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Executives

Douglas R. Wilburne - Vice President of Investor Relations

Scott C. Donnelly - Chairman, Chief Executive Officer, President, Member of Management Committee and Member of Executive Committee

Frank T. Connor - Chief Financial Officer and Executive Vice President

Analysts

Peter J. Skibitski - Drexel Hamilton, LLC, Research Division

Robert Stallard - RBC Capital Markets, LLC, Research Division

Jason M. Gursky - Citigroup Inc, Research Division

John D. Godyn - Morgan Stanley, Research Division

Joseph B. Nadol - JP Morgan Chase & Co, Research Division

Noah Poponak - Goldman Sachs Group Inc., Research Division

Ronald J. Epstein - BofA Merrill Lynch, Research Division

Cai Von Rumohr - Cowen and Company, LLC, Research Division

George Shapiro

Myles A. Walton - Deutsche Bank AG, Research Division

Charles Clarke - Crédit Suisse AG, Research Division

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

Textron (TXT) Q3 2013 Earnings Call October 18, 2013 8:00 AM ET

Operator

Ladies and gentlemen, thank you for standing by, and welcome to the Textron Third Quarter Earnings Conference Call. [Operator Instructions] And as a reminder, this conference is being recorded. I would now like to turn the conference over to our host, Doug Wilburne, Vice President of Investor Relations. Please go ahead, sir.

Douglas R. Wilburne

Thank you, Roxanne, and good morning, everyone. Before we begin, I'd like to mention we will be discussing future estimates and expectations during our call today. These forward-looking statements are subject to various risk factors, which are detailed in our SEC filings and also in today's press release. On the call today, we have Scott Donnelly, Textron's Chairman and CEO; and Frank Connor, our Chief Financial Officer. Our earnings call presentation can be found in the Investor Relations section of our website.

Moving now to third quarter results, starting with Slide #3. Total revenues in the quarter were $2.9 billion, down 3% from a year ago. Our income from continuing operations was $0.35 per share, down from $0.48 in the third quarter of 2012. Third quarter manufacturing cash flow before pension contributions was $269 million compared to $153 million in last year's third quarter. We contributed $60 million to our pension plans during the quarter.

And with that, I'll turn the call over to Scott.

Scott C. Donnelly

Thanks, Doug, and good morning, everybody. Third quarter revenues were down as growth at Bell, Industrial and Textron Systems was more than offset by decline in Cessna as the light to mid-sized business jet market remained soft. Operationally, we saw good performance at Systems and Industrial. At Cessna, despite cost actions that we implemented in the second quarter, our results reflected continuing weakness in the business jet market.

Margins and revenue at Bell were below our expectations due to manufacturing efficiencies associated with labor disruptions resulting from negotiations with our UAW bargaining employees in Fort Worth and with the implementation of a new enterprise resource planning system. The factory inefficiencies had a negative impact on cost and our ability to ship aftermarket spare parts. This did not prevent our downstream and final assembly and completions centers for meeting our aircraft delivery commitments. The labor issue is now behind us as this past weekend our employees did ratify a new 5-year contract. However, we will not fully recover with respect to margins in the fourth quarter as higher-cost work in progress makes its way to our production lines and as we continue the ERP integration process.

From a market perspective, we saw another significant increase in our commercial business during the third quarter with 54 units delivered, up from 46 last year. Recent notable successes were Bell commercial products around the globe, including the first deliveries of our 407GX into both Poland and Russia; 7 orders for new helicopters at the 2013 Jet Expo show in Moscow; delivery of the first 2 429s into the U.K.; a purchase agreement signed at 2013 Helitech show in London for up to 20 helicopters for a large global operator; and orders for 14 helicopters in China.

On the new product development front, we continue to make progress on our short light single and 525 Relentless programs and remain on track to fly both of these new aircraft by the end of next year. On the military side, we delivered 10 V-22s and 7 H-1s in the quarter compared to 11 V-22s and 5 H-1s in last year's third quarter. During the quarter, we successfully demonstrated the V-22's ability to function as an air refueling tanker, which will enhance its versatility and value by expanding its mission set for future applications. We also recently announced a number of important teaming partners on our V-280 platform for the joint multi-role tech demonstration program, including Lockheed Martin, General Electric, Moog and GKN.

Moving to Cessna. Demand continues to be soft in the light to mid-sized business jet segment as we delivered 25 jets in the quarter, down from 41 last year. Cessna recorded a segment loss of $23 million as a result of the low volume and a number of headwinds in the quarter, including used aircraft valuation adjustments. Looking forward and taking into account where we are year-to-date at the current state of the business jet market, we're taking a more conservative view of Cessna full year deliveries. Despite the lack of a near-term recovery, we continue to believe that the global light to mid-sized jet market is a growth market in the long term, and we remain committed to our strategy of investing in new products.

On that front, we're on track to certify and begin delivering the M2 and the new Sovereign this quarter. And we're on track to certify and deliver the world's fastest commercial jet, the new Citation X, in the first quarter of next year. Our new wide-body Latitude is also on track to our first scheduled flight for next year as we completed wing mate on our first test aircraft this past quarter. So we believe we're doing the right things for the future success of the business with respect to attractive new products, competitive cost structure, superior service network and expanded sales coverage.

Moving now to our Finance segment. Our captive business is performing well, although the loan originations have been light, consistent with the soft new jet sales at Cessna. On the noncaptive side, we continue to liquidate remaining assets at levels favorable to book value, which benefited segment profit in the quarter.

Shifting to Industrial. We saw good top line growth, reflecting growth in auto markets and the impact of the Sherman & Reilly acquisition last quarter at Greenlee. We also had good execution with an overall margin improvement of 170 basis points. On the new product front, during the quarter, we introduced our new hybrid-powered Bad Boy Ambush iS. The vehicle gives customers 3 power modes, gas for long range, electric for quiet approach, important to hunting applications for our hybrid mode for greater power.

Moving to Systems. Revenues were up slightly over last year, reflecting growth in our precision munitions product line, and margins improved, reflecting better performance across most of the businesses. On the vehicle front, preparations for the Canadian Forces' Tactical Armoured Patrol Vehicle program continued with customer testing and training activities progressing well on the first 5 preproduction vehicles. We also signed an order for 28 COMMANDO armored vehicles for the Colombian National Police force. And we're actively working with a number of customers around the world on other vehicle opportunities. On the precision munitions front, we continued to deliver product to the Kingdom of Saudi Arabia under a contract that was definitized during the quarter. And we have a number of international opportunities under active discussion.

With respect to fee-for-service UAS program, we continue to experience unacceptable quality from our engine supplier. Therefore, we've decided to transition the manufacturer of that engine into Lycoming, which we believe will allow us to improve performance on the contracts. Looking forward across Systems, we have a substantial amount of global sales activity underway and continue to believe this business can maintain a flat to slightly growing top line over the next several years.

To wrap up, the third quarter was disappointing with respect to performance at Bell and the continued lack of sales strength at Cessna. The Bell labor situation has been resolved. And this will allow the Bell management team to return their focus to ERP integration and improving factory productivity. We expected to get our M2 and Sovereign models certified. And that should provide a nice pickup for Cessna revenue and profit in the fourth quarter. Overall, we are seeing improved performance at Systems and we'll continue to pursue global sales opportunities.

Finally, in Industrial, we demonstrated solid execution and we should expect to see top line growth and margin going forward. With that, I'll turn the call over to Frank.

Frank T. Connor

Thank you, Scott, and good morning, everyone. Manufacturing segment profit in the quarter was $195 million, down $59 million from the third quarter of 2012 and a $65 million decrease in manufacturing revenues.

Let's look at how each of the segments contributed, starting with Cessna. Revenues at Cessna were down $185 million on a year-over-year basis, reflecting lower new jet volume, partially offset by growth in aftermarket revenue. The segment had a loss of $23 million compared to a profit of $30 million in last year's third quarter. At Bell, revenues were up $87 million, primarily due to higher military and commercial volumes. Segment profit decreased $34 million, primarily reflecting unfavorable performance associated with the labor disruption and ERP system integration issues.

At Textron Systems, revenues increased $5 million, primarily due to higher volumes in Weapons and Sensor products, partially offset by lower UAS and Marine & Land Systems volumes. Segment profit increased $14 million, reflecting good performance across most of Textron Systems' product lines. Industrial revenues increased $28 million, primarily due to the impact of acquisitions and increased volumes at our fuel systems business. Segment profit increased $14 million, primarily due to the improved performance and the higher volume.

Moving to Finance. Total Finance receivables ended the quarter down $94 million from the prior quarter. This segment had a profit of $13 million. Nonaccrual accounts ended the quarter at $105 million while 60-day delinquencies ended at $88 million.

Moving to corporate items. Corporate expenses were $34 million in the quarter, down $4 million from last year. Interest expense was $25 million, down $6 million from last year, primarily reflecting the retirement of our convertible debt this past May. Moving to cash flow. We generated $269 million in free cash flow, which reflected better working capital performance.

To wrap up, as Scott discussed earlier, we are reducing our outlook for the year at Bell and Cessna. On this basis, we are now targeting full year manufacturing cash flow from operations before pension contributions in the range of $200 million to $300 million with pension contributions of about $200 million. And we are adjusting our full year EPS outlook to a range of $1.75 to $1.85 per share.

That concludes our prepared remarks. So operator, we can open the lines for questions.

Question-and-Answer Session

Operator

Our first question comes from the line of Peter Skibitski with Drexel Hamilton.

Peter J. Skibitski - Drexel Hamilton, LLC, Research Division

Hey, Scott, can you give us a sense of how the government shutdown is expected to impact your fourth quarter? It sounds like you don't think it will have any impact at all.

Scott C. Donnelly

I don't think it will, Peter. I mean, obviously, we had some concerns in the early part of the shutdown just because the FAA and the government inspectors are pretty important. Frankly, on the military side, the DCMA did provide inspectors an on-site support for the Bell folks even when the shutdown was going on. And now that the thing is over, any concerns we would've had around FAA and certification has pretty well been alleviated. So I would say no impact.

Peter J. Skibitski - Drexel Hamilton, LLC, Research Division

Okay. And the issues that you'd had previously on the Garmin avionics for the new programs, those are resolved as well?

Scott C. Donnelly

Yes, that's correct. Those have been resolved. And the M2 and Sovereign and Citation X test flights and [indiscernible] have been progressing very well.

Peter J. Skibitski - Drexel Hamilton, LLC, Research Division

Okay. And then I just wondered what your sense is in terms of if you could sort of bifurcate your thoughts on the market versus kind of your stiffer pricing terms that you've been implementing out there.

Scott C. Donnelly

Well, as we've talked about sort of coming into -- after the first quarter, Peter, we stopped doing a lot of the very deep discounting that, I think, was helping to create some demand in the marketplace. As we went through the second quarter, obviously, we saw the impacts of that in significantly reduced deliveries. We pretty well held those prices, both sequentially and year-over-year in terms of third quarter, so we're keeping the pricing around where we expected it to be. And I think, as a result, we're just seeing what's the normal market out there as opposed to dragging people into it that aren't ready to do upgrades or trade-in activity. And so that's reflecting in lower volume, which again, I think, for the long term is healthy for the market. We've got to let this cycle play through. Certainly, as we went through the third quarter, we continued to see a fairly active used market, a lot of transactions that are happening over there. I mean, in our case, we certainly sold more aircraft than we took in trades, and we continue to see the number of used aircraft available for sale, particularly in those relatively newer aircraft, continue to bleed down. So I think at this stage of the game, we're not happy with where we are in the cycle, but we're letting the cycle play through.

Peter J. Skibitski - Drexel Hamilton, LLC, Research Division

Got it. And comps essentially are easier for you from here on out in terms of having new aircraft to market. Would you agree with that?

Scott C. Donnelly

Yes. I don't think there's any question. When you look at the M2 and the new X, had a very nice receptivity. And again, we're not competing against relatively new used aircraft. The Sovereign, obviously, we've been out there now doing demo flights over the last few months and have started to book orders on that. And we still have orders to go here for the fourth quarter. But yes, I think there's no question that new product does matter in the market and does help to create demand and stimulate people to do upgrades and trade-ins.

Operator

Our next question comes from the line of Robert Stallard with Royal Bank of Canada.

Robert Stallard - RBC Capital Markets, LLC, Research Division

Scott, staying on the Cessna front, I saw your backlog there was up versus last quarter. I was wondering if you could comment on where that might have come from.

Scott C. Donnelly

Well, we continue to book orders for sales that will be either fourth quarter or going forward. Obviously, we started to see some Sovereign orders come into the backlog and had no sales in that area. We continue to see some sales activity around M2s and Latitude. So in general, Robert, I'd say it's just kind of a -- sales activity has gotten better. Certainly, it got a little bit better in the September timeframe. And as a result, again a part of it unfortunately is fairly low deliveries in the third quarter, generated some positive book-to-bill.

Robert Stallard - RBC Capital Markets, LLC, Research Division

Okay. And then secondly on Cessna, there was a comment you said about a negative adjustment due to pricing. I was wondering if you clarify what the situation is there. And also maybe in conjunction with that, what you are seeing in terms of pricing in the used market.

Scott C. Donnelly

So pricing on new aircraft was pretty stable, not a lot of change there from where we were in the second quarter. There does continue to be softness in the used market in terms of pricing. So I think if you look at BRF and blue book, we continue to see downward motion. So that did result in several million dollars of residual write-down of used aircraft beyond what we saw, let's say, in the second quarter. So I'd say there's still softness, a lot of activity and quite a lot of transactions but still softness in the pricing in the used market, but I would say stability in terms of pricing in the new market.

Robert Stallard - RBC Capital Markets, LLC, Research Division

And then just thirdly, you mentioned on Textron Systems, you are still confident that it's a flat to up environment. Are you anticipating a more negative drag from sequester within that forecast?

Scott C. Donnelly

As we look across those business segments, Robert, so first of all, the precision munitions business is virtually entirely driven by international sales. So there's really nothing going on there from a sequester standpoint. The same is largely true in our Marine & Land Systems business. Most of the sales, particularly in the vehicle side of the business, international at this point, we do have the Ship-to-Shore Connector program, which is a U.S. government program. Although at this point, that's in the development phase, so it's not a lot of money. The business which is most subject to annual budgets and U.S. budgets really is in our UAS business, although we haven't seen really an impact at this point of sequestration. And we do have some intelligence in the software businesses, where we have seen some reductions in the number of licenses and things like that. But at this point, Robert, we certainly have not seen anything material from, that I would say, directly from a sequestration impact.

Operator

Our next question is from Jason Gursky with Citi.

Jason M. Gursky - Citigroup Inc, Research Division

2 quick questions. Scott, can you just update us all on the cadence of V-22 volumes as we move out over the next couple of years? And then I'd also be curious to know -- well, there's been some press reports about Beechcraft potentially being for sale. Are you aware of Beechcraft being for sale at this point?

Scott C. Donnelly

So on the firsthand, with respect to V-22, the multiyear -- and I know there's been a couple of people with questions, so I think a couple of aircraft moved in terms of which year they're delivered. And there's nothing particularly special going on there. It's just when the contract was definitized, the number of deliveries per year moved a little bit from what was originally discussed. But the multiyear contract made pushing aircraft between years. But it still is unchanged with respect to the 99-plus, so far one of the options which has been exercised. So there's no material change in terms of the multiyear, too. With respect to Beechcraft, look, we see the things in the paper. I know there's a lot of rumors and whatnot banging around. Look, our view of Beechcraft is the same as we've discussed in the past. There's certainly interest that we would have in some of those assets in terms of the status of what's going on. And all the rumors in the articles, I guess, at this point, I wouldn't comment on any of that.

Jason M. Gursky - Citigroup Inc, Research Division

And on the V-22, is there any way for you to offer a specific cadence for the next several years just to make sure we all model it correctly?

Scott C. Donnelly

We can certainly do that. I'm not sure I would do it on the call. But I mean, we -- again, it's a contract, it's a program record. And if there's any confusion out there as to how many aircraft in which years, we can certainly put something out that clarifies that.

Frank T. Connor

I mean, it's in our presentation, Jason. It's 36 next year and 22 in '15.

Operator

We have a question from the line of John Godyn with Morgan Stanley.

John D. Godyn - Morgan Stanley, Research Division

Scott, I was hoping to ask about how you're thinking about breakeven margins at Cessna. And what I'm getting at is, of course, the environment is soft, but you've also changed your pricing strategy a bit. You also continue to sort of restructure and try to drive productivity improvements. How many jets do we need to sell in a quarter to hit breakeven more or less?

Scott C. Donnelly

Well, look, it's a tricky question because obviously it depends a lot on the mix. What I can tell you is that the way we see it right now is given where the market has been, the amount of activity that's out there right now, we feel that about the midpoint of where we're guiding to you guys would basically reflect sort of a breakeven year for Cessna.

John D. Godyn - Morgan Stanley, Research Division

Got it. That's very helpful. And I was also hoping to follow up on Bell margins. I thought I heard you say that margins wouldn't recover in the fourth quarter. I was hoping that you could just sort of elaborate on the specific impact of what's going on with ERP. And if we look out sort of a year from now, should we see margins kind of recover to what we saw earlier this year? I'm just trying to kind of understand some of the nuance there.

Scott C. Donnelly

Well, so the issue for us, of course, is that obviously you saw some of the margin impact in this quarter as a result of higher cost. But at the same time, obviously we're a relatively long-cycle manufacturing business. And so there's a fair bit of product that is work in progress, which is then executed at that higher cost with those inefficiencies. And so that will turn into revenue here as we go forward, which is why we said we would not expect a lot of change in terms of margin rate going through the fourth quarter. I don't think we want to get into 2014 guidance at this point. But needless to say, we're going to be pressured in terms of the margins as we go through the balance of this year and in the beginning of next year as that higher-cost, less-efficient production works its way through into revenue, which will happen over the course of the next year. So the margin rates, I think if you look at it year-to-date, where we are on Bell is at around probably an aggregate of about 12.5%. And that's probably a number that we would expect to see through the balance of this year.

John D. Godyn - Morgan Stanley, Research Division

Great. And is there anything you can tell us just to add clarity to the kind of the impact this quarter from the labor disruption as opposed to the ERP?

Scott C. Donnelly

Jason, it's very difficult because these things are sort of compounding problems, right, when you're going through one of these big IT implementation systems. We've run into a number of issues in the implementation and just sort of working our way through those challenges. And when you do that, you need to do a certain amount of sort of brute force to try to keep things going. And unfortunately, what we ran into was, at the same time, we needed to have kind of that brute force to work our way through it. We went through a labor disruption. So it'd be very, very difficult to say how many dollars is attributable to one versus the other. I think the thing we're focused on at this point is at least we have the labor issue behind us. And now we have the human resources and our ability to get our hourly workforce focused on delivering output and the management team focused on resolving those issues that we still have outstanding on the integration of the ERP system, whereas up until now, frankly, our management team and salaried teams were working most of their day jobs during the day and were working a lot of overtime and weekends to try to help make sure we got deliveries completed for customers because we didn't have the ability to get our hourly team in there doing the production work. So hard to tease out exactly. And really the impact here is, I think, we can kind of handle one or the other. The fact that we had them both at the same time was a pretty serious blow.

Operator

We have a question from the line of John Nadol with JPMorgan.

Joseph B. Nadol - JP Morgan Chase & Co, Research Division

First, at Bell, Scott, were there -- or Frank, were there -- was there a negative cumulative adjustment taken on any of your major programs that was going to enable you to bounce back a little bit in Q4? Or is this all just regular way of improvement we're expecting sequentially?

Scott C. Donnelly

Yes, I'm not sure I have the data to say any kind of a -- are you talking about a kind of cume catch or [indiscernible] adjustments?

Joseph B. Nadol - JP Morgan Chase & Co, Research Division

Yes, on H-1 or V-22.

Frank T. Connor

No, there was no meaningful negative adjustment. It kind of was prior-period adjustment.

Joseph B. Nadol - JP Morgan Chase & Co, Research Division

Okay. And then just on the spares issue, you've highlighted for a couple of quarters, or maybe 2 or 3, the ERP system and how that's negatively impacted your ability to ship. Is the spares demand still where it was? Because some others had been talking about significantly lower aftermarket demand in the military side for rotorcraft.

Scott C. Donnelly

No, our demand actually has been up. So as a result, we've actually been building some backlog in terms of spares. So just to be clear, we kind of went through -- again, this is sort of a -- I hate to make this messy, but we had sort of a 2-step a process here, okay? The initial problems we talked about with respect to spares in the early part of the year when we first turned on our new system really had to do with our inability to ship. And when I say that, I mean that the IT system in terms of generating demand, people knowing what parts to go in and get off the shelf and put it in a box and ship it to our customers, we had a lot of those sorts of issues when we first started our new IT system. Those have largely been resolved. So the issues we have now in terms of building backlog is these are parts that we need to be manufacturing. And so the slowdowns and the inability to get enough hours into the factory to actually build the parts has what's been now slowing down our deliveries. So it's purely a matter now of working the stuff through and getting the volume out of the factories. It is not in any way, shape or form demand-related. We've actually been building backlogs. So there are demand for those parts, we've just got to get them through the factory.

Joseph B. Nadol - JP Morgan Chase & Co, Research Division

Okay, that's helpful. And then over at Cessna, just on the valuation adjustment, you said it was several million dollars larger than the one you took in Q2. So it was double-digit? Because I thought you said $8 million in Q2.

Scott C. Donnelly

Yes. And I think we were about $11 million. If you look at forfeiture deposit and used aircraft valuation, that was about minus $11 million.

Joseph B. Nadol - JP Morgan Chase & Co, Research Division

Okay. And then just finally on the cash flow, you took it down by $100 million to $200 million, which is obviously more than the reduction in earnings. How much of that is the residual issues at Bell roughly? And how much of that is either incremental used aircraft or white tails that you expect to have at Cessna?

Scott C. Donnelly

I'd say it's predominantly related to our view on the number of Cessna deliveries we'll have. So we'll have more finished goods inventory at Cessna than we would have originally expected.

Operator

Our next question comes from Noah Poponak of Goldman Sachs.

Noah Poponak - Goldman Sachs Group Inc., Research Division

Scott, somewhere in the call on Cessna, you made the comment letting the cycle play through, which was -- and the timing of that is obviously the million-dollar question here. So I just wondered if, big picture, you could walk us through your own latest version of attempting to quantify how much longer that actually takes?

Scott C. Donnelly

Well, Noah, certainly we are watching the number of used aircraft available for sale. That's, I think, one of the key, if not the most significant indicator at this point. And I think there's 2 reasons for that. Obviously, one, as we look at new aircraft that we're introducing for which there are either none or virtually no used aircraft that are like that kind of a product, we see a pretty strong uptake of the product. In the cases where we're still selling a product, where there's a significant competition out there in terms of relatively new used aircraft, we still see sluggish behavior in that marketplace. And so I think we watch that number pretty carefully. And certainly, there's some volatility as you see aircraft kind of coming in and going out of the market. But in general, we continue to see the number of used available-for-sale, particularly in that less than 5-year category, continuing to drop. Now the pace of that is not as fast as we like, but it does continue to go down.

Noah Poponak - Goldman Sachs Group Inc., Research Division

Okay. So when you're looking out to 2014 for Cessna production, I know it's still October, do you sort of have a law of small numbers situation, where Cessna almost has to be up a decent percentage just because the starting point is so low and you have these multiple new product intros? Or can some of those legacy programs, where you still have a used product issue, decline enough to actually keep the total production number closer to flat or even down again?

Scott C. Donnelly

Well, look, Noah, I hope it's a combination of both of those things. I mean, let me just give you anecdotally, if you look at something like a CJ4, okay, which has been out there in the market for a while, and certainly as you came out of '08, in the '09, '10, '11, you had a fair number of used aircraft available for sale that were CJ4s. We came into this year with around 9 of those that were out there on the market. And I think you saw CJ4 sales were pretty tough in the first couple of quarters. And we got down at the end of this quarter, we're sitting there where we know of 1 used CJ4 out there that's less than 5 years old and we see 8 sales of new CJ4s. So I mean, there's certainly a correlation of activity between what's out there that we're competing with in the used market versus what we can sell on the new. So I do think that that trend in terms of our volume, we certainly have expectation that will continue to pick up as you see these used aircraft go away. On the other hand, certainly not by design, we're working off a very low base. So yes, at some point, the absorption of those used aircraft is going to turn into demand for new aircraft. And again, on the new models, if you'll again choose a perfect example, right, that we don't have M2s out there in the market. There are no used M2s available because it's a brand-new product. And as a result, we've seen very strong uptake in terms of order generation. So I think part of it is absolutely, look, we are working off a very low base. And if you go back and you look at historical cycles and sort of average out how many aircraft should go into the market, we're on the way low side of that right now, just given where we are in the cycle. And so we would expect sort of it has to go up, right? But again, I think the -- we've been thinking that for a while, Noah. I mean, let's be honest. It's gone down lower than we would have ever imagined it to go down in terms of number of new aircraft being sold into the market. And I don't just mean Citation. I mean, you look at the whole market, right? I mean, the number of new aircraft in light to mid from anybody is, all total, is a very small number. So I think that it would tell you that eventually the cycle has to move in the other direction. And of course, I think the new product will help that.

Noah Poponak - Goldman Sachs Group Inc., Research Division

Okay, that's helpful. Just one other one on Systems. With the fee-for-service product, I'm just curious if you can talk about the risk you see of cost implications as you are making that switch back internally or if you expect that to be fairly smooth.

Scott C. Donnelly

No, I would expect it to be fairly smooth, Noah. It's going to be accomplished in several phases, right? So to start with, we've been able to bring in already some of the manufacturing, where we were experiencing pretty significant quality issues. But in that case, I mean, in large part, we are manufacturing to the same sort of design criteria. And I think there are opportunities beyond just manufacturing at higher quality but also putting some design improvement into this product to make it a more robust product. And so that will happen here over the next 6 to 12 months as we go forward. So the cost side of this thing, Noah, is not something I worry. I mean, obviously, we're spending some money to do that. But that's not the big issue here. I mean, the issue for us has just been when you lose -- when one of these engines fails, you lose an aircraft. And so the cost of loss of that aircraft, which is both airframes and sensors and navigation systems, that cost is quite significant compared to the trivial amount of cost of actually manufacturing this engine. So that's what's unfortunate with this thing. I mean, we have a system out there that's a very complicated system. It involves control systems and launchers and obviously airframes and communication systems and navigation systems, all of which are working fabulously, but the weak point in the system is this engine. So it's not costing us a lot. We couldn't spend too much right now to make that engine work.

Operator

Question from Ron Epstein with Bank of America.

Ronald J. Epstein - BofA Merrill Lynch, Research Division

So just maybe a yet even bigger-picture question. So Scott, when you think about the portfolio of businesses that you have, I think among investors, kind of the elephant in the room is what happens if we go through another year or 2 and the mid and light market still is punky, right? I agree with you completely that longer-term, it's going to come back. Who knows exactly when? Maybe in 6 months, that'd be great. But say that doesn't happen, right? So say, as the leader of this organization, you're looking at your businesses, say, Cessna is still punky 2 years from now. Then the question becomes, all right, Bell gets a little bit tougher. What do you do? I mean, how do you manage through that, right? I think that's probably, I think, one of the biggest questions right now among at least the people I talk to. I mean, how do you think about that?

Scott C. Donnelly

Look, Ron, you do some things we've been trying to do over the last few years. You continue to focus on both the cost of your current operations to try to get enough productivity to improve as much as you can. You try to make sure that you're investing in the thing so that when the cycle does turn, you're in as good a position as you can be in to do that. So I think if you look at Cessna today, there's no question, we've been in a very, very deep down cycle. But as you know -- and again, I don't know either. Is it 6 months? Is it 2 years? That's sort of the unknowable. But the cycle will come back around and you've got to make sure that you're positioned to capitalize on that. When we've seen up cycles in this business, we've been able to capitalize and take advantage of that. But you don't do that if you don't have competitive product and you don't have the right service network, you don't have the right sales force out there. So I think that's what we'll continue to focus on. If you look at where we are today, obviously we've spent a lot of R&D dollars, but we're on the cusp here of having the new M2, having the Sovereign, having the new X. So I think over time, those investments will have proven to be the right things to do. As you look into 2015, you're going to have the Latitude coming in. I think that's the right thing to do. That program is coming along very well. It's a significant change in our product portfolio at Cessna, and I think one that would be very, very attractive to a lot of our customers out there that want to upgrade from current product into our wider-body aircraft. So we -- I don't know, Ron, if there's really anything you would do different. If you mothball the business, if you don't invest in having the right products, you're not going to be able to capitalize on this market when it does turn. So calling it is virtually impossible, but I think that we have to continue to do that. I'd say the same thing is true at Bell. We know we have enjoyed a great ramp on V-22. We know where the production volumes of V-22 are going. But we also know that we have the ability to grow that business through the commercial side. We've been successful doing that over the last couple of years through some product upgrades, through better focus in terms of how we go to market in the commercial world. But we also know we need new product, and so the investments in the 525, the investments in the XLS, clearly longer-term investment on the military on the V-280. All we can do is make sure that we're making the right investments and that we're ready to serve that market as it turns at Cessna and that we're ready to expand the portfolio and continue to gain share in the commercial market at Bell.

Ronald J. Epstein - BofA Merrill Lynch, Research Division

And I mean, is there any point -- you probably can't answer this, so I'll just preface it with that. I mean, is there any point where you -- I think you can kind of see what's going to happen in the 2Ds [ph] at Bell. We're not exactly sure with Cessna. Although long term, we do think it's going to come back, that were you step out a year or 2 or 3 from now and you have to do something strategically very different, either just pursue a different path and strategy to continue to grow the company. I mean, do you ever think about that? Or is it just too soon to even think about that?

Scott C. Donnelly

Well, certainly, across all the businesses, we look at things that we can do that are complementary to those businesses to try to give us some more markets and give us some abilities to grow beyond just that quarter that we're in today. But now look, as we talked about before, we're not going to stray very far from these things. We need to do things that are the same customers in the same markets and the places that we understand and feel comfortable from an M&A standpoint. In terms of the current businesses, I mean, if you look at Cessna, Ron, I mean, look, if we knew we were 2 years from seeing a market rebound, it'd be wonderful if you had some concept of a way that you could just sort of mothball a business. I don't think there's any precedent for doing that. I mean, this is a very highly technical business. You need to have a great engineering team, you need to have a great sales force and you can continue obviously to service the customers that we have out there today. So it would be great if you can go into sort of a state of suspended animation. I don't think you can do that. I think you hunker down as much as you can on cost and productivity. But I think you've got to continue to make sure that you're doing the right things in terms of new product because that's what you're going to be rewarded for when the market does turn. You don't make those investments, then you're not going to have the upside when it does go.

Ronald J. Epstein - BofA Merrill Lynch, Research Division

Sure. And then maybe one last question related to that. Just I thought probably 1 of the coolest new things out there in the last 6 months was the Scorpion. Nobody has asked about that. I mean, can you give us some more color on the Scorpion and maybe more specifically, how it came to be and maybe what your hopes are for what it could mean for Textron?

Scott C. Donnelly

Well, Scorpion is a good example of some of the things we're trying to do, Ron. I mean, and obviously, we haven't talked much about that. We kept the thing pretty well a secret for almost 2 years. But as we look at what kind of technical skills we have, what we think is going on in market dynamics and where growth opportunities are in something that's pretty close to home, namely, fixed wing aviation, our perspective was that there is going to be a need out there in the market for a military aircraft that is something that has a better performance envelope, more capability than a turboprop but not something that has the price point and the sophistication and both the acquisition cost and the maintenance and operating cost of something like an F-35. And so if you look at historically, the U.S. has had a family, a range of military product -- the industry, frankly, has usually had a range of military product that span all these various price points and capability points. And the trend seems like it's been for the last 20 years or so to only invest in very, very high-performance, very high-end fighter/attack aircraft. And look, these are amazing machines. An F-35 can do amazing things and F-22 and so on and so forth. But we see a very large customer base out there in both the U.S., as well as a lot of international opportunities that will never be able to afford aircraft at those price points, and yet need a capability and need to replace aircraft here in the coming years that historically have been more affordable to acquire and operate. And so we decided this was something that was an investment worth making. And so I think we positioned ourselves now where we can enter a segment where we have not participated in many, many, many years because we see a gap capability in the industry. And so, so far, I'm not talking too much about the program yet. I mean, we're making very good progress towards first flight. And just last week, we were able to run full engine power and verify inlet designs and airflows. So I mean, we're getting very close to starting taxi and flight tests. We've had a lot of interest from the international community, as well as within the U.S. about the aircraft. And so it's still obviously in its very early days, but we think it represents significant growth opportunity for the company. We're not talking too much about it yet because it's not quantifiable yet, right? But we're working on it.

Ronald J. Epstein - BofA Merrill Lynch, Research Division

And maybe just one last question, and then I'll hop off, I know other people have questions. Most of your peers, as you know, if you look at any of the other defense contractors, typically, they're not willing to, so far, put their skin in the game in terms of making a company-funded investment in a new product, particularly a piece of big hardware like that. When you thought about the business case for it, can you add any color around, and I commend you guys for doing it, I mean, I hope it's a huge success, about doing some R&D on your own P&L for a defense product? How did you think about that trade? Because most of your peers don't do it or if they do it, they do it to a very teeny, tiny extent.

Scott C. Donnelly

Well, Ron, I think within the defense community, if you look on a purely defense basis, we've been trained over the years that the way this works is that you have a customer who comes out with a requirement, and then you bid to that requirement and you design and develop to that requirement. That can take a very long time. It's a very, very complex process, a very expensive process. And in this case, we felt there's -- this was really thought of more along commercial lines. In other words, when you look at our commercial businesses, we think about market opportunities, we talk to lots of different customers, and then we derive a requirement and we go design and build to that requirement. And then we look to go market that capability to many different customers. So our view, again, seeing what we think is a market opportunity, the whole genesis of this thing was derived more like you would think about the way the process we use for a commercial product, talking to lots of different customers, looking at the whole competitive dynamic and the marketplace needs and deriving and designing and building to our own requirement. So it's a military application that has been derived through a more commercial process, and as a result, moving more at commercial speeds and at commercial costs. So it is different. But I think what we're trying to do here is say, "Look, we understand military, we understand how you market and sell to the defense -- to the DoDs around the world, but we're able to leverage and utilize more of a commercial practice in terms of market identification, design and build, which we think is kind of a unique capability because we understand military, but we understand commercial."

Operator

We have a question from Cai Von Rumohr with Cowen and Company.

Cai Von Rumohr - Cowen and Company, LLC, Research Division

So Cessna, could you give us some color? Was R&D up? Or where was R&D relative to prior quarters?

Scott C. Donnelly

Yes. Cai, R&D was up. As you can imagine, we're sort of in the -- we're sort of at a point right now with both the M2 and the Sovereign and the new Citation X all in the certification process and a lot of work going on, on the Latitude program. As I said, we've got first wing mate, so there's a lot of work going on getting that aircraft prepped and ready to go into flight tests starting next year. So R&D was certainly up in the quarter. And I would expect that we'll continue to see a lot of R&D spending through the fourth quarter.

Cai Von Rumohr - Cowen and Company, LLC, Research Division

So I mean, can you give us some quantification, $5 million to $10 million or more?

Scott C. Donnelly

No, Cai, we haven't historically done this on a by-business basis. I guess, all I would say is the R&D spending is on track and consistent with what we guided for the year. And the total number we gave you guys, we spend about 3/4 of that. So I'd say I mean, yes, it was up, but in line with what we had guided in terms of R&D spending across the company.

Cai Von Rumohr - Cowen and Company, LLC, Research Division

Terrific. And then can you give us some color by geography of demand at Cessna?

Scott C. Donnelly

It stays -- both orders and deliveries in the quarter, Cai, were about 2/3 domestic and about 1/3 international. And if you look at deliveries, it was 2/3, 1/3. And that 1/3 was pretty evenly spread between Latin America, Europe and Asia Pacific.

Cai Von Rumohr - Cowen and Company, LLC, Research Division

Okay. And then you mentioned near-breakeven in the fourth quarter. That would imply, I mean, by my math, something like $80 million, a swing of $100 million from the third, $400 million uptick or 26% incremental margin. Is that kind of the way you're looking at it?

Scott C. Donnelly

Yes. I still think, as we've kind of always talked, Cai, I think incremental margins at Cessna should be around 25%. Now when we go quarter-to-quarter, we had some quarters where it's been more or less than that, up or down. And frankly, that's largely an artifact of the numbers are pretty small. And so if you get a few million dollars of aircraft valuation change or you get a few million dollars of a LIFO or whatever adjustment, it's going to swing around a little bit. But yes, 25% incremental conversion is about right.

Cai Von Rumohr - Cowen and Company, LLC, Research Division

Okay. And then pension, maybe you can give us some color. What was your investment performance like year-to-date? And maybe give us some preliminary color on where you think that could be both in terms of P&L impact and cash impact next year.

Frank T. Connor

Sure. We haven't obviously made any decisions about kind of necessarily the '14 plan. But as it relates to performance to date, we've been above our kind of expected return levels, so we're positive to that. Obviously, we need to close out the year, but that is positive. As we look at '14, I think we should get some tailwind on the pension side. We'll get a little bit of a tailwind from just with lower prior-period amortization expense. From a P&L standpoint, that's a $25 million-ish type area when you look at what would flow through the P&L in 2014. And as we sit here right now, the discount rate, if you valued it today, it's probably 75 basis points higher than it was a year ago. And that would give you another $25-ish million P&L-type impact, so as much as kind of $50 million-ish P&L impact based on where we are today.

Cai Von Rumohr - Cowen and Company, LLC, Research Division

Terrific. And then a last question, with regard to Beechcraft, if you were to look at it, under what circumstances would you kind of buy any or all of Beech? What would you -- I mean, what kind of financial metrics do you have to see if you were to consider kind of any transaction?

Scott C. Donnelly

It would have to be good. Cai, I just don't think -- I mean, it's -- given the nature of where all this stuff is, I just don't think we'd want to comment. We certainly wouldn't going into any kind of commentary. It just wouldn't be appropriate because they're rumors.

Operator

Our next question then comes from the line of George Shapiro with Shapiro Research.

George Shapiro

A couple of questions on Cessna. One, if I look at the Q3 profit or loss after the $11 million inventory adjustment you said, so it would have been up about $2 million from the third -- from the second quarter making the same adjustments, in essence, a loss of $12 million versus a loss of $14 million. Based on what you just said of 25% incremental margins, since revenues were up 33%, you would have expect that the sequential profit to be up $8 million. So is that difference of 6% primarily R&D? Or is it reflecting the mix difference, where you had probably lower -- higher-margin XLSs versus higher deliveries of the lower margin CJ4s?

Scott C. Donnelly

Yes, George, I think your math is absolutely correct. And this was referring to -- when we're talking about these spreads of $8 million, a few million dollars of used aircraft valuation, some numbers, a small number of millions dollars of R&D being up, you look at the fact that we only had a small -- the 4 XLSs, which is some amount of mix that's in there. These small numbers, you can take 3 or 4 factors and pretty quickly get to $8 million.

George Shapiro

Okay. And then Scott, if you look at the orders itself in the third quarter, there were $654 million. That's the best third quarter order number since in at least 4 years or so. Is there anything to draw that that is a beginning of some improvement in the market? Or is it just reflecting orders for the newer planes that you have?

Scott C. Donnelly

Well, George, I mean, we can only hope, right? If you look at the quarter, I mean, I can tell you that July and August were -- which are typically slow, were very, very slow this year. September was certainly considerably better. We just -- it'd be too early to comment at this point to know whether that's going to continue through the fourth quarter or not. So certainly, that -- the number on an absolute basis is encouraging. The dynamic of the fact that it was virtually all the month of September is encouraging. But whether that's the beginning of anything or how that plays out through the fourth quarter obviously remains to be seen.

George Shapiro

And then one, how much was the aftermarket up at Cessna? I know that's been running pretty double-digit increases.

Frank T. Connor

Yes. Aftermarket was up year-over-year at 25%. 15% of that or 15 percentage points was organic and 10% was due to some of the service center acquisition activity that's taking place.

George Shapiro

Okay. And then just one last one. Commercial helicopter deliveries, I mean, last year, they were up 20-plus or so in the fourth quarter versus the third quarter. Would you expect them to be up at least 20% again or maybe even more?

Scott C. Donnelly

Right. It's going to be in that range, George. We would expect another pretty significant growth in Q4.

Operator

Question from Myles Walton with Deutsche Bank.

Myles A. Walton - Deutsche Bank AG, Research Division

Just a couple of quick cleanups. You talked about the pension expense side. Can you talk about the funding side for next year, Frank? And also with respect to CapEx for the full year, what's the current guidance?

Frank T. Connor

Yes. On the funding side, again we haven't made any decision yet. We'll kind of see how things close out here. But I would expect that the funding will come down from what we've been doing in the past couple of years. So I think that will be, we think higher discount rates and with good returns, and therefore, a significant reduction in the overall kind of liability relative to the asset pool, I think we'll be looking at pulling our funding activity down as we look at 2014. On the CapEx side for this year, we're in the $510-ish million type area at this point. So we've continued to look hard at the CapEx budgets and are kind of still spending a lot of money to push forward on all the important programs that we have. But we're clamping down a bit on some of the other things.

Myles A. Walton - Deutsche Bank AG, Research Division

Okay. So a little bit of a pullback from where you started the year, but not -- you're still implying a pretty big quarterly number?

Frank T. Connor

Yes. We've tended to kind of underspend over the past couple of years, what people have looked a lot to do. And we're doing -- we're kind of in the same type of position this year.

Myles A. Walton - Deutsche Bank AG, Research Division

Okay. And then Scott, on the 25% incremental margins, I mean, you point out the light versus the heavy. But what about new versus current -- new products versus in-production products, how much of a discrepancy are we going to see in that kind of incremental margin as it folds in over the next several quarters?

Scott C. Donnelly

I don't think that you should expect to see very much in terms of the change. In other words, if you looked at the margin rates of Sovereigns versus new Sovereigns or you look at the margin rates of M2 versus sort of CJ or the Mustang class, there's not a big discrepancies in there. So I think we'll continue to see a fairly similar margin rate, depending on the kind of mix of the size of aircraft you're talking about.

Myles A. Walton - Deutsche Bank AG, Research Division

Okay. And then the last one for me. I mean, earlier in the conversation, you talked about managing the down cycle at Cessna. But managing the down cycle of Bell is really a lot different because you can see, map, know exactly what at least the military production is going to be contractually. So from a standpoint of getting the cost structure right for '15, when the production of the V-22s, 22 aircraft, can you put up the same margins? Can you put up the 13% margins in a context of V-22s at 22, that you can put up the V-22s in the context of 40 deliveries a year?

Scott C. Donnelly

Well, I mean, we'll -- again, we don't want to do any long-term guiding here. But certainly, we have a lot more visibility at Bell today and very good visibility obviously with respect to V-22. And so in terms of cost actions, I mean, these have already started. We've already done several pretty significant reductions at Bell. And clearly, there will be more to come as that volume works its way through the factory. We know exactly what we need to do in terms of the V-22 volumes, and we'll be making adjustments accordingly.

Frank T. Connor

Listen, the other part of that, Myles, is not just the reduction in volume, but the contractual rates that we're going to be able to earn on those contracts are different. So at the end of the day, you can't make up all that margin out of cost savings.

Operator

We have a question from Julian Mitchell with Crédit Suisse.

Charles Clarke - Crédit Suisse AG, Research Division

It's Charlie for Julian. I just didn't know, just 2 real quick ones because obviously we'd run over here. Just to know just for expectations if you could kind of frame just -- probably don't want to get into specific numbers, but just maybe frame kind of a range for kind of what you guys are thinking for M2s or what you guys are thinking for the new Sovereigns, just to kind of put expectations kind of in context for Q4.

Scott C. Donnelly

In terms of?

Charles Clarke - Crédit Suisse AG, Research Division

Just delivery numbers.

Scott C. Donnelly

Deliveries, number of aircraft? We haven't been providing any sort of guidance on particular models, so I don't think we probably want to go there.

Charles Clarke - Crédit Suisse AG, Research Division

Okay. Or even just for mediums versus lights, I mean, any -- I mean, obviously, I think mediums -- sorry, lights, through the first 3 quarters, down about 40 and mediums down about a little over that. But anything different into the end of Q4, no?

Scott C. Donnelly

Well, the only thing I have to say is, I mean, you certainly would expect to see more of the mediums in Q4 because we're at least back shipping Sovereigns again. We were absent in the second and third quarter. But that's really only the color, I guess, I would provide on that is that...

Charles Clarke - Crédit Suisse AG, Research Division

Yes. I just didn't know if you thought, like, if Sovereign would be between 5 and 10 -- or I mean, obviously, I think it'd be higher than that. Or if 10 to 20 is a range or -- but I guess you guys want to get away from that.

Scott C. Donnelly

Yes. No, we haven't been providing that number.

Charles Clarke - Crédit Suisse AG, Research Division

Okay. No. Yes, I just -- and then just real quick at Bell. Obviously, commercial has been strong. I just didn't know if you had any color on just customers, just end-market customers. Is it still a lot of oil and gas? Is it a lot -- where are the customers coming from here?

Scott C. Donnelly

Oil and gas has still been strong. A lot of foreign military customers are still in there, a lot of police, emergency medical services. It really has been reasonably across the board.

Frank T. Connor

So I think [indiscernible] in Scott's comments. We're seeing a lot of good development of demand around the globe outside the United States, like Russia and China, the Middle East.

Operator

Last question is from Sam Pearlstein with Wells Fargo.

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

Just on the Cessna deliveries, I know you don't want to get into specific models, but the increase in the finished goods inventory that you see at year end, is that M2s and Sovereigns because the timing of the certification? Or is it anticipation of the Xs? Can you give any color as to what's increasing in terms of finished goods?

Scott C. Donnelly

Well, certainly, Xs, right, because we had originally been manufacturing, expecting to get cert by late this year. Those have all moved into 2014. Beyond that, I guess I wouldn't provide any guidance. I mean, it will depend on obviously how this quarter plays out and what orders and sales conversion looks like.

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

Okay. And then if I can ask you just a question on Bell and the V-22 multiyear, you talked about some of the delivery expectations over that multiyear. We've seen recently companies like Sikorsky talk about a reduction in volume even within a multiyear. And so, is there flexibility from the customer to adjust those, even if it's in delivery and still be able to move it even though there is a firm commitment on the total?

Scott C. Donnelly

No, it would be a renegotiation if there was a change. That's a mixed multi-year contract.

Douglas R. Wilburne

All right, ladies and gentlemen, thank you for joining us today. And we know we have a couple of follow-up calls in queue that we'll call back. Thank you very much.

Operator

And ladies and gentlemen, this conference will be available for replay after 10:00 a.m. today, running through January 24, 2014 at midnight. You may access the AT&T Executive Playback service at any time by dialing 1 (800) 475-6701 and entering the access code 265927. International participants may dial 1 (320) 365-3844, and again the code is 265927. That does conclude our conference for today. Thank you for your participation and for using AT&T Executive TeleConference service. You may now disconnect.

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