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Rockwell Collins, Inc. (NYSE:COL)

F4Q09 (Qtr End 09/30/09) Earnings Call Transcript

November 3, 2009 9:00 am ET

Executives

Dan Swenson – VP, IR

Clay Jones – Chairman, President and CEO

Patrick Allen – SVP and CFO

Analysts

Noah Poponak [ph]

Howard Rubel [ph]

Robert Stallard [ph]

Cai von Rumohr [ph]

Joe Nadol [ph]

George Shapiro [ph]

Carter Copeland [ph]

Operator

Good morning, and welcome to the Rockwell Collins third [ph] quarter fiscal year 2009 earnings conference call. Today's call is being recorded. For opening remarks and management introductions, I would like to turn the call over to Rockwell Collins’ Vice President of Investor Relations, Dan Swenson. Please go ahead, sir.

Dan Swenson

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

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

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

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

Clay Jones

Thanks Dan, and good morning, everybody. To start off by stating the obvious, 2009 was the year of extraordinary volatility and challenges for Rockwell Collins and the rest of the world. For (inaudible) less obvious, it was also a year that tested our business model and validated our strategic balance between commercial and government markets. During a time which every component of commercial systems was -- may have been impacted by market events, government systems provided a stabilizing effect to year-over-year growth and revenues, and earnings.

Looking at our financial performance for the year, total sales were $4.47 billion, down 6% from 2008 as the 21% decline in commercial systems revenues was partially offset by a 9% increase in government system sales. Total segment operating margins came in at 21.4% in 2009, only slightly lower than the 21.9% in 2008 as overall cost control and record profitability in government systems helped offset the substantially lower earnings in commercial systems. And as a result, earnings per share declined by only 10% to $3.73 despite a $500 million revenue decline in what has been our most profitable business.

Now while these results were not in keeping with our long term focus on growth, let me share with you how we have been positioning our business for the future. First, in the midst of this market and business volatility, we maintained our level of investment in research and development, spending almost $850 million or 19% of sales on R&D.

We also delivered very strong cash flow, generating a record $633 million of operating cash flow, including the impact of the $139 million in pension plan contributions we made in 2009. This strong cash flow profile and the strength of our balance sheet enabled easy access to credit markets to secure long term financing and execute our acquisitions strategy, something other companies found extraordinarily difficult or impossible over the last year.

This last quarter, we also announced additional actions that generate greater efficiency. Specifically, we're closing our San Jose, California facility and relocating related manufacturing service and engineering to lower cost work centers. The fact that San Jose is a government systems facility and the work is being moved to commercial locations is testament to our integrated business model. These moves will be carefully orchestrated over the coming months to ensure we meet product delivery and commitments to our customers. However, once finalized, this will provide us with a leaner manufacturing and engineering footprint that will improve future profitability.

Together, our strong capital profile, ability to generate consisting cash flow, and focus on operating efficiencies will help us execute our business plans as the aerospace market recovers over the coming years. But before we get there, we are going to have to weather a little more turbulence in 2010 as the final stages of the down cycle continue to unfold.

In particular, the first quarter of fiscal 2010 should mark our twelfth period in terms of overall revenue and earnings performance. While we expect to see a year-over-year Q1 improvement in air transport OEM revenues due to the effect of the BOEING strike last year, it's still way too early in the cycle to say that it's the same for the rest of commercial systems. In particular, the impact of lower business jet production will weigh heavily in the quarter due to tough comparability in the first quarter of 2009, in which the business jet OEMs had not yet felt the full effect of the economic recession.

Our aftermarket business will also be down on a year-over-year basis in Q1 as we have not seen enough of the recovery in business jet utilization and airline traffic to drive higher spending on hardware and repairs.

Additionally, we're experiencing some delays on a few government systems programs that may cause their revenue growth to be around mid-single digits for the first quarter. These are primarily timing issues that are not anticipated to impact full year growth expectations of approximately 12% to government systems. While a combination of a lower revenue base and higher compensation and pension costs, we'll also -- we also expect margins to be lower in first quarter of 2010 than they were in the fourth quarter of 2009.

However, we do believe that the first quarter will be the low watermark for our business. And we should close sequential growth of the course of 2010 with the potential for year-over-year growth from both businesses by the second half of the year.

As is usually the case, the initial driver of recovery for commercial systems is expected to be in aftermarket activity as increases in business jet utilization and airline passenger traffic lead to an increase in basic repair maintenance services. We're beginning to see evidence of this and data on business jet utilization already. While the comparables are down year-over-year, we have seen a trend of sequential recovery with flight cycles up on a sequential basis in six of the last eight months.

Additionally, we believe that by the second half of our fiscal year, the overall economic recovery will gain traction on the commercial airline travel market leading to an increase in air transport maintenance and repair. In addition, government systems should continue with its long term growth trajectory over the course of 2010.

We saw exceptionally strong profit margins from our core government business during 2009, which were reset to a lower level by the acquisition of DataPath. While this acquisition was strategically oriented to solidify our SATCOM offerings and complement our network communication strategy. It also establishes a new level from which we can grow our earnings. This will come with the increased operating margins as we integrate our proven shared service and lean operating model.

As the cycle improves, our longer term growth prospects remain solid, using the platforms we've often discussed. Our R&D investment continuously oriented toward important opportunity such as the Airbus A320 business. Additionally, we accomplished the successful first flight of our Pro Line fusion avionics recently, and will continue to develop back systems for application on the Gulfstream G250, the Bombardier Global Express, and the (inaudible) regional jet among numerous other platforms.

We're also focused on positioning government systems to succeed in a budget-constrained environment. We have a balanced approached to new platform opportunities such as F-35, UAVs, and the next generation tanker as well as flight time extension and mission effectiveness solutions on existing tankers, transports, and helicopters. And despite this challenging budgetary environment, there's still a strong DOD focus on forcible application and improving the communication and situation awareness capabilities of our soldiers, which is providing support for problems such as the Joint Tactical radio system, integrated computer system, and ground soldiers system.

So in summary, I feel the worst is almost behind us. And we've come through it, I believe, in very good shape. While 2010 will be a challenging year, its feeling more and more like we are at the pivot point. And I believe we'll see sequential and substantial improvement as we move through the year, with even better prospect for 2010 -- 2011 and beyond. And so with that now, I'll turn the call over to Pat to take you through more of the specifics of our fourth quarter. Pat?

Patrick Allen

Thanks, Clay, and good morning to everyone as well. Let us get started by first reviewing our fourth quarter results. Let us start out on slides three and four. Total company sales for the quarter declined 7%, compared to last year of sales, while net income and earnings per share both decreased 26%. This decrease in net income and earnings per share came primarily from lower commercial systems revenues, but was also impacted by restructuring and asset impairment charge of $14 million after tax or $0.09 per share. Additionally, our effective income tax rate for the fourth quarter was 29.5%, compared to 24.5% from last year's fourth quarter.

Last year's rate benefit from the renewal of the Federal Research Development tax credit that was signed into law on our -- the last day of our fiscal year 2008. The renewal of the credit netted against the associate increase in our employee incentive compensation contributed $0.08 to our earnings per share for the fourth quarter fiscal year 2008. Adjusting for the comparability of these items, earnings per share would have been $0.93 per share in the fourth quarter of 2009, compared to $1.50 in the fourth quarter of 2008, or decline of just 11%.

Turning to slides five and six, we have our fourth quarter results for government systems. Total government systems revenues increased 17% from $636 million last year to $741 million this year. Airborne solutions sales increased $16 million, with $5 million of this growth coming from the acquisition of SEOS group. The organic revenue growth of $11 million was primarily from higher sales of displays of F-15 aircraft and increased revenues from unmanned aerial vehicle control systems.

Surface solutions sales increased $89 million, with $61 million of the growth coming from the acquisition of DataPath. Organic revenue growth of $28 million came from higher sales from the UK Ministry of Defense Precision Targeting Program, increased revenue from the Joint Tactical Radio Assistance Program, and higher revenue from the Joint Precision Approach and Landing Systems Program. These are partially offset by lower sales from the defense advanced GPS receiver or DAGR and ground-based GPS receiver application module products.

Page six shows operating mark -- operating revenues within the government systems increased 27% from $125 million in the fourth quarter of 2008 to $159 million in the fourth quarter of 2009. Operating margin increased from 19.7% of sales to 21.5% of sales over the same time period. This increase in operating earnings and margin was primarily due to higher sales and lower employee incentive compensation costs, which were partially offset by an increase in research and development costs.

Moving to page seven, our total commercial systems revenues decreased 30% from $641 million to $449 million. Revenues in our OEM business decreased $113 million or 34% to $220 million as a result of reduced production rate at business jet OEMs. Our aftermarket revenues declined $60 million or 23% to $205 million, due primarily to lower hardware sales resulting from reduced discretionary spending by airlines. Avionics service as support revenues also declined, but at a lower percentage of net shown by the overall after market. Finally, sales of in-flight entertainment products and systems provided by the aircraft decreased $19 million or 44% to $24 million, compared to the prior year period.

On page eight, we see that our commercial systems operating margins declined from 22.5% in the fourth quarter of 2008 to 15.8% this quarter. The margin decline was primarily due to lower sales volume, which we were able to partially offset with productions from discretionary research and development expenses, lower employee incentive compensation costs, and other cost saving activities. However, with incremental margins of less than 40%. It is clear that we are beginning to see benefits of our cost savings activities.

On slide nine, we have our fiscal year total company financial results for sales, EPS, net income, and operating cash flow. Of note in this slide is our cash flow from operations of $633 million, which as Clay mentioned, was a record level for the company and represented 107% of net income.

Contributing factors to the strong cash flow included collections on receivables and positive results from our efforts to improve and (inaudible). The results of these efforts were demonstrated by the $67 million reduction in finished goods inventory, and the $27 million reduction in overall inventory, compared to the end of fiscal year of 2008, even after getting effect to $41 million additional inventory from acquisitions. These items were partially offset by the $139 million in contributions we made to our defined benefit pension plans and cash payments made from employee compensation related to 2008 performance.

Slide ten provides an overview of our capital structure for both fiscal years 2008 and 2009. During 2009, we were able to equalize our investment rate, credit rating, and strong capital structure profile to issue $300 million of ten-year bonds to pay the short term borrowings and to finance the acquisition of DataPath. With the 20 million percent debt-to-capital ratio, we believe our balance sheet is well positioned to have flexibility to invest in organic and acquisition growth opportunities.

On to slide 11, we review the progress and status of our share repurchase program. We were active in the fourth quarter as we repurchased 1.3 million shares with $58 million bringing our fifth year 2009 totals to 3.9 million shares repurchased9 for the value of $156 million.

Our program date recap shows that we are -- that share repurchases have been a consistently utilized method for enhancing shareholder value. As we've used about $2.5 billion of our available capital to repurchase almost 54.5 million shares at an average price of less that $46 per share. Our Board recently increased our share repurchase authorization by $200 million, so we now have $209 million in total share repurchase authorization.

Now, on to our final slide, slide 12, where we provide the details of our fiscal year 2010 financial guidance. New guidance figures are unchanged from what we originally issued them on September 17.

Looking first to our revenue projections, we continue to expect revenues for 2010 of between $4.6 billion and $4.8 billion. In commercial systems, we anticipate full fiscal year 2000 revenues to be down about 7% for 2009. This consists of overall OEM revenues being down in the high single digits, with low double digit growth from both air transport of regional jet OEM revenues, offset by business jet OEM revenue declines of roughly 30%.

Aftermarket revenue is expected to experience low single-digit growth across both air transport and business to regional markets, while wide-body IFE revenues are expected to decline by approximately 40%. Note that as Clay highlighted, we expect revenue declines from commercial systems to continue into the second quarter of the year, but anticipate aftermarket business conditions will improve enough in the second half of the year to contribute to year-over-year growth in the third and fourth quarters.

In government systems, we continue to expect full year revenue growth of about 12%, with 6 percentage points from organic growth and 6 percentage points from the acquisition of DataPath. This organic growth will be oriented toward the back half of the year because some general program delays are expected in the first quarter as well as the overall ebb and flow of order activity being oriented toward the latter portion of 2010. While we expect full year total segment operating margins to be approximately 18.5% to 19.5%, we should highlight that we anticipate margins in the first quarter, in particular, to be quite weak given the depressed revenue profile.

On our predicted operating cash flow, I would point out that our guidance of $600 million to $700 million includes the $98 million contribution we made to our defined bank and pension plan during October. We did not anticipate being required to make any additional contributions to the plan during fiscal year of 2010, but may make additional volunteer contributions depending on our cash generation during the year.

That's today's results and projections, so Dan back to you to pick up the Q&A Session.

Dan Swenson

Thank you, Patrick. In order to give everyone the opportunity to ask questions, we ask that you limit your questions to two per caller. If you have further questions, simply reinsert yourself into the queue and we’ll answer those questions as time permits.

Operator, we are now ready to open the lines.

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes form the line of Noah Poponak [ph].

Noah Poponak

Good morning, everybody.

Patrick Allen

Good morning.

Clay Jones

Good morning.

Noah Poponak

Guys, I wonder if you could elaborate on the delays that we are seeing in government systems. We’ve heard this from a multiple defense companies, and it sounds like everyone's attributing it to timing. Why is it not attributable to the fact that budget authority outlays are down? And can you give us some color exactly what else you’re seeing in there?

Clayton Jones

Well, I think we agree with everybody else. Anytime you go from the transition from one fiscal year to the next and you’re operating under a continuing resolution that in itself stops you form increasing the spending typically -- especially on development programs.

To answer your second question, almost all of the impact of the domestic order rate is from development-type programs, where we’re either trying to get on contract or we’re trying to increase the spending level that normally happens through, let’s say, a year one to year two development cycles. And in most of the cases, where we’re seeing order delay is because either they’re delaying the on-contract time because of budget authority, or whether or not increasing the stem [ph] rate because of lack of budget authority.

I would say, in our case, there is also a proportion of those delays that are coming from international orders as well. And I'm not sure I could put my finger on the phenomena for international orders other than they are just always hard.

I'll give you a good example. We see some growth in India now because of the recent agreements that the United States and India have signed on defense cooperation. But if you know anything about India, patience is certainly a virtue. And so, our ability to forecast when those orders come in are probably difficult at best. And so, I would say proportionate delay are international orders where we see that ebb and flow, and they tend to be lumpy. And then the rest is due to the developmental programs from DOD.

Noah Poponak

That's how far -- I guess, I'm just a little confused if budget authority is down. And you guys have, I think, been a little more willing to admit than others that you expect outlays to decline. Wouldn't you expect to be seeing this slower order activity?

Clay Jones

Well, not really because, again, focus on where we come from here, no one needs development programs. The budget authority, which I think is primarily declining are in supplementals. And supplementals are directed mostly to procurement of production-type hardware.

We've said in the past, in our case, we have very little of that. And in fact, in the biggest area we had in DAGR, that's coming down anyway. We've forecast that for sometime. And as Pat said at his (inaudible), we're expecting DAGR to be down year-over-year as we move in from 10 to11 again as it was from 8 to 9 -- 9 to 10. So I don't think, in our case, we're seeing budget authority and the striking budget having so much an effect as we are, if I could say, the development-type programs.

Noah Poponak

Okay. Thank, and one quick one for Patrick. There's a big jump in retirement benefits on the balance sheet. Can you just walk through what that's attributable to?

Patrick Allen

Yes. That's our weekly measurement of the pension liability, Noah. Our year-over-year debt cover went from 7.6%, down to about 5.5%. That costs roughly $650 million jump in our pension liability. So it's almost entirely pensions, and almost entirely related to the change of the discovery.

Noah Poponak

Makes sense. Thanks guys.

Operator

Your next question comes from the line of Howard Rubel [ph].

Clay Jones

Good morning, Howard.

Howard Rubel

Good morning, gentlemen. Could you address, Clay, a little bit of the R&D spending, how you went about making the changes? And if you can address a little bit of the mix between the corporate and customer-funded, please?

Clay Jones

Are you talking about for 2009 or the upcoming year?

Howard Rubel

Both years would be helpful, please?

Clay Jones

Okay. Well, 2009 is pretty easy. We reduced our -- I'll call it discretionary, company-funded R&D by about $40 million year-over-year. And almost all of that came from programs that either were deferred by the customer, things like the Columbus program. That would be an example where they canceled that. And there were several other ones where the development was stretched out, primarily in the business jet area. And that and a combination of some internal discretionary developments that we had that were being done to position us in these markets, which are sort of moving to the right.

And so, we were able to reduce, or in some cases eliminate, some of the spendings for the year just because the market has moved. But if you look at that, that's about 10% of our total discretionary spend for the past year. In the coming year, again, we're getting a -- we're seeing a lot holes that are consistent with the revenue flow at around 19% of sales. And I think the mix stays about the same when you look at the year-over-year impact. And what we have moved around in the 2010 budget, again, will be consistent with what out customers were saying they need to do on their development programs because we're meeting all the commitments we've already signed up.

Howard Rubel

I appreciate that. And then as a follow-up, could you -- I know this a little bit strange. But the international markets have proven to be a little bit more resilient. Are you seeing that in both defense and in OE -- oh excuse me, and aftermarket forum that's just in any way that you can address?

Clay Jones

No. I think it's extremely regional there, Howard. I think you almost have to look region by region as to what those markets are doing across all the markets. So for example, business jet, there's not a lot of business jets in Asia. So we're not seeing much there. We're seeing the after market hang in pretty good in the Middle East because utilization rates didn't cut as much. But the utilization rates were cut almost everywhere else worldwide, and that brought our after market spending down for that.

Where we are seeing, actually, the biggest impact in the aftermarket, as you noticed in this last quarter, was an airline spending for discretionary aftermarket items. These are retrofits and upgrades. They're just not spending right now. And I think it's because the yields are down, because they're really managing their cash well. And so that was the biggest impact of fourth quarter, and we think that will carry over in the fourth quarter -- first quarter of 2010. And that's worldwide. We don't see a lot of activity there anywhere. Where we believe we'll first see the improvement that I just described here will be as the fleets stabilized. And I think we're still one to two quarters away from fleet stabilization.

I'll give you an example, we believe about 800 airplanes have been taken out of the fleet since we started counting about a year ago. And we think there's going to be about another 200 to 250 more come out over the course of the winter. And so that will continue to dampen the aftermarket. But when that gets stabilized, we think that as we approach next spring, we are going to see an economic recovery. We will see the utilization rates go up. We believe some of their planes will come back in. And that's where we'll see some of these after market pent up demand that is always there to come back in.

Relative to government markets, it's all over the place. Whoever's got the money is spending the money. Europe is not very good right now. Middle East is very good right now. Asia's pretty good, and outside United States that's where we see most of the effect.

Howard Rubel – Jefferies

Thank you very much for your help.

Operator

Your next question comes from the line of Robert Stallard [ph].

Robert Stallard

Good morning.

Clay Jones

Good morning, Rob.

Robert Stallard

Clay, just to follow-up on the after market topic. I was wondering if you could give us a little bit more comfort on what your assumptions are with regards to the discretionary spend next year. And also if you've built in and I think it's (inaudible) with regard to restocking of spare parts?

Clay Jones

Yes. Let me give you some synthetic. Yes, we're not -- we're encouraged by the aftermarket, but we're not a -- ours is not the shoot the moon scenario here. We're talking about over the year aftermarket growth in the low single digits. So I don't think our eyes are bigger than our appetite here in terms of what we're expecting. And again, the flow of it is another quarter or two of probably none or negative growth, followed by spring or summer of next year with the aftermarket picking up.

Again, we think that the thing that will drive that is a combination of both just more flight hours being flown as traffic picks up in the airline side. I think it will be led, Rob, by the business jet side because everyone has seen the steady increase in utilization of a business aircraft, and we absolutely think that will continue. We think that's actually the one of most positive trends in the aftermarket.

And then, we'll see just incrementally some of these of these retrofits come back in. I used the analogy of, “You can delay painting your house, but you can't not paint your house forever.” And if you're going to maintain these aircrafts, ultimately, there's going to be airspace modernization and efficiency improvements where the technology and the products are there, they just need a little bit of comfort that that cash won't have to be used somewhere else, like survival, before they upgrade those assets. And in our view, that's about 6 to 12 months away. So that'll happen a little bit in the back half of our year, but we're not counting on a whole lot of that, Rob.

Robert Stallard

Yes. So you're not making any major assumptions on this to meet your full cost for the year then?

Clay Jones

No, absolutely not. Like I say, this is a very modest aftermarket growth forecast, and probably more modest that a lot of other people think about.

Now let me address the de-stocking question because, again, we see a lot of our peers talk about de-stocking. First of all, I don't think we saw a big de-stocking phenomena because most of our equipment is safety of flight. You can't empty these benches out and still fly the aircraft reliably and safely, whereas in other more discretionary products you might be able to do that. So we saw aftermarket for the year down in the mid to maybe high teens for this past year, which is far less than some of the other companies saw that were "de-stocked". And so because it was not big decrement, we're not counting on a big restocking of our equipment.

The other thing is, a lot of our equipment is based on exchange type programs, which are flight-hour type things where we manage the spares. So some of that effect came in and prevented that sort of de-stocking. So I think, where our company’s concerned, there’s not going to be a big re-stocking tailwind whereas you might see it at another place.

Robert Stallard

Okay. And just a quick follow up for Patrick. On the balance sheet, the change in shareowners' equity, is that the other side of that pension issue you were talking about earlier?

Patrick Allen

Yes. The way we look at the pension liability is you record the liability, record the related tax asset, and then the difference goes into equity. And that’s the big change in equity you're seeing.

Robert Stallard

That’s great. Thanks very much.

Operator

Our next question comes from the line of Cai von Rumohr [ph].

Cai von Rumohr

Thank you very much. Can you talk a little bit about the sequential changes in commercial OE and aftermarket from the third to the fourth? And then what you’re assuming for the full -- for the first quarter?

Clay Jones

Soon as I get the data, I can, Cai.

Cai von Rumohr

Okay.

Clay Jones

The short answer is commercial systems sequentially from third to fourth was roughly flat. It was up a little bit and I think it was up mostly at the OE area. And as we look into the first quarter, the first quarter tends to be, just by its nature, lower volume. Less working days, which tends to be light. So we’re expecting it to go down both in the OE and in the aftermarket principally as a result of the seasonality.

Cai von Rumohr

Got it. Okay. And if I take the comments you've made, 12% in (inaudible), it looks like that comes out just arithmetically much closer to the low end of your guidance, so that -- is it fair to say that while you haven’t changed your guidance, it looks like more of it is focused on the lower end?

Clay Jones

I think it’s fair to say that given our current guidance, we'd probably be closer to the lower end than to the higher end.

Cai von Rumohr

Okay. And could you update us on your thinking of employee incentive comp overall, and the incentive comp program, incentive comp bonuses--?

Clay Jones

I think it will flow through the year. It should flow rapidly as we disclosed. We’re expecting about -- well, we’re planning right now about $40 million from incentive compensation. And if I were forecasting, then I’d have to pay $10 million a quarter.

Cai von Rumohr

Thank you very much.

Operator

And next question comes from the line of Joe Nadol [ph].

Joe Nadol

Thank you. Good morning.

Clay Jones

Good morning, Joe.

Joe Nadol

Clay, just on your sentiment that Q1 will be the bottom and never going to go up sequentially from here, just wondering how much of that is your analysis doing essentially what we do in taking stock of the world and where things are going? And how much of that is things that we can’t see like what you’re hearing from customers and order trends that you’re getting internally?

Clay Jones

I’d say the majority of it is the former, not the latter. I don’t think we’re hearing a lot of things from customers that are not fairly well known out there. Again, I would say that in the first quarter as we've said here, we’re going to have a really bad business shift comparability, again, as we move that -- sort of stabilize the effect to the system. We will see some improvement in the airline OEMs sales -- the air transport OEM, as a result of Boeing's strike. So you know that.

And then the issue on the aftermarket again, in that case, we're hearing from our customers and we’re saying there’s probably not a lot of flight activity and not a lot retrofit activity available to us out there. So on the commercial side, we think we have it pretty well pegged. And then on the government side, it’s what we've said before, we pretty much know what orders we have and helped what they’re going to do. Even if they pass an Appropriations Bill later on, the bureaucracy's got to flush back through the system.

And so our system there is probably more of talking to customers and knowing what’s coming down the way, that you’d probably wouldn’t have as ready access to for the kind of small programs that we do. So I’d say in the government is more the customer discretion, and the commercial market's more just a macro environment that pretty much all of us know what’s going on there.

Joe Nadol

Okay. And then on your commercial OE outlook, I may have missed it. If you guys broke out broadly what you’re anticipating for Fiscal Year '10 in -- for biz jets and for your transport that would be helpful. And then what underlying assumptions do you have there? You had talked about a narrow body cut in your numbers before. Is that still part of the plan?

Clay Jones

Yes, it is. If you look at our commercial sector, it’s a combination of ups and downs. We’re seeing an increase and improvement in OE sales here in the -- probably first maybe even the second quarter as the effect of the Boeing strike to the positive variants.

And then offsetting that toward the back half of the year will be the reduction in the wide body production rates that have already been announced as well as the -- at least, potential anticipation of a narrow body cut that could occur probably in our fourth quarter. So we are accommodating that, even though the closer we get to that, the likelihood of it is anybody’s guess. But that was contained in our guidance.

And then for business jets, we’re just assuming that after this quarter were at stabilized rate and we’ll see no growth in that for the year. We’ll probably see a little improvement in regional jets as those become a little bit more popular in this constrained economic environment.

Joe Nadol

So for biz jets you’re baking in negative. But that’s really the first half of the year comparable from the back half of the year, you’re looking for that to go positive? Did I get that right?

Clay Jones

No, no, no, not at all. What we think is you’ll see -- we’re saying that we’ll see no growth. Maybe just a slight decline as the OEMs continue to rationalize their output levels. And then the comparables having that big effect in the first half of the year or so. If I was looking at net for the year, we’re looking at biz jets being down 30% year-over-year.

Joe Nadol

Right.

Clay Jones

So forget the seasonality. Just say net for 2009 and then compare it to 2010. It's down 30%.

Joe Nadol

Okay, okay. All right. Thank you.

Operator

Your next question comes from the line of George Shapiro [ph].

Clay Jones

Hi there, George.

George Shapiro

Good morning.

Clay Jones

Good morning.

George Shapiro

Clay, from when you gave the guidance in mid-September, you were saying sales around 45 would -- came in at 447, I assume that’s slightly weaker is due to aftermarket? If you could lay out where in the aftermarket you saw some weakness more than what you might have expected in mid-September?

Clay Jones

No. I don’t think that’s correct, George.

Patrick Allen

No. It’s not.

Clay Jones

Yes. I think it’s some government orders that began to slow down to the same effect that we’re seeing into Q1 of 2010 was probably the predominant effect. If you can call it that, that was it.

I think it was the government orders being weaker, not the commercial. Commercial came in about where we thought they would, fourth quarter. Which, by the way, gives us some confidence in this whole stability thing. Let’s face it, after the year we had last year, just being able to predict correctly where commercial is going is a wonderful thing. And right now, we may have a lot more confidence in those predictions given what we have seen now for about three or four months and what we project going forward into our -- as our discussions with our customers.

George Shapiro

Okay. Then a second one. You’ve mentioned in the release, OE was down 34% in the quarter. That was more than I thought because I think in Q4 last year you had mentioned that you have been impacted by $25 million, which would have been maybe 400 bits of growth from the Boeing strike. So did OE get worse in that regard? Or am I missing something?

Clay Jones

Well, the specific impact that probably is not as clear, George, is the effect in our fourth quarter of business jet OEM manufacturers. That was the driving force far and away. And whatever early impact that we did take for the Boeing strike, and we did try to anticipate a little of it, was completely dwarfed by the business jet production rates.

Remember, in our fourth quarter is the period of time where almost every single business jet OEM shut down their factories to try to eliminate white tails and stabilize their effect. In some cases, like at Hawker Beechcraft, (inaudible) for very long time. And so, given that most of our product had been pre-shipped to them, there were just no orders coming in for business jet. And we were down over 50% in the fourth quarter. So that was the primary effect, George.

George Shapiro

Okay. That’s a good answer. Thanks very much, Clay.

Clay Jones

You bet.

Operator

(Operator instructions) You have a follow-up question from Noah Poponak.

Noah Poponak

Thanks. Can you guys comment on the extent to which you see white tails are your mid-cabin business jet customers? Even if you can just talk qualitatively where it is versus three or six months ago.

Clay Joes

Noah, I think some of the OEMs are carrying a few white tails just because of their ability to turn the faucet of. But, at least in our discussions, I think there is some encouragement that because the price points are approaching some stabilization, they either are moving them or feel confident that they can move them toward the end of the year. I don't have any visibility, Noah, as to what the numbers and amounts are, but I know that there's some out there.

But if you look at -- again, the general trend in business aviation, I think, has clearly and definitely turned. Now nobody's having a big celebration. But when we see things like utilization rates going up, the relative numbers of aircraft in the used market beginning to turn around and go down, and most especially encouraging, those young aircraft less than ten years old going down, we are seeing signs of some price stabilization albeit at low levels, and the phone are ringing again.

While NBAA was extremely quiet, in my discussions, there were OEMs that were taking orders down there. And not a lot of orders have been taken lately. So I think there's general churn now coming back into the market for pure, economic supply-and-demand reasons that are beginning to make that look more stable. But the numbers I don't have.

Noah Poponak

That's helpful. And I'll ask one more. Can you talk about profitability at DataPath in the quarter? Better or worse than you thought? And just update us on the pace of improvement you expect there.

Patrick Allen

I would say that DataPath was modestly more profitable than we expected in the quarter, but not a significant order to profitability. And as we talked about it, I think 2010 is going to be a year of integration of DataPath. So we'll expect some level of modest profitability, single digit margins, and -- but steadily improving from there. Particularly in 2011 once we get DataPath fully integrated into our share and surface business model.

Noah Poponak

So this is a government systems margin in fiscal '11?

Patrick Allen

I would say working its way towards a government systems type margin.

Noah Poponak

Okay.

Clay Jones

That's a pretty high bar you set for us here, Noah.

Patrick Allen

Yes.

Clay Jones

It will take a little while to get up there.

Noah Poponak

That's a fair statement. Thank you, guys.

Operator

Your next question comes from the line of Carter Copeland [ph].

Carter Copeland

Hey, good morning, guys.

Clay Jones

Good morning, Carter.

Carter Copeland

Clay, just a real quick one. You may have addressed this in the past but I'm just wondering if you can help us size the risk around the C-130 AMP program cancellation and whether or not you've considered that in the guidance or how are you thinking about that, going forward?

Clay Jones

We have not sized it in the past. Nor will I, today. But I can tell you it would not be terribly material. As is normally the case with us, Carter, we obviously would like to see that program continued and like to see the activity rate go forward. But the key to success in our company is ubiquity.

If that were to be cancelled by the Air Force, then we believe there will still be a demand to upgrade those aircraft. And we have a lot of capability to be able to do that. Now that's again not our plan, but we believe we have -- in the long term we wouldn't necessarily lose all that revenue because a lot of the products we're providing to the AMP program would still be required just to have those aircraft fly through the airspace, much less to be able to do it reliably with the kind of displays and the systems that they are going to need.

So I don't think it's going to be a big effect to us one way or the other. Especially in the long term. If they were cancelled outright we'll lose a few sales in this year. But with the size of a -- almost $3 billion government business, I don't think it would be terribly material.

Carter Copeland

And so it would be fair to characterize it as within the normal puts and takes that you called out earlier. That you're watching for that business as a whole?

Clay Jones

That's correct.

Carter Copeland

Okay. Great. Thanks, guys.

Operator

You have a follow-up question from Howard Rubel.

Howard Rubel

Thank you. With the increase in the pension liability and your apparent -- and your willingness to contribute a little bit more to the pension plan, could you first talk about pension expense. And then talk about where you are in terms of your thoughts going forward on that, Patrick. What will drive you to lower the liability and so on?

Patrick Allen

Sure, Howard. When we issued our guidance in September, we were assuming about a 5.75% discount rate. It came in at about 5.5%. So it was roughly another $4 million of expense. So what was $40 million is now about $44 million for FY '10.

As we looked forward in terms of the -- reducing that liability -- the under-funded portion of the liability, I think it's going to come from two places. One is additional contributions. We've made $150 million now, between $50 million in September and about $100 million in October as well as increases in the discount rate.

If you look at the net under-funded position, our assets, net of -- between benefit payments, contributions, and asset returns, we're basically flat year-over-year. The entire unfunded -- increase in the under-funded position was created by the discount rate. So you could say a combination of contributions from us as well as if the economy improves, the interest rates rise. That's going to take care of a portion of the under-funded position as well.

Howard Rubel

Sure. I get it. Thank you.

Operator

You have a follow-up question from Cai von Rumohr.

Cai von Rumohr

Yes. Could you tell us what was your pension return last year? And since everyone uses a different discount rate metric, if you measure the discount rate today, where would it be?

Patrick Allen

The return for the year was low single digit. Now that was a combination of a fairly substantial drop off in the first half of the year from September 30th through middle March, accompanied by a fairly significant rally in the back half of the year. So net positive for the year I would say about 4%.

As it relates to the discount rate, what we use is we use a duration adjusted Citigroup liability index. That way we pick the bottom of that, at least as we look at it today. Because it's probably up 25 to 50 basis points since September 30th.

Cai von Rumohr

Okay. And could you comment about where within your guidance range the R&D might come in? And any seasonality in terms of the pattern throughout the year?

Patrick Allen

Well Cai, I think you identified the (inaudible) number as probably edging toward the low end of the range. I would say that R&D is as well. Largely because of these -- some of these government delays that Clay referenced. So I would suspect that the R&D is edging toward the lower end of the range as well.

Cai von Rumohr

Thank you.

Operator

You have a follow-up question from Robert Stallard.

Robert Stallard

A couple of quick ones. First of all on the 787, have you got any assumptions for shipments on the 787 in FY '10?

Clay Jones

We do. We have some modest shipments towards the end of the fiscal year.

Robert Stallard

Okay.

Clay Jones

Very, very modest.

Robert Stallard

And on helicopters, Clay, clearly the helicopter fleet is getting a very big thrashing in Afghanistan and that could increase from here. What's your assumptions regarding helicopter spares and repairs next year? And could there be potential upside to that?

Clay Jones

Yes. Right now we have some -- I'll call it modest growth. The revenue's we're getting from helicopter retrofits are pretty substantial now. But we seeing some modest single digit growth year-over-year in helicopter retrofits. I think that's right, Dan?

Patrick Allen

Right.

Clay Jones

And so could there be an upside to that? Yes. History has shown that's certainly an opportunity. It depends on what they do with them and where they put them. How are retrofits going on in Afghanistan or in Iraq right now is typically when they bring them out.

Robert Stallard

Okay. Thanks very much.

Operator

You have a follow-up question from George Shapiro.

George Shapiro

Clay, could you break out in the 23% aftermarket decline, break it out between the large commercial and business jet, and RJ [ph]?

Clay Jones

Yes. I'd say that the largest portion is the large aircraft, half the market, predominantly in the retrofits, spares, and upgrade. If you were to take that, I think the number is -- I can't see it.

Patrick Allen

Twenty-six percent.

Clay Jones

Yes. If you look at just the MRO-type brake fix, it's probably 18%, 19%. And so, the portion that you're looking at that 20-something percent after market downer, with much greater in the retrofit market and the MRO-type repairs and overhauls were in the mid to high teens.

George Shapiro

Okay. And then just to follow-up to what I asked before, you mentioned that you had 50% OE decline in the business jet area. So what did that leave for large commercial? It probably wasn't down very much then in the quarter.

Clay Jones

That was about 12%.

Patrick Allen

It was about flat.

Clay Jones

It's about flat.

George Shapiro

Yes. That's what I would have guessed.

Clay Jones

They didn't cut in half. And so, OE (inaudible) transport's about flat, business jets down over 50%.

George Shapiro

Yes. That's what I figured. Okay. Thanks again.

Clay Jones

You bet.

Operator

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

Dan Swenson

We plan to file our form 10-K, including our complete annual financial statements and put (inaudible) in a couple of weeks here. So keep an eye out for that. Well thank you for joining us, and participating on today's conference call.

Operator

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

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Source: Rockwell Collins, Inc. F4Q09 (Qtr End 09/30/09) Earnings Call Transcript
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