales decline in Europe are disproportionately large due to the decline in wind energy sales and the magnitude of the Airbus-related inventory corrections. As most of you know, taking labor costs out of European operations is often a time-consuming and costly proposition. In fact, it's not generally financially practical unless the sales reductions are expected to be permanent.

While we do expect the inventory corrections to last another quarter or two, we still have confidence that composites demand will outpace general economic recovery. So our operational cost reduction strategy includes aggressively reducing the number of days that several of our facilities are in operation. While this approach doesn't fully align costs with sales, it does improve our cash flows and allows us to retain critical skills and capabilities we need for the longer term.

Beyond work schedules, we've reduced global headcount by more than 15% and reduced SG&A by about 10%. As we did in 2002, we hope to lock in fixed cost gains to create a new base from which to leverage when growth returns.

Now let me turn the call back to Wayne for some additional comments on the financials for the quarter.

Wayne Pensky

Thanks, Dave. Gross margin of about $52 million for the quarter was 20.3% of sales, a decrease from the 21.5% gross margin for the third quarter of 2008 and down from the 22.8% for the second quarter of 2009. The decline was driven by the significantly lower sales volumes which more than offset the year-on-year operational improvements, cost controls, and headcount reductions taken during the quarter. Sequentially, the gross margin declined due to seasonality, lower sales volumes, and exchange rates.

Selling, general and administrative expenses remained well-controlled, down $1.1 million or 4.1% to $25.8 million for the quarter reflecting lower spending and aided by the weaker Euro and British pound. Research and technology costs were about 20% higher than last year on a constant currency basis, primarily due to the higher qualification costs for new programs.

Our R&D spending patterns are a bit lumpy, and one should not overemphasize one quarter but look at the year-to-date figures to determine trends. The year-to-date R&D spending on a constant currency basis is slightly higher than last year's amount.

Because many of our European sales are denominated in dollars, the strengthening Euro is a headwind for us, particularly in margin percentages terms. If current rates hold for the quarter, we would expect a negative fourth quarter gross margin impact of about a 100 basis points and operating margin impact of about 60 basis points as compared to the fourth quarter of 2008.

Our effective tax rate for the third quarter was 20%. The quarter reflects the benefits from recording additional U.S. R&D tax credits, which added just over $0.01 to our diluted earnings per share this quarter. Our underlying tax run rate is now about 30%.

As you may recall, last year's third quarter effective tax rate was 39% before one-time events. The improvement in the rate over last year reflects the various tax initiatives we have implemented over the past year.

Total debt net of cash stood at $298 million at the end of the quarter, down $46 million for the year. We're very pleased with the results, and it reflects both large improvements in working capital as well as our prudent reduction of capital spending to maintain alignment of spending with expected demand.

Year-to-date, we have managed nearly a $39 million reduction in inventories and also a $38 million reduction in accounts receivable. While most of the reduction of an accounts receivable come from the sales drop, we have also been able to lower our days outstanding.

At the end of the quarter, our revolver remained undrawn and in total, we have over $200 million of cash on hand and available borrowings under the revolver.

Interest expense for the quarter was $6.9 million, higher than last year's $4.6 million in the same period. The difference was the result of the following factors. First, our new credit facility incrementally adds almost $2 million to quarterly borrowing costs due to higher average borrowing rates.

Second, last year's third quarter interest expense was slightly lower than normal due to the reversal of accrued interest associated with reserves for uncertain tax positions in that quarter.

Finally, the current quarter also reflects accelerated amortization of deferred financing costs in the new facility as a result of term loan repayments we made this quarter.

We did record $1.7 million of other income this quarter, which primarily came from an earn-out payment from our August 2007 sale of the EBGI business. After tax this added about $0.01 to our earnings per share.

In the adjusted non-GAAP operating income and net income numbers that we have provided, we excluded this income as it was not from ongoing operations.

So, now, we'd be happy to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions). We'll take our first question from Howard Rubel with Jefferies & Co.

Howard Rubel - Jefferies & Co

I just have two. First, Dave, you talked about factory days in the quarter. How might we think about factory days for the fourth? I mean you do have some holidays in there, but you also had August in Europe.

Dave Berges

Well, historically, the fourth quarter is pretty similar to the third quarter. The strong quarters from a seasonal standpoint historically at Hexcel are strongest in the first quarter, pretty strong second quarter, and then weakest third and a pretty weak fourth. So typically, to your point, we do have a lot of holidays and downtime in December as we do in August.

We did take some pretty violent actions in the third quarter, and until we see some demand pressure build, we'd likely do the same in the fourth quarter because we don't want to build inventory. We are trying to work the cash flow basis.

Looking at it plant by plant is not a very practical method, or we'd offer you some information on that. You go from an extreme example of a carbon fiber plant that's got very high fixed costs and very low labor. We've closed the plant in Spain, the new facility in Spain, for quite a number of weeks in the third quarter and will likely also in the fourth quarter. So it doesn't take a lot of labor costs out. It doesn't even really get a lot of fixed costs out, but it's what we want to do to stay positioned for the recovery.

Howard Rubel - Jefferies & Co

Then while I know R&D is lumpy in any given period, can you talk a little bit about what you're doing either to improve your penetration in some of existing models or to give us a little bit of look forward to some other opportunities you see on the horizon?

Dave Berges

Well, we are always actively involved with almost all of our customers for their next aircraft or next turbine or next product. So we've often got a lot of activities going on individually with customers, most often with confidentiality agreements in place and a lot of basic research. The pop-up this quarter was more about actual qualification activities, specifically in the A350. We expect that the year-to-date average is probably more typical. I don't think that that's the start of a new trend. So I don't know if that helps you.

Howard Rubel - Jefferies & Co

No. It will be all right. And then just one last thing from Wayne, did I hear you correctly in that you said the gross margins in the final quarter would probably suffer by about a 100 basis points versus the year-ago numbers?

Wayne Pensky

Correct. That's...

Dave Berges

Because of currency.

Wayne Pensky

That's just because of currency. If you looked at last year the fourth quarter, the dollar started to recover against the Euro. I think the average Euro rate for the fourth quarter of '08 was like 1.32, and today the rate is almost 1.50.

Dave Berges

So that's a differential attributed to currency. It's not a forecast for the gross margin for the fourth quarter.

Wayne Pensky

Correct.

Operator

We'll move now to Al Kaschalk with Wedbush Securities.

Al Kaschalk - Wedbush Securities

Just to clarify, and I think it's something you highlighted on your preview but also in the earnings release. The clarity that you're speaking to on in the industrial side, wind energy in particular, are you referring to the grant program or what are you referring to in terms of that should help restart the order flow?

Dave Berges

Yes, the grant program in the U.S. So the investment tax credit ran out. There was a lot of talk about doing something to stimulate renewable energy in the U.S., but, in fact, nothing really got clarified until July. We'd hoped that it would have happened sooner and we'd keep the momentum that the U.S. wind turbine business had last year and the year before when they saw record amounts of new capacity.

There was a big lull, not only because of credit markets but because people are waiting to see what the government assistance program would look like. That was clarified in July, I believe, the summer. It looks very encouraging for the wind turbine makers. So now they have access to funds that can help them get the financing to start the growth again. I think it will take some time for that to work its way through the system, and, of course, credit markets also have to cooperate, but we are encouraged by that ruling.

Al Kaschalk - Wedbush Securities

So unlike maybe some of your competitors or other members of the supply chain in that business, you're not really ready to go out there and say 2010 could be at the levels of 2008 based on both credit markets still yet to open and just the general process of getting things started?

Dave Berges

Well, as you know, Vestas is our biggest customer in this space. They just released earnings this morning. If you haven't seen them, they still were maintaining growth of the topline for this year, as I recall, at 17%, though it's only 11% of installed megawatts. So that means the growth is not necessarily coming from the large turbines.

They had indicated a growth expectation that could be as high as 40%, so that differential is obviously creating the inventory correction that's affecting our sales right now. Their outlook for next year was modestly up from this year. So we only have that to go on at this stage.

Al Kaschalk - Wedbush Securities

I just wanted to ask a little bit further to the overhead/margin question given the volumes. I hear what you're saying in terms of keeping factory days down, but have you changed your thought or have your thoughts changed relative to, say, a month or two ago based on the volumes you're seeing heading into 2010?

Are you still extremely cautious about maybe having to take a little bit more headcount and increase the number of days that you're down relative to sustaining margins at the level that you'd like to have them at?

Dave Berges

Well, taking days down is a pretty iterative process that goes on plant by plant based on what the demand is from the customers. So that outlook changes week to week to week. With respect to direct labor, we make an attempt to always track direct labor with sales, with the exception of the difficulties in Europe in taking out direct labor workforce.

So if we do short time the plants, it doesn't necessarily mean that there is no cost to the direct labor. That's why it's not as efficient as a straight layoff, severance aside. I think we're always on a mission to reduce what we refer to as fixed costs, though they are not fixed when we're going down. We, in fact, I think are down on a cash fixed cost basis almost $15 million year-to-date. So, that decrease is our overhead costs and should allow us more leverage when we grow.

Is that the bottom? I hope not, but we have an increase in fixed costs from the new facilities that we put in place of over $10 million for the year. So I feel pretty good that we've managed to take that much out.

Al Kaschalk - Wedbush Securities

So if I may try to summarize, I guess what we should anticipate is a customer base that's going to manage inventory pretty aggressively. That probably doesn't allow you to start ramping volumes until first quarter at the earliest. Is that fair?

Dave Berges

Well, ramping volume sounds a little optimistic. I guess a ramp could be any...

Al Kaschalk - Wedbush Securities

Or sustain...

Dave Berges

Yeah, I guess this is obvious to you, I'm sure, Al, but we've got a strong first quarter in the whole business jet and other commercial aerospace segment. They didn't really move down until the second quarter of last year. The same is true of wind. We had a very strong first quarter in wind. So, on a year-over-year comp basis, we've got those difficulties to deal with.

On the other side of the coin, Boeing was on strike last year in the fourth quarter and that had some impact in the first quarter. Sequentially, I guess is what your question is. I think sequentially we'd see commercial aerospace for the big airplanes as eventually when the inventory is worked through, and I wouldn't really expect that to be in the fourth quarter. I would expect that the inventory correction completion would allow us to start to drift up as we get better aligned with what are the current build rates. You get to add to that any impact of new aircraft, and it's pretty minimal to date. So I'd see that as upside.

On the other hand, one could argue the business jet market might not have found bottom yet. All in all, I would see that we should start to drift up as we get into the second quarter of next year there. In space and defense, there might be some late year decline if the F22 timing is aggressive, but I'd see that pretty strong in the first half still.

Wind, hard to imagine, it will be much worse than what it was this quarter. On the other hand, we've got to overcome the USEC loss. So I guess my visualization of this is that we're sort of in the middle of a four-quarter bathtub from a topline standpoint, and that of course assumes that build rates stay where they are or start to grow later next year.

Operator

Our next question comes from Noah Poponak with Goldman Sachs.

Noah Poponak - Goldman Sachs

So I guess maybe to bring all those comments there together with everything you see today, is your best guess that 2010 revenue is higher or lower?

Dave Berges

We're not ready to give guidance on 2010 yet. We should be doing that sometime in the fourth quarter. I think, though, what is a good way to look at it is the second and third quarter are sort of the typical part of what is the bottom of the bathtub. So I could see next year second half being better than the first half and we haven't got a full year number for you yet.

Noah Poponak - Goldman Sachs

A little more color on the defense business. It's flat in the quarter. Presumably helicopter is still pretty strong. We've only just begun on the F22 ramp-down and haven't really yet on the C17 ramp-down. Going forward, investment accounts presumably aren't getting any stronger. So I wonder why we shouldn't be concerned that this maybe becomes a flat to declining business going forward.

Dave Berges

Well, the V22 is still stepping up. That's one of our most important programs. The Joint Strike Fighter is going to grow, and it's certainly got a lot more of our material on it than the F18 and the F16, which it replaces. We have had steady good growth in most all helicopter programs, both commercial and military.

There are a couple of new programs out a year or two, plus some re-blading programs for things such as the Blackhawk that are pretty strong growers for us. The A400M, say, what you will about it, hopefully it's going to fly in the next few months. Assuming that program goes, it's going to be a pretty significant gain for us. It's got a composite wing, and it's a big airplane, and carbon fiber composite propellers with lots of blades. So it's more the secular penetration of composites that has us feeling good about the long-term prospects for this business, as opposed to the airplane counts or the dollars the government spends.

Noah Poponak - Goldman Sachs

So it sounds like you've got some longer term programs like JSF or A400M that you're really positive on, but there is potentially a small gap between current programs coming down and those programs going up, such that we could have a few quarters of year-over-year decline in the defense and space business?

Dave Berges

That's right.

Noah Poponak - Goldman Sachs

One other thing I'd love to ask you about. We've got these funding issues in the wind business, and I just wonder if you could elaborate on why there is kind of this lag in the financing issue in wind. We had aircraft financing panic much earlier in the year, and credit markets were much worse earlier in the year and have improved dramatically, yet the wind financing issues are kind of just coming through in the middle and later part of the year. Can you just discuss why there is that lag effect there?

Dave Berges

Well, I think in the case of commercial aerospace, an awful lot of the current production was funded sometime ago. Big cash deposits and help from Exim banks and so forth. In the case of wind, I think it's just hitting production now with this inventory correction.

I think the programs that were funded and underway before September of last year have now flowed through the system, and the order intake hasn't kept up. It's a much tighter delivery schedule and cycle time for wind turbines than it is commercial aerospace. They're both longer than most industries, but commercial aerospace order intake today is for airplanes that might be three or four or five years out.

In the case of wind, sometimes the orders come in the same year that they're going to be delivered. So I think there was hope that the markets would open up quickly and they'd be able to fill the gap of the second half and at the beginning of 2010, and that didn't really happen.

I think if you look at the Vestas press release this morning, it spells out pretty well the combination of things that they think are causing the financing problems. That is that a number of the banks that used to finance these wind projects are either no longer financing it or no longer in existence, that they are not able to get the duration of loans that they used to be able to get, that it normally takes a club of banks now, not a single bank to do it, thus it takes longer to get the funds through. Finally, the interest rates are much higher.

On the offset, if you read that you'll notice there is a bit of a flight to quality which bodes well for the big turbine players versus the small upstarts, particularly the Chinese. So reliability and warranty issues also affect the ability to fund. So the ease of financing a year and a half ago compared to what's going on today is what we're talking about, and not that it's not better now than it was six months ago. They give some clear indication that things have gotten a little bit better. They're just nowhere as near what they were a year ago.

Operator

From Deutsche Bank, we have Nigel Coe.

Nigel Coe - Deutsche Bank

I appreciate the color you've given on 2010. It's very, very helpful. Maybe a bit more color on 4Q, I mean typically 3Q is your weakest quarter from a revenue standpoint for obvious reasons. You always see a pickup in 4Q. Is there any reason to think that that might not occur this year?

Dave Berges

I think we've got the USEC decline versus third quarter. If we're not shifting to USEC would be one reason to believe it. The other is I assume most people will manage their inventory through year end. We often have anomalies in our December numbers just because of inventory management programs by our immediate customers, sometimes that snaps right back in January, but the fourth quarter is always a little difficult to predict because we don't know what people are doing for their fiscal year end management. So I would say those are possible reasons that it wouldn't be stronger, but I agree with you, typically the fourth quarter should be a sequentially better than the third quarter.

Nigel Coe - Deutsche Bank

Then on the destocking, to get to aerospace, if you look at the shipments through September and into October, are you seeing any rays of light there? Are you seeing maybe a moderation in the rates of destocking?

Dave Berges

I would say no. It's why I introduced the bathtub analogy this morning as opposed to a V. Certainly at some locations there are. Certainly there will be some recovery, but you've still got business jets that are looking pretty sick. I look at what some of our peers, at least those I've looked at in their earnings release, seem to be indicating that they are not seeing much uptick. I think one of them did talk about a little bit of strength showing. So I am hopeful that we're nearing the end.

Nigel Coe - Deutsche Bank

Then turning to winds, China and U.S. markets had pretty big wind markets, essentially virgin territory for you guys. First of all, can you just talk about China, what you're seeing in China? Then secondly, will we start to see the impact of these two ramp-ups becoming more meaningful, maybe not in 4Q but certainly in the first half of 2010?

Dave Berges

I know you understand this, but I'd clarify for the others on the call, that it's not exactly virgin territory for us. It's that our sales have been in Europe because the turbines were exported from Europe to those regions. So to the extent Vestas, Gamesa or others are now manufacturing in China or manufacturing in the U.S. and we're providing prepreg in those regions. That's really just a displacement of the sales that would otherwise have been in Europe.

China is growing pretty quickly, and it's a very competitive marketplace there. Vestas is not the dominant share provider there, but they do have a good position there. They also are likely to export turbines out of China to places like Southeast Asia. So I do expect our sales in China to grow. Certainly, we will have good growth of sales in the U.S. as well. I think, as you'd see in the release from this morning from Vestas, the European business was expected to be backfilled with growth in Europe.

So the slowdown in financing in Europe and a little bit of a pause, particularly in Spain, a strong wind country, has changed their view of how quickly they will be able to backfill their European manufacturing facilities. In fact, they closed a blade-making facility on the Isle of Wight in the last quarter. So it's more a displacement from Europe without enough global growth to be able to keep up with previous projections, thus creating the inventory lag.

Nigel Coe - Deutsche Bank

Then a quick one for Wayne, you called out the 4Q impact from FX. Can you just maybe talk about 3Q? I'm assuming it's probably fairly flat year-on-year for 3Q and then perhaps, maybe if you could look through 2010 at current rates, what impact that might be?

Wayne Pensky

Yeah, well, I'm not quite ready to predict 2010 exchange rates just yet. But if you look, actually the hedges we have in place for 2010 as compared to '09, they're roughly in the same order of magnitude. So the hedge rate in effect would be about the same. For the third quarter, the FX impact on the operating income, it was about 70 basis points better as compared to the third quarter of '08. I think year-to-date we're at about that same range.

Operator

We'll move now to Steve Levenson with Stifel Nicolaus.

Steve Levenson - Stifel Nicolaus

You used to give a statistic about what a 5% change in the Euro would mean on revenue and margin. Is that still accurate? If so...

Wayne Pensky

The answer is it probably still is off the top of my head I've kind of lost track of it. But if you think about our, we have about a third of our sales in Euros. So if that helps you do some math, so a 5% change is presumably one or two points. I think if we have a 10% change, it's roughly in the 3% range of impact.

Steve Levenson - Stifel Nicolaus

In terms of the inventory destocking, I've been asking everybody this question, do you think your customers have over de-destocked? Do you expect to see any sort of spike in demand relating to build rates holding where they are?

Dave Berges

I don't know I would use the word spike. I think what I hope for is that as inventories are tight, when they catch up, we'll catch right up to what should be the run rates. If they are build rate increases, such as on the 77, we'll get the benefit pretty quickly. So I think it would help our recovery pace, but I don't mean to make it sound like it's going to be a step function.

Steve Levenson - Stifel Nicolaus

On new programs, are you focused more or are your customers coming in more on airplane or engine parts?

Dave Berges

Well, engines and the cells is certainly a very important target for us. As you know, we've got a quite a bit of content on a number of engines, in particular, the GE 90 engine that powers the 777 with the composite fan blade. The GEnx engine, which is going to power the 787, also has a carbon fiber composite fan blade. In addition to that, an increasing amount of composites are going into containment cases, structural core.

We introduced a new product recently called Acousti-Cap core that is an acoustical treatment that is used in our honeycomb core that is becoming sort of the standard for a number of new, in the cell designs to quiet engine noise.

I think the importance of engines and the cells can't be understated as any replacement of the 737 or the A320 or most new aircraft are going to be heavily dependent upon improved engine efficiency. Efficiency is partly thrust, but it's also thrust per weight. As we get to increasingly difficult noise requirements, our acoustical treatment should be improved in demand. So we're working very closely with all of the engine and the cells manufacturers, just as we are with the large OEMs.

Steve Levenson - Stifel Nicolaus

Do you see retrofit opportunities or do you think the designs are pretty much frozen, that they are not going to go back for re-engineering or retrofitting new in the cells?

Dave Berges

Retrofitting of an airplane is different than retrofitting an engine. I don't think that changes made to an engine are likely to happen to the fleet of engines that are out there. Retrofitting of an airplane is something that we don't root for because we'd just as soon see a new airframe as well. But if they did say re-engine the 737 or an A320 with some new engine, we'd want to make darn sure that we've got maximum composites on both the engine and the cell.

Again though, I don't think that's a retrofit. I think it's a design change to a new program that has a different engine on it. The 747-8 is an example of that. The 747-8 has a number of new components, but it's heavily metal. However, the engines are based on the GEnx engine from GE, and both the engine and the cell has a lot of Hexcel content on it. So the 747-8 has become an important program to us.

Steve Levenson - Stifel Nicolaus

Have you given or would you give approximate content?

Dave Berges

No, we haven't, yet, Steve, but it's a good program.

Operator

Our next question comes from Michael Lew with ThinkEquity.

Michael Lew - ThinkEquity

Dave, you had mentioned Vestas this morning, highlighted expectations for a back-end loaded 2010. What is the typical lead time for fiberglass prepreg?

Dave Berges

It's very tight. The question is how many blades they have in the system. So we don't have a good tracking mechanism for whether they are ahead or behind on blades. We work very closely with the blade making shop, so if the blade making shop is running, we're delivering daily. Lead time from when the actual turbine is sold, I'm not clear on, but it's probably inside six months.

Michael Lew - ThinkEquity

Could you also comment or provide some commentary on like what you're seeing out of Gamesa in terms of demand? Also, like based on what we're seeing out of Vestas right now, I mean they are the market lead and you have a couple of tough comps ahead in 4Q and 1Q. Is it fair to say that the wind segment could return to growth by 2Q of 2010?

Dave Berges

I'd sure hope so because I really think that what we're seeing right now is more an inventory correction than a decline in the wind business. I mean Vestas is saying their megawatts of cell this year are going to be up 11%. We, obviously, are down double digits. I attribute the difference to inventory correction. So to get a sequential growth, we just need to get through the inventory.

Michael Lew - ThinkEquity

In terms of Gamesa, any commentary?

Dave Berges

Same story.

Michael Lew - ThinkEquity

Same story?

Dave Berges

Yes.

Michael Lew - ThinkEquity

So just netting it out then, based on inventory destocking and then Vestas's comments, inventory destocking in commercial aerospace for another one to two quarters, Vestas's outlook this morning. I guess it's fair to say that 2010 is really shaping up to be very back-end loaded at this point in time?

Dave Berges

Well, let's say that if there is going to be a step-up, it's going to be in the second half. So I hope a year from now we'll say that.

Michael Lew - ThinkEquity

In terms of CapEx, I mean, is the plan to have it evenly allocated throughout the year or is it also going to be second-half driven?

Dave Berges

We're not ready to give you a whole lot more on 2010 right now. We'll talk to you next quarter on that. Okay?

Michael Lew - ThinkEquity

Okay. One last question, in regional business jets, how many tough quarters do you anticipate are ahead before the bottom is reached?

Dave Berges

Well, I am hoping that we're at the bottom, but I would say if I had to pick one of these markets that maybe hasn't found bottom yet, if you force me to pick one, that's the one I would probably pick business jets more than regional jets. We just ran strong through the first quarter, and it didn't make a lot of sense. I don't think anybody really expected that it was going to stay strong in the first quarter.

We had a difficult time explaining why our first quarter was so strong. But the NBAA show was last week, and it's clear to me that this market is going to stay soft for some period of time whether or not we've found bottom is the question, but we're down 50% year-over-year, and that's sort of what people forecast the build rates to be down. So its possible there is more of an inventory correction in front of us that we aren't aware of, but it seems to me that a 50% or $100 million run rate per year is a safe planning point.

Operator

With UBS, we'll move to Cristina Fernandez.

Cristina Fernandez - UBS

Dave, I wanted to see if you can help us think about margins here over the next couple of quarters while the inventory destocking continues. I mean Q3 has typically been the lowest on a seasonal basis, but now you also have some FX headwinds to overcome. If sales stay flat in Q4, I mean could we see margin improvement just in seasonality or could margins stay at these lower levels for a bit longer?

Dave Berges

I'm not really ready to forecast gross margin quarter-by-quarter. We do have headwinds in depreciation and oil and freight starting to move up, and FX as you note, on a percentage basis margins will artificially move with the dollar.

On the other hand, we've incrementally been taking out costs each quarter. So we've got lower running costs, lower fixed costs and pretty good cost control. So if we stay flat, it boils down to what the mix looks like. Certainly a delay in the USEC program hurts mixes, as do any programs that use our fiber. If fiber sales are down, it affects our mix.

On the other hand, wind is a little lower than the average on margin. So it probably is going to be more a matter of mix in a one or two quarter outlook if sales are flat.

Cristina Fernandez - UBS

So on Q3, was there anything that was from a mix perspective, worse than expected?

Dave Berges

Well, the stop of the USEC program was not something we were happy about.

Cristina Fernandez - UBS

Then a quick one for Wayne, on the tax rate, the underlying 30% that you saw this quarter, is that what we should be using going forward? I mean previously you had guided to 32%, 33%.

Wayne Pensky

Yes. Cristina, I think we're headed down towards 30%. I mean it depends a little bit on the mix of countries and other items, but we're on track to 30% for the year and going forward.

Operator

Our next question comes from [Peter Kazam] with KeyBanc Capital Markets.

Unidentified Analyst

Obviously, a lot of questions have been answered already, but can you just give me a little bit of color into maybe some of your other industrial markets, kind of the trends you're seeing, particularly maybe in automotive.

Dave Berges

Well, automotive is down pretty dramatically, as you would expect. It's a pretty small number, so the percentage is large, but the impact is small. I'd say automotive sales for Hexcel are approaching the not material category. Recreation is a pretty decent quarter. It's seasonally usually strong in the third quarter. It's not up significantly over any particular period in time and tends to stay pretty flat, but it's held up.

Other industrial, which is our biggest subcategory, is down a little bit but not a lot, because last year we pruned quite a few programs out of that category.

Unidentified Analyst

Just one more. In regards to the U.S. wind market, with clarifications on the grant programming, what kind of normalized I guess long-term growth rates do you see in this market going for?

Dave Berges

Well, I don't know. People have indicated numbers in the 20% range, people like American Wind Energy Association and others. I don't know if I did the math right this morning, not specifically U.S., but Vestas talked about a three by 15 program. I think they wanted to get to...

Wayne Pensky

Percent operation margin

Dave Berges

15% operating margins, no, $15 billion in sales by 2015 and they projected next year to be in the $7 billion to $8 billion range. So if I did the math right that would work out to a CAGR of 15%, which is certainly down from what we've heard before from them. So it seems like they have lowered the slope of the growth curve, but I'd still be happy with 15% per year.

Operator

We'll move to Avinash Kant from DA Davidson.

Avinash Kant - DA Davidson

A few quick questions. You may have talked about this one, but at this point as you talk about Q4 and going forward, what are your assumptions for the Boeing 787 plan working out? Is it based on the fact that 787 flies in November?

Dave Berges

They have said that they expect it to fly before year end, and I don't have any further information for you on that.

Avinash Kant - DA Davidson

So you're going by the assumption that it does, right?

Dave Berges

I'm not sure what you're talking about. The aircraft that are currently built, we shipped our materials months and months ago. So it's the production ramp rate that we have to keep our eye on. How many planes are going to be built next year and the following year is what we're trying to manage. When the first airplane flies doesn't particularly concern me.

Avinash Kant - DA Davidson

Right, right, but the follow through is dependent on this one. So I am assuming that you do believe that this one is a successful flight for them so they could follow through on the schedule that they have publicly stated at this point.

Dave Berges

I always believe my customer.

Avinash Kant - DA Davidson

With that moving on to the second part, the wind side of the equation here. Vestas, historically, actually have had a very heavy second half. Historically, their first half has been low. Now, what I would try to understand is that how that has impacted your revenues in the past?

Dave Berges

Our sales don't vary seasonally as much as Vestas's sales do. They've got a certain capacity for blade-making, as do we for prepreg-making. So the blade building business tends to be a little more level loaded through the year, as opposed to big turbine installations all coming at year end for Vestas and the other wind turbine manufacturers.

Avinash Kant - DA Davidson

So you have not seen the same seasonality as they see in their revenue, as they tend to kind of distribute it throughout the year for you?

Dave Berges

We have some seasonality, but nothing like what they have.

Avinash Kant - DA Davidson

In the same time, like the second half being heavy for you also, but not by the same order?

Dave Berges

Let me just look. We're typically pretty level loaded. There have been a couple of years that have been stronger in the second half, but it's pretty level loaded.

Avinash Kant - DA Davidson

One final question, in terms of the Q4, you've talked about being kind of at the same level or similar levels of Q3. You don't expect barring there is no changes in terms of the production schedule of major aircraft, you'd expect that to kind of be the bottom level at this point?

Dave Berges

On large commercial aircraft, I wouldn't expect it to be any lower than it is right now. Our business jets could be lower and industrial could be lower because of the stoppage of the USEC program.

Avinash Kant - DA Davidson

When you talked about Q4 being flat from Q3, you're talking only commercial or you're talking about overall revenues?

Dave Berges

I haven't picked a number for the fourth quarter. I just think that we're sort of at the bottom but not expecting a big recovery in the fourth quarter. Fourth quarter is mostly dependent on how our customers think about their year end inventory levels.

Operator

We have a follow-up question from Howard Rubel with Jefferies & Co.

Howard Rubel - Jefferies & Co

David, one of the things that is happening is there has also been a deferral in aircraft maintenance and as you see a lot of narrow bodies parked or whatever, as they start to open up engines, they typically replace elements inside, then the cells. As you sort of think about it, how do you sort of think about the opportunity going forward there? I mean, that business has obviously fallen off as well.

Dave Berges

I can't say that I have much visibility into the after-market that our OEMs experience with respect to composites. Almost everything we do is shipping materials to the OEM or to the component manufacturer. We don't know whether those components are going on a new or used aircraft. I suspect that almost all of it is going into OEM. We don't have the problem or the opportunities, you might say, of fatigue and corrosion and things that metal producers have. Our materials have great durability and last. So I suspect that we have a lower percentages impact of MRO activity than anyone else.

Howard Rubel - Jefferies & Co

Your CapEx you've scaled back a couple of times. Where has most of the reduction in emphasis been?

Dave Berges

Well, the big spending for us is always carbon fiber. I mean the numbers for carbon fiber are just overwhelmed numbers for all the rest of our products. If we didn't invest in our carbon fiber for these new programs, we probably wouldn't be talking about CapEx much. So we delayed, deferred or slowed down certain of our carbon fiber lines. They've got a couple that we mothballed partially complete that we will be finishing up in the next number of months.

We're keeping an eye on USEC funding. If USEC is refunded, that's one solution. If it's not, then we'll deploy that carbon fiber capacity to the rest of our business, and it would result in lower CapEx. So we're mostly now other than carbon fiber focused on productivity projects and also yield per CapEx projects. So to the extent that we spend so much money on carbon fiber, we're as interested in finding a way to get more out per CapEx dollar in carbon fiber, and that's a real important productivity measure for us.

So we've got some ideas that have been developed by our R&D group over the last two or three years that we now have time to try to implement to improve our throughput on carbon fiber facilities. So a bunch of capital is going into that. Finally, we have some new materials developments that will require some capital, that we're working on.

Operator

We have no further questions. That does conclude today's Hexcel Corporation third quarter earnings call. We thank you for your participation.

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Source: Hexcel Corporation Q3 2009 Earnings Call Transcript
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