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Moog Inc (NYSE:MOG.A)

F2Q2014 Earnings Conference Call

April 25, 2014 10:00 AM ET

Executives

Ann Marie Luhr – Investor Relations Manager

John R. Scannell – Chairman & Chief Executive Officer

Donald R. Fishback – Chief Financial Officer & Vice President

Analysts

Julie Yates-Stewart – Credit Suisse Securities LLC

Cai Von Rumohr – Cowen and Company, LLC

Tyler E. Hojo – Sidoti & Co. LLC

Kristine Tan Liwag – Merrill Lynch, Pierce, Fenner & Smith, Inc.

Michael F. Ciarmoli – KeyBanc Capital Markets Inc

Steven L. Cahall – RBC Capital Markets LLC

Operator

Good day, welcome to the Moog Fiscal Year 2014 Second Quarter Earnings Call. Today’s conference is being recorded. At this time I’d like to turn the conference over to Investor Relations Manager Ms. Ann Luhr. Please go ahead, Ma’am.

Ann Marie Luhr

Good morning. Before we begin, we call your attention to the fact we may make forward–looking statements, during the course of this conference call. The forward–looking statements are not guarantees of our future performance and are subject to risks, uncertainties and other factors that could cause actual performance to differ materially from such statements. A description of these risks, uncertainties and other factors is contained in our news release of April 25, 2014 in our most recent Form 8–K filed on April 25, 2014. And certain of our other public filings with the SEC on our website at www.moov.com we prepared, it contains supplemental dated sheet for your convenience. John?

John R. Scannel

Thanks, Ann. Good morning, thanks for joining us. This morning we will report on the second quarter of fiscal 2014 and update our guidance for the full year. It’s good news quarter with results coming in a little ahead of what we had forecast. On this call, we also provide a progress updates on our strategic review of our medical devices segment. I will start with the headlines for the quarter, update our thinking for the year and then dive into the numbers. Starting with the headline.

Sales for the quarter were up 1% and our operations did well delivering earnings per share of $0.82, slightly above the top end of the range we had forecast 20 days ago. Given the challenging conditions in several of our markets, we consider any sales growth real positive. In general, the macro picture remains unchanged, commercial aircraft market is very strong, our industrial markets are essentially flat. And our [indiscernible] market continues to be soft with some bright spots outside the U.S.

In total our defense sales across all our segments were down 6% from the same quarter last year, with our other markets making up the shortfall. We also had another quarter of good tax flow. During the quarter, we commenced our share buyback program which Don will describe in more detail later. Late on the results of the second quarter, we are edging our sales forecast up very slightly for the year, by keeping our earnings forecast unchanged at $3.55 per share. This earnings forecast is exclusive of the impact of the share buyback which could add an additional $0.05 per share to the total.

Now let me provide an update on the strategic review of our Medical Devices segment/ You remember that we entered the Medical Devices segment back in 2006. We chose pumps as our area of focus. We believes that a company like ours could be successful in this market through continuous products and innovation, the better Moog strategy as we like to call it.

Between 2006 and 2009 we completed five acquisitions of small medical device companies and proceeded to integrate them as our single segment. Some time around in 2010, the regulatory environment changed and the FDA started to put increased scrutiny on all medical pumps. As a result the length of time to get a new product approved by the FDA went from month to years.

With the increase time, the cost of new product developments also went up significantly. In the face of this new regulatory environments our strategy of continuous innovation became very difficult.

Last July, we announced that we were partnering with RBC to conduct a strategic review of the segment including the potential of the sale. Over the last nine months we’ve gone through an intensive process to seeking a suitable buyer for the complete segments.

Unfortunately, late in the quarter an anticipated sale of the business to a prospective buyer under an exclusive arrangements fell through. This is a disappointing setback, but does not change our overall strategy for these segments. The medical pumps is not core for Moog and we believe this business will be more successful in the long run under alternative ownership.

Our strategy up to now is we can find a single buyer for the complete segments. However the business consists of several product lines and we have learned from different buyers at different interest levels in the various product lines. As we move forward, we continue our process of seeking a suitable buyer for the full segments, but we’ll also broaden our approach to consider options for each of the product lines if appropriate. We provide the market with updates as newsworthy events across.

Now let me move to the details starting with the second quarter results. Sales in the quarter of $650 million were up 1% from last year. Sales were up in our Aircraft, Industrial and Component segments but were lower in our Space and Defense and Medical segments.

Taking a look at the P&L, our gross margin is down slightly from last year on the less favorable mix of sales in our Aircraft business. R&D is also down slightly, but administrative expenses are higher as a result of our SAP startup activates. In the quarter our SAP investments to gross margins by about 100 basis points.

Q2 was the peak spend rate for this project in this fiscal year and we are anticipating that the expenses in the third and fourth quarters will be about half the expenses in the second quarter. Interest expense was $4 million lower than last year due to the retirement of our 7.25% high-yield bonds which we completed in our first quarter.

Taking all together, net earnings of $38 million and earnings per share of $0.82, with both about 3% higher than last year.

Fiscal 2014, outlook, we are increasing our sales forecast for the year slightly to $2.64 billion. We are also adjusting the mix, based on the second quarter results. Relative to our forecast from 90 days ago, sales in our Industrial and Aircraft segments will be up marginally, while sales in our Medical Devices segments could be lower. These sales streaks will not affect our earnings per share forecast which remains unchanged at $3.65 per share.

Now to the segments, I would remind our listeners that we provided a two page supplemental data package posted on our website which provide all the detailed numbers for your models. We suggest you follow this in parallel with the guidance.

Beginning with Aircraft, Q2 sales in the quarter were up 6% from last year to $275 million, the sales story remains unchanged, strong organic growth on the commercial side, compensation for slowing the time sales. Commercial sales were up 17% in the quarter with strength in both the OEM and the aftermarket segments. Sales to Boeing and Airbus continue to grow, driven by the 787 ramp and the startup of production on the A350. Commercial aftermarket also had another good quarter up by strong initial provisioning of the 787.

In the military markets, sales were down 3% from last year. F-35 production was up nicely in the quarter, but the development contracts continues to a base down about $2 million from last year.

Helicopter sales was down, as activity slowed on the V-22, Black Hawk and several of our smaller programs. The KC-46 tanker program remains a bright flash, but lower foreign military sales this quarter resulted in a net reduction in the other military OEM category of about 4%. The military aftermarket was down in the quarter, but up from our first quarter. Last year, we had some unusually strong foreign military aftermarket sales in Q2, which should not repeat this quarter.

On a positive note, we are stating to see the first signs of F-35’s aftermarkets (indiscernible).

Aircraft fiscal 2014, we are increasing our sales forecast for the year by $10 million, the increase is all in the commercial aftermarkets. 787 initial provisioning is running well ahead of our forecast, although the rest of our commercial aftermarkets is a little softer than forecast. The net result is a $10million increase of the year’s commercial aftermarket total. There is no change for our military forecast.

Margins, margins in the quarter were relatively soft at 9.4%, an unfavorable mix combined with higher operating expenses resulted in relatively soft margins. R&D is up relative to last year, driven by the Embraer program. Administration expenses are also up as a result of our SAP initiative. Despite the relatively soft second quarter we are maintaining our margin forecast for the full year at 12.1%.

Turning now to Space and Defense; sales in the quarter were down 10% to $95 million. The weakness was all in the space side of the business. We had lower sales on both satellite and launch vehicles as various production jobs mown down, and the follow on job have not yet ramped up.

On a positive note, we had very strong bookings in our space segment over the last couple of quarters and our backlog supports a much stronger second half of the year. Defense sales in the quarter were about even with last year. Sales on U.S military vehicles were lower, but sales on foreign vehicle programs were higher. Taken together, vehicles sales in total was round about 10% in the quarter, so balancing this out were higher security sales which were up about 10% in the quarter.

Space and Defense fiscal 2014, we are keeping our sales forecast for the year unchanged at $420 million. This forecast assumes stronger second half in both our state and defense markets. In space we should see higher sales on a variety of satellite programs. And on the soft capture and space launch systems for NASA. On the defense side we are anticipating a sales uptick in the second half in missiles, naval systems and various military vehicle programs.

Margin, margins in the quarter were 9.4% compared to margins of 7.3% a year ago. We are seeing the benefit of restructuring of the restructuring we completed in the fourth quarter as well as stellar performance in some of our recent space acquisitions. We are forecasting second half margins of 9.5% to yield full year margins of 9.1%.

Turning now to industrial systems, sales in the quarter of $151 million were 5% higher than last year. We are starting to see topic of good news in some of our industrial market, although not enough evidence just yet to turn bullish on the overall segment. Sales in energy market were up nicely in the quarter with wind energy sales up 17% from a year ago. The strength in wins came from some recent contract wins in Brazil for our new AC system as well as slightly higher sales in Asia.

The wind business has been a real challenge for us over the last few years, but we think we may be turning a corner for the better.

Industrial Automation sales were also up nicely in the quarter with increases across all our major market categories. In particular, we had a strong quarter for our Formula One business in Q2. This is a seasonal business, which had a boost this year as the F1 governing body changed some of the regulations which resulted in additional multi-content on each car. This F1 business this will not repeat in the next few quarters.

Finally, our Stimulation and Test business was down in the quarter as several of our large stimulation customers continue to adjust their inventory levels.

Industrial Systems fiscal 2014, we’re inching our sales forecast for the year up by $15 million to $590 million. This forecast assumes a second half about even with the first half.

Margins, margin in the quarter were 9.9%, up from 5.4% a year ago. Overall margins are benefiting from the restructuring actions we took last year. For the full-year fiscal 2014, we’re forecasting margins of 11%, up from fiscal 2013 operating margins of 7.1%.

Components, sales in the quarter of $101 million were up 2% over last year. Our Aspen Industrial Motors acquisition which we completed in Q2 2013 contributed an incremental $8 million in sales over the same quarter a year ago. Excluding acquisitions, organic sales were down 5% in the quarter. Sales in the Aerospace and Defense markets were lower as a result of reduced sales on a range of aircrafts and vehicle programs. The SAP missile program was a bright spot in the portfolio, but across the rest of the programs we’re seeing push outs and continued declines in production rates.

Sales into the energy and medical markets were about flat with last year while sales for industrial applications were up strongly as a result of the acquired sales from Aspen Motion technologies. Overall, the markets across our component segment remain challenging as a result of the decline in Military budgets and the slow industrial recovery.

Components fiscal 2014, we’re keeping our sales forecast for the year unchanged from 90 days ago at $438 million. This forecast assumes a pick up in the second half of the year based on higher foreign military sales, completion of some large projects in our energy sector and an improvement in the industrial markets.

Margins. Margins in the second quarter were unusually soft at 13.4%, excluding the costs associated with our SAP project, margin in the quarter would have been 14.4%. Declining organic sales and an unfavorable shift in the mix away from military sales is having a negative impact on the high margins. We are continually adjusting our cost structure in response with these challenges. For the year, we’re maintaining our margin forecasts at 14.7%.

Medical, Q2 was a very mixed quarter on our Medical segment with weak sales, but respectable operating margins. Sales in the quarter of $27 million were $8 million lower than last year, $3 million of the difference is due to the disposal of the Buffalo Ethox facility which we completed in June of 2013. Excluding the effect of the divestiture, there are two reasons for the decline in organic sales.

First, similar to what we’re seeing in some of our investment markets, one of our medical device distribution partner is going through an inventory adjustment profit. Second, the management team in this segment has been very busy with the strategic review process over the last few quarters. And this distraction from the day-to-day business has taken a temporary toll on the sales performance.

Fiscal 2014, given the soft sales in the second quarter combined with the outlook that the inventory adjustment on delay had a distribution partner will take another quarter to walk through. We’re moderating our sales forecast for the full year by $10 million down to $127 million. The reduction is split evenly between pumps and sets.

Margins, margins in the quarter up 5%, were 130 basis points higher than the same period last year despite the significantly lower sales. Even the lower sales forecast for the year were moderating our full year margin forecast to 6.9% down from 7.1% 90 days ago.

As I said in my opening remarks, we are determined that this segment is not core to our business long-term. As we move forward, we continue our process is seeking a suitable buyer of the four segments, we would also broaden our approach to consider options for each of the product lines if appropriate.

Now to the summary, our second quarter was a fairly quite quarter, earnings came in a little head of what we had forecasted. And we experienced a temporary setback in the strategic review process of our Medical Devices segment. Coming out of the quarter, we’re increasing our full year sales forecast lightly and keeping our earnings forecast unchanged from 90 days ago.

The defense markets remain challenging and we continue to look for signs of sustained improvement in our industrial markets. Commercial Aircraft remains the bright spot. Just to remind you, our full year sales forecast of $2.64 billion was up about 1% over fiscal 2013. Earnings per share should be $3.65. We’re anticipating a stronger second half with earnings per share in the third quarter of about $1 plus or minus $0.05 and earnings per share in the fourth quarter of about $1.13.

Our earnings forecast of $3.65 per share is exclusive of the effect of our share buyback program which could add an additional $0.05 per share to the total.

Now, let me pass you to Don, who will provide some color on our cash flow and balance sheet.

Donald R. Fishback

Thank you John and good morning everybody. Free cash flow in the quarter was $32 million compared with the reduction in our net debt over the last 90 days of $9 million. The difference relates to cash used to repurchase company shares during the quarter on the buyback program we announced three months ago. On a year-to-date basis, free cash flow was $81 million reflecting 116% cash conversion ratio.

Our free cash flow outlook for the year remains unchanged since our last forecast at $165 million reflecting a cash conversion ratio of just about 100%. Our share repurchase program began late in the quarter due to the timing of the events associated with our efforts to sell the Medical Devices segment which John briefly described.

During March, we purchased approximately 357,000 shares under our $4 million share buyback authorization. The impact of our weighted average shares outstanding in the quarter was negligible. We expect to complete our buyback program by the end of the calendar year.

Looking at the balance sheet, cash free, debt free, working capital was relatively flat compared with last quarter and the sales that were up modestly. Accounts receivable were up $16 million due to the timing of collections on linked-quarter and invoicing, which we expect will improve next quarter. This was offset by increases in a number of miscellaneous accruals, inventories were flat, customer advances were down $9 million over the last 90 days to $137 million. And loss reserves declined by $4 million to $35 million.

Capital expenditures were $15 million, and depreciation and amortization totaled $28 million in the quarter. We’re leaving our forecast for CapEx and depreciation and amortization for all of fiscal 2014 unchanged at $105 million and $113 million respectively.

Cash contributions to our defined benefit pension plans globally, totaled $14 million in our second quarter, in line with our projected contributions for all of fiscal 2014 of around $55 million.

Our effective tax rate in the second quarter was 29.6%, up from last year’s 26.9% due to higher R&D tax credits a year ago. Our forecasted effective tax rate for all of FY 2014 is 31.5%, unchanged from our last forecast 90 days ago.

Our financial ratios at the end of the quarter were solid. Net debt as a percentage of total capitalization was 24.3%, down from 32.8% in last year’s second quarter. Our leverage ratio was 1.47 times. At quarter-end we had $295 million of unused borrowing capacity on our $900 million revolver that terms out in 2018.

In summary, as John described, we’re projecting FY 2014 earnings per share of $3.65 before consideration for the effects of the share buyback program. We’re optimistic we’ll end up reporting record sales, record net earnings and record earnings per share by the time this fiscal year is complete.

And with that, I’d like to turn it back to John for any questions that you may have.

John R. Scannell

Thanks, Don. And Jessica, can you see if there are questions in queue please?

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) And at this time our first question should come from Julie Yates-Stewart.

John R. Scannell

Good morning, Julie.

Julie Yates-Stewart – Credit Suisse Securities LLC

On Aircraft margins, John, can you just talk about the levers for improvement in the second half of the year? It looks like you need to average nearly 14% to achieve the guidance of 12.1%, which is well above the historical run rate.

John R. Scannell

Yes. So there’s two effects I would say in the second half, Julie, that will drive the improvement in margins. One is the reduction in the R&D spend as we go through the second half and the other is an improving mix, which we have in the backlog, which is driven by some of the foreign militaries sales that we have. So those are the two really big effects that drive the second half.

Julie Yates-Stewart – Credit Suisse Securities LLC

And then I realize it’s a little early to be talking about FY 2015, but is that the run rate that we should assume that will go into 2015 or will you have kind of a similar H1/H2 dynamic next year as well?

John R. Scannell

I would agree that it’s a little bit too early to talk about 2015 and we’ll provide that guidance at our next call in 90 days, Julie.

Julie Yates-Stewart – Credit Suisse Securities LLC

Okay. And then just on aftermarket, your comment that the core aftermarket was a bit soft. Can you just give us a little color on what might be contributing to that?

John R. Scannell

When you say the core aftermarket, are you talking commercial or military?

Julie Yates-Stewart – Credit Suisse Securities LLC

I’m sorry. Commercial 787 provisioning.

John R. Scannell

It’s just we have aftermarket on a variety of older programs and some of those programs are being replaced by some of the newer jets and we’re seeing a slow decline in some of that underlying aftermarket that we have. It’s something that we’ve been anticipating happening and it’s been replenished by the newer problems as they come online. So it’s not as surprise and, I would just say it’s a part of the change out in the fleets.

Julie Yates-Stewart – Credit Suisse Securities LLC

Okay. And then just on Military aftermarket. I know visibility has been limited there and I think you had guided to down 10% for the year. Are you still expecting that?

John R. Scannell

Total Military, that’s right down about 10% for the year. My prepared remark said it’s down from the second quarter of last year, but it was actually a very strong quarter. At $59 million it was way up from the first quarter, which was about $50 million. It’s just that last year we had a particularly strong second quarter. So it was actually better than the run rate that we had last year.

So I would say Q2 was a strong quarter for the military aftermarket. We anticipate that the rest of the year will be a little bit lower. So I wouldn’t draw a conclusion that the military aftermarket was actually soft. It was actually pretty healthy this quarter and this quarter will help to make sure we make the number we have anticipated for the year.

Julie Yates-Stewart – Credit Suisse Securities LLC

Okay, great. Thank you.

John R. Scannell

You’re welcome.

Operator

Thank you. And our next question will come from Cai Von Rumohr.

John R. Scannell

Good morning, Cai.

Cai Von Rumohr – Cowen and Company, LLC

Yes. Thank you very much. So John, so your guidance for the full year, you’ve added $10 million of Commercial aftermarket, $15 million of industrial legacy, your high margin business and taken $10 million out of Medical, which is I would assume average certainly not the same incremental margin. Your SAP expenses were $7 million in this quarter and I think you projected $10 million in the second half the same. So how come the guidance hasn't gone up? What's the offset to those positives?

John R. Scannell

I would say at this stage, Cai, it’s too early to change the guidance. You’re right. Some of the improvements are positive effects. Having said that, we have had a low overall margin performance in the second quarter. We anticipate that that will get a lot better in the second half. But it’s too earlier at this stage, given the increase that we’ve already forecasted in the second half to inch that up.

Cai Von Rumohr – Cowen and Company, LLC

Okay. And then, so now we know you’ve been trying to sell Medical. You’re still trying to sell it. Your financial position already is strong. What happens with the cash?

Donald R. Fishback

Which cash, Cai?

Cai Von Rumohr – Cowen and Company, LLC

Well, I mean, I assume when you sell Medical you will get a large check from someone. So that will substantially improve your already strong financial position. So as you think about cash deployment, I mean you’re buying back even with your buyback. You’re going to be very, very strong. Is the thought more incremental share buyback, dividend, special dividend? What’s the thinking in terms of what you will do with the proceeds?

John R. Scannell

Well, I think it’s a little bit early to say because I’m not sure at this stage we probably would have a deal, we probably would be announcing a deal, to be honest, on this call. That fell through. So we got to regroup within the organization that we got to go out and start the process again.

And as I said on the call, in my prepared remarks, one of things that we have learned through this process is that because we develop this segment out of five different acquisitions there are a couple of different product lines and different buyers have different interest levels, which may mean that we end up in a situation where we perhaps

have to find different solutions for some of the different product lines. That process is likely to take us well into 2015 given how long it’s taken us so far and how long that process has really taken. Therefore, to determine what we would do with the cash at this stage, I think it’s a little bit early.

I would say we’ve engaged in the buyback program. As Don said, that’s probably going to last to next two to three quarters. That’s the present set of activities that will increase our leverage ratio and at the end of that period of time we’ll take a look at to see where we go next. There’s always the potential of acquisitions. We have slowed our acquisition activity over the last 12 months. But a lot of that is – in fact some of the markets that we’re in haven’t give us interesting opportunities. And also, as we said, we want to make sure that we are looking at acquisition opportunities in the light of other capital deployment strategy. For that we continue to be in the acquisition, search mode and if some – an acquisition were to come along that maybe where we will deploy some of that capital.

So I think it’s just too early to tell as opportunities come along, we will evaluate them and we will also evaluate the possibility of using the money to give it back to shareholders. We just haven’t got there yet though until we have that nice big check in our hands I think it’s premature to say what we will do with that.

Cai Von Rumohr – Cowen and Company, LLC

And last question, so you're going to buy the 4 million shares over the next two to three quarters. You bought a substantially slower pace in the current quarter, and yet you announced your quarterly results were towards the end of January, so it doesn't look like you did anything in February. How come?

Donald R. Fishback

Because we were in this agreement to sell the medical devices business, and we have felt that it was inappropriate to be in the markets with that new potentially coming out towards the end of March. And what happened was when the deal fell through in the middle of March we then engaged – we kicked in the share buyback cover.

So that’s why it is such a small number in the quarter and that’s why we anticipate that we can get it done over the next two to three quarters at the pace that we saw and towards the back end of March. So that’s the reason for that.

Cai Von Rumohr – Cowen and Company, LLC

Good explanation, thank you so much.

John R. Scannell

Welcome.

Operator

And our next question will come from Tyler Hojo.

John R. Scannell

Good morning, Tyler.

Tyler E. Hojo – Sidoti & Co. LLC

Yes, hi. Good morning. I actually wanted to follow up on one of Julie's questions with regard to the Commercial aftermarket. So if you look at the core aftermarket growth rate in Commercial, so X-787 provisioning. What would that growth rate have been in the quarter? And what is the expectation for the year?

Donald R. Fishback

Well, maybe at the back of the envelope here. I think if you do X-787 and you compare –by comparison to the same quarter a year ago, it’s about flat. And actually Tyler, people back in 2011, 2012, 2013 and what we are forecasting for 2014 X-787 initial provisioning that underlying is about flat as well. So…

Tyler E. Hojo – Sidoti & Co. LLC

Okay.

Donald R. Fishback

So as I said to Julie that on the one hand you’ve got a lot of activity in the commercial aftermarket. On the other hand what we are seeing is the change over some of the older airplanes 757, 767s that we have traditionally been part of our aftermarket. So we are seeing that abate a little bit, but we are seeing the positive of some of the new programs 787 and of course later the A350 will kick in so.

Tyler E. Hojo – Sidoti & Co. LLC

Okay. Got it. Very helpful on that front. And then also, just with looking for a little bit more detail in regards to one of your comments in regards to the simulation and test business. I guess also, some inventory fluctuation issues impacting your outlook there. Could you maybe talk a little bit about your longer term expectations? Is there still a tail wind in that end market or do you see things starting to turn there?

John R. Scannell

So short-term we have an inventory adjustment at least our customers in that business are adjusting their inventory for whatever set of reasons they have. They’ve gotten a little bit ahead in terms of their inventory over the last year. They are not going through a period of adjusting for that, and we have a very, very strong position in that markets. And the answer to your question, really is based on the outlook CAEs, the flight safety, some industries which is not a lucky margin. Their view of the overall commercial training simulation market.

And I think right now that is still a pretty bullish outlook. If you think it’s a new airplane coming on line. You think it’s global commercial airplane. Do you think of additional regulations that are starting to –that are coming out in terms of pilot training. I think overall that market has a fairly positive outlook for the future and therefore we’re optimistic that we should continue to see that as a very strong market.

Tyler E. Hojo – Sidoti & Co. LLC

Okay, very good. And just lastly for me, on CapEx, in order to get to your guidance range for the full year, I mean you're going to need to significantly ramp up CapEx in the back half of the year. What's that spending on and is it possible that you’ll fall below kind of the range?

Donald R. Fishback

Tyler this is Don. It’s a great question and you’re right. We’ve got to spend a lot in the second half to hit that forecast of $105 million and there are a couple of drivers. One would and we got a facility that we're constructing in Europe that will consume some of that growth but not all of it of course. It’s a minor facility, it’s under $10 million. And then the other thing is the SAP project. The capital part of that project begins to ramp up here in the second half of the year and that will consume some incremental capital and I guess as I think about it there’s a third element which is a program driven investment and some of the programs we’ve invested in A350 and Embraer Air to continue to kick in.

So you are right. We may end up with a number that’s below $105 million. We thought it was too early with two quarters in to adjust it down at this stage. But it could be a positive from a cash perspective.

Tyler E. Hojo – Sidoti & Co. LLC

Perfect. I'll hop back in the queue. I appreciate it.

Donald R. Fishback

Thank you.

Operator

Thank you. (Operator Instructions) We’ll take our next question from Ron Epstein.

John R. Scannell

Good morning Ron.

Kristine Tan Liwag – Merrill Lynch, Pierce, Fenner & Smith, Inc.

Hi good morning actually Kristine Liwag instead of Ron.

John R. Scannell

Hello Christine.

Kristine Tan Liwag – Merrill Lynch, Pierce, Fenner & Smith, Inc.

Hello. So you paid down debt this quarter and your net debt-to-capital ratio is low as it’s been in the past 10 years. How are you thinking about your capital structure going forward? And a follow-up to that would be, how does the strength of your balance sheet change your priorities with regards to your capital diplomatic strategy? It seems like an M&A or returning cash to shareholders?

Donald R. Fishback

Kristine, it’s Don. We have as you point out a very unfortunate situation that we are in, a strong balance sheet, long-term but this juncture, we’ll probably, clearly underlevered from a optimal leverage perspective cost of capital. I think, we shouldn’t – we said in fact that we got a share buyback program which was announced three months ago. We are in the middle of that will consume $215 plus million of capital. So that will moderate some of that I guess positive picture all by itself.

And as John said earlier, we are not out of the M&A market. M&A has been and I think will continue to be an important part of the future of our company. We are in a little bit of a low now, it’s been about a year since we’ve announced any deal of consequence. And I would expect that term will continue to look for appropriate ways of to deploy capital. That being one alternative, and as John said the other choices that we particularly and the prospect of selling the medical business, other returns to capital – returns of capital to our shareholders, so.

John R. Scannell

Let me add a little bit Kristine, if you look historically, we have been levered to do that debt-to-EBITDA up somewhere around 1.5 to 2.5 range. We have agreements with our bank in terms of 3.5 being a maximum in terms of some confidence and so, but typically that kind of 1.5 to 2.5 is the sweet spot that we found our leverage and we pick a little bit up off the 2.5 overtime. But so that’s between 1.5 and 2.5 right now we’re in the 1.5 and clearly we are relatively, we had low leverage compared with our historical averages.

We have announced a buyback and I think, that will start to keep that leverage up and what we would like to do is complete this buyback over the next two to three quarters. And then, look at the next step in sales, they know what’s the next step in terms of where do we go next with capital deployment. We’re generating some nice strong cash flow that’s a real positive. We have pension thing opportunities if we wanted to pay down some pension expense from underfunding there. And there is also the continued opportunity to return capital to shareholders.

So we’d like to get through this present buyback and then what we like to do is come back to the market and say, do the next phase of our capital allocation process. I think again as Tom said, we’d like to go through what we’ve already announced, get that done and then come back to the market and say what the next step is.

Kristine Tan Liwag – Merrill Lynch, Pierce, Fenner & Smith, Inc.

Okay, great. And a different question, a follow-up to what I think was asked already with a 787 provisioning, I guess my question would be, when should we expect the 787 provisioning to actually begin being accretive to Aircraft Controls segment margins?

Donald R. Fishback

It is accretive to the margins, but it’s 787 initial provisioning is about 1% of their sales. So I guess over the course of the year it may be 2% to 3%. But so, it’s not a huge number, so yet it’s accretive. The initial provisioning is a positive affect on the margins overall. But you got to put into context of 100 other programs and the large shift of the mix away from the military and more to the commercial OEM side and early on in the commercial OEM side in the program’s history you tend to have rather lower margins.

So there is a multiple things going on, Kristine. And therefore, you can’t single out just one piece of that side and determine that you should actually see that drop to the bottom line. Our commercial aftermarket is gone about just over 20% of our total commercial business. And I think, relative to some of our peers who have a more long-term established position where they don’t see as much growth in the OEM side. It’s a much higher percentage of the commercial aftermarket, it’s a much higher percentage. But because we’re in this significant growth pace, after-markets has yet to catch-up. And that’s probably going to take three, four, five years before you really see the 787 kick in and the A350 kick in and some of the biz jets. And then you should start to see that aftermarket total as a percentage of the totally commercial OEM but we really start to build and see further margin improvement from that. But I think, But I think, singling out, one of the piece is a thing you need to do carefully.

Kristine Tan Liwag – Merrill Lynch, Pierce, Fenner & Smith, Inc.

Okay, great. Thank you.

Donald R. Fishback

Welcome.

Operator

Thank you. And our next question comes from Michael Ciarmoli.

John R. Scannell

Good morning, Michael.

Donald R. Fishback

Good morning.

Michael F. Ciarmoli – KeyBanc Capital Markets Inc

Good morning. Thanks for taking my questions. John, just quickly on the Medical. You know, if sale doesn't seem to be imminent, have you guys thought about just compartmentalizing this into sort of non-core operations. So we can actually start to maybe look and get a cleaner look at the business without if there is management distraction or noise, something that impacts the bottom line that's not really relevant going forward?

John R. Scannell

I’m not sure. I understand Michael your question, in terms of what that separation as you call it would mean. I can tell you that it’s a separate segment, it has separate facilities, it has separate managements. Its run as a segment and actually over the last year as we have gone down this process, we’ve continued to kind of separate it out and make sure that if and when we find a suitable buyer, it will be relatively easy to transfer a separate information systems as up.

So I’m not sure of it. Can you help me understand your question?

Michael F. Ciarmoli – KeyBanc Capital Markets Inc

I guess maybe just from financial reporting purposes, if it's designated as assets and operations for sale and you pull it out of your consolidated operations.

Donald R. Fishback

This is Don, Michael, how are you doing?

Michael F. Ciarmoli – KeyBanc Capital Markets Inc

Good, how are you doing?

Donald R. Fishback

As far as the – that’s an option we have I think going forward, I don’t think right now we are on that path. I think we’ve talked about it and we know there are options out there right now as we are trying to sell the business, it seems most appropriate to keep it isolated, but there maybe an opportunity for us to take the component and separating the some of the rest of the segments.

Michael F. Ciarmoli – KeyBanc Capital Markets Inc

Okay, that’s fair. Just looking at the Space and Defense, you've got a pretty steep sequential, or second half ramp over first half, to get to that guidance. You talked about the booking strength. Can you maybe elaborate on actually some of those satellite and Space programs that give you that confidence?

John R. Scannell

Yes, the major drivers, in the second half are there is – I have mentioned it in the text. There is a couple of NASA programs, the SAP outdoor system and the Space Launch system. We also have some additional activity on some ATK programs, some actuators for ATK, so there is a variety of programs where we have the backlog, the challenge in that business and because these are development programs, Michael is actually get the work down.

And if you remember in the first quarter our space margins were relatively soft even coming out of the fourth quarter where we’ve done a restructuring and what we described was we have a year that’s two half, that has in the first half, it has relatively soft sales and in the second half there is a huge ramp-up in sales.

Now that sales ramp-up is an input based ramp-up in other words, if engineers doing the work on these development programs and therefore we kept some of the SAP, we needed SAP in the first half, in order to be able to realize in the second half. So the challenge will be ramping up the engineering activity to achieve the sales. It’s not the backlog, that’s not the challenge it can be actually get enough bodies on the programs to incur the costs to actually drive the output on us.

So that’s really the essentially the challenge in the second half, it’s not if we don’t have the backlog there on the space sites and maybe the forecast it can be get enough of the engineering folks to do it, a little bit of it is we’ve see some engineers coming up some of the aircraft programs and they work, that the plan is to transform the cost into some of those space programs.

Michael F. Ciarmoli – KeyBanc Capital Markets Inc

Okay. That's very helpful. And then just a last one to follow up on Julie's question on the Aircraft margins, the second half ramp. How do you guys contemplate it? It sounds like you got good mix in there. You got the E-Jets ramping up. You’ve talked about the A350. How do we think about the 777X in there as we get later into the year? Is that contemplated in the margin assumptions? I'm just trying to balance the steady R&D that's happening there with these strong margins and this run rate.

John R. Scannell

777X does not have an impact on us in this year because the competitions for the flight control systems have not yet happened. There will be a little bit of activity in terms of bid and proposal, but it slightly about any awards of probably going to be summer or maybe even into the fog, I don’t have the exact timing on that.

Michael F. Ciarmoli – KeyBanc Capital Markets Inc

Okay.

John R. Scannell

But even if that happens, there wouldn’t any significant ramp in the R&D in this fiscal year. So if we work to win a position on the 777X it would a fiscal 2015 impacts and 2016 and beyond it really it’s not going to be a fiscal 2014 impact.

Michael F. Ciarmoli – KeyBanc Capital Markets Inc

Got it. Perfect thank you very much guys.

John R. Scannell

Welcome.

Operator

Thank you our next question comes from Steven Cahall from Royal Bank of Canada.

John R. Scannell

Good morning.

Steven L. Cahall – RBC Capital Markets LLC

Yes, thank you good morning. Maybe just a question on industrial. You said that you saw some pockets of good news, it wasn't enough to turn you bullish. I know that last year this was a segment that maybe burned you a bit where it looked like things were improving and you put some of the cost in and the volume didn't come through. Can you give us some color on what you're seeing and then what might change your mind actually seeing a recovery in industrial?

Donald R. Fishback

The strength in the industrial business if I compare the quarter, let’s say, we do the sequential because rather than the year-over-year. So if I look at it relative to the first quarter and I go back to the fourth quarter, and even the third quarter and the strength is really in the industrial automation markets. And that was up nicely in the quarter and we saw a little bit of a pick up across all of those markets were metal forming classics heavy the industry each one of them had a little bit of a pickup in the second quarter relative to the first.

Now, I also mentioned in the text the Formula One business we have, it’s not a huge business. It’s about $3 million or $4 million in the quarter. But it is the seasonal business and where before that they start the season, we need to deliver all our products, and then you get in the next couple of quarters and it wind down significantly.

So you had a little bit of an uptick in Formula One business in the quarter that make it looks better than what I called the run rate of the underlying business. We want some additional positions, it’s just our Formula One business is up relative to last year. But as I said it is the seasonal affect.

So the run rate of the industrial automation business in the second quarter was $80 million. But we are not anticipating the $320 million, we’re anticipating it will be above $300 million for the year, and said that the first quarter was only about $72 million. So a little bit of an uptick, a little bit of positive picture, I would say in Europe. But, I was talking to somebody earlier today we had an internal discussion yesterday about the overall economic outlook for our business, and one of top points was that home builders are in the U.S. particular kind of bullish at the moment, and then this morning the front of the Wall Street Journal says that mortgage originations are way off.

So it goes from a little bit of good news, little bit of not too good news. And therefore we are a little bit cautious to go with one quarter and say it’s actually starting to structurally get better. I think the economies in Europe are doing a little bit better and the economy in the space is doing a little bit better, age is slowing down a little bit, so the macro picture doesn’t supports a significantly bullish outlook. And what we said is we think the second half similar to the first, we’d be delighted if we can report that kind of uptick that we are seeing in those businesses.

Steven L. Cahall – RBC Capital Markets LLC

And just as a follow onto that, given the restructuring that you've done to right size that business, if you did start to see good volume growth, is there a target incremental margin that you think that business sees?

John R. Scannell

If we start figure incremental growth, we’d see a nice improvement in the margins. The what an incremental margins is depends a very much on which of the product lines you actually see that business. So at the moment, we’re seeing a little bit of North America uptick in the industrial automation, on the other hands we’re seeing the simulation business come up significantly because of this inventory adjustments. So it depends on which market and allow to give you a number because it may turn out that we see some nice improvement in one market and not in the different one, then the number turns out to be slightly different. But if you start to see a sales pick up given the fact that we as you say, we right size the business. We should see some nice incremental margin improvement.

Steven L. Cahall – RBC Capital Markets LLC

Okay. Thank you. And just a final one as a follow-up on some of the R&D discussion. Can you just give us a sense on a medium-term view? Are you at sort of peak R&D levels with 787, morphing into A350 and you’ll be here for some time? Are we past peak R&D for the cycle or are we still approaching peak R&D for the cycle? Thank you.

John R. Scannell

Okay. Well, the cycle, I’m not sure I can answer the cycle question because I think there is a commercial cycle, but in our business it’s a program-by-program event rather than just the cycles. What we’ve said is that we had anticipated that R&D would start to drop off post the A350. We will definitely see that, but we’ve replaced that with the Embraer Air job. We took that job because we think it’s a very nice job for us in the long-term. It will be a very nice piece of business for us.

So that’s going to keep the R&D elevated for the next couple of years and then we should start to see a drop off again, but it depends on whether or not we find some additional interesting opportunities that come along. So it’s too early to say. Next quarter we’ll give you an outlook for 2015. We’d tell you what we think the R&D is going to look in 2015. We can also give you an update on 777X and I think at that stage we’ll have a much better picture of all the outlooks over the next year or two.

Steven L. Cahall – RBC Capital Markets LLC

Great. Thank you very much.

John R. Scannell

Welcome.

Operator

Thank you. At this time we have one question remaining in the queue. (Operator Instructions) We’ll take our next question from (indiscernible).

Unidentified Analyst

Hey, good morning. Thanks for taking my question. Specifically to the F-35, I know Lockheed’s talked about some kind of increases in production at a pretty rapid clip over the next couple of years, but you guys already have seen that. And then I’ve a second question on the aftermarket opportunity. Are they the same dollar levels for the F-35, 787, A350 or all the other ones that you talked about, as the OEM side wise? Thanks.

John R. Scannell

So let me do the F-35 question first. First of all, we are on all the variance. So whatever Lockheed says they’re going to produce. Our forecast is just a reflection of that complemented by the mix of content that we have on the various areas. Our best knowledge at the moment is that we’re looking at this year 41, 44 next year, and then 2016 ramping up 65 and 2017, so 99 airplanes now.

Those should correspond with what Lockheed is publishing, what the government is publishing and perhaps it’s a little bit of a timing shift because our stuff obviously gets made perhaps six months, or more, in advance of when the airplane will actually shift. So there maybe some timing issues there. So we are anticipating – we’re hoping that there will be nice ramp-up in kind of 2016, 2017 and from there on out. So that should be a real positive for us. So that’s the F-35 OEM question. The aftermarket one, I’m not sure I fully understood the question. So could you repeat the question for me please?

Unidentified Analyst

Yes. So I think over various, I guess, times in the past, and you’ve said let’s say the 778 OEM component was like around $1 million. So would the spare parts be around the same level? And I guess, I mean, I’m asking the same question for the F-35 and the A350. Are the OEM values per aircraft kind of the same as the aftermarket ones would be?

Donald R. Fishback

Let me do the Commercial piece first. It’s quite different. So when Boeing ships 787 we have a shipped set of content on it, which involves about 30 different actuators and a lot more components when you take some of the high lifts stuff into account. So we have a very broad range of components on it.

Then the airlines do what’s called initial provisioning and what they are doing is they are saying I’m going to have five 787 and I need to have one of this actuator and two of those and one of these and one of those, because those are the actuators that – are those of the aftermarket parts that we deem as being very important and that we want to be able to respond instantly if there’s a problem or an issue somewhere that we need to repair or replace a unit. So it's a little bit like your car, you decide while I need some wipers and I need brake pads, but I’m not going to get myself a sparse steering wheel because the steering wheel is not going to fall out hopefully so. So it’s a little bit like that. The aftermarket is very different. It's selected depending on some of the components, how big is the airline fleet is, and what they want to provision.

On the Military side, I’d say, I would say it's somewhat similar except of course, the Military, typically it’s a single customer, the DoD, three or four customers, but they are coordinated as they feel appropriate. And we've noticed in the past that it's very hard to correlate our spares. If I take some of the more mature programs, Black Hawk or even the B-22, it's very difficult for us to correlate the activity that we do for spares and repairs with the size of the fleet. They are running their airplanes much more intensely than the commercial side. It's a much different type of duty cycle, it's a much different set of technologies and therefore the aftermarket calculation there is quite different from the commercial side of the business.

It really depends on the fleet hours. One more example. B-22 was used extensively in the desert. When it’s the desert it generates a lot of repair activity versus if they’re used in the B-22, say in a more normal environment. So it really depends on the Military side on side on the activity. Does that help answer the question?

Unidentified Analyst

Yes. That’s very helpful. Thanks a lot for the detail.

John R. Scannell

My pleasure. Jessica, do have any other questions in queue?

Operator

Yes. We have again a question from Cai Von Rumohr.

Cai von Rumohr – Cowen & Co. LLC

Yes, gentlemen, just a housekeeping issue. Why was interest expenses as low as it was in the second quarter? And maybe you could give us full year expectations for interest expense, equity comp and corporate expense. Thanks.

Donald R. Fishback

Okay, interest expense is 1.25 because we called in our bonds back in December, and so the result and so we were relying all on our revolving credit facility which is a pretty low cost facility for us. So the outlook for the year-over-year interest, we got a forecast right now of around $14 million to $15 million and corporate expense, we’ve got a forecast for all of 2014 of $27 million and equity base cap, we’ve got about $7 million of forecast for the full year.

Cai von Rumohr – Cowen & Co. LLC

Thank you very much.

Donald R. Fishback

You are welcome.

Operator

And it appears that there are no further questions at this time, Ms. Ann Luhr, I’d like to turn the conference back to you for any additional or closing remarks.

Ann Marie Luhr

We have none. Thank you, very much. See you next quarter.

John R. Scannell

Thank you.

Operator

Thank you and this concludes today’s conference. Thank you for your participation.

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