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Executives

Dan Swenson – VP, IR

Clay Jones – Chairman, President and CEO

Patrick Allen – SVP and CFO

Analysts

Howard Rubel – Jefferies & Company

Cai von Rumohr – Cowen and Company

Robert Stallard – Macquarie

Troy Lahr – Stifel Nicolaus

Ronald Epstein – Banc of America/Merrill Lynch

David Strauss – UBS

George Shapiro – Access 342

Noah Poponak – Goldman Sachs

Robert Spingarn – Credit Suisse

Joe Nadol – JPMorgan

Peter Arment – Broadpoint Gleacher

Heidi Wood – Morgan Stanley

Samuel Pearlstein – Wells Fargo

Joseph Campbell – Barclays Capital

Carter Leake – Davenport & Company

Richard Safran – Buckingham Research

Rockwell Collins, Inc. (COL) F2Q10 (Qtr End 03/31/10) Earnings Call Transcript April 23, 2010 9:00 AM ET

Operator

Good morning and welcome to the Rockwell Collins second quarter fiscal year 2010 earnings conference call. Today's call is being recorded.

For opening remarks and management introductions, I would like to turn the call over to Rockwell Collins’ Vice President of Investor Relations, Dan Swenson. Please go ahead, sir.

Dan Swenson

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

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

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

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

Clay Jones

Thanks, Dan and good morning, everybody. Well, consistency has once again become a prevalent and, I might say, very welcome theme at Rockwell Collins. And after what we experienced last year, it feels pretty good as we posted second quarter financial results that were in line with our expectations for the quarter.

Overall revenues came in at $1.14 billion, generally flat with Q2 of 2009 as Government Systems saw strong growth of 13%, which offset the 14% revenue decline within Commercial Systems. Combined segment operating margins of 19.2% continue to be at the upper end of our guidance range, fueled by Government Systems which turned in another quarter of margins near 22% while Commercial Systems saw margins trough at 15.4%.

Primarily influenced by the absorption of year-over-year increases in compensation and pension expenses, second quarter EPS came at $0.93 a share compared to $1.03 a share last year. I feel it's important to note on a sequential basis, we saw increases in revenues, operating profits, and EPS as we move further into the period of recovery in the commercial aerospace market.

We are also very pleased with our operating cash flow performance, which halfway through the year stands at $280 million, well ahead of the $137 million at this point in 2009. Cumulative results for the first half of 2010 compared to our expectations for the second half of 2010, highlight the story of how this year is a tale of two halves. With our first half results in line with expectations, we are forecasting continued improvements in our business and sequential growth in both revenues and operating profit.

In commercial aviation, we see positive indicators in virtually every aspect of the market. Airlines are seeing passenger and cargo traffic grow faster than expected and anyone who has flown commercial recently appreciates the very high load factors being experienced. This is providing a lift to airline profit expectations even though airlines in aggregate still call for losses through this year. However, even with these near-term losses, airlines are looking at their long-term prospects and remain committed to the delivery slots that they've got on order at Boeing and Airbus.

As a result, we've heard announcements from Airbus of an increase in their narrow-body production rates and from Boeing, an increase of their wide-body production rates. These changes won't have a great impact on our 2010 results, but will provide a key lift to what we are beginning to see in 2011. And that's in addition to the production of the 787 and the 7478 aircraft, all of which will be very meaningful for future growth.

Now, these positive trends in passenger traffic also support our expectations for the air transport aftermarket. As expected, we saw service revenues down year-over-year in the first half, but it's important to note that flight hours were still down just over 1% year-to-date versus 2009. More importantly to our business, flight hours on out-of-warranty aircraft were down 4% during this time period. However, as an indication of the direction of the market, our second quarter air transport aftermarket revenues did show sequential growth. And as we look into the second half of 2010, we see positive drivers that continue to provide lift for the discretionary and the non-discretionary aftermarket.

First, tight capacity in the commercial air system has been accommodated through higher utilization of newer in-warranty aircraft. So we believe that this is reaching a point where airlines will begin to increase utilization of older, out-of-warranty aircraft, which should directly benefit our service business.

Second, improved traffic is leading some airlines to expand their route structure, including flights over open water where avionics upgrades are required as part of the equipment to the aircraft and where enhanced navigation capabilities and the more efficient routes they enable could directly benefit airlines operating cost structure.

Now, to date, airlines have been reluctant to set down any aircraft for a length of time to perform these retrofits and upgrade work, but we believe as they expand the investments in avionics upgrades to optimize that potential route structure and operating efficiency will become increasingly more attractive.

We are also seeing positive indicators within the business jet market. We are encouraged by improvements in the equity markets and corporate earnings because growth in both of those provide bullish signals for utilization and ultimately, for purchases of business jets. Aircraft utilization continues to increase with preliminary March data showing growth of about 12%. This trend provided a year-over-year and a sequential lift to our business jet services revenue in the second quarter and we expect this trend to continue into the second half of the year.

Another important market data point is the feedback we are hearing from our dealer network that aircraft service providers are seeing really good workflow and a high level of what they call pre-buy activity. Now, I believe that this pre-buy activity is a result of buyers beginning to sense that we may have seen a bottom for pricing in the used market. This activity provides very positive leading indicators for our retrofit business, which we believe will begin to pick up toward the end of fiscal 2010 and then gain momentum into 2011.

Order books, as we all know, have stabilized for large-cabin business aircraft and seem to be running about the 1 to 1 book-to-bill. But we've not yet seen that order stabilization make its way down to the smaller end of the market. However, even with that there is sufficient delivery equilibrium that with the market share gains that we are anticipating with the certification of the CJ4 and with the Head-Up Guidance System that we are installing at Gulfstream, we should see sequential improvements in business jet OEM revenues as we move from the first to the second half of 2010.

Additionally, we will have a much easier comparable in the second half of the year, providing an opportunity for positive year-over-year comparisons as well. So for Commercial Systems as a whole, we believe we will see around 10% growth in the second half of 2010 compared to 2009 and continue to see sequential growth across quarters three and four.

Now, moving to Government Systems, some remind me of the benefits of having this component of a balanced portfolio of businesses as overall GS sales, earnings, and margins stayed very strong. And the contribution of DataPath to our results in the second quarter – in the first two quarters of the year provided profitable growth to our business even as we saw program delays impact our organic operations.

As we move into the second half of 2010, we fully expect Government Systems to realize more organic growth. This organic growth is anticipated to come from a number of areas within airborne solutions, they include our tanker and transport programs like the KC-135 Block 45 program and a global air traffic management upgrade for the Turkish KC-135s as well. It will also be driven by development revenues for avionics on CH-47 Chinooks going to international market and revenues from electronics for aircraft such as P8 in both the domestic and international market.

And last week, we were awarded the $200 million Senior Leader Command, Control, and Communications System or SLC3S for short, which includes communications equipment for various U.S. government VIP aircraft. In surface solutions, we expect to see near-term revenue growth provided by deliveries in our integrated vehicle electronic system to the California Highway Patrol. These items, together with DataPath, should provide for second half year-over-year Government Systems growth just over 12% and a full-year growth of about 12%.

So with stable improving market conditions driving sequential growth, we remain confident in our ability to meet our financial commitments in 2010 and continue this very positive trend into 2011.

With that, I would like to hand the call over to Patrick for the details of the financials. Pat?

Patrick Allen

Thanks, Clay and good morning to everyone as well. Let's get started by first reviewing our results for the total company that are shown in slides three and four.

Total company sales for the quarter were relatively flat compared to last year's sales, while net income and earnings per share both decreased 10%. This decrease in net income and earnings per share came primarily from lower Commercial Systems revenues and higher employee compensation and pension expenses.

Our effective tax rate for the quarter declined from 31.7% in the second quarter of 2009 to 24.5% in the second quarter of 2010. This rate decrease was due to the favorable impact of the IRS completing its examination of our returns for the years ended September 30th, 2006 and 2007, which provided roughly a 10 percentage point reduction in our effective tax rate. This was partially offset by impacts from the expiration of the federal research and development tax credit and a $1.3 million charge related to the tax treatment of the Medicare part D subsidies resulting from the new health care legislation, which together provided about a 3 percentage point increase to the effective tax rate.

Turning to slides five and six, we take a look at our – at the second quarter results of our Government Systems business, which achieved a revenue increase of 13% from $613 million in 2009 to $693 million in 2010.

Airborne solutions sales increased $24 million or 6% to $455 million. This growth came from an $18 million increase in tanker and transport program revenues, a $12 million increase in revenues related to special mission aircraft. These items were partially offset by a decrease of $11 million in fighter jet program revenues.

Surface solutions sales increased $56 million or 31% to $238 million. Incremental sales from the acquisition of DataPath contributed $78 million and organic sales declined $22 million, primarily due to lower Defense Advanced GPS Receiver sales.

Page six shows Government Systems second quarter operating earnings, which increased 3% from $145 million in 2009 to $150 million in 2010, while operating margins declined from 23.7% to 21.6%. The increase in operating earnings was due to higher revenues, while the decline in operating margins was driven by a $13 million increase in employee incentive compensation and pension expenses and a $7 million increase in company-funded R&D expense.

Additionally, we had two offsetting non-cash items. The first was a $6 million favorable change to our warranty accruals. The second was a $6 million unfavorable adjustment related to certain simulation and training contracts.

Moving on to page seven, Commercial Systems second quarter revenues were down 14% from $525 million in 2009 to $449 million in 2010. Sales at air transport aviation electronics decreased $8 million or 3% to $251 million as a result of a $13 million decline in aftermarket sales and a $6 million reduction in sales of wide-body in-flight entertainment products. These items were offset by $11 million increase in air transport OEM revenues from higher sales of airline selectable equipment and slightly higher shipset delivery rates to Boeing.

Moving on to business and regional aviation electronics, sales decreased $68 million or 26% from the three months ended March 31st, 2010 compared to the same period in the prior year, primarily due to a $65 million decline in business jet OEM sales and an $8 million decline in the regional jet OEM sales from reduced production rates.

Organic aftermarket sales decreased $4 million as an $8 million decrease in aftermarket hardware sales was partially offset by a $4 million increase in service and support. Incremental revenues from the Air Routing acquisition contributed $9 million to aftermarket sales.

On page eight, we see Commercial Systems operating earnings decrease 37% to $69 million or 15.4% of sales for the three months ended March 31st, 2010 compared to operating earnings of $110 million or 21% of sales for the three months ended March 31st, 2009.

The reduction in earnings and the decrease in operating margins was primarily due to a $40 million decline from lower earnings on lower sales volumes and a $10 million increase in employee incentive compensation and pension expenses. These were partially offset by a $7 million reduction in company-funded R&D expense as certain projects near completion and as we continue to manage our investment in discretionary products – projects.

On slide nine, we have our six-month year-to-date total company financial results for sales, EPS, net income, and operating cash flow. Of note on this slide is the increase in our year-to-date operating cash flow from $137 million in 2009 to $280 million in 2010. Main drivers here were lower compensation payments related to elimination of employee incentive compensation during 2009, as well as strong cash receipts from customers reducing accounts receivable.

Moving to slide 10, we show the status of our capital structure. As of the end of the second quarter, we had $527 million in long-term debt outstanding as compared to $532 million at the end of fiscal year 2009. Ending the quarter, we had a debt-to-total capital ratio of 26%, a level we are comfortable with and that in combination with our investment-grade credit ratings provides us the ability to fund our growth needs cost-effectively.

The updated status of our share repurchase program as of the end of the second quarter is detailed on slide 11. During the second quarter, we repurchased a total of 700,000 shares at an average cost of $57.49 per share. This brings our total repurchase activity since 2002 to about 56 million or $2.6 billion returned to shareowners through maintaining the active share repurchase program.

Now, into our final slide, slide 12, where we provide details of our fiscal year 2010 financial guidance. Our overall guidance again remains unchanged when we originally issued it on September 17th, 2009. However, a couple of detailed items have changed slightly.

We continue to expect total revenues for 2010 of between $4.6 billion to $4.8 billion. In Commercial Systems, we anticipate fiscal year 2010 revenues to be down about 3% in 2009. This consists of overall OEM revenues being down in the mid-single digits with air transport revenues up about 20% and business and regional OEM revenues down about 20%.

Aftermarket revenues are expected to experience low-single digit growth with air transport flat and business and regional up high-single digits. Wide-body IFE revenues are expected to decline by approximately 45%. Looking specifically at the second half of 2010 compared to 2009, we expect Commercial Systems revenue in total to be up about 10% with overall OEM revenues up about 12%, consisting of air transport OEM revenues up in high-teens and business and regional OEM revenues up in the high-single digits.

Aftermarket revenues for the second half of 2010 are expected to be up in the mid-teens with air transport aftermarket up in the high-single digits and business and regional aftermarket up about $20 million from the Air Routing acquisition and in the mid-teens from organic growth. These growth rates will be partially offset by wide-body IFE being down about $30 million from the second half of 2009.

In Government Systems, we continue to expect full-year revenue growth of about 12%, a little over 4% organic growth, and the remainder from very strong revenue performance from DataPath. For the second half of 2010, this implies just over 12% year-over-year growth compared to the second half of 2009.

On earnings per share, I would point out that our range of $3.35 to $3.55 continues to be based upon effective tax rate in the range of 30% to 31%. But that tax rate now assumes that the federal research and development tax credit is not renewed by the end of our fiscal year. This amounts to a reduction in our effective tax rate guidance due to the impact of the favorable settlement of tax matters during this past quarter.

That completes my review of the financial results and projections. So Dan, back to you to kick off the Q&A session.

Dan Swenson

Thank you, Patrick. Now, operator, in order to give everyone the opportunity to ask questions or participants, I'd ask that you limit your questions to one per caller. If you have further questions, I'd ask that you reinsert yourself into the queue and we will answer those questions as time permits. Operator, we are now ready to open the lines.

Question-and-Answer Session

Operator

(Operator Instructions). We will pause for just a moment to compile the roster. (Operator Instructions). Your first question comes from the line of Howard Rubel with Jefferies & Company.

Howard Rubel – Jefferies & Company

Good morning. Thank you. Clay, you've made a number of acquisitions and they all look like they fit very well and into the way the organization has performed. Could you talk about some of the initiatives, for example in simulators, how you've been able to capture some new customers and grow that and also do the same with DataPath, please?

Clay Jones

Sure. Well, I think we are very pleased with our simulation training system right. Obviously, with the full complement and capability from the three acquisitions we've made.

We think that will become increasingly attractive as the op-tempo in Iraq and then perhaps subsequently in Afghanistan over the next two years winds down and the cost of fuel and the need to constrain the defense budget moves that pilot training back into the traditional way of doing it and that is not through op-tempo, but through simulation. And our position that we have won a number of simulator programs over the last couple of years that are in development now, I think, will continue to serve us well there.

We've nibbled at the edges in the commercial arena by providing some capability to other suppliers, most notably in the display area where I think we've got world-class display that's often looked at and as that market grows, we think there is going to be more simulator pool through there. So we are – we feel very comfortable where we are in simulation now and the market trends that we see in front of us, I think, is going to serve us in that business well.

In DataPath, I'll tell you, we – these are the kind of acquisitions you just hope to get every once in a while where you have an underperforming business that can be quickly converted into an accretive part of your business and DataPath has just gone splendidly. And I give great compliments to our people who have gone down there and done the good work of integration.

As we have said before, that business had gotten a little overgrown as a result of some expectations. We are able to take that cost out very quickly and you are beginning – we are beginning to see the accretive effect of that. And that's before you think about the strategic implications of taking their Commercial SATCOM, which is still going to remain the predominant way that our forces communicate around the world and marry it with the military SATCOM that we have traditionally had a strength on and as we look at new programs in development into the future, marrying those two capabilities and to more integrated systems, we believe, is the way the department is going to go.

So we feel great about those two and then the next one in the horizon is Air Routing, which is the beginning of filling out some of the portfolio we are looking at in information management for Commercial Systems and we think that has great promise too.

Howard Rubel – Jefferies & Company

Thank you.

Operator

Your next question comes from the line of Cai von Rumohr with Cowen and Company.

Cai von Rumohr – Cowen and Company

Yes, thank you very much. Could you give us some color on where you were in terms of the bonus accruals in this quarter year-to-date and what your plans are for the year?

Patrick Allen

Yes, Cai. Well, given the fact that we haven't changed guidance, we haven't really changed our method of accrual. So I think we indicated there was about a $40 million accrual related to incentive compensation. We've accrued about $20 million year-to-date. And until we change guidance, we are not going to change the – that pattern of accrual.

Cai von Rumohr – Cowen and Company

And the second one and last one will be, it looks like from your guidance, you are going at about a $500 million run rate in this bizjets and RJs in the second half. (inaudible) as we go into 2011 and it looks like you would have with a pretty good growth that you are up fairly substantially from the first half.

Clay Jones

Well, as I sort of provided in my remarks there, Cai, we are very pleased with the momentum we are building in the second half. I full well expect that momentum to carry over into 2011. It will predominantly be from aftermarket as the utilization rates grow and then we are going to be waiting and seeing what the OEMs do relative to their build rates. We are not anticipating those build rates to change at all in 2010. I think we have reached the stabilization point and what will be very interesting to look at over the next, I'll say six months, is what their order fill rates are and then what the ultimate economic recovery vector is that will drive new production builds.

As we all know, typically the equity markets and corporate profitabilities are the absolute best indicator of growth in the business jet market. I believe that it will grow into the future. The only question begins is when does that OEM rate begin to kick up and here is the way I would do it. I would say we are not expecting any OEM build rate increases in 2010, although we will enjoy some market share gain upper that I indicated here.

In 2012, I feel very confident we will see increases in OEM build rates as the economy takes hold. The great unknown is what's going to happen in 2011 and so we are going to watch that for the balance of this year and we will have more color as we approach that guidance point.

Cai von Rumohr – Cowen and Company

Thank you very much.

Clay Jones

Sure.

Operator

Your next question comes from the line of Robert Stallard with Macquarie.

Robert Stallard – Macquarie

Patrick, you mentioned that you expect aftermarket revenues to be up mid-teens in the second half of the year. Do you expect that rate to accelerate as you move into fiscal '11 and as a follow-up, do you feel comfortable that Commercial Systems is prepared to deal with this rate of growth?

Patrick Allen

Well, let me take the second half first. I'd say, absolutely, we are prepared to deal with that rate of growth. I think we are anticipating it, we are building inventories accordingly and so no issues there. As for the momentum, what I'd say is this, as we look forward, we are going to see accelerated momentum in the back half of the year. So the fourth quarter growth rate will be faster than the third quarter growth rate. As it goes into 2011, I certainly anticipate continued strong growth in the aftermarket, but I wouldn't want to comment on kind of the quarterly pattern as of this point.

Clay Jones

And let me add some color to that, Rob, because I think we talked about that often in the past. Where we are seeing most of the strength in our aftermarket business, as we have expected and as always the case for our business, is in the service or the MRO area. We may see a little bit of, I'll call it more discretionary aftermarket at the end of this year as I indicated and we are seeing signs that now the airlines are moving back into that as they look to add things like HF radios and multi-mode receivers to fly over water. So that's very encouraging.

But the real face of recovery for that discretionary piece, we think, will occur in 2011. And so if you look at the additive effects of MRO at the end of this year continuing to build combined with the discretionary piece in '11, I think there is momentum clearly moving into that year.

Robert Stallard – Macquarie

Okay, thank you.

Operator

Your next question comes from the line of Troy Lahr with Stifel Nicolaus.

Troy Lahr – Stifel Nicolaus

Thanks. Yes, on the commercial side, can you talk a little bit about where you are seeing the pockets of strength? I mean, it's just mostly international carriers in Asia and Middle East. Are you still seeing softness though in U.S. and European carriers? Can you just kind of differentiate that a little bit?

Clay Jones

Well, you are correct in that the biggest point of strength and the highest flight rates are in Asia, Middle East as you've heard from the airlines and as you've heard from other suppliers. And so that is what's driving the early recovery of the market. But even as we look at U.S. carriers, as I mentioned in my remarks, we believe they pretty much saturated the in-warranty aircraft and they are going to have to move to increase capacities in these out-of-warranty aircraft that to date are still showing a year-over-year decline in passenger traffic or in flight hours, but that will have to increase as passenger traffic increases.

And so we think that – we think there is a natural evolution in – well, I'd say the relatively weaker markets in North America and in Europe follow into next year. The other area besides the one you mentioned that I would add to that where we are seeing strength is Latin America. And so I would say Asia, Middle East, Latin America.

Troy Lahr – Stifel Nicolaus

Great. Thank you.

Operator

Your next question comes from the line of Ronald Epstein with Banc of America/Merrill Lynch.

Ronald Epstein – Banc of America/Merrill Lynch

Good morning, Clay and Patrick. Just a question on the regional jet market. What – when do you expect that to come back, Clay and what indicators are you looking for as leading indicators for regional jets to pick up?

Clay Jones

Well, the regional jet market is lagging a little bit right now and I think that's the sort of a natural transition that we are seeing from the conversion from 50-seat regional jets up to the 70 and 90-seat regional. There is a lot of utilization of those aircraft in the system, especially in Europe and North America. But I guess what I just said the two weakest markets are Europe and North America. And so my sense is until we see a more robust recovery in those two continents, you are probably going to see the regional jet market lag out of this recovery.

Ronald Epstein – Banc of America/Merrill Lynch

Great. Thank you.

Operator

Your next question comes from the line of David Strauss with UBS.

David Strauss – UBS

Good morning.

Clay Jones

Good morning, Dave.

David Strauss – UBS

Clay, just some color on the '11 if you could. Obviously, a lot of moving pieces as we think about aftermarket picking up, 787 kicking in, I assume better margins on DataPath, the benefit of San Jose, but then the comp of – can you just give some color and based on all those moving pieces, you think you could get back to kind of a mid-teens earnings growth rate?

Clay Jones

Well, Dave, as much as I'd like to do it, it's maybe a little premature to give guidance on 2011. But you made a very good summary of all the positive things that we are looking into 2011 to occur. I think that – especially in the commercial market, there is just a lot of momentum building in there and as I said, you mentioned a good litany of them. I think it would just again be premature for me to tell you that we got a specific growth rate and a specific margin rate. But we expect both of those to improve.

Operator

Your next question comes from the line of George Shapiro with Access 342.

George Shapiro – Access 342

Good morning.

Clay Jones

Good morning, George.

George Shapiro – Access 342

Clay, I just want to pursue the aftermarket a little bit. At the JPMorgan Conference, you said that first half you expected aftermarket to be down about 5%. It turned out to be down 8% and given that you made that statement in March, so you probably knew the data except for March, it implies that March had to be a lot weaker than what you were thinking when you made that statement. And I was just wondering if that indeed was the case and if so, why do you think it happened that way?

Dan Swenson

George, this is Dan. I'm going to chime in here. I think that when we said the 5% down for the first half, we were looking at first quarter results matched against our second quarter plan for the entirety of the quarter. I think the 5% was more of a reflection of what we had anticipated for results overall for the second quarter versus where the second quarter in its entirety ended up coming in. So I wouldn't be so specific as to drive through a certain month and what we saw in that month.

George Shapiro – Access 342

Okay. Even though you made the statement in March, you wouldn't have factored in what you saw in January and February?

Clay Jones

I think – well, obviously, I guess if we said that, we didn’t nail it very well, did we? But I know one area – I guess, one area, if I had to say there has been greater weakness than we would have expected back in that time is our in-flight entertainment service revenue. As you know in-flight entertainment is the most discretionary thing on the aircraft. We think that there was less robust maintenance activity.

We think that also that there is kind of a movement especially on the wide-body and some carriers to modernize their cabins and to move to a different IFE system. As you know, we've made a strategic decision not to reinvest in that. So there's probably been accelerated disembodiments of that area. And I think the combination, if there was one single weak area that was maybe less than we would have predicted back in that time, George, is IFE.

George Shapiro – Access 342

I'm not trying to be critical. I mean, I'm growing a hell of a lot at the time, but I was just trying to get a flavor for whether that was anything that worries you for what you are projecting still to continue to have low-double digit – I mean, low-single digit traffic growth in the second half of the year, because it requires a pretty substantial pickup on a sequential, as well as year-over-year basis.

Clay Jones

I appreciate that clarification on the intent of the question, George and I think I can answer it better this way. Two things I would say. As I have always said, the good news about being in this business is the transparency and visibility you have in the things like military business and the OEM business is usually pretty good, long cycle business. But as you also know, the most unpredictable part of our business is in the aftermarket and the most predictable part of that is the retrofit side, when are they going to do an upgrade and a modification.

And so what we are doing basically is trying to predict the most unpredictable part and so we are going to see some variance. That said, we looked in great detail and talked with our customers in great detail and our dealers as to what we think is on the horizon. And so I would say, I'm relatively comfortable with the forecast that I've given you. Is there some variance in that? Always it is, but I believe in the discussions we've had with our customers and the directions we see in the market and as it phrases the general economic recovery and all those leading indicators I referred to in there, I'm as comfortable with this as I can be.

Operator

Your next question comes from the line of Noah Poponak with Goldman Sachs.

Noah Poponak – Goldman Sachs

Hi, good morning.

Clay Jones

Good morning, Noah.

Noah Poponak – Goldman Sachs

Question on the direction of the Government Systems margin. You've had DataPath in here for a few quarters now and in each one we've kind of recalibrated down to 21.5% or so. You talked about making improvement with DataPath. I just wonder sort of where we are in that process and is this kind of the new norm for the profitability of GS or can it get back into that closer to the mid-20s type of range we saw before DataPath.

Patrick Allen

I would say to this, Noah, first of all, we are making very progress with respect to the profitability at DataPath. However, it still is a margin headwind. So as I think about – let me talk about the Government Systems margins both short term and long term.

Over the course of the next couple of quarters, we are anticipating a little bit of weakness in the Government Systems margins in the third quarter, simply as the result of the San Jose closure and as those costs flow through inventory into cost of sales, we are going to see a little bit of margin headwind in the third quarter, but that headshake aside, I think there is the potential for further margin expansion in the Government Systems business longer term as the DataPath profitability continues to improve. I wouldn't want to project a specific margin rate. I do think there is – I do think there is opportunity to improve it as that improves and as hopefully pension headwinds start to recede into 2011.

Noah Poponak – Goldman Sachs

In that longer-term dynamic, I wonder, is there – as the government sort of puts more responsibility and accountability on contractors, is there a longer-term threat to your economics as the government sort of encourages others to adapt parts of your differentiated business model?

Clay Jones

No, actually quite the contrary, Noah. I look at that as a long-term opportunity or a protection, if you will. The thing that the Pentagon has said that they want to do is move to more fixed-price contracting. We do an awful lot of that, we are very comfortable with that. I think we are good risk managers to be able to step up to that. And so, if anything, the trend I think is moving more in our direction.

Also, at least in all of my discussions with the acquisition executives in the Pentagon, they very much realize the benefit of commercial contracting and they want to see more competition and more commercial capabilities being brought into the Pentagon because these are things they don't have to spend large amounts of money developing, if they can do that.

And then if they move to this more push-the-risk-to-contractors approach, we've already seen some indication of some contractors shying away from that risk, whereas, I think in our case, because we are mostly a commercial company and we are used to managing commercial-type contracts that are fixed price, we are very comfortable in that environment. So I'd say the market is moving more to us than away from us in that regard.

Noah Poponak – Goldman Sachs

Okay. That makes sense. Very helpful, thanks a lot.

Clay Jones

You bet.

Operator

Your next question comes from the line of Robert Spingarn with Credit Suisse.

Robert Spingarn – Credit Suisse

Good morning.

Clay Jones

Good morning.

Robert Spingarn – Credit Suisse

Clay, you've done a lot of work and given us a lot of information throughout the last couple of years on aircraft retirements and Collins' view on the large aircraft market and in fact, you'll recall back in summer a year and a half ago at Paris talking about production cuts and such. And how do you feel about the upward pressure on narrow-body rates? Do you see it when you talk to your customers?

Clay Jones

Well, we certainly see it when we talk to our OEM customers and – because of our skepticism that was made evidenced last summer and in through our guidance, we spent a lot of time talking to them about the quality of their backlog and how they arrived at the point that they think that the narrow-body rates not only can be sustained, but enhanced as we've already seen Airbus do and as everybody knows, Boeing is thinking about right now.

My sense is that the thing we missed as I was discussing that area that probably we knew less about is the amount of over-booking that was done in the absorption rate, number one. And number two, the agility of the OEMs to reschedule during that period of time where they were having a lot of ins and outs of airlines trying to shuffle around. And then I think the third thing that we always knew, but we probably underappreciated is the role that the leasing companies play, even their weakened state of being an absorber of that capacity.

I think all of those things played in to allow the OEMs to manage through this area better than they have in previous cycles and that surprises. As we look forward, the thing that's more important is not how they did that, but what we think the driving dynamics are in the future. And I think the concern about oil price increases, which we think are inevitable as the economic recovery gains traction and the efficiency not only in maintenance, but in ability to be adaptable to root structures make new aircraft very attractive to airlines and why I think that those narrow-body rates now, I believe, are more sustainable.

So I've kind of come around, Rob, to sort of the inevitability of that strength, assuming we continue to see this traffic growth and growth in emerging markets, especially in Asia and other places like that. So we are encouraged about that, we are encouraged – we are actually more encouraged with the wide-body production rates coming back in as we see the long-range aircraft to be more attractive and the expansion of commerce across the longer distances.

Robert Spingarn – Credit Suisse

Okay, thanks very much.

Clay Jones

Sure.

Operator

Your next question comes from the line of Joe Nadol with JPMorgan.

Joe Nadol – JPMorgan

Hey, good morning, guys.

Clay Jones

Good morning, Joe.

Joe Nadol – JPMorgan

Just my questions on back on commercial and it's looking at the margin and I'd like to – before, I want to say this. Pat and Clay, thanks so much for the additional disclosure that you provided in this press release for the first time. I think that's really going to be helpful. But if I look – Pat, you show year-on-year in your slides. If I look sequentially in Commercial, you gained about $38 million of sales and you only gained $1 million of EBIT. Presumably, the pension and the comp is the same quarter-to-quarter. So why didn’t you get any improvement in profit?

Patrick Allen

Well, a couple of things, Joe. First of all, there is a little bit of incremental compensation headwind, because our merit increases came in the second quarter as opposed to the first quarter. So there is a little bit of headwind there. The biggest difference is related to a contract adjustment we made in the first quarter in Commercial Systems to the tune of about $4 million or $5 million that benefitted first quarter margins and did not benefit the second quarter margins.

Joe Nadol – JPMorgan

Okay. I hadn't recalled that, but – okay, so looking forward in margins in the back part of the year in Commercial, where do you think we might get given your sales projections?

Patrick Allen

I think the back-half margins are going to be higher than the first half margins, particularly in the fourth quarter, as we accelerate not only sales, but the benefit from some of our cost reduction actions, particularly in San Jose, because that benefits both the Government Systems business and the Commercial Systems business.

Clay Jones

And I believe it will penalize both in the third quarter reduction that Pat mentioned earlier, too. So we have a little hump, kind of a one-time hump in the evolution of San Jose to get across in the third quarter and then we will begin to see a very nice benefit from that in the fourth quarter and of course into 2011.

Joe Nadol – JPMorgan

Okay. Thanks, guys.

Operator

Your next question comes from the line of Peter Arment with Broadpoint Gleacher.

Peter Arment – Broadpoint Gleacher

Yes, good morning. You've touched upon a lot of my questions, but I guess and I'm sorry if I missed this, but given that you are projecting a 10% growth, I guess, heading into the second half on Commercial, could you just give us a little color that – I mean, I assume your assumptions are that destocking is essentially completed and that we are going to continue on this path with increasing flight hours.

Clay Jones

Well, yes, I'll summarize again. I think the thing that will be driving the aftermarket are increasing flight hours and activity rates. That will help us in the service aftermarket. I think we'll actually see some pickup in the discretionary aftermarket, which is actually a pleasant surprise because of these route structures I talked about.

And then in the OEM area, what we are seeing there is the impact of the market share gains we have that I recall in the CJ4 and the Heads-Up displays in the business jet area, which is again a nice little upper, something that is probably a pleasant surprise to everybody. And then I think just continued solid BFE mix and strengthening of the narrow-body rates against what we projected in the fourth quarter for the air transport side. So each one of those has a sort of a cumulative and a contributory effect.

Peter Arment – Broadpoint Gleacher

Okay, that's great. Thank you very much.

Clay Jones

Okay.

Operator

Your next question comes from the line of Heidi Wood with Morgan Stanley.

Heidi Wood – Morgan Stanley

Yes, thanks. I want to put a little bit more of a finer point on your comments in 2011 for us to kind of think about the pieces of it, Clay, as we think about the margins. It sounds like from your comments that you expect the second quarter margins seemed like the trough. You've been very clear about the second half being stronger.

So as we think ahead in 2011 with obviously the full-year benefits of the higher OE and aftermarket volumes, business jets coming in, what would be the gating elements that we should be considering now with restrained margins or why couldn’t you get to 20% plus margins by 2011?

Clay Jones

Well, I think the one thing – two things, I would say, we are looking for is one, we never know and that's what happened to pensions. We think there is more probably for tailwind to headwind, but you never know on interest rates.

I think the bigger one is going back to a normalized compensation program. As you know, we are about 40% of it in the incentive program this year. We are hoping to close that gap completely next year. But I would suggest that the biggest headwind that we will have that you can kind of count on is the compensation headwind, hopefully no worse than it was this year and depending on how we end the year, we'll see.

And then I think the other – always variable, Heidi, is what we do in research and development. Right now, we are not suggesting that it's going to be much greater, because typically we see some of the new starts being a little bit lower when we are in a trough cycle. But R&D is always a variable. Anything else?

Patrick Allen

Yes, the only thing I'd add, Heidi, is I think as we look forward, third quarter will probably be the trough margin from a total company – total segment operating margin perspective simply because of the San Jose impact that Clay and I have referred earlier in the call.

Heidi Wood – Morgan Stanley

Oh, that's helpful. Thank you. And then the – as we look at the evidence of the use in the traffic recovery, again, I want to make sure I understand your comments, Clay. Are you sort of intimating that you guys think that this is just rates uptick in 2011 or are you still thinking about 2012?

Clay Jones

No. Let me clear on what I said. I know they will increase this year. I strongly believe they will increase in '12. I don't know what's going to happen in '11.

Heidi Wood – Morgan Stanley

Okay.

Clay Jones

That – to me, that's where we are looking at the margin. If we see more aggressive recovery and we see people move from the used market into the new market as they become more attractive, they are – I'm holding out some possibility for some rate increase in '11, but that may not be the case if we don't see good order fill rates between now and the end of the year.

So my think – my thinking now is by the time we get to September and give our guidance, we will have a much better sense from the OEMs, how their success rate on applying orders into '11 is going to be and if that's good and better than we expect, I'm saying we could see some in '11. If not, then we will go back to – we'll see the bizjet OE recover in '12, which is I think the convention right now.

Now, let me – again, let me put a point on this. That's for, I'll say, the normalized market. We fully expect to grow in '11, because we will have some more market share gains coming into play in that year because of the success rate we've had and it's just the matter of the rate to grow.

Heidi Wood – Morgan Stanley

That's excellent. Thanks a lot, Clay.

Clay Jones

Sure.

Operator

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

Samuel Pearlstein – Wells Fargo

Good morning. I just wanted to go back to a question in Government Systems. You highlighted an increase in company-funded R&D. Can you talk about what that is just because my impression was that most of government would have been customer-funded, not company-funded?

Clay Jones

Yes, we do have a – certainly have a much larger mix of customer-funded R&D on the Government Systems side. I would say that there are two drivers and the biggest one is DataPath and the increase in research and development related to the DataPath acquisition. There was also a modest uptick in our company-funded R&D and that's just due to the nature of the research and development projects that are a little bit lumpy and so it was a little bit higher this period.

Samuel Pearlstein – Wells Fargo

Okay. And then Clay, just the comment you were talking about in terms of route structures and upgrades airlines are going to have to make, is that something where there is an existing order already? Is that something where you are in discussions and can you talk about how big of a factor that would be? I just – I'm just trying to visualize or think about airlines. It wouldn't seem like that's a huge number of people who are expanding and needing to make those upgrades.

Clay Jones

Well, first thing, the answer to your first question is both, some where we already have orders, some where we are into discussions. And the airlines are the ones that you would expect that are flying around the edge of the country, maybe flying from California into Alaska, flying from the Mainland into South America or into Caribbean where activity rate is picking and the meaningful – so let's look at it this way.

When your basic retrofit market has dried up as much as this one has, almost anything like that is a trend that's meaningful. And yes, it's a few million dollars, but on the margin, that's important trend information and getting us back into this more discretionary piece of the aftermarket.

Samuel Pearlstein – Wells Fargo

Okay. Thank you very much.

Operator

Your next question comes from the line of Joseph Campbell with Barclays Capital.

Joseph Campbell – Barclays Capital

Good morning. It's Joe Campbell and Carter Copeland. We would like to mirror Joe Nadol's "thanks for that new breakout of the Commercial data." That's very helpful and I wondered if we could ask sort of for all us whether we could get the balance of the 2009 quarterly offline rather than sort of getting it quarter at a time.

On to our question, you said that the uncertainty is how we transition from no-growth at our stabilization point for the OE build rates in 2010 to probably with a better certainty growth rates in 2012, but 2011 an unknown. How the Collins share gain sort of affect the way Collins will see the cycle compared to the overall market?

And I gather, but wanted to make sure that we have this right that you expect, as a result of the Collins share gains in all these six new programs where you've once – got product, that you will have overall a stronger cycle than the market as a whole and a higher peak and an earlier start than the market and that it will be better than last cycle. Is this – now, do we understand your expatiations right?

Clay Jones

I agree with everything you just said. Only thing I can't say is better than last cycle, because that depends on the rate of growth in aggregate, even though I think we will have the ability to outgrow the market there because of these incremental market share gains and attractive platforms that we are going to be on. I would agree with that. But the rate of growth obviously determined against the last cycle will be the only variable that could be at variance to what you are thinking. But everything else you said, I agree with, Joe.

Joseph Campbell – Barclays Capital

Clay, just one – thinking about the flip of this, are there some older jets where Collins has good positions where we might need to think about weakness in some of those product lines that might offset the share gains from these new wins that you are proud of?

Clay Jones

Well, I think in some of those areas, Joe, we are replacing ourselves. So – I mean, that could be an offsetting effect where it's not pure market share gain. There is a couple of those. Most notably, let's say look at Gulfstream when we cut into G250. At some point, we are cutting off the G200. Now, we have a little bit more content on the 250, so there is still net gain there, but that has a dampening effect in those few platforms where we are replacing ourselves. I would agree with that.

Joseph Campbell – Barclays Capital

So if we were to look at those six wins, which of them are replacing yourself?

Clay Jones

I don't have that at my fingertip, Joe. I'd have to go back through.

Patrick Allen

Yes. So if we talk about, for example, the Embraer Legacy platforms, those are pure all gain. I think that if we look at the Bombardier Global, we have – that's another aircraft like the G250 where we have additional content that we are putting in that's all gain.

Clay Jones

Now, that's all gain in the cockpit. Joe, I got to get back to you on that. The only one I know of off top of my head is the Gulfstream 250 and maybe Gulfstream –

Joseph Campbell – Barclays Capital

Well, what about other products that are just not – where it's – there is – it's not a case of gain or do we have some products that you are on that we might expect to be unusually weaker that are kind of dying off?

Clay Jones

I wouldn't say dying off. What you may see, I think, are less growth in those areas. There may be some aircraft that will be at a steady state and as a result of that, sort of steady state in their market cycle. You don't expect a big ramp-up or down in that. But probably better that we go do our research and come back to you offline, Joe, just because I hate to say something –

Joseph Campbell – Barclays Capital

Terrific. We'll get with Dan later in the day or early week.

Clay Jones

Right. Sorry we can’t –

Joseph Campbell – Barclays Capital

Thanks very much.

Operator

Your next question comes from the line of Carter Leake with Davenport & Company.

Carter Leake – Davenport & Company

Good morning. Most of my questions have been answered, but – and if you've already done this, please excuse me, but comments on NextGen equipage, just macro comments would be helpful.

Clay Jones

Well, first thing, we've got to have a NextGen before we can equip them and I think if you look at probably the – there is two or three things I would point to, some more soon than others. Actually, the – probably the soonest equipage we will have for air traffic upgrade is not NextGen, but it's Caesar [ph] in Europe.

There is a LINK 2000+ that is a data link mandate that's coming into Europe that will be in effect I believe, if my memory serves me correct, please don't hold me to this, around 2013 and the Europeans are offering an incentive to early equippers of that and so we may actually see some acceleration in data link equipage in Europe as a result of this impending mandate coming up there.

In the United States, the next big put for NextGen is going to be Automatic Dependent Surveillance-Broadcast, ADS-B. That probably won't begin to happen on the current plan until about 2014 or 2015 is the early implementation date with full implementation by 2020.

So we've got a little ways to go before that. That's a little frustrating. We hope that they could accelerate, there is a lot of discussion about accelerating it. But I don't think anything we can count on right now. And so that would be the next sort of big meaningful change in avionics that we see out in the future that's directly related to NextGen.

Carter Leake – Davenport & Company

Great. Thank you.

Clay Jones

Sure.

Operator

Your next question comes from the line of Richard Safran with Buckingham Research.

Richard Safran – Buckingham Research

Good morning.

Clay Jones

Good morning, Rich.

Richard Safran – Buckingham Research

Just wanted to ask a question on R&D. So Boeing, as you are aware, that in 2011 they expect R&D to drop. I wanted to know is there any spillover or impact to Rockwell. In other words, do you see, because Boeing programs are moving into maturity, because some of your other portfolio programs are moving to maturity, do you see your R&D falling off? If so, when do you see your peak?

Clay Jones

Well, again, we are much broader portfolio of R&D than Boeing has specifically, directly related to the Boeing programs that are referenced here, certainly on the 787 and the 7478, which are the big development programs they have. That R&D will drop significantly in 2011 and in fact for the 787, it's already at a fairly low rate and by the end of this year, the 7478 will have dropped off as well.

And so I don't think that's going to be a big driver for our R&D into the future, that being Boeing. And even if they re-engine their narrow bodies, we are expecting to get very little impact to the cockpit from that.

But the things that will drive our R&D in the next year are going to be the completion of the Fusion development, the application of both Fusion and the Venue cabin product into these business jet platforms that I've referred to several times that incrementally roll out over the next three or four years. That will probably be the largest commercial R&D element. And then right behind that is going to be the A350 at Airbus, which as you know, is still in very much in robust development. So I'd say those are the two driving influences for us.

Richard Safran – Buckingham Research

Okay. Thanks very much, that was helpful.

Clay Jones

Sure.

Operator

Your next question is a follow-up from comes from Howard Rubel with Jefferies & Company.

Howard Rubel – Jefferies & Company

I just had two radio questions, Clay. I figured you got to ask a JTRS question. I know there is progress. Could you discuss that? And then the senior executive radio contract, how is that spread out and does that sort of give you an open end at opportunity for long duration or is it very finite in nature?

Clay Jones

Well, on JTRS, the development continues to proceed at pace, we are in that testing phase that I talk to often and that testing phase will extend through the balance of this summer and then we will be preparing for a milestone next decision in the Pentagon whether to go into the low-rate initial production, which we still expect at the end of the year. There is really not a lot to say that's changed on that. There are no big issues that have come up. The development and the testing is still proceeding well and I think the drama there, if there is still remaining drama, we'll be continuing to watch the Defense budget and the affordability of all systems.

And so anybody doing business with the Defense budget – with the Defense Department and has got any new programs in the queue is being very watchful for the relative allocation of resources. And so that's the big watchword for us is to make sure that we keep that soul and keep developing it and that we move it into the next phase and then the rates will be what the rates are.

On SLC3S program, we do believe this has a longer life. Right now, it's going to be an upgrade of a number – basically, it's every VIP aircraft in the inventory, except Air Force One. The KC-135, the Gulfstreams, all of those are being reequipped with both communications equipment, video conferencing equipment, and cabin equipment to allow these very high government officials to stay in touch while they are in air.

It – I'm not exactly sure what the length of the contract is at the top of my mind, but we believe that, as always is the case, once you are on the aircraft with a major system as we know, communications equipment changes and needs to be replaced and we think that initial value of $200 million could grow substantially beyond that as we get into the improvement upgrade in ECP world with technology evolution.

Howard Rubel – Jefferies & Company

And Patrick, you kicked the R&D tax credit out of this year's numbers. So if we get a bill in October but before you report, would there be a subsequent adjustment or would this all just the benefit of 2010 be a large credit in 2011?

Patrick Allen

Yes, if it happens after our fiscal year-end but before we issue financial statements, it would be a 2011 event, Howard.

Howard Rubel – Jefferies & Company

Thank you.

Dan Swenson

Operator, I think we have time for one more call before we conclude today's announcement.

Operator

Yes, sir. Your final question is a follow-up from Cai von Rumohr with Cowen and Company.

Cai von Rumohr – Cowen and Company

Clay, could you give us some help in understanding what your commercial incremental margin might be in 2011?

Clay Jones

No. Again Cai, I'd love to be able to. I know there is a great deal of interest on 2011 because of the – I think the bullishness that we all feel for this market. But I think, again, it would be inappropriate for me with six more months to go and with the ambiguity around, some of the business jet OEM markets and just stuff that happens to get too far out in front of guidance that we will normally give you in September.

Cai von Rumohr – Cowen and Company

Okay, thank you.

Clay Jones

You bet. Thank you, all.

Dan Swenson

All right. Well, thank you, everyone. We plan to file our Form 10-Q in the next few days. So please be sure to see that document for additional notes and disclosures. Thank you for joining us and participating on today's conference call.

Operator

This concludes today's conference call. You may now disconnect.

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Source: Rockwell Collins, Inc. F2Q10 (Qtr End 03/31/10) Earnings Call Transcript
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