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Hexcel Corporation (NYSE:HXL)

Q2 2010 Earnings Call

July 27, 2010 10:00 am ET

Executives

Wayne Pensky - CFO

Dave Berges - Chairman and CEO

Analysts

Noah Poponak - Goldman Sachs

Abhi Rajendran - Credit Suisse

Steve Levenson - Stifel Nicolaus

Christine Leva - Bank of America-Merrill Lynch

Ken Herbert - Wedbush Securities

Peter Cozzone - KeyBanc Capital Markets

Eric Ramos - D. A. Davidson & Company

Kwang Wei Ling - Capstone Investments

Operator

Good day, everyone, and welcome to this Hexcel Corporation Second Quarter 2010 Earnings Release Conference Call. As a reminder, today's conference is being recorded. For opening remarks and introductions, I would like to turn the call over to Wayne Pensky, Chief Financial Officer. Please go ahead, sir.

Wayne Pensky

Great, thank you. Good morning, everyone. Welcome to Hexcel Corporation's 2010 second quarter earnings conference call on July 27th, 2010. Before beginning, let me cover the formalities.

First, I want to remind everyone about the Safe Harbor provisions related to any forward-looking statements we may make during the course of this call. Certain statements contained in this call may constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. They involve estimates, assumptions, judgments, and uncertainties caused by a variety of factors that could cause future actual results or outcomes to differ materially from our forward-looking statements today. Such factors are detailed in the company's SEC filings, including our 2009 10-K, our second quarter 10-Q and last night's press release.

Lastly, this call is being recorded by Hexcel Corporation and is copyrighted material. It cannot be recorded or rebroadcast without our expressed permission. Your participation on this call constitutes your consent to that request.

With me today are Dave Berges, Hexcel's Chairman and CEO; and Michael Bacal, our Communications and Investor Relations Manager.

The purpose of the call is to review our 2010 second quarter results detailed in our press release issued yesterday. First, Dave will cover the market, then I will cover some of the financial details before taking your questions.

Dave Berges

Thanks, Wayne. Second quarter revenues of $305 million were up 10% from 2009, 12% higher, if you adjust to a constant currency comparison and 18% higher than the first quarter on an FX adjusted basis. Operating income of $40.5 million or 13.3% of sales were substantially higher than last year's adjusted $31.4 million. The operating income of $40.5 million is the highest in our history, yet on sales 15% below our second quarter 2008 sales peak.

Our diluted earnings per share of $0.23 is $0.05 above the adjusted EPS of $0.18 in the second quarter of last year. We are particularly pleased with our second sale quarter of over 25% gross margins.

Now let me cover the markets using constant dollars to describe the sales trends. Commercial aerospace sales were $161 million for the quarter, up 18% in constant currency from last year's second quarter, and 6% higher than the first quarter. Airbus and Boeing-related sales were up about 20% from a year ago, and were at the highest level since the peak of 2008.

Sales growth was driven primarily by new Airbus and Boeing programs that is the A380, 787, 747-8 and the A350. New program sales, in fact, doubled for the quarter as compared to last year, and now account for more than 20% of our commercial aerospace sales in the quarter.

Sales to other commercial aerospace, which includes regional and business aircraft, were slightly higher than both last year's quarter-end 2010's first quarter levels, seem to have stabilized at about the $100 million per year rate.

Sales to space and defense markets were up over 7% on a constant currency basis versus the second quarter of 2009, and 9.5%, sequentially, as growth in composites for rotorcraft outpaced the wind-down of the F22 program.

In industrial markets, sales were $64.7 million, up almost 4% in constant currency versus last year and up 68% compared to the first quarter of this year. After the significant inventory correction by our largest wind turbine customer in the first quarter, our wind energy sales were up more than $20 million, sequentially, and have now returned to the 2009 second half run rate as we expected.

Recent large orders announced by Vestas, give us confidence for the near-term with wind sales and we remain cautious about the timing of the return to significant growth.

In total, our remaining industrial sales on wind were flat compared to a year ago in constant currency, but up sequentially, but with the exception of the decline in the sales to USEC's American Centrifuge Project, which was put on hold after the second quarter of last year, all other industrial submarkets were up sequentially and year-over-year.

Now, let me turn the call back to Wayne for some additional financial comments.

Wayne Pensky

As Dave pointed out, our adjusted diluted earnings per share was $0.23 compared to $0.18 a year ago and were up 53% from the first quarter of this year. For the first half of the year we are at $0.38.

Gross margin of about $78 million for the quarter was 25.7% of sales, 290 basis points greater than a year ago. The improvement reflects the higher volume, factory productivity and cost reduction initiatives and favorable product mix.

In addition exchange rates contributed about 50 basis points in the improvement enough to offset the $1.5 million step up in depreciation expense included in constant sales that was primarily due to the completion in the quarter of our newest carbon fiber precursor line.

Selling, general, and administrative expenses for the quarter were $29.6 million or $4.3 million higher than last year's quarter primarily due to the impact of our improved outlook and variable compensation expenses versus the same time last year.

Research and technology costs were $8.3 million almost $2 million higher than last year reflecting higher development and qualification costs for new commercial aerospace programs. So, our operating income for the quarter was $45.5 million or 13.3% of sales as compared to adjusted operating income of $31.4 million or 11.3% a year ago.

Interest expense for the quarter was $7.1 million. As we mentioned in the release, earlier this month we successfully refinanced our senior credit facilities to a new five-year facility, which lowered our initial interest rate by 125 basis points and more importantly removed the 2.5% LIBOR floor from the prior facility. We expect this will lower interest costs over the next 12 months by more than $5 million based on current borrowing levels and forecasted LIBOR rates.

The payback on the $3.7 million of refinancing costs should be about nine months. Remind you that the third quarter will include a charge of $6.8 million for the accelerated amortization of the deferred financing costs of the old facilities. After tax, this is about $0.04 per share.

Our year-to-date effective tax rate was 30.8% excluding one time items which is inline with our expectations. We now have over 90% of our euro and British pound exposure of the operating income line hedge for the year, so further exchange rate movements will not significantly impact our 2010 operating income dollars.

Our average hedge rate for the second half for the year is slightly more favorable than last years average rate. Our free cash flow for the first half of the year is about $12 million as compared to last year's $22 million. Our higher sales and improved outlook led to the use of nearly $44 million of cash in the first half of the year from higher working capital. The capital expenditures remained well below last year.

We do expect the pace of capital expenditures to increase in the second half of the year but to be less than $75 million for the year.

Now, let me turn the call over to the operator to take your calls.

Question-and-Answer Session

Operator

Thank you. The question-and-answer session will be conducted electronically. (Operator Instructions) Our first question comes from Noah Poponak with Goldman Sachs

Noah Poponak - Goldman Sachs

Your commercial aerospace business in normal years is stronger in the second half and has tended to have particularly stronger fourth quarters. This year, if you just model it flat sequentially from the second quarter, it still show over 20 year-over-year growth just because the comps are so easy, but I think it would be up sequentially given we have got higher rates announced and that you guys are alluding to progress in new programs. I guess what I am getting at is just how big are the year-over-year growth rates for aerospace going to be in the back half?

Dave Berges

The new programs are stronger than I expected this quarter. I hope they are going to continue, A380 does seem to have started to get some traction and we are finally starting to ship again, so I think that's going to keep going.

787 has come on pretty strong, and I hope it's not getting ahead of itself with respect to inventory. Of course, we need those programs to come off on time, so I would say new programs probably will still look about as strong at least in the second half.

You are right. We have some easier comps, particularly the third quarter, which was our bottom last year, so we think we will end up with pretty good looking percentage in the third quarter.

I don't think our business in regional jet is really going anywhere anytime soon, and the only thing left is what future ramp ups do to us at the end of the year or if there was a bit of an inventory correction that still has yet to be played out, but I would think high teens would be an easy average for the second half on commercial aerospace.

Noah Poponak - Goldman Sachs

On that point of the inventory movements related to production rates on legacy programs, I think you and some others that are longer lead suppliers had talked about being de-stocked pretty hard when everybody assumed there were production cuts coming.

Production cuts didn't come. Now, we're taking rates higher, but it sounds like many of you are saying, you haven't yet actually seen that play out in order flow. Is that right and when should we start to feel that impact?

Dave Berges

I still don't think it's a precise science. We thought, we over shipped by, as I recall, 10% versus line rates in 2008 and under shipped by about 10% 2009, really in an accurate science. I did look at the seven quarters prior to the Boeing strike, and we'd say we are still running on legacy programs maybe $5 million a quarter lighter than we should be.

It's so inexact, I wouldn't get too carried away with that. Mainly, went through the exercise to see whether the second quarter was over hypes where the people were ramping up too fast and that we're going to have a settling out. My conclusion is, second quarter was a good quarter and not overheated.

Noah Poponak - Goldman Sachs

I'll throw in one more on the wind business. You are making the comment that you are cautious on the timing of a return to significant growth. I think Vestas received its largest order ever in July. Is that correct? Can you just give us a little more color around what you are seeing on the wind side?

Dave Berges

It was the largest order in the US. They have had trouble penetrating the US compared to General Electric, or getting their share up in the US, so it's largest in the US, which is very encouraging. They are going to make the blades they say in their Windsor, Colorado facility, which is encouraging since we have a prepreg plan for their Windsor blade plan right down on the street in Colorado, so we were very happy with that order.

It's a big order, but this is a very short cycle business or at least it's behaving that way of late. That order, I think compared to what they wanted to have for total for the year is 10% of what they said they wanted for orders for this year, just put into perspective, so, we are thrilled to see that.

I think they said half of that was going to ship this year, which points to the fact that their backlog is pretty close. It's pretty tight. It's not like seven-year backlog, Boeing and Airbus have. So it's why we still are a little cautious about it. We need to see more and more orders.

China is still a question mark, whether the government is going to give western provider's turbines a fair shot at participating in their growth. Europe is doing better, particularly with offshore and in the UK. So we are encouraged the wind is going to be stable for a while.

We expect longer term it's going to be back on a serious ramp-up, but I don't think that right to today, I wouldn't predict that's going to have a slope that we had in prior years, nor would I say when that slope starts. As we have said the last two or three calls, I think the safe bet is to say industrial sales in the second half of this year might look a lot like last year.

Operator

Our next question comes from John McNulty with Credit Suisse.

Abhi Rajendran - Credit Suisse

This is Abhi Rajendran calling in for John McNulty. I had a quick question about the space and defense business, which came in very solidly with the record quarter. Given the lumpiness of the business how should we think about it for the second half, especially given the F22 wind-down?

Dave Berges

The F22 wind-down, I think the impact about, it seems to me about three quarters, we still are shipping F22 materials, partly spares to the spares market I should say. Customers were making spares. It's running about one quarter of what it was before, I think for two quarters now, so we have two more before we lap it. One more before we lap it Wayne tells me.

The strength this quarter was, as we said in rotorcraft in particular, V-22 came in pretty strong. That is a little stronger than we would normally expect, so I would called that part of the lumpiness, where you're normally expecting.

I think, generally, we say low single-digit kind of growth is what we'd look for. The fact that we had such a strong second quarter, maybe back offing that little bit, but no big movement either way. I don't expect a big drop-off. I don't expect explosive growth. Just single-digit, probably plus possibly minus on a quarter or two.

Abhi Rajendran - Credit Suisse

Just a quick follow-up if I may. You had given an update for about 10% plus growth going forward at your Investor Day, recently. Given the recent data points that have come out of the Farnborough Airshow and further ramp up data on new planes, any update on that forecast?

Dave Berges

We said double-digits, you said 10 plus. That double-digit covers a lot of ground, so I would say we're still safely in the double-digit range. The growth as the previous caller went over is going to be very strong on the Boeing and Airbus portion of commercial aerospace, which is about 40% of the company.

It's enough that it's going to be carrying in the rest of it assuming space and defense gives us single-digit, so until we see some significant growth in business and regional jets or wind, all the growth is going to be coming from Boeing and Airbus, but you have to just temp it down a little bit by recognizing it's 40% of the company, not a 100% of the company.

Abhi Rajendran - Credit Suisse

Just one last quick one. Any update on the USEC contract for the Centrifuge Project coming back?

Dave Berges

No update other than what you have seen publicly. They are hoping to a reapply to the DoE some time later this summer, I believe, is what I saw last. They are seemingly optimistic as are we, but we think that if it does get the approval that it won't result in significant sales for us, but probably in another 12 months or so, because of prior shipments.

Operator

We'll hear next from Steve Levenson with Stifel Nicolaus.

Steve Levenson - Stifel Nicolaus

How much longer do you think the qualification cost are going to run at this level or do you think it's going to be sort of up and down?

Dave Berges

I think it's sort of up and down. I don't expect big, big numbers. It was a little bit more this particular quarter than most, but as a percent of sales, I don't see any big changes in the R&T run rates.

Steve Levenson - Stifel Nicolaus

One of the things that came up at Farnborough last week was the re-engineering or new aircraft design to replace single-aisle planes and the CFM guys with the LEAP-X seem pretty confident while the Geared Turbofan guys seemed a little defensive.

What impact could LEAP-X have on Hexcel in the cowl section fan and fan case made out of your material?

Dave Berges

The current view of the LEAP-X is in infusion fan blade that would be good for us from a carbon fiber perspective, but it wouldn't be prepreg like the GEnx engine of the GE90 engine. All of the engines are likely to have a lot more composites in the cell and containment cases and so forth. So, regardless of who the winner is, I'm sure they would be some significant in the cell and accessory parts to it. The core engine itself though the Geared Turbofan is still metallic fan and the CFAN is presumably going to be carbon fiber.

Steve Levenson - Stifel Nicolaus

Is there something that could be $100 million a year run rate for you, more or less?

Dave Berges

I don't have a number, because I don't know what kind of engine count re-engineering. That's a little early for me to be figuring out. Long-term, if they re-engine or if they put a GEnx engine on a narrow body like a 737 or A320, I'm sure it'd be a good size number, but I don't see that as a near-term big swing either way.

Operator

Our next question comes from Ronald Epstein with Bank of America-Merrill Lynch.

Christine Leva - Bank of America-Merrill Lynch

This is actually [Christine Leva] calling in for Ron. Can you give us more color on your operating margin performance, especially in composites? Were there many one-time items in the quarter or is the 17.1% more of a sustainable rate going forward?

Dave Berges

Those are two different questions. There aren't any big one-times in there. It's a widespread improvement. In fact all the business is a good widespread across the board, sort of performance almost every plant, almost every product and we typically have seasonal step down in the second half from the first half I think almost every year since 2001 with the exception of one per seasonal reasons.

So, I'd expect it to pull back a little bit. Just in general we hope to continue all the improvements we have were pretty sweet spot with respect to composite utilization if you get up to 100% or 110% like we were in the second quarter of 2008 it starts to get difficult. We are coming up of the low base and are able to put us some pretty good leverage numbers and hope we can continue that.

Christine Leva - Bank of America-Merrill Lynch

I guess and a quick follow-up. What's your capacity utilization now? You said you are in a sweet spot right so like what kind of range are you looking at?

Dave Berges

I guess I set myself after that question. The single number doesn't really make a lot of sense with our business we have got. Multiple products, many products are only qualified and certain lines so there is a wide, wide range of where we are capacity wise. If I had to come up with the real general number I'd say that in the second quarter of 2008, when we were running 15% higher than this we were just about of the capacity and just about every product, and just about every plant. We have since added some capacity so that we don't have that problem anytime soon. So, we came down in sales 15%. In general term, we are moving back up in that zone, but again we can have individual products that are tighter capacity, some of that have excess.

Operator

Our next question comes from Ken Herbert with Wedbush Securities.

Ken Herbert - Wedbush Securities

Just wanted to maybe look at that from a slightly differently perspective, it looks like the incremental margin within the composite material segment was obviously very strong in the second quarter. Is that and I know you talked about for the company 20%, 25% as you are in the sweet spot that you are now or maybe you are not having to look at adding headcount or other costs as much. What run rate are you looking at on the incremental margin, specifically within composite materials?

Dave Berges

Let me ask couple of verifying questions that you're talking about. Year-over-year sequentially and are you talking about operating or gross?

Ken Herbert - Wedbush Securities

Sequentially on the operating line.

Dave Berges

I'd normally caution people against doing a sequential calculation particularly on the operating line because of seasonal factors. On the gross margin line maybe you can, but seasonally it's pretty dangerous to do that. I like to do year-over-year because it's the same quarter and it's got the same ramp up per shutdown period and so forth.

I still like to see 20% operating leverage year-over-year in both businesses, expect that we can do it. It bounces around quite a bit, but over the long haul that we should be able to do. The exception was 2008, when we were struggling with capacity and had five new startup plans and I'd like to not have that happen again. I really hope that if we get to the volumes that we had in 2008 we'd be delivering a lot better operating income.

Ken Herbert - Wedbush Securities

Okay. Are you facing anytime in the next six to 12 months, any material step-up in the operating expenses either from as volume continued to ramp as you look at the growth across the organization from either, from the variable cost standpoint in particular or anything we should be thinking about from that standpoint?

Dave Berges

Well, I think we do a pretty good job of managing raw material exposures with back to back contracts or contracts that are longer term rather than volatile. We don't control every commodity. Acrylonitrile is one, for instance, that moves around quite a bit and affects our carbon fiber cost. Those costs are rising.

Utility is another one, we don't have complete control over and those are pretty stable at a natural gas level, but are likely against our creeping up as oil does and some of the other elements in transportation. In general, we have had good variable margins for six months in a row through combination of lots of pieces and parts. No special one timers. No special magic golf ball or new clubs. We just hit a lot of fairways and didn't three putt any. So, I'm hopeful we are going to be able to continue this.

Ken Herbert - Wedbush Securities

Finally one follow-up on the wind side, it seems like, and based on what you said earlier, nothing unusual in the quarter, just you are back to normalized volumes there as that continues to ramp. Just remind me again about the lead times in that business and you say that cycles seem to be shortening obviously, but what are the lead times you're typically faced?

Dave Berges

In our prepreg business, for almost all customers, it's a very narrow band. It's a pull system because our materials have to be kept in a freezer. So, we don't get big blanket orders that we fill. We ship when they need it. So, when I was talking about lead times, I was talking about the backlog at Vestas or Dagneux, the big prepreg users. Their backlogs are lower than they have been in the past.

Two or three years ago, there wasn't enough capacity to deliver wind turbines and backlogs built up pretty high. Today, they are pretty close, so Vestas announcing this big order in the US and saying that half of that was going to be shipped yet this year. Give you sense that they are running pretty close between order and delivery, so to the extent we ship as they make the blades, it's pretty tight supply chain today.

Operator

Our next question comes from Peter Cozzone with KeyBanc Capital Markets.

Peter Cozzone - KeyBanc Capital Markets

On the wind business, can you talk about maybe the monthly trends in that in the second quarter? Any sequential pick up as quarter progressed, and maybe an update on kind of how it's holding up in July thus far?

Dave Berges

We don't normally give monthly numbers, and that I wouldn't be comfortable disclosing a mid-quarter point. I think the main thing I recall is that last year, we had the second quarter started out strong and tailed off at the end, so we have easier comps in the third and fourth quarter for sure and I don't think there are going to be big swings as we see things right now.

Our customers have a certain number of blade moulds. They try to run on the certain number of days a week and we have match in capacity to go with it, so they can't double their output easily. They need to add moulds and it takes some time. They can, as we saw on the first quarter, stop mould and not run the plants, but we are again projecting that the second half is going to be kind of blockbuster maybe up a little bit from last year, but no big movement either way.

Peter Cozzone - KeyBanc Capital Markets

Then maybe more generally speaking as far as trends given Vestas in recent activity in the North American market maybe kind of what you are seeing in terms of benefit from the US market and maybe your outlook longer term versus some of the other market you ship to?

Dave Berges

European market has been, is the oldest market. It's been running for a long time. There is a lot of support in the EU for renewable energy a lot of commitments that they've made with penalties, if they don't get there, to the European market has always been a pretty steady good producer for us. The US has been the fastest growing market in many of recent years though divest of share of that is it's not been large. So we're happy to see that they are penetrating in the US and hope that's the start of a trend.

China is now the biggest and fastest growing, but pretty erratic rules being put up by the government and it's a bit of wildcard that we don't have our arms around.

Peter Cozzone - KeyBanc Capital Markets

Then there is one more in FX, could you maybe provide some more color on the impact in the second quarter and is there any rule that we can apply in regards maybe a 1% move in the euro or I guess maybe another way of asking is this current rates hold up, what are your expectations as far as EPS impact on the full year?

Wayne Pensky

With respect to the second quarter FX contributed about 50 basis points to the operating income versus last year. Our total exposure in a year to both the euro and the pound is about $100 million with the operating income line, but when you look at it for the rest of 2010 almost all that is either been hedged or has already occurred and so any additional movements between now and end of the year probably won't have much effect on our operating income dollars. Now, obviously if it carries over in 2011 it will start to impact us there. But we already have about half of the exposure hedge for next year.

Dave Berges

Of course it could affect our percentages. Change the top-line.

Wayne Pensky

The operating income dollar lines is not likely to change but the percentage will change because of the sales were move but the operating income will hold the same as result of our hedges in place.

Operator

Our next question comes from Avinash Kant with D. A. Davidson & Company.

Eric Ramos - D. A. Davidson & Company

Hi, this is Eric Ramos in for Avinash. What is your dollar content for the Boeing 777?

Dave Berges

We don't disclose that, but it's less than the 787. It means that, the generation whatever is the most recent airplane it's better than the previous airplane. It's the prior airplane to 787. It's a real good program for us but not a size of 787 that is averaging $1.5 million.

Eric Ramos - D. A. Davidson & Company

Okay. Thank you. What do you expect CapEx and depreciation to be for 2010?

Dave Berges

We've said that we're going to stay below $75 million for CapEx, we'll need to start ramping up in the second half back for the growth.

Wayne Pensky

Depreciation expense will probably be in a $55 million range.

Operator

Our final question today comes from Kwang Wei Ling with Capstone Investments.

Kwang Wei Ling - Capstone Investments

Last year, good morning, we have seen revenue from new aircraft programs as a percent of commercial aerospace revenue essentially double. Any estimates or color you can provide in terms of where that number could be in a year or two?

Dave Berges

I haven't done the math on what the bill rates are going to be in a year or two, but if the A380 gets up to 30 or 35 aircraft per year times, $3.3 million that's 100 and 77 pick of a line rate if it gets to 100 a year, that's $1.5 million, that's another $150 million. A350 isn't going to be a big in a couple of years. It will be in, probably, three, so I don't know, somebody do the math what do I get. Roughly 250, say 300 on top of today's commercial aerospace base of two waiting on per year.

Wayne Pensky

Then I guess you could get the 50%, a dollar per shift side on all those programs, so really you can make your own assumptions and how quickly you think you can ramp up.

Kwang Wei Ling - Capstone Investments

Did you say 50%?

Dave Berges

I didn't. I guess, I didn't.

Wayne Pensky

It's just what we were just saying, even we've given out the dollars per ship and even you can pick your own point, Kwang.

Kwang Wei Ling - Capstone Investments

Just want to roughly get your view on that, and just try with this one but just looking at old programs versus new programs, any rough color you can give in terms of the margin delta?

Dave Berges

No, we don't have wide ranges of margin across our businesses. They're all sort of in the same neighborhood and I wouldn't say there is a big swing one way or the other.

Kwang Wei Ling - Capstone Investments

Between new programs and old programs?

Dave Berges

Right, correct.

Operator

That concludes our conference for today. Thank you for your participation.

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