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Executives

Robert F. Weber - Vice Chairman, Chief Financial Officer, Principal Accounting Officer and Treasurer

Thomas A. Gendron - Chairman, Chief Executive Officer, President and Chairman of Executive Committee

Analysts

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

William D. Bremer - Maxim Group LLC, Research Division

Tyler Hojo - Sidoti & Company, LLC

Julie Yates - Crédit Suisse AG, Research Division

Sheila Kahyaoglu - Jefferies LLC, Research Division

Peter Lisnic - Robert W. Baird & Co. Incorporated, Research Division

J. B. Groh - D.A. Davidson & Co., Research Division

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

Steven McNeil

Woodward (WWD) Q4 2013 Earnings Call November 12, 2013 4:30 PM ET

Operator

Thank you for standing by, and welcome to the Woodward, Inc. Fourth Quarter Fiscal 2013 Earnings Call. [Operator Instructions] I would like to inform you that this call is being recorded for rebroadcast. [Operator Instructions] Joining us today from the company are Tom -- Mr. Tom Gendron, Chairman and Chief Executive Officer; and Bob Weber, Vice Chairman, Chief Financial Officer and Treasurer. I would now like to turn the call over to Mr. Weber.

Robert F. Weber

Thank you, operator. We would like to welcome all of you to Woodward's fourth quarter fiscal year 2013 earnings call. In today's call, Tom will comment on our markets and related strategies and I will discuss our financial results as outlined in our earnings release. At the end of our presentation, we'll take questions.

For those who have not seen today's earnings release, you can find it on our website at www.woodward.com. We have again included some presentation materials to go along with today's call that are also accessible on our website. An audio replay of this call will be available through November 26, 2013. The phone number for the audio replay is on the press release announcing this call and will be repeated by the operator at the end of the call. In addition, a replay of this call will be accessible on our website for 14 days.

Before we begin, I would like to refer to and highlight our cautionary statement as shown on Slide 3. As always, elements of this presentation are forward-looking or based on our outlook and assumptions for the global economy and our businesses more specifically. Those elements can and do frequently change. Please consider our comments in light of this uncertainty.

We also direct your attention to the reconciliations of certain non-U.S. GAAP measures included in today's slide presentation and our earnings release and related schedules. Management uses these non-U.S. GAAP measures in monitoring and evaluating the ongoing performance of Woodward and each business segment.

Turning to the quarter, net sales for the quarter, first -- excuse me, net sales for the fourth quarter of fiscal 2013 were $558 million, including the Duarte business acquisition compared to $529 million in the fourth quarter of last year, an increase of 6%. Earnings per share were up 15% to $0.76 for the fourth quarter of 2013 compared to $0.66 as reported for the fourth quarter of last year. Total EBIT for the fourth quarter of 2013 was $82 million compared to $72 million for the fourth quarter of the prior year, an increase of 13%. Free cash flow year-to-date increased slightly to $81 million after absorbing an increase of almost $80 million in capital expenditures.

Now I will turn the call over to Tom to comment further on our results, strategies and markets.

Thomas A. Gendron

Thank you, Bob. Welcome to those joining us today. We ended the year on a strong note, more in line with our original expectations despite ongoing global, political and economic challenges. With volatile markets impacting top line growth, we remained focused on execution and operational improvements.

In our Aerospace segment, we continue to win market share on next-generation engine and airframe platforms. We signed a new agreement with Pratt & Whitney for its PurePower family of engines, significantly extending our current contract. As announced earlier this month, we were awarded the fuel system on the Snecma Silvercrest engine program, which consists of a suite of components, including the integrated fuel pump and metering unit, variable stator vane actuator and variable bleed valve actuator. This engine has been selected by Dassault for its Falcon 5X aircraft and Cessna for its Citation Longitude.

Commercial OEM sales remained solid, reflecting the strong backlogs and increased demand for fuel efficiency. Boeing 787 production continues to ramp up. The 787-9 flew for the first time in the quarter and represents increased Woodward content on this key platform. Passenger miles continued to increase at healthy rates. We saw a moderate increase in commercial aftermarket in the quarter even when compared to a strong fourth quarter of 2012. We expect this to continue in fiscal year '14.

Aftermarket growth in our airframe business is a key element of our profitability improvement initiatives. Aftermarket sales in 2013 increased to approximately 25% of total sales from less than 20% several years ago and is moving toward the industry average of about 35% of sales. While the defense aftermarket was strong this year, significant upgrade programs on the F100 and T700 engines are coming to an end. As we go forward, we continue to expect softer defense spending. The Duarte business integration is proceeding as planned. We had a good year, both operationally and financially.

Turning to our Energy markets. Most of our activity in the Energy markets is tied to significant investments in infrastructure that require long lead times. The current economic uncertainties in the U.S., China and Europe are increasing the risks associated with these investments and therefore, negatively impacting sales volumes related to shipbuilding, mining, renewable power and large electric power generation plants.

The oil and gas value stream is an area where certain infrastructure development activities are experiencing strength. For example, compressed natural gas systems in Asia continue to be driven by the desire for cleaner emissions and the existence of a supporting infrastructure. Aeroderivative gas turbines used in applications related to oil and gas exploration and pipeline construction are also a growing market segment.

Our industrial turbine business, including the heavy frame segment, while relatively flat over the last several quarters, will benefit from the recently announced Algerian power project over the next 2 years. Joint research projects of several of our customers are focusing on dual fuel locomotive engines where the ability to use diesel fuel or natural gas provides cost savings and lower emissions.

As we called out last quarter, our renewable power business sales finished the year down by approximately $95 million. While the fourth quarter decline moderated from the previous quarters, we continue to anticipate ongoing volatility.

In summary, we continue to invest where we see growth opportunities, such as selected segments of the commercial aerospace and natural gas markets. Additionally, our focus on operational performance, even where sales growth has been slow, enhances our competitive position to shareholder value. We believe these strategies are particularly appropriate during times of economic and political uncertainty.

Now let me turn it back to Bob for the financials.

Robert F. Weber

Thank you, Tom. Our Aerospace segment sales for the fourth quarter of 2013 were once again favorably impacted by strong defense aftermarket sales. Organic sales were up slightly when compared to the fourth quarter of the prior year. Aerospace earnings as a percent of segment sales were 18% this quarter, roughly comparable to the same quarter a year ago. Earnings were positively impacted by margin improvement initiatives, favorable product pricing and mix, as well as lower investments in research and development. These were offset by higher variable compensation expense in the quarter.

In our Energy segment, sales decreased approximately $14 million in the quarter. Excluding renewable power systems sales, sales for the Energy segment were flat when compared to the prior year. Renewable power system sales declined approximately $95 million for the full year compared to 2012. Strong sales of compressed natural gas systems and aeroderivative gas turbine systems were offset by softness in mining, power generation and marine applications.

Energy earnings as a percent of segment sales were approximately 15% this quarter compared to about 13% in the same quarter a year ago, reflecting our focus on improved financial performance initiatives. Segment earnings were primarily impacted by favorable product pricing and mix and lower research and development expense, partially offset by decreased wind turbine converter sales volume and higher variable compensation expense.

Now I'd like to focus on certain specific elements of our consolidated financial statements. Gross margin percent for the fourth quarter of 30.3% was comparable to the prior year quarter. Research and development costs were $31 million for the fourth quarter of 2013 compared to $36 million for the fourth quarter of 2012. As a percentage of net sales, research and development was 5.5% for the fourth quarter of 2013 compared to 6.8% in the fourth quarter of 2012.

For the full 12 months of fiscal 2013, research and development was 6.7% of sales compared to 7.7% for the same period of 2012. For fiscal 2014, we expect our spending on R&D expense to be approximately 7.5% of net sales on increases in hardware builds for prototypes in both segments. We will continue to see quarterly variability through the timing of achieving development milestones, prototype hardware builds and other project costs.

Selling, general and administrative expenses were $48 million or 8.5% of net sales this quarter compared to $46 million or 8.6% of net sales in the same period of 2012. Our effective tax rate for the fourth quarter of 2013 was 30.2%, consistent with the same quarter last year.

Our full-year effective tax rate was 26.9%, down from 28.4% in the prior year. The decrease in income tax rate for the full year was primarily due to the favorable impact of the reinstatement of the research and experimentation tax credit. For fiscal 2014, we expect the effective tax rate to be approximately 28%.

Looking at the balance sheet and cash flows, we generated a strong $223 million of cash flow from operations for fiscal 2013 compared to $144 million for the prior year, primarily the result of improved working capital management and the timing of sales during the year. Free cash flow for fiscal 2013 was $81 million, largely consistent with the prior year.

Capital expenditures increased $77 million in 2013 compared to the prior year. And as previously mentioned, our capacity expansion projects related to awarded narrow-body programs and anticipated natural gas growth opportunities are underway. Capital expenditures for fiscal 2013 increased as expected to $142 million from $65 million for fiscal 2012. For fiscal 2014, we anticipate capital expenditures to be approximately $220 million, subject to the inherent variability of large-scale construction projects. Our original projection of $500 million in capacity expansion spread over a 3- to 4-year period is still on track.

Lastly, let me turn to our outlook. We anticipate fiscal 2014 sales to be between $1.95 billion and $2.05 billion and earnings per share to be between $2.10 and $2.30 for fiscal 2014. We expect slight growth in our fiscal 2014 sales for both our Aerospace and Energy segments. In Aerospace, we anticipate growth in commercial aerospace, offset by declines in defense. For Energy, the increases in sales of natural gas-related products and systems are expected to be partially offset by decreases in products related to other large capital investment projects.

We believe segment operating margins will be largely consistent with fiscal 2013 after adjusting for the impacts of the renewable power business's specific charges. Once again, our first quarter sales will be sequentially lower as a result of normal historical trends, such as customer calendar year buying patterns and holiday plant shutdowns.

I'd like to point out that on December 6, Woodward will host an Investor and Analyst Day in New York City as mentioned in the press release issued in October. Tom and I, as well as other members of the executive team, will review Woodward's markets, strategies and financial performance, as well as answering your questions. We look forward to seeing many of you there.

This concludes our comments on the business and results for the fourth quarter and full year of fiscal 2013 and our fiscal 2014 outlook. Operator, we are now ready to open the call to questions.

Question-and-Answer Session

Operator

[Operator Instructions] Okay. And our first question comes from Pete Skibitski from Drexel Hamilton.

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

Yes. I guess I wanted to start with the Aerospace guidance for fiscal '14. Maybe first, can you tell -- of your total kind of guidance for revenue for Aerospace next year, how much of the total is commercial? Is that maybe 2/3 of the business now, now that you've bought Duarte? And that -- can you give us a sense of how much commercial should be growing next year because I would think it will be up pretty good and enough to offset defense unless defense is down pretty meaningfully next year?

Thomas A. Gendron

Yes. Maybe just a comment on defense sales, we expect defense to be kind of flat with a range of plus or minus 5% or so of sales and will be like that for a number of years. When the OE is down, we can see some aftermarket and upgrades compensating for that, so we see that kind of being flat. They account for about -- defense is about 22% of sales. So as we go forward, you're correct that commercial is getting to be a larger part. We see good -- really good backlogs in the large commercial, we see line rates improving, we see like 787 coming up to speed, so we see that as a positive. And we also anticipate slight growth in the aftermarket. So we think commercial will be more than offsetting the defense decline.

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

Okay. And I guess, can you give us what the backlog is for -- end of year backlog for Aerospace?

Thomas A. Gendron

Yes. We don't publish that. And the reason is, with a lot of our customers, we're on what we refer to as a pull system and we don't necessarily have long orders, but what we have are exclusive positions on the program. So we know we're going to get the backlog that's out there, but it's not booked in orders because of the production system we run with our customers.

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

Okay. Let me just ask one last one before I get back in the queue. Can you give us what your expectations for D&A next year? I'm just wondering what the offsets are. D&A, there's a lot of different things going on. So can you give us your expectation for that next year?

Robert F. Weber

Yes. It will be largely flat with the current year. So slight decrease in the A, slight increase in the D, overall being largely offset.

Operator

And our next question comes from William Bremer from Maxim Group.

William D. Bremer - Maxim Group LLC, Research Division

Can you give us an idea? Operating margins in Energy up sequentially significantly and over year-over-year. What contributed to the high 15% plus operating margins this quarter?

Robert F. Weber

Yes. So we've been kind of talking about operating margin improvement initiatives over quite some time, and we are starting to see those come into play. Obviously, in the third quarter, you had a significant impact of the renewable power system that dragged it down. But even then, when we were showing the energy without that impact, you saw a significant increase. It's been a lot of hard work on the part of both our turbine business and our engine business in terms of bringing up those margins, and we're seeing that come into play.

William D. Bremer - Maxim Group LLC, Research Division

Do you expect those margins -- I heard your earlier comments, but how should we look at the operating margins in the Energy segment as we go through '14, very similar to your historical quarters or is it going to be more of a pull through?

Robert F. Weber

It should be very similar when you exclude the results. So obviously, both the charges, the specific charges related to renewable and the lack of favorable leverage sales decline will hopefully start coming back a bit next year in terms of the impact of getting some leverage on wind sales. But the rest of the business will continue to see sequential increases as we go forward but overall, we've called them out as substantially similar to this year.

Operator

And our next question is coming from Tyler Hojo from Sidoti & Company.

Tyler Hojo - Sidoti & Company, LLC

First question, just wanted to touch on the $220 million CapEx expectation for FY '14. I was hoping that you could maybe provide us with a little bit of detail in regards to what that goes to this year. And also when you talk about your 3-year goal for $500 million, that's fiscal '13 through fiscal '15 or is that fiscal '14 through fiscal '16?

Thomas A. Gendron

Yes. Well, we're kind of seeing '13 through '16, a 3- or 4-year period, it's kind of timing. As we highlighted in previous discussions. With the large amount of business we've been awarded on the commercial aerospace market, we really were in that segment running out of capacity. At the same time, with the volumes that are coming with the narrow-body programs, we decided to put in really advanced, lean value streams, lean flows to accommodate that and sort of look and really needed to construct a new facility. So we have a very large, new, modern facility being built to support the narrow-body programs and some of the wide-body programs. So that's a big chunk of the $500 million. The other part of that is really supporting the growth we see coming in the natural gas value stream. And there, we see a lot of activity coming in and will be coming on the turbomachinery side, as well as in the engine side. And there, we started looking at, we are going to run out of test capacity, we needed some more investment in the R&D infrastructure to support the development programs that are underway. We see a lot of growth coming over those over the next 5 years. And basically, what we're doing is getting ready for the growth that we think will start kicking off in this 3- to 5-year horizon. So those are the main -- the facilities and the equipment to support the volumes that we're forecasting with commercial aerospace and natural gas.

Tyler Hojo - Sidoti & Company, LLC

Okay, great. And then just if we look at your free cash flow expectations in 2014, I don't believe you guys provided a guidance range for that. Would you mind updating us?

Robert F. Weber

So we continue to anticipate strong cash flow from operating activities in 2014. And if you take that $220 million of CapEx expectation at the moment, we're going to be pretty close to -- we do anticipate we will fund the CapEx through cash flow from operations, but it won't be a significant delta over that expectation. So yes, it will be close, but we will be over on overall free cash flow.

Tyler Hojo - Sidoti & Company, LLC

Okay. And I was also hoping to dig a little bit more into the 2014 revenue guidance. Did I hear you correctly, Tom, in regards to IGT? You expect that business to grow next year vis-à-vis the Algeria order that GE got?

Thomas A. Gendron

We expect to be on the large train [ph] turbines, kind of flat to maybe slightly up. Aeroderivative, which we put in the IGT category, will be up year-over-year. And the small industrials will be flat slightly up, but they're not real not significant to us. So what we see is aeroderivative driving increased sales in our turbomachinery group.

Tyler Hojo - Sidoti & Company, LLC

So I guess, what I don't understand, Tom, is when we look at GE's large gas turbine deliveries, they've fallen off quite a bit this year. What's made your business more stable, and why will it be more stable to growing next year when your customers won't?

Thomas A. Gendron

Well, one is -- just remind everybody that GE is our largest customer. We also this do significant amount of work with Siemens and Mitsubishi. So you got to look at the whole industrial turbine market, including the heavy frames and the aeroderivatives. So we have really solid positions in both. And when you take the whole market together on the heavy frames, it will be slightly up, aeroderivatives will be up much better, so...

Tyler Hojo - Sidoti & Company, LLC

Okay, great. And just last one for me. I think everybody understands why the wind inverter business was down this year. What's your -- what's baked into the guidance in terms of expectations there for your fiscal '14?

Thomas A. Gendron

Yes, we really -- in the third quarter, we called out that we thought that was the bottom of the trough, and we do think that was the bottom. So we're going to see a slight growth in '14. We do anticipate we're going to be profitable in '14, and it may take us into '15 and the like to get up to the expectation levels. But we really believe we got the business sized correctly. The markets have turned. We're on the upswing now, and we think we're positioned well moving in '14 and '15.

Operator

And our next question comes from Julie Yates from Crédit Suisse.

Julie Yates - Crédit Suisse AG, Research Division

Well, it looks like the defense aftermarket was a source of strength again. So what was the growth rate in the quarter and then for the year? And then what are you embedding in your guidance for next year as these programs come to an end?

Robert F. Weber

So it was -- roughly 2.5% was the growth again this quarter. And right now, as you point out, we are expecting it to drop down a bit. We have some substantial upgrade activity that was taking place in 2013 that won't continue in '14, but then there's the likely comeback in '15 and some other upgrade programs. So we have a lot of good content on a lot of equipment that's still getting a lot of use. So next year, we expect -- we do not expect the same strength in defense aftermarket, but we believe, overall, it will remain fairly stable.

Julie Yates - Crédit Suisse AG, Research Division

Okay. I think last quarter, it was up 38% year-to-date for the first 9 months. So what does that fourth quarter number bring you to for the entire year?

Robert F. Weber

Hold on one second, Julie. We're trying to quickly...

Julie Yates - Crédit Suisse AG, Research Division

Okay. Well, I can follow-up with that afterwards.

Robert F. Weber

Do you know the total dollar amount? [indiscernible] 18% for the quarter? Not 2.5%? Okay. The 2.5%, commercial.

Thomas A. Gendron

Commercial aftermarket is 2.5% after the [indiscernible].

Robert F. Weber

Commercial, I'm sorry. Okay, I gave you the commercial, Julie. So it's 18% up in the quarter for military, 31% for the full year. What does that bring to us in total dollars?

Julie Yates - Crédit Suisse AG, Research Division

Just the growth rate was all I need. So 31% for the year in military aftermarket?

Robert F. Weber

All right, good.

Julie Yates - Crédit Suisse AG, Research Division

Okay. All right. And then what are you embedding for incentive comp in the FY '14 guidance?

Robert F. Weber

So it's a significant headwind, and we have a couple of significant headwinds, both in variable comp and R&D, will return. We kind of talked about having a fairly heavy prototype build coming in 2014. So between the 2 of those, we're in the neighborhood of $30 million of headwind between the 2. Variable comp will be about 2/3 of that number.

Julie Yates - Crédit Suisse AG, Research Division

Okay. And then just last question. The last 2 years, actual results have come in below your initial expectations. So can you talk about any changes you've made to your guidance-setting process and how you feel about the $2.10 to $2.30 range in terms of level of conservatism that you are embedding?

Thomas A. Gendron

Well, thanks for pointing that out, Julie. But we think we've had a decent process over the time. We had more issues on the top line. If you watch the way the things materialize, our cost control, our margins have been pretty accurate. We had -- we were suffering top line in some of our markets from -- the way you want to look at mining or renewables or shipbuilding, took bigger hits than our forecast. So we've been looking conservatively at our forecast and trying to ensure we have a good handle on the potential volatility and if want to say, the range on what they can go. We're closely monitoring the global economy and each country specifically where we have significant sales. I still think we're going to be -- as Bob mentioned, some of the numbers will be, I think, quite accurate on our costs and our margins. So it's truly -- my mind is getting the top line right to ensure that we do not miss our guidance that we're giving you. But I think we're on top of that right now.

Operator

And our next question comes from Sheila Kahyaoglu from Jefferies.

Sheila Kahyaoglu - Jefferies LLC, Research Division

Just a few quick questions, if you don't mind. The first one, in terms of Energy market, it seems, excluding wind, your sales were flattish in the second half of '13. And it appears that things will grow, be at least flat, to grow in low-single digits next year. Is there any part of your business within Energy, aside from wind, that you could see potentially down next year?

Thomas A. Gendron

Well, right now, we're still seeing softness in our sales to go to mining. We think that's not going to recover necessarily in '14. Some of the shipbuilding is still very soft. So those are probably 2 where we have a high degree of concern on. As we mentioned, we see a little bit on large gas turbines, but that's not like huge growth, but we see a little bit there. So those are kind of the underlying fundamentals, and we're going to be watching closely the economy and our customers. But where we have some growth, we have -- as we mentioned earlier, we have some of these things that are offsetting it and overall, we're seeing slight growth. And it's going to be -- we are anticipating -- as we move further into the year, we're going to see some of that pick up. So really, it's second half oriented in our forecast.

Sheila Kahyaoglu - Jefferies LLC, Research Division

Okay, got it. And is it fair to say that shipbuilding and mining is about 10% to 15% of Energy sales?

Thomas A. Gendron

That's in the right range, yes.

Sheila Kahyaoglu - Jefferies LLC, Research Division

Okay, got it. And then just one quick one on defense aftermarket. What percentage of your business is tied up into long-term contracts. So what proportion do you have visibility into next year?

Thomas A. Gendron

On the aftermarket?

Sheila Kahyaoglu - Jefferies LLC, Research Division

Yes.

Thomas A. Gendron

We usually have contracts that go 1 to 2 years in the aftermarket, defense aftermarket. So depending on the upgrade program, sometimes they go a little bit longer depending on how they move through. So you have some visibility, but then, some of the aftermarket work is repair and overhaul and the like and that's a little bit more -- we don't have as much visibility there.

Sheila Kahyaoglu - Jefferies LLC, Research Division

Okay, I understand. And then just lastly, on margins, I understand the sales forecast and the EPS guide. But the -- in terms of margins, it seems like you're basically embedding flattish margin expansion and that's because of the $30 million headwind, 2/3 due to variable comps and 1/3 due to R&D. Is there, I mean -- and organic growth is flattish, so your incrementals are about 20%. Is there anything else we should think about in our forecast?

Robert F. Weber

Sure. Maybe what kind of points to is we still do have a lot of margin improvement opportunities and productivity improvement that are kind of offsetting a lot of those headwinds. So you're right. On flat sales, to be covering those headwinds and still be seeing consistent segment margins, is actually covering a lot of cost increases.

Operator

And our next question comes from Peter Lisnic from Robert W. Baird.

Peter Lisnic - Robert W. Baird & Co. Incorporated, Research Division

Just -- I want to clarify one first. Bob, you talked about a $30 million headwind with variable comp in 2/3. But if I do the math in R&D, it's 7.5% on $2 billion of revenue. There's $20 million right there. So in my -- did I hear incorrectly or is the headwind more like $40 million, or am I just suffering from using midpoints for my math? Or kind of what's the reconciliation there?

Robert F. Weber

All of the above. We've had a struggle with the -- again, if you do the maths at the midpoint and so on, the R&D number could be a little bit higher, so my 2/3 is a rough and tough, sort of to give you a directional. And you know how variable some of those can be. And that's the other thing that we try to call out is that both R&D and obviously, variable comp is always variable based on how we do and the prototype builds and everything else. So $30 million, $40 million, I know that sounds like a big range, but the reality is that's what it can be, so...

Peter Lisnic - Robert W. Baird & Co. Incorporated, Research Division

Okay. But on a combined basis, those 2 are the reason why you have sales up when you look at '14 versus '13 and EPS down when you're looking at the midpoint at least, correct?

Thomas A. Gendron

Correct.

Robert F. Weber

That's right.

Peter Lisnic - Robert W. Baird & Co. Incorporated, Research Division

Okay. All right. And then I was wondering if you could maybe give us a little bit of color in terms of inventory position of your customers. Are there any risks as you look to the various businesses in '14, to customers maybe having to cut back inventory even more than they have and that leading to any sort of production hits or absorption units that you might have to absorb in '14 that wouldn't be embedded in your forecast?

Thomas A. Gendron

Well, Pete, what I would say is we're kind of looking at the opposite. I don't know if you've heard of the term bullwhip effect at inventory. If you look at a lot of our major customers, I mean, they've taken inventory down for the last couple of years and took it down in '13, and particularly, if you look at CAT and some of the activity of GE and some of our other larger customers. So I don't think we have a big risk on anything with further drops in inventory. That's not in our -- we're not anticipating that. We are trying to make sure that we're going to be agile if we do see the bullwhip effect that we can respond to it. But that's something that we plan for, but we don't know if that will hit in '14 or not. But we think the inventories are actually more of an opportunity going forward than a headwind.

Peter Lisnic - Robert W. Baird & Co. Incorporated, Research Division

Okay. All right. That helps there. And then I just want to go back to R&D for the last question. The 7.5% obviously acceleration from what we saw in '13, kind of more in line with '12. Is that just a reflection of expenses being pulled forward a bit, just given customer requirements? Or is there a new business there that maybe is going to lead you to talk about more or think about stronger growth rates as you look to '15, '16, '17? Is it incremental or is it just kind of timing, I guess, would be the way of asking it.

Thomas A. Gendron

What I would say is we've continued to secure more content. So we do have that. And as we promised, December 6, we're going to release some of those content numbers on the Aerospace side. What we do have -- and it's an exciting time right now. If you look, a lot of the big programs we're on have made some huge milestones. And I know you guys all follow this, but the CSM LEAP engine has run. They're going to start moving to further engine testing, flight testing. PurePower flew on the CSeries and it worked well. The Passport 20 engine is fired up, and we're going to -- and on -- each of these big engine platforms are going to the airframes as well. There is a lot of development, growth testing and then flight testing, and what we're really seeing in 2014 is a very large amount of prototype and flight test hardware on the arrow side that's going -- that's driving the R&D up, and what we really had was getting to that point in '13. And the real promising things is all these programs are holding to schedule so far. So I'm quite encouraged that they're moving along well. On the Energy side, we also have quite a bit of development activity going on. And it's -- we've mentioned before that on the R&D number, we're going to have quarter-to-quarter variability, and that variability is not tied to like our engineering or our technician load. It's really tied to hardware and specific deliverables. And so that's what you're seeing here. And so there wasn't any push-outs or anything. It's just the timing of both the Energy programs and all these arrow programs migrating to actually tests and flight tests. So expensive but exciting times, and we're looking forward that they hold to those schedules and we start going to production in '15.

Operator

And our next question comes from J. B. Groh from D.A. Davidson & Co.

J. B. Groh - D.A. Davidson & Co., Research Division

When do you start to see the benefit of your nice market share wins on LEAP and PurePower? Does that -- would that be something that kicked in sort of early 2015?

Thomas A. Gendron

Yes. The forecast right now is like the A320neo is going to go third quarter '15, and so that brings the LEAP and PurePower both. It's a dual-sourced aircraft. Boeing right now is talking 2017 and it's a little flexible on the exact quarter, but that's coming, so that's on its heels. Flight test on the Bombardier Global Express with Passport 20 is going to be in the '16, '17 timeframe. And then you got the CSeries, which is in flight testing right now. I know they pushed out a little slightly, but that's coming online, too. And all these programs, we have significant content. And the other one not to forget, too, is the 787-9. We have more content on the -9 than we do with the -8. So that being in flight testing and then going into production here in the next year is going to be a positive for us.

J. B. Groh - D.A. Davidson & Co., Research Division

So theoretically, R&D peaks in 2014?

Thomas A. Gendron

Yes, I believe so, in terms of -- probably in terms of dollars and hardware rolling to '16. Then you're going to see R&D expenses come down both dollars and then as a percent of sales as we go forward from here because we've been operating at, I'd say, elevated levels these large wins that we're all concentrated in, in a shortened amount of time. So that is an expectation. So if you look 1 to 2, somewhat in this range, we've been running at this 7% to 8%, which is what we've been running the last couple of years. You got a 3- to 5-year time period that's going to drop 6% and below.

J. B. Groh - D.A. Davidson & Co., Research Division

Okay. And then maybe one for Bob. Bob, can you give us interest expense expectation, any potential balance sheet changes?

Robert F. Weber

No significant change at all on the interest side of the equation. You saw some of our announcements regarding locking in some nice favorable long-term low rates. So it will be down a little bit as we go forward. Significant balance sheet, overall, largely will be driven by the CapEx, and so that will be coming online as we've been pointing out. And so you -- over time, you will see some increase indeed to that question regarding depreciation and amortization as we go forward. But other than that, not a lot of significant change overall in the balance sheet.

Operator

And our next question comes from Michael Ciarmoli from KeyBanc Capital.

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

Bob, just to follow-up on that. So can you quantify how much interest will be down year-over-year?

Robert F. Weber

It isn't a significant amount in the first year here, so I would model pretty much flat with this year.

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

Okay, perfect. And then just on the military aftermarket, you guys obviously had a tremendous year. You're up 31%. Looking at what a lot of other companies in this space have had to say, I mean, they've seen some pretty significant declines and being down 5% next year seems like it might be a little bit of an optimistic view in light of readiness spending coming down, flight hours coming down. I mean, do you have pretty good visibility? I know you said you're kind of on 1- to 2-year contracts there. I mean, do you have pretty good visibility, or could you sort of see some surprises with ongoing sequestration? Just trying to get your comfort level on that down 5% versus what is likely a peak level for you guys here.

Thomas A. Gendron

One clarity on that, that was total defense sales.

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

Okay. Not just defense aftermarket?

Thomas A. Gendron

Not just defense -- okay. And so there's a mix. And we have -- there still things that are increasing. And just to remind everybody, we do have excellent position on the F-35 and the tanker and some of that activity is moving forward. We see the mix on the aftermarket, and that we're calling out, that will be down. But overall, I could say, we're -- it's not going to be dramatic on total defense sales, but -- and our view is that's going to continue to be, if you want to call it, 5% to 10% band through the next few years. So it's going to be this, what I call, just this underpinning of the business. It's not going to be a cliff, it's not going to be growth, but it's going to be on the steady category with about that type of range of variability.

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

Okay, okay, that's helpful. And then just shifting into Aerospace. You mentioned the 787-9, and even with the 787 coming online, you've got -- you mentioned a bunch of the new engines. Are those going to be a margin headwind for you as those programs ramp up or do you expect those programs to sort of not be dilutive to your Aerospace segment margins on kind of these initial deliveries?

Robert F. Weber

We expect our Aerospace margins to continue to increase towards our targeted level that we have provided. So we think, overall, when you look at the Aerospace, what we call the Aerospace, you won't say the value model, even when you launch a new OEM program, you're going to also sell initial provisioning spares. Those come with very good margins. And then as they accumulate hours on it, then you start to get piece, parts and repair and overhaul revenue to go with that, we think we would be able to manage that and continue to grow margins through that time period.

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

Okay, perfect. And then just the last one for me, the Silvercrest engine, does that roll through R&D? Is that something that's hitting this year? Just trying to get a sense of what else is driving up that R&D this year.

Thomas A. Gendron

Yes, the Silvercrest is in there, it has been over the last couple of years. It's a big program as you can tell by all the content we had. The engine is performing well and the biz jet manufacturers take a little more time before they announce their planes. So you're going to see -- like on the Falcon, it's going to start flight testing not that far. So you can see that has been going for a while. So that has a very nice engine for that market. And yes, we've been spending on it and it's been going for the last 2 years.

Operator

And our next question, coming from Pete Skibitski from Drexel Hamilton.

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

Just a couple of follow-ups. Tom, on the -- just to clarify on the military sales, up 31% in fiscal '13. That was total military, but that's not all organic, right?

Thomas A. Gendron

No [ph], for the confusion. That was military aftermarket, not total military.

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

Okay. That's military aftermarket. But again, that's not all organic, right? Duarte has some military?

Thomas A. Gendron

Correct.

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

Got it. You don't happen to have the organic number, do you?

Robert F. Weber

No, that was -- we're trying to get our -- all our numbers straight here on that piece, but that is the organic growth for aftermarket, ME, [ph] for defense aftermarket. And do we have it with Duarte?

Thomas A. Gendron

For aftermarket?

Robert F. Weber

It's 46%, including Duarte.

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

Okay, got it, got it. And then just to -- I might have missed this earlier, but on the Aerospace revenue guidance, you've got the military down roughly 5%, and then it sounds like maybe the balance of the -- the commercial is maybe up 5% or so. And if we parse that, are you kind of assuming that commercial aftermarket is only modestly up, kind of in line with the traffic growth, but -- and OE is maybe up mid single -- mid to high single digits?

Robert F. Weber

Yes, that would be a correct assessment. So we continue to see the underlying dynamics of the aftermarket that have not declined. So we anticipate it should continue growing in next year. And you've seen some of the production rate increases on the commercial OEM side and we envision those will be low single digits as well.

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

Okay, okay. Last one, on the incentive comp, can you just remind us kind of what that's based on, so maybe we can extrapolate out a couple of years because I think it is -- obviously, the top line was kind of weak this year and up only modestly in fiscal '14. So it's a little surprising to hear that's going to be a kind of have a meaningful headwind in fiscal '14. And it looks like it's going to even outpace earnings growth and certainly, free cash generation. So can you give us a sense of what the drivers are there?

Thomas A. Gendron

Yes, a little bit if you look at incentive comp. And the reason there's a headwind is that we did not meet across-the-board target incentive comp in all our business segments, okay? So what we do each year is we set a target incentive comp based on performance that we seek to achieve in the year. So there's many elements of our incentive comp. But in fiscal year '13, when you take it all together -- and our philosophy in our company is that we have everybody has an incentive comp piece to their total compensation package, that we did not meet target performance for fiscal year '13. So when you roll that into '14, you reset everything, we're resetting it to achieve target performance, and that's the headwind.

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

Okay, and -- but target performance, is there kind of a main driver? What that is, is that earnings or something or...

Thomas A. Gendron

The main driver is earnings. And as we discussed earlier, we did not hit our earnings guidance that we've initially set out for the year as we discussed earlier. And that's the main reason, parts of the incentive comp, and there's various plans and as they said, every -- all of our members worldwide have a portion as incentive pay, and we did not -- and EPS was the main driver.

Operator

And our next question comes from Steve McNeil from Jennison.

Steven McNeil

Just building on the last point. Is this -- I'm just trying to triangulate. Has the bar, the performance bar, is it -- is equally high this year as it was last year?

Thomas A. Gendron

We look at -- Steve, as you look in -- we look at, you say, the performance bar as earnings percentages, whether at the segment level or the company level, and like there's improvement in all our metrics that we go. So the bar is not being dropped from that standpoint. So that's how we base and seek to improve. And within those improvements is also the ability to pay for the bonus, as well as pay for the additional wage benefits, R&D expenses. So there's a lot of expenses that all have to be absorbed and an improvement in our margins to then trigger our incentive plans.

Steven McNeil

But I mean, to be fair, I mean, the -- and I guess, are you -- should we be using the $2.10 number that you reported, including the charge this year?

Thomas A. Gendron

What we use -- if I am to [ph] match it, what we use for incentive comp purposes was $2.03 on earnings. And the reason that is, is that earnings less the 2012 retroactive R&D credit, is that was a non-operating result from the prior year, so that didn't get included.

Steven McNeil

But the midpoint of the guidance is only 8% growth year-over-year.

Robert F. Weber

On earnings, yes.

Steven McNeil

On earnings?

Robert F. Weber

Yes.

Steven McNeil

And that triggers a $20 million comp?

Robert F. Weber

If you go from a relatively low level to back to target -- I don't know if you recall, Steve. It was not that many years ago when we kind of called out what the range was. Yes, it has a significant impact.

Thomas A. Gendron

And never [ph] -- so you understand? Again, I would want to highlight, every member in Woodward has an incentive comp piece to their salary, okay? And so when you look at that number, that's across 7,000 people, okay? So that's -- so and we think the philosophy works, and it helps keep everybody aligned. And so yes, the numbers -- total incentive comp is when you run a high variable pay based on performance, it's a big number.

Steven McNeil

Yes. And what was the -- so you said $2.03 for '13. What was the number in '12? Do you remember?

Robert F. Weber

Yes, $2.01 was the actual number, Steve.

Steven McNeil

For '12?

Robert F. Weber

Yes. So you can see, there's not a significant increase going from $2.01 to $2.03 and that's why, as Tom pointed out, we did not meet our expectations and therefore, variable comp was not at target. What I'm also pointing out, there's 2 other pieces to the puzzle that -- the question was asked how was it based. As Tom mentioned, there's a very broad-based earnings per share target. There's also stock comp and long-term incentive plans. Stock comp is driven by share price. And as you've seen what the market's done, that piece is increasing as well, and an LTIP is relative to our peer group, and we're holding our own relative as everybody's pointing out.

Thomas A. Gendron

I would refer everybody that wants some more detail on this. It's really spelled out well in the proxy. And you can look at last year's proxy, the plan's the same, so I would go look at the proxy. It's really well spelled out. We think it hits all the key metrics that drive -- we have annual and long term, so we're trying to make sure we perform in the short term, but that we have all the incentives in the right place to bring long-term value to our shareholders. And if you look, I think it's -- they're very good plans and they're really well spelled out in the proxy, so...

Steven McNeil

Okay, great. One of the things on the R&D, Tom, you referenced dropping to 6%. Is that something that happens in '15, or is that something that's more '16?

Thomas A. Gendron

I think you're going to see -- it's more like '16 to '17. We're going to do watch as how the program's -- if they stay on schedule and everything or it will be sooner. But there's a lot of variations in R&D, but this has been a very high load that we won a lot of programs all at once, and so that's why we ramped -- the R&D ramped up so high. As these come out of development, anticipate we'll still win more program, but it's not going to be all these ones kind of at this peak that we have had here for a few years. So we'll start coming back down and that will be more towards historical levels and like going forward. And with the growth rate and you talked about percentages, but the growth rate in sales that have kicked in, it will be a little lower number.

Operator

[Operator Instructions] Okay. And we'll take our next question from William Bremer from Maxim Group.

William D. Bremer - Maxim Group LLC, Research Division

Last one, what is a good fully diluted earnings per share figure for '14? Shares outstanding, I meant, sorry gentlemen.

Thomas A. Gendron

We thought we gave that one to you, Bill, already.

Robert F. Weber

Approximately 70 million shares.

Operator

Okay. So again, we'll take our next question from Julie Yates from Crédit Suisse.

Julie Yates - Crédit Suisse AG, Research Division

Bob, I wanted to just get what the commercial aftermarket growth for FY '13 was.

Robert F. Weber

Okay. Hold on, we're going to pull this number and make sure we get the right number going here. Commercial -- okay, commercial aftermarket, organic, down 3.3%.

Julie Yates - Crédit Suisse AG, Research Division

Okay. And just to be clear, you're expecting that to return to mid-single digit growth in FY '14.

Robert F. Weber

That's right.

Julie Yates - Crédit Suisse AG, Research Division

Okay. And then on wind or renewables, where did you end the year in terms of an absolute dollar basis? Was it around the $100 million target that you had...

Robert F. Weber

Yes, slightly above. It was about $117 million.

Julie Yates - Crédit Suisse AG, Research Division

$117 million?

Robert F. Weber

Right.

Julie Yates - Crédit Suisse AG, Research Division

Okay. And so that's why you think if you can skip to that $120 million number, which is where you needed to breakeven.

Robert F. Weber

That's right.

Julie Yates - Crédit Suisse AG, Research Division

Next year?

Robert F. Weber

That's right.

Thomas A. Gendron

Yes.

Operator

And Mr. Gendron, there are no further questions at this time. I would now turn the conference back to you.

Thomas A. Gendron

Okay. Well, appreciate everybody joining us today and appreciate your questions. I hope a lot of you will make it to our conference in New York on the 6th. We're going to provide some more details, and I look forward to seeing a lot of you there. So thanks, again, for joining us.

Operator

Okay. Ladies and gentlemen, that concludes our conference call today. If you would like to listen to a rebroadcast of this conference call, it will be available today at 7:30 P.M. Eastern Standard Time by dialing 1 (888) 266-2081 for a U.S. call or 1 (703) 925-2533 for a non-U.S. call and by entering the access code 1626043. A rebroadcast will also be available at the company's website, www.woodward.com, for 14 days. We thank you for your participation on today's conference and ask that you please disconnect your line.

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