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Rockwell Collins Inc. (NYSE:COL)

F3Q10 (Qtr End 05/30/10) Earnings Call

July 16, 2010 09:00 am ET

Executives

Dan Swenson - VP of IR

Clay Jones - Chairman, President & CEO

Patrick Allen - SVP & CFO

Analysts

Peter Arment - Gleacher

Robert Spingarn - Credit Suisse

Carter Copeland - Barclays Capital

Ronald Epstein - Banc of America/Merrill Lynch

Myles Walton - Deutsche Bank

Joe Nadol - JPMorgan

George Shapiro - Access 342

Cai von Rumohr - Cowen and Company

Howard Rubel - Jefferies & Co.

David Strauss - UBS

Sam Pearlstein - Wells Fargo

Operator

Good morning and welcome to the Rockwell Collins third quarter fiscal year 2010 earnings conference call. (Operator Instructions). Today’s call is being recorded. For opening remarks and management introduction, 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 and good morning everyone. With me on the line this morning are Rockwell Collins’ Chairman, President and CEO, 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 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. Well today we get the opportunity to kick off the earnings season for the Aerospace and Defense Group. I have to say I’m pleased with the overall results and the general direction of our end markets. In a time of great volatility in the capital markets, uncertainty about the strength of economic recovery in the United States and around the globe and the potential impacts of tightening government budgets worldwide, predictions are very difficult to make and much more difficult to realize. However, to this point of our fiscal year, we’re performing to the guidance we set back in September 2009.

And the second half of this fiscal year is on track and it has come in even stronger than the second half of 2009, as we turn the corner to recovery in our commercial markets and continue to make steady progress in our defense business.

Looking to the financial highlights of the third quarter as predicted, we saw growth across both businesses, with Government Systems and Commercial Systems posting year-over-year growth in revenues. Government Systems saw a very robust year-over-year growth of 16%. And importantly, organic growth in the third quarter was 11% driven primarily by growth opportunities in our Surface Solutions portfolio.

Commercial Systems’ revenue increased over 6%, its first quarter of year-over-year growth since the fourth quarter of 2008 thanks to sales increases with OEM customers and significant growth in our business and regional jet aftermarket.

With an increase in revenues from the second to the third quarter, we were also able to grow total segment operating profit on a sequential basis from $219 million in the second quarter to $228 million this quarter. And as an additional financial highlight, we continue to generate very strong cash flow from operations of $440 million through the first nine months of 2010 as compared to $381 million at this point in 2009.

As a result of this strong performance and confidence in our outlook for the fourth quarter, we’re updating our guidance with expectations for full year revenues of about $4.7 billion, combined segment operating margins of about 19%, EPS of about $3.50 a share and operating cash flow of about $700 million.

Now, for as many things as we correctly call this year, there have been a few areas where our predictions have not played out exactly as expected. Within Commercial Systems as an example, even prior to the beginning of our fiscal year, we made an assumption that Boeing and Airbus would reduce their narrow-body production rates. Of course, that hasn’t happened. And instead, they put in place plans to increase those production rates. And there’s been other welcome good news from the OEM market sector. We have seen the benefits of beginning 787 shipments and higher year-over-year deliveries as Boeing created lift in air transport systems.

We’ve also seen shipments for Chinese aircraft and market share gains with the Cessna CJ4, creating some positive impact in an otherwise depressed business and regional OEM market.

Now let me remind you, about 50% of our total commercial revenue is OEM related and the strength in this area has helped offset a delay in the recovery of our air transport aftermarket business. Now, since I know that there is both high interest and great expectations surrounding this air transport aftermarket recovery, let me add some important color from our perspective.

We’ve all seen an abundance of market data that shows passenger traffic is experiencing a very robust recovery with an accelerating trend. That acceleration has led us to increase our calendar year traffic growth assumptions from about 3% previously to between 4% and 5% now. This is very good news and considering past cycle impacts should be an important leading indicator for growth in the air transport aftermarket.

I believe this is still the case. However, at this point in this recovery cycle we have under appreciated the level of rigor in which the airlines manage their capacity and accommodated the greater demand through higher load factors and higher utilization of their most efficient aircraft. And as we look at more of a Rockwell Collin specific fiscal year view of the data, we see that while traffic is up 2.3% over the first nine months of our fiscal year, airlines have absorbed this demand while actually reducing supply or available seat miles a few percentage points.

This phenomena has occurred around the globe and as a result load factors are at historically high levels, such as in the United States where the average is now running around 85%. For example, Delta has recently said that in June, its planes flew almost 88% full and even though they have seen year-to-date traffic up modestly, their capacity has actually fallen by 2.4%.

So as a result, aircraft miles flown have been down year-to-date, primarily from reduction in utilization of out-of-warranty aircraft. In addition to these operational economies, airlines are also still spending less on discretionary retrofit programs relative to last year, when several programs were in place and winding down.

The net result of all these conditions was a decline in year-over-year air transport aftermarket revenues in Q3 with the primary impact coming from that discretionary retrofit segment.

For some added color though, if you strip out that discretionary component of the aftermarket and the in-flight entertainment service revenues which is now strategically not aligned with our ongoing business, the non-discretionary core avionics service and support was actually up by 10% in the air transport segment. But of course, it was not enough to offset those other declines.

Now, the silver lining to all this is that the air transport aftermarket recovery is inevitable and it’s only been delayed by these actions. Based on our current order activity, we expect significant improvements in this fourth quarter which should extend and accelerate through 2011.

Now, let me turn briefly to government systems expectations. We originally called for 12% growth with half from DataPath and half organically. Here again the top line number was correct, but the mix change thanks to a bit more growth of DataPath offsetting lower organic growth from program delays throughout the year has shifted. These delays were from multiple sources such as the extended source selection process for the KC-X tanker, the C-130 AMP Nunn-McCurdy review and the protest of our recently won [slickest] program that we announced last quarter.

So now as we enter this last quarter of our fiscal 2010, both your and my attention turns increasingly to what these varying and at times unpredictable trends mean for our business in 2011. So let me share here some thoughts with you.

First as the largest part of our business, we are watchful of government systems and the dynamics playing out in its addressed markets. Certainly, there has been a heightened level of concern created around the funding profiles of various defense departments both here in the United States and particularly in Europe. However, we do feel that our broad product reach across multiple platforms and the attractiveness of electronic upgrades in legacy platforms has us positioned well for these more austere times.

As an example, Italy has been one of the countries under enormous pressure to cut their defense spending profile. And they’ve announced plans to do so in area such as ship building and acquisition plans for fighter aircraft. But they have made very public statements in support of helicopter programs which is a key product area is very meaningful to our business.

And in the United States, the focus has been on holding defense contractors much more accountable via greater use of fixed price contracts, again an area that plays well to our focus on bringing a commercially oriented approach to the operation of our government system’s business.

In the commercial system segment, the dynamics playing out today actually create opportunities for 2001. The delay we’ve seen in the start of the air transport after market recovery places more of that growth into 2011, and we should see a lift in the MRO services that comes from greater utilization of out of warranty aircraft and capacity expansion once the airlines reach that maximum absorption point on load factors. Plus we expect to see some release of pent-up demand for discretionary retrofits and upgrades which enable lease aircraft to realize greater operational efficiencies. The commercial systems OEM sector is poised to be an area of strength for 2011 and beyond, and air transport systems will see growth from a full year of delivery of 787 ship sets, the start of shipments on the 787-478 and an increase in the 777 production rates. And while we believe 2011 will be a challenging year in terms of overall business jet production deliveries, we have been emphasizing for some time the market share gains which will be realized over the next several years. This is an area that’s been of interest to a number of you and as sort of a way of sizing what this could mean to Rockwell Collins, we’ve estimated that if the business jet market were to recover to achieve a delivery rate of about 7% over the next five years, which is our estimate, our business jet OEM revenues could grow at a rate of 14%, clearly a differentiating point for our company. So with summary let me now turn the call over to Patrick for a review of the financial. Pat?

Patrick Allen

Thanks, Clay, and good morning to everyone as well. Let’s get started by reviewing our results for the total company that are shown on slides 3 and 4. Total company sales for the quarter increased 12% compared to last year's sales, while net income and earnings per share both decreased 2%. This decrease in net income and earnings per share came primarily from higher employee incentive compensation and pension expenses.

An item of note here and for the full year guidance is the impact of changes during the quarter in our accrual rates for incentive compensation. Through the second quarter of 2010, we were accruing to an incentive compensation path of about $40 million for the full year or about $10 million per quarter. Given the strong performance against our cash flow metrics, we are now on track to have an incentive compensation payout of about $60 million for the full year. As a result of this increase, we saw a sequential ramp-up in our incentive accrual, a little over $10 million from the second quarter to the third quarter. Based upon our current guidance for sales, EPS and cash flow, we should see about $20 million of incentive compensation expense in the fourth quarter.

Our effective tax rate for the quarter declined from 32.6% in the third quarter of 2009 to 30.7% in the third quarter of 2010. This rate decrease was due to the favorable impacts of tax benefits from prior year’s tax returns which were partially offset by the absence of the Federal Research and Development Tax Credit which expired on December 31, 2009.

Turning to slides 5 and 6, we take a look at the third quarter results of our Government Systems business, which achieved a revenue increase of 16% from $651 million in 2009 to $754 million in 2010. Airborne Solutions sales increased $8 million or 2% to $460 million. This growth came from an $18 million increase in tanker and transport program revenues, which was partially offset by a decrease of $15 million in fighter jet program revenues.

Surface Solutions sales increased $95 million or 48% to $294 million. Incremental April and May sales from the acquisition of DataPath contributed $34 million. Our organic sales increased $61 million, primarily due to the integrated vehicle electronic systems for the California highway patrol and from increases across a number of international programs.

Page 6 shows Government Systems’ third quarter operating earnings, which decreased 3% from $158 million in 2009 to $153 million in 2010, while operating margins declined from 24.3% to 20.3%. The decrease in operating earnings and margins was primarily due to higher employee incentive compensation and pension expenses, transition costs related to the San Jose, California facility shutdown and higher research and development expenditures. These were partially offset as a benefit of a favorable contract adjustment, a reduction in warranty expenses and incremental earnings on higher revenues.

Moving to page 7. Commercial Systems' third quarter revenues were up 6% from $433 million in 2009 to $460 million in 2010. Sales related to aircraft original equipment manufacturers increased $29 million or 14% to $240 million. Air transport OEM sales increased $23 million or 25%, primarily due to higher revenues to Boeing, as a result of the absence of last year’s post-strike inventory rationalization and from higher 787 program revenues.

Business/Regional OEM sales increased $6 million or 5%, primarily due to higher equipment sales for Chinese Turbo-Prop Aircraft. Aftermarket sales increased $11 million or 6% to $210 million. Aftermarket sales to the air transport market declined $15 million or 12% from lower retrofits and spares revenues and a reduction in wide-body IFE service related revenue, which were partially offset by an increase in our core avionics MRO and service related revenues. Aftermarket sales in the business and regional jet market increased $26 million or 38%. As Air Routing sales contributed $9 million to revenue growth, while organic sales increased $17 million due to a general increase in service, retrofit and spare sales, including some large spare part orders associated with Project Liberty border patrol aircraft program. Finally, revenues related to wide-body in-flight entertainment products decreased $13 million to $10 million.

On page 8, you see Commercial Systems' operating earnings were flat at $75 million; our operating margins declined from 17.3% of sales with a three months ended June 30, 2009 to 16.3% of sales for the three months ended June 30, 2010. The reduction in operating margins is primarily due to an increase in employee incentive composition pension expenses, offsetting the incremental earnings in the higher records.

On slide 9, we have our nine-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 $381 million in 2009 to $440 million in 2010. The main drivers here were lower compensation payments made in 2010 related to the elimination of employee incentive compensation during 2009, as well as overall disciplined working capital management.

Moving to slide 10, we showed the status of our capital structure. As of the end of third quarter we had $22 million in short-term borrowings and $516 million in long-term debt outstanding as compared to no short-term borrowings and $532 million of long-term debt at the end of fiscal year 2009. Ending the quarter we had a debt-to-total capital ratio of 25%, 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 third quarter is detailed on slide 11. During the quarter, we repurchased a total of 845,000 shares, an average cost of $60.17 per share. This brings our total share repurchase activity since 2002 to just over $56 million shares or $2.6 billion return to share owners through maintaining an active share repurchase program.

Now onto our final slide, slide 12. We will provide the details of our fiscal year 2010 financial guidance. We are updating several components of our guidance today to point towards the middle or upper end of our prior ranges. We expect total revenues for 2010 of about $4.7 billion.

In Commercial Systems, we anticipate fiscal year revenues to be down about 4% from 2009. Though a little bit lower than the 3% decline we expected previously primarily due to the slower than expected recovery in the air transport aftermarket and the impact of the declines we’d experienced in IFE service revenues.

In Government Systems, we continue to expect full year revenue growth of about 12%. About 5% organic growth and the remainder from the acquisition related revenues have already seen from DataPath.

From a margin perspective, we are narrowing our guidance to point towards total segment operating margins of about 19%. As the higher accruals received for incentive compensation related to our strong cash flow are somewhat offsetting the earnings flow and the expected revenue growth.

Total research development expenditures are currently forecasting about $850 million. The decrease from our prior guidance of $870 to $900 million is due to lower customer funded development programs we’ve seen during the year. Company-funded research and development is still expected to be about 7% of total company sales.

On earnings per share, I would point out that the guidance of $3.50, continues to be based on an effective tax rate in the range of 30% to 31%, and as before that rate assumes that the Federal R&D Tax Credit is not renewed by the end of our fiscal year. If it where to be passed before the end of our fiscal year, the R&D Tax Credit will represent a benefit of about two percentage points to our tax rate or about $0.08 per share to our EPS guidance.

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

Dan Swenson

Thanks Patrick. In order to give everyone the opportunity to ask questions, we ask that you limit your questions to two per caller. If you have further questions, simply reinsert yourself into the queue and we will answer those questions as time permits. Operator, we are now ready to open the lines.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Peter Arment with Gleacher.

Peter Arment - Gleacher

Good morning, Clay, Patrick, Dan. Thanks for the color on the Q3 drop in air transport aftermarket Clay. Can you give us I guess a little more color on where the strength is being generated regarding the orders, is it primarily international carriers in maybe Asia or Middle East and how do the US and European carrier stack up at the moment?

Clay Jones

You are exactly right Peter, in the areas where you would expect to see strength. Obviously international traffic has been higher than that 4% to 5% I talked about. I think Iona is talking about around 7% plus, so we are seeing those international carriers begin to bring some orders in. Asia, who was leading us out of this, so you are right the Asian orders are very good.

We are not very strong in North America or Europe where the domestic traffic has been relatively less strong than the others, and where as I said the load factors have been the absolute highest in North America and specifically in United States. And so, as that kind of works itself through, we see strength in those areas you’ve mentioned and we expect ultimately to see those other theaters begin to come in as they saturate the existing newer aircraft and they can only fill them up so much. And at some point, I think we are all waiting to see what that point is. Then they are going to have to bring on more utilized, more out-of-warranty aircraft, that helps us, and then ultimately we’ll see the flight hours begin to increase. And since our basic MRO is attached to meantime between players, we have to have time on the aircraft to have that correlative effect to flow through our service centers.

Peter Arment - Gleacher

Okay, and then just one follow-up, if I could. Have you seen any change in the aftermarket activity in the last two months in Europe, either biz jet owners or completion houses, or any of your major airline customers regarding programs or retrofits?

Clay Jones

Well I could put some more color on that. First thing you mentioned business jet; the whole business jet aftermarket is reacting as a normal cycle would react. We’ve seen dramatic increases in business jet utilization rates, since last summer and we’re seeing it tend at our MRO flow as a result of that.

Moreover, we’re seeing people who are now using those aircraft, actually go back into and upgrade those aircraft for greater efficiencies. And so both, our, I call it basic MRO flow as well as the retrofits seem to be going pretty well, and the completion houses are actually at good volume. So, we think that will continue in that area.

In Europe, we’re seeing a couple effects. We’re seeing the relatively lower domestic travel, again using things like load factors and utilization rates just as here in Unites States. Obviously we had the unique experiences last quarter of the volcano which probably knocked off a couple of million dollars of our service revenue. We didn’t casual it because these other things are much bigger but that was a factor in there in some of those and so that had an effect in Europe this quarter as well. But we are beginning to see more flow as I referred to in my opening remarks. And so the way I would put it as opposed to the way I’ve been talking to you this whole year, as we probably set the recovery over by a quarter, we had clearly expected to see some of that affected by this quarter based on the traffic flow and increase. What we did not expect is the utilization rates by the airlines and the load factors to absorb as much as they did. We believe we are about at that saturation point and now we will begin to see even improving aftermarket growth in our fourth quarter and of course on in 2011.

Operator

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

Robert Spingarn - Credit Suisse

Clay, a follow up to last one and then something else. The airline customers, you know you talked about the discipline on the capacity and grounding aircraft that need heavy checks and someone flying without, but it still seems like it’s a big mystery. We’ll have to wait and see what they do. What are the customers telling your sales people?

Clay Jones

Well, I don’t think it’s as much a mystery today Rob as it was three months ago. We were hearing from them that they believe there is too much capacity and therefore they are managing that capacity. We didn’t know exactly how they are going to do it, they didn’t outline all their strategies to us, but they were clearly telling us they still believe there was too much capacity to get the yields and the profitability that they needed to have.

Well guess what, in the last three months, they have executed I think a very adroit plan to do exactly that. And all of you I think have reported on the fact that the capacity has not kept pace with the traffic and therefore they are in fact managing to be able to command higher prices, which gives higher yields, which puts them back in a better profitability. And again, all the indications we see are that’s exactly the effect that they’re doing.

And so what they had been telling us is this, quite concisely, is, we’re probably not going to go in and retrofit our airplanes until we get back to that yield and profitability. We sort of expected that for the year, right? And then what they’re saying is, if I don’t fly the airplanes, I’m not going to bring you and your service center a broken part. And they don’t tell us anything about that until it arrives on the dock. So it’s not as if they sit and forecast for us what they need to do in terms of basic MRO, but they will talk to us relevant to these retrofits and spare parts. And again, they don’t need the spare parts, if they are not flying the out-of-warranty aircraft any heavier than they are right now. So, it’s a good strategy for the airlines. I think if I were them I’d do the exact same thing. It will make them healthier and in the long term, we will benefit from it, but it’s just sliding to the right.

Robert Spingarn - Credit Suisse

Okay and then the second one, thank you for that. The second one I guess is for Patrick, and you touched on this earlier, but you’re margin guidance implies a declining trend as we progress through the year and I guess some of that reflects one-offs in the beginning of the year that pushed margins up but I’m looking at about 18.5% in Q4, do you have any relief from the conclusion of San Jose in there or no?

Patrick Allen

Rob, there might be a little bit of the San Jose release, not a lot. I think we are still seeing some of the costs flow through inventory and through cost of sales. So, I’m going to say San Jose is probably about a net neutral. The biggest impact probably first half to second half from a margin perspective is the incentive compensation. We are going up about $20 million first half to second half, that’s probably the biggest impact on margins we are seeing right now.

Clay Jones

Let me speak, Rob, to that, just to make sure there is color by everyone on the call. To me, our incentive compensation this year is the best form of pay for performance and is indicative what I think is responsible corporate governance. As you all know because of this transition, we did not put back in place a full incentive compensation program. We set it at about 40% of what normal would be. But we put an accelerator on it that said listen, for our employees, if you meet the commitments we've made to our share owners and now all of a sudden if you start generating additional sales and profitability, we are going to share that with you, the employees at a greater rate.

So we meet our commitments to share owners first and then we backend load that, and that’s the affect that you are seeing now that we are seeing cash flow will be in higher and we will be seeing revenue being at least as good as we want to and all the good work they are doing on profitability, so that is going to be shared with employees and therefore we are going to hopefully pay out to them at a higher level of incentive compensation. And I think that’s a sound way to structure it, but the effect of that is what you picked up, Rob, and that is a dampening effect on order margins in the back half as we see this accelerating affect.

Operator

Your next question comes from the line of Carter Copeland with Barclays Capital.

Carter Copeland - Barclays Capital

I'm wondering if you would switch gears for a second and shift to defense; two questions, the first Clay, it looks like the sack mark on the fiscal 2011 budget is about $8 billion down. Is there anything in there that impacts you in that mark?

Clay Jones

We don’t think there is anything at all, nothing that would be a material event.

Carter Copeland - Barclays Capital

And another one and I know these things are sometimes difficult to parse, but when you look at the stuff you are shipping into theater and I am thinking less things like DAGRs and ARC-210s which you have been very good about calling out with the clients there, but I am thinking more in terms of spare parts on rotary wing and fixed wing aircrafts, what sort of trends are you seeing in the stuff you are shipping to theater.

Clay Jones

Well I can’t say that we have great color on that, Carter but I would answer the question by saying other than those unique replaceable items that you just mentioned; DAGRs and ARC-210s which are the ones that typically are impacted by supplemental appropriations, we are not seeing a lot of that. Most of our real high dollar revenue is going to come, not from the spare part we ship in to the theater because most likely what we are doing is we are going that to a depot and then they are shipping it out and so we are a little bit dis-intermediated unless their inventories spike.

And we are not seeing any inordinant change one way or the other and I will say depot inventories. But where we are going to get it is when they actually bring the helicopter back out of theater and they want to reset it by doing the major cockpit upgrade by putting the CAAS cockpit in it or resetting it because we haven’t seen a great deal of that quite yet to bring the troops, but not all our equipment, we’re seeing no significant flow one way or the other.

Operator

Your next question comes from the line of Ron Epstein with Banc of America.

Ronald Epstein - Banc of America/Merrill Lynch

Clay, two questions for you, my first one, when you look at the new GE AVIC AV, how do you think about that? Are they trying to create a new competitor here or how does that change the avionics landscape?

Clay Jones

I think clearly they are trying to move into the avionics realm and I would class them not as a new competitor but as an existing competitor. They were a competitor when they were Smiths and they are still selling the similar product, now that they are under the GE mantra. I think what they have done in China, I think is the more interesting question to answer because they are doing what every other system supplier is doing and they are seeing a potential new market, and they want to establish the beachhead in that new market. And it’s not just them; it’s every single one of us are over there. I can’t speak for them or their strategy, I’ll let them answer that, but I can’t speak to ours.

We’ve been in China for over 25 years. We have great relationship with all the airlines, where we have been selling equipment. We did co-production and joint ventures 15 years ago for things like TCAS and weather radar parts. And as you all know we’re the avionics integrator on the ARJ21, which is flying now and we just announced this week, we’ve been selected for Comm/Nav and surveillance components of the 919s. So, everybody is trying to get a piece of that action. We’ve got ours, they have got theirs, and you will see how in the long term that develops.

Ronald Epstein - Banc of America/Merrill Lynch

One more question unrelated, what do you think what the FAA NextGen opportunity for Collins, I mean how do you think about the size of that? How should we think about it?

Clay Jones

Well I think you should think about it as a long-term growth opportunity and I say that because it’s going to be a long time that we see NextGen developing. First I am a huge supporter of NextGen. I think the country, the world and the industry needs it to continue to grow, both economically and within our space. I fear it’s going a little, way too slow, the technology is ready, it’s just that the procedures, policy makers and the legislators aren’t quite ready to move ahead with it, but we do have a plan, implementation plan, we have an architecture, we have technology readiness and so there is momentum moving on, but if you look at the next big opportunity which is Automatic Dependent Surveillance Broadcast you know that won’t really be initially implemented until 2015 and it won’t go into full implementation 2020 and so we will sell products that is both compatible with and upgrades to that over the next decade. And along with that behind it we will have datacomms, Data Link communications that will begin going in place over that same decade.

So I would say over the next 10 years of the growth opportunity, we will be in the middle of it for sure, but you will have to patient to see it come around.

Operator

Your next question comes from the line of Myles Walton with Deutsche Bank.

Myles Walton - Deutsche Bank

If you look at the air transport aftermarket and Clay you mentioned the non-discretionary aftermarket up 10% was that in line with your expectations and also how large is that relative to air transport aftermarket?

Clay Jones

Giving the answer to the second question but while you’re looking it up, I would say it was probably a little short of our expectation, because of that phenomenon, that I mentioned before, higher utilization of in-warranty aircraft meaning less flow through there, and less flight hours flown, we would have thought at the beginning of the year that that number would have been higher. It’s still an encouraging number because it’s growing in double-digits, but we would have hoped that it would be higher.

Patrick Allen

And Myles, in terms of the total amount it’s about half of the total, it’s when you strip out the IFE service revenue and the retrofits and spares, what’s remaining is about half.

Myles Walton - Deutsche Bank

What is now that the expectation for the full year within air transport aftermarket, I know you said it was improving to the forth quarter, but obviously the prior comment has to be relooked at, so, what is kind of the outlook for air transports aftermarket full year?

Patrick Allen

It’s down roughly, down about 4% for the full year, so it implies roughly about a 10% growth rate in the fourth quarter.

Myles Walton - Deutsche Bank

And then the other questions the CHIPS impact in the third quarter, obviously a pretty nice boost. Can you describe the size of that program and the longevity and the contribution to the organic growth in the quarter?

Patrick Allen

I would tell you that I think we saw that the bulk of the benefit in the third quarter, we’ll see a little bit in the fourth quarter, but it’s fairly short-lived program as it exists today. However, there is potential on a follow-on orders.

Clay Jones

We are obviously moving into that, and to remind you of our strategy; a lot of this technology work came out of the canceled Future Combat System, where we are working on ground vehicles. And along the way California Highway Patrol also popped up and we said, look what we can do for you and they liked it. And so this has kind of got us looking at a sector that probably two years ago we’d even think about which is this public safety because we got such an attractive product and no one else seems to be in that space. So adding California Highway Patrol, the largest law enforcement agency in the country and having credential there allow us to get into the Royal Canadian Mountain Police doing the same thing.

And so we believe, overtime there are follow-on opportunities, maybe not at that scale but as we demonstrate this we are getting a lot of buzz at these trade shows, we are finding out that how these folks go to them. And so we think there is a follow-on to other municipalities wanting this kind of product. Moreover, once you get it installed like everything else, they want to do an upgrade. So right now they are going to buy new motorcycles and they want the motorcycles not have the full system, but they want to have interconnectivity of this, so we are involved in doing that.

So I think this is going to be a tidy little growth business. I think as Pat said we saw a big kind of bubble go through in the third quarter because frankly we had some delayed shipments from second quarter that bounced into there and you have to kind of take this amount and maybe spread it over second and third quarter to get realistic, what it should have been. But I think it could be a nice little growth business for us.

Operator

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

Joe Nadol - JPMorgan

I want to dive back into at transport aftermarket just on Myles’s question there, so half of this business is now what you consider to be non-discretionary but what was that because one would think the discretionary pieces of business is off, fairly significantly in the last couple of years, was the discretionary piece that big to go back two years or how do we think about that?

Patrick Allen

Let me just clarify something Joe, half of it is either discretionary or IFE service related. And so to think about that bucket that 50% be at about half and half, half IFE service and about half discretionary, so discretionary is really about a quarter of the total.

Joe Nadol - JPMorgan

Okay. What was that maybe two years ago before the downturn?

Patrick Allen

No, it says it may have been 40% of the total.

Clay Jones

One other thing, Joe, just again to put color on this, remember what we say about that discretionary piece; it’s always very lumpy whereas the non-discretionary, you can kind of go back and see kind of a steady flow and it doesn’t change all that much. The discretionary piece comes and goes with programs that we contract with. So it is the lumpiest thing that we do. As I tried to mention there, a year ago, even though when we were in the midst of the downturn, there were already committed programs that we had that probably raised that to a level for the environment at the time that was all higher than expected.

Now we are going into an environment which is a little lower than we expect because they haven’t entered into any of these contracts, because it typically takes maybe several quarters from contract signing to actually retrofitting whatever we are doing.

And so there have been nobody going into periods here putting new upgrades into place, so we are kind of waiting for the pig to go through the python here in an opposite direction and as they get profitable they are into it. So I think we saw a year-over-year comparator that was particularly unattractive.

Joe Nadol - JPMorgan

Okay. And then just a couple of quickies which I’ll give you both at once. DataPath was down a little bit sequentially, I know it’s beat this year but I’m wondering if you are seeing any beginnings of a decline in the service related revenues there in theater? And then any color you can give since the press release that has just come out over the past couple of weeks on where we are looking at in terms on content per shipset on the 919 if you have a sense yet. Thanks.

Patrick Allen

Let me answer that DataPath question. The number we disclosed for DataPath was really just the acquisition related revenues, so we acquired in June of 2009 and so what we disclosed Joe was April and May’s revenues. So it doesn’t imply necessarily that DataPath was up or down sequentially because it was only two-thirds of the quarter.

Joe Nadol - JPMorgan

That was 27 a year ago, so if add it together, you still get below where you were the last three quarters.

Patrick Allen

It was $27 million in June of ‘09.

Clay Jones

We didn’t disclose June of ‘10.

Joe Nadol - JPMorgan

Okay, well.

Clay Jones

Why don’t we get back to you on that, Joe, because we ought to give a due diligence here to make sure we are giving you the right numbers. On the second question, we have not disclosed the content, we do have a good idea what the content is but like we do on all of our commercial programs we rarely disclose that, but I will give you, I think an interesting tip there. There was a bunch of articles out yesterday and today where there’s great discussion about this growing new narrow body market that’s coming internationally. The Chinese have a program, the Canadians have a program, the Russians have a program, obviously we are on all three of those other programs. And what I can tell you is our content per aircraft on the CSeries at Bombardier, on the MC21 in Russia and on the 919 in China is higher than any of the narrow bodies that Boeing and Airbus have.

So we're extremely well positioned I think out in the future however that market share changes out, and I think that speaks to the ubiquity of our company and the success we've had over the last five years with this technology investment positioning within the industry as hopefully a best of breed contractor. So as I said we are not giving any specific number but we are very pleased with the number we have.

Operator

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

George Shapiro - Access 342

The business jet aftermarket being up 25% year-over-year I mean was also up 22% sequentially. I mean was there anything that different sequentially that you saw? I mean obviously cycles were better but did something standout and also was there any link to the low end or the middle end, if you could expand on that?

Clay Jones

Well, probably the biggest single, I'll say accelerator of that was Project Liberty where we had about I think $7 million incrementally this quarter in those turbo prop aircraft, I think they are King Air derivatives, that are going into the theater. And so that was I'd say maybe the singular accelerator, George. Everything else was stuff that we normally do, both MRO, I would say significant upgrade opportunities which I think are as we had predicted, people who were trying to sell the airplanes are trying to position them to sell. People who buy the new airplanes are upgrading them for more efficiency. And we have a lot of products that we’re pushing through there, including things like WAAS LPV and some of the air traffic improvements that some of these aircraft need. So I think we’re sort of across the board as now we’re seeing some churn, and basically improved utility of these aircraft.

George Shapiro - Access 342

And you’d expect the fourth quarter to be higher?

Dan Swenson

I don’t think I gave guidance for the fourth quarter.

Clay Jones

Well, here’s what I expect, I expect the whole commercial aftermarket to be higher, and so it’s in there.

Dan Swenson

And I would say, yes, we are expecting it to be higher, right?

Clay Jones

Yes, sequentially higher, yes.

George Shapiro - Access 342

And then a couple of quick ones for Patrick, can you quantify the San Jose and favorable adjustment in the government business, or they were offsetting or what?

Patrick Allen

Yes, they were about the same, George. They were about $5 million each, the San Jose unfavorable and the favorable contract adjustment virtually offset.

Dan Swenson

Just one point of clarification on the business jet aftermarket, we expect to sequentially as we move into the fourth quarter that’s probably down. But I think as you look at the full company guidance for aftermarket, we’re seeing full aftermarket, probably up in the mid teens.

George Shapiro - Access 342

And then, Patrick, just another quick one. Compensation expense was about $100 million pre-recession. Is there any chance to get back there next year if you would meet all of your goals, or that’s still a couple of years out?

Patrick Allen

I would say this, George. That’s what we would plan on, is that it would go up to $100 million of incentive compensation. So, I guess the good news with respect to the incremental incentive compensation we'll book in this year as our headwind becomes that much lighter going into 2011.

Operator

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

Cai von Rumohr - Cowen and Company

So pension, we’ve had a tough stock market, the discount rate is down, I know at one point you are looking for pension to be a favorable swing next year. Maybe update us as to where you are year-to-date on the pension and some general thoughts, color on where it might go next year?

Patrick Allen

The best way I would handicap it right now is we are probably not seeing much of a benefit at all from the discount rate or from asset returns. If I was to peg it today and we haven’t done a valuation of course but it if I was to peg it today, I’d say we are probably about flat from a pension expense perspective.

Cai von Rumohr - Cowen and Company

And the $10 million sequential improvement in incentive comp, how's that split between your two businesses? And actually you know to follow-up on George’s point, it’s less of a negative next year, actually given you are going at an 18 million run-rate in the third and the fourth quarter, it’s relatively small. You know it looks like negligible, it's 20 million negative versus that run-rate and should essentially offset that with the San Jose plus, is that correct?

Patrick Allen

I think you are absolutely right. If you compare it to the back half of the year, the incremental headwind would be about $20 million. And as it breaks out between Government Systems, Commercial Systems and General Corporate net, about 10% goes to General Corporate net; probably about 55%, Government System; about 45% going to Commercial Systems.

Operator

Your next question comes from the line of Howard Rubel with Jefferies.

Howard Rubel - Jefferies & Co.

First, could you address, Clay, bookings in the Government business and could you talk about both your competitive advantage with some of these proposals that the Defense Department is alluding to or trying to implement and how you might see this play out?

Clay Jones

For us bookings are hard to equate. As you know we typically don’t talk about backlog because when we win an instant contract, it may be $15 million on a $200 million order long term. So unlike some of the big OEM primes that book these large programs, backlog is not a real meaningful measure of what we have done. But what I will say is the vast majority of what we do are just ins and outs, follows on from the roughly 2,000 contracts we have under administration at any one time, where we’re getting more ARC-210s, more DAGRs, more datalinks, those types of things. And those bookings have gone okay, they have gone okay. Where we've been frustrated and I mentioned it in there, are some of the relative delays we have seen in some of the major new start programs. I mentioned three of them, I won’t repeat them in my opening statement. For example, we are seeing JTRS move to the right as the development and test program goes along. Now my guess is, it would be probably middle of next fiscal year when we get a production go-ahead rather than at the end of this calendar year as we’d earlier hoped.

The tanker program, that anybody’s guess, but we are hoping that this fall will see an order there. Those are the things that I think that we're waiting to see that gives us in the overall bookings, a little bit more anxiety about when things are going to happen.

Now to the second question, we really like our chances in this sort of changing landscape that we see in the Department of Defense. So, when you have this form of defense coming out saying we need billions of dollars of savings. Well, I think we are very well positioned to try to help them think about how to do that. And there’s a lot of overhead in the procurement systems, today. And there are a lot of non-commercial practices in the business department today that we believe we have ways to streamline for them.

And so our position, as a primarily, commercially-oriented contractor, as one who does about 80% of our business on fixed price contracting today. We are very comfortable in that environment, and I think we will be able to move and shift in the direction of Defense Department wants, just like we did with open systems architectures. We introduced those into the department, and they are already citing that as one way they are going to get more future efficiencies. But we are already there. We have a product there.

So, I won’t repeat the whole story here, but I think this movement in a particular reform, plays right into our wheelhouse.

Howard Rubel - Jefferies & Co.

And so, when you net the regular and ordinary business like DAGRs and ARC-210s, and so on with some of the delays the growth rates that you’ve experienced in Defense are probably, at best mid-single digits, for a while, is that fair?

Clay Jones

That’s fair.

Howard Rubel - Jefferies & Co.

And then finally just as a follow-on, your supply base needs to adjust to the change and the acceleration in the market. Are you seeing any shortages, or how are you managing that change to make sure that after this [moribund] period of demand that you are going to be able to get which you need and respond to your customers.

Clay Jones

We are not seeing any supply problems at all at the current time. Obviously, we use a lot of local suppliers, every once in a while we are using Intel or somebody like that for processors and things like that or Sharp for liquid crystal displays. But there is plain capacity in those markets, plain foundries to do that. The only thing that I have got my eye on is that because everyone has lower capacities in general and they have been reluctant to put capital at play and this is across all industries, not just ours.

If we do get a roaring recovery, I think the next thing you will hear about is what we heard about back in the middle of the last decade capacity matching to that growth. That’s a high class problem that I hope we have Howard, we don’t have that problem today. Don’t see it happening in the next couple of years.

Operator

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

David Strauss - UBS

Clay you talked about the upside that you have in your business chapters in the next couple of years bringing about 7% above the market rate. You talked about all the platforms on the air transport side. We have content; could you give us any sort of quantification of how much above the air transport market rate do you think your business can grow?

Clay Jones

I probably could but I don’t have that at my finger tips right now, David. I think again if you look at that same five-year period, I can tell you notionally, we have share gain coming in from 787, 7478, 8350 when it comes down around 13 will add to that, CSeries will add to that if you put down it in there. So, without giving your number just because I don’t have it ready, I believe we are in the same environments in the air transport side with those platforms I mentioned that are going to be all entering into production over the next five years.

David Strauss - UBS

And then you have given out the number, I just want to make sure on the aftermarket for the [fourth quarter] I am clear, you are talking about mid-teens year-over-year growth including but that includes business to regional kind of flat sequentially but air transport looks like significantly, sequentially is that right?

Patrick Allen

You got it exactly right David.

Operator

Your final question comes from the line of Sam Pearlstein with Wells Fargo.

Sam Pearlstein - Wells Fargo

I just want to follow-up on Davis’ discussion, when you had that 7% better growth rate over the next several years, because that business sheds a loan or are you counting things like CSeries and may be MC-21 or other of the smaller large jets?

Clay Jones

No, purely business jets alone. We segmented that out of that regional or the larger jets there, so that was just taken the biz jet platforms that we know we’ve already won and the relative roll out over the next five years. And we don’t put that in the book in ‘11 either because I think you are going to see probably a still fairly weak ‘11 and ‘12 as one we always predicted the recovery is most likely to happen and then you’d get an acceleration from there over a five-year period. And then on top of that just a normal rollout acceleration which we’re calling about 7%, we think the market share gains will add yet another 7% on top of that if we give those same rates of change.

Sam Pearlstein - Wells Fargo

And then you mentioned within the governments, I guess it’s within Government Systems about reduction of a customer funded R&D program, is that something that has just been shifted out somewhat into the fourth quarter or into next year or is it something that might be gone forever?

Patrick Allen

I think for the most part Sam it’s kind of shifting out, it seems like the slickest program that Clay mentioned earlier it’s the KC-X delays, those type of things are moving out of the year as a result the customer-funded research and development on the government side is down a little bit.

Sam Pearlstein - Wells Fargo

And one last question is just on the 787, if I remember there was some portion of the settlement we should have seen this quarter are we done with that and then are you done with your Dash 9 negotiations or is there anything that’s really different in the avionics it’s from the Dash 8 to Dash 9?

Patrick Allen

We collected all the cash and really no negotiations on any of the areas are outstanding at this moment.

Clay Jones

Well, that concludes our Q&A on today’s earnings call. We plan to file our Form 10-Q on or about July 27, so please see that document for additional notes and disclosures. Thank you for joining us and participating on today’s conference call.

Operator

Thank you. This concludes today’s conference call. You may now disconnect your line.

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Source: Rockwell Collins Inc. F3Q10 (Qtr End 05/30/10) Earnings Call Transcript
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