Moog's (MOG.A) CEO John Scannell on Q3 2014 Results - Earnings Call Transcript

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Moog Inc. (NYSE:MOG.A)

Q3 2014 Earnings Conference Call

July 25, 2014 10:00 am ET


Ann Marie Luhr - IR

John R. Scannell - CEO

Donald R. Fishback - VP and CFO


Cai von Rumohr - Cowen and Company

Tyler Hojo - Sidoti and Company

Steven Cahall - RBC Capital Markets

Julie Yates Stewart - Credit Suisse Securities

Kristine Tan Liwag - Merrill Lynch, Pierce, Fenner & Smith,

Mike Ciarmoli - KeyBanc Capital Markets


Good day and welcome to the Moog Third Quarter Earnings Conference Call. Today's conference is being recorded. At this time, I would 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 that we may make forward-looking statements during the course of this conference call. These 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 July 25, 2014, our most recent Form 8-K filed on July 25, 2014, and in certain of our other public filings with the SEC.

We have provided some financial schedules to help our listeners better follow along with the prepared comments. For those of you who do not already have the document, a copy of today's financial presentation is available on our investor relations home page and webcast page at John?

John R. Scannell

Thanks Ann. Good morning. Thanks for joining us. This morning we report on the third quarter of fiscal '14 and update our guidance for the full year. We'll also provide our first look at fiscal '15. Let's start with the headlines.

First, Q3 was a good quarter. Sales were up modestly on growth in the commercial aircraft business. Operating margins were 11% and earnings per share of $1.08 were up 44% from last year. We also had a very strong quarter of free cash flow at $72 million.

Second, fiscal '14 is on track to meet our earnings guidance. We're affirming our EPS guidance of $3.65 per share excluding the effect of our share buyback program. The buyback program is running well and we're more than halfway through at the end of June. The effect of the buyback will be to add $0.07 per share to this year's earnings.

However, we anticipate the need in the fourth quarter to incur some restructuring charges to set ourselves up to meet our fiscal '15 outlook. We estimate that this restructuring will be about $0.07 per share, cancelling out the contribution from the share buyback. The details of the restructuring are still under review, so for the moment we've put a placeholder for the restructuring reserve in our corporate cost.

Turning now to free cash flow, we're increasing our forecast for the year to reflect the strong performance we've seen in the first nine months of the year.

Third, for fiscal '15 we're projecting a 1% increase in sales, a 50 basis point increase in operating margins to 11.7%, and a 16% increase in earnings per share to $4.25. We're also projecting a cash conversion ratio of over 100%.

While fiscal '15 will be another year of improving performance, the pace of operating margin expansion is slower than we've been anticipating. Excluding our Aircraft segment, we're forecasting 90 basis points of margin expansion next year in the other four segments. So that's very positive.

However, we're forecasting flat margins in our Aircraft segment. This is disappointing but it's the result of the long-term approach we're taking to our investment strategy in the commercial aircraft business. Our major programs are costing us more in the short-term than we had anticipated. Long-term however they will pay off handsomely.

Let me provide a little background and some perspective on the future. Over the last decade, Moog has gone from being a second-tier supplier of hydraulic components to the leading supplier of flight control systems on commercial airplanes. We've won major positions on all the significant new platforms, including the 787, A350, C919, Gulfstream Business Jets, and most recently the Embraer E2 program.

We consolidated the industry through our acquisition of the GE, formerly Smiths' pilot company, in the U.K. We've delivered on all our program commitments and have established an excellent reputation in the market. Establishing this industry-leading position has required an enormous investment of resources as well as the dedication and commitment of thousands of staff around the globe. It's been an incredible accomplishment over a ten-year period.

Today, we have an enviable position in the market while at the same time we have an immature book of business when compared to other companies in the industry. Approximately half our OEM book of business today is on brand new programs and our aftermarket is only 20% of our sales. In addition, our R&D expense continues high as we invest in new opportunities by completing out the commitments we've already made.

In our segment of the commercial aircraft market, the business is characterized by large upfront investments followed by 20 plus years of production and another 20 years of aftermarket. Margins suffer in the investment years, recover slightly in the early years of production, and then improve dramatically as we move through the production lifecycle and the aftermarket grows with the fleet size.

Going back a couple of years to fiscal '12, military aircraft made up 60% of our total aircraft sales. In fiscal '15, that ratio will drop below 50% as military sales slow and commercial sales grow. This commercial growth is coming from new platforms. In addition, our R&D run rate today is $20 million to $30 million ahead of what we anticipated back in 2012. This increased spending is due to our decision to invest in the new Embraer program as well as higher costs to complete out existing projects.

The combination of slowing military sales, early production commercial work and higher R&D is putting margins under more pressure than we had expected. We're seeing this effect come through in the second half of fiscal '14 and based on our latest estimates we continue to see this pressure for a couple of years to come. As we lookout to fiscal '17 and beyond, we'll see margins expand again as our commercial book of business matures and our R&D spending comes down to about 5% of sales.

Our financial goals remain unchanged. We're looking to increase our operating margins into the mid-teens, deliver a 100% plus free cash flow conversion each year, grow organically faster than our markets and allocate capital prudently to maximize long-term shareholder value. Our revised outlook for Aircraft margins does not change our strategy, rather it means it will take us a couple of years longer to reach our margin goals than we had planned.

Now let me provide you with some numbers starting with the third quarter results. Sales in the third quarter of $684 million were up 2% from last year. Organic growth in the commercial aircraft market of 25% with some nice increases in our Space business offset a $10 million decline in sales in the Medical Devices segment. Sales in Industrial Systems and Components were more or less flat.

Taking a look at the P&L, our gross margin is unchanged from last year, R&D is down slightly, while G&A costs are up slightly as a result of our SAP startup activity. In Q3 fiscal '13, we had several unusual items including restructuring cost and the loss on the sale of our Ethox Buffalo operations. This quarter we had no unusual items. Interest expense in the quarter was down almost $4 million and we benefited from some favorable tax specials giving us an unusually low rate of 25.6%.

Fiscal '14 outlook; we're increasing our full-year sales forecast by $9 million. On the positive side, commercial aircraft sales continue to exceed our expectations, while on the negative side our Medical Devices sales are coming in well short of plan. We're moderating our forecast for operating margins by 30 basis points to 11.2% on lower Aircraft margins. We're forecasting earnings per share of $3.65 including both the effect of our share buyback and some restructuring costs we anticipate in the fourth quarter. Cash flow is strong and we're increasing our forecast for the year by $20 million to $185 million.

Fiscal '15 outlook; for next year, we're projecting sales of $2.69 billion, up 1% from fiscal '14. We anticipate commercial aircraft will continue to grow and that we'll see some recovery in our industrial markets. Defense sales will be up slightly from fiscal '14. Operating margins of fiscal '15 are forecasted to be 11.7%, up from 11.2% this year. We're projecting earnings per share of $4.25. Cash flow next year is projected at $190 million, 105% of net income.

Now to the segments. I'll remind our listeners that we've provided a two-page supplemental data package posted on our Web-site which provides all the detailed numbers for your models. We suggest you follow this in parallel with the text. Starting with Aircraft, Q3, sales in the quarter were up 8% from last year to $294 million. The familiar pattern continues, strong organic growth on the commercial side compensating for slowing defense sales.

Commercial sales were up 25% in the quarter with strength in both the OEM and aftermarket segments. Sales to Boeing and Airbus maintained their upward trajectory led by the continued 787 ramp and the start-up of production on the A350. Commercial aftermarket also had a strong quarter driven by continued strong initial provisioning on the 787.

In the military markets, sales were down 5% from last year. Sales on OEM platforms were down 11% with lower sales in both the V-22 and F-35 platforms. In our third quarter last year, we received a long-awaited order for the F-35 LRIP 6 resulting in an unusual pop in sales in that quarter. This quarter, the F-35 sales were running at a more normal level. The military aftermarket was up in the quarter, ironically those are with higher sales on both the V-22 and F-35 platforms.

Aircraft's fiscal '14; given the strong sales in the third quarter, we're increasing our full year fiscal '14 sales forecast by $38 million to just over $1.1 billion. Military sales will be $13 million higher and commercial sales will be $25 million higher. On the military side, the increase is on the F-35 production contract and across the range of aftermarket programs. On the commercial side, the increase is in both the OEM and aftermarket categories driven by the 787 program.

Aircraft's fiscal '15; we're projecting a minimum sales change between fiscal '14 and fiscal '15, although the mix will continue to shift from military to commercial. Military OEM sales will be $17 million lower with the reduction split evenly between domestic and foreign military sales. The military aftermarket will be about $5 million lower.

Commercial OEM sales will be $35 million higher as the A350 production ramps up. On the other hand, the commercial aftermarket is forecasted to be down $17 million next year on a significant slowdown in the 787 initial provisioning, up almost $20 million from our forecasted fiscal '14 total. In fiscal '14, we enjoyed abnormally strong initial provisioning on the 787 and various customers put large amounts of hardware on the shelf in anticipation of their future fleet sizes.

Aircraft margins; margins in the quarter were 10.3%. This was below our forecast. Given the results of the third quarter, we're moderating our margin forecast for the year to 11.1%, down 100 bps from our forecast 90 days ago. One-third of this margin reduction is due to higher R&D cost and the other two-thirds are due to higher early production costs on our commercial programs. Given the margin challenges in fiscal '14, we've taken a hard look at fiscal '15 and beyond. In fiscal '15, we're forecasting full year margins of 11.1%, in line with fiscal '14.

On the military side, we're seeing margin pressure on some domestic programs and lower sales on a variety of foreign military platforms. On the commercial side, the initial production ramp-up on the A350 program combined with $20 million lower 787 initial provisioning sales, are further margin headwinds. Balancing these out, we'll see some relief on the R&D expenditures as the A350 development slows down. As I said in my opening comments, when we look beyond fiscal '15, we believe we'll continue to see margin headwinds for another year or so before R&D starts to ease off and the new commercial production programs mature.

Turning out to Space and Defense; Q3, sales in the quarter were up 2% from last year to $103 million. Strong growth in the Space market compensated for lower sales in the Defense market. Within our Space market, we had higher sales of components on both satellites and launch vehicles. We benefited from several large production orders for fluid components for satellite and our work on the NASA's Soft Capture System was up nicely from last year. In the Defense markets, the lower sales were the military vehicle applications. Last year we enjoyed a very strong quarter of spare sales for the LAV-25 vehicle and this quarter those sales did not repeat.

Space and Defense fiscal '14; we're moderating our sales forecast for the year by $10 million down to $410 million. The change is all in the Defense market where the military vehicle business continues to be softer than we were forecasting. The softness is in both the domestic and foreign military markets. We're keeping our Space forecast unchanged from 90 days ago.

Space and Defense fiscal '15; for fiscal '15 we're projecting a 2% increase in segment sales to $418 million. We're forecasting a stronger Defense business as the military vehicle market recovers from the low point in 2014. In the U.S., our military vehicle sales have dropped from 50 million in 2012 to less than 15 million in fiscal '14. We anticipate a modest recovery in the U.S. vehicle sales in fiscal '15 as well as stronger foreign military vehicle sales. We should also see slightly higher sales in both naval and security applications. Space sales in fiscal '15 will be slightly lower than 2014, a combination of lower satellite components sales compensated partially by higher launch vehicle sales.

Space and Defense margins; margins in the quarter were 8.5%, up from 6.7% a year ago. Margins continue to improve as we move through fiscal '14 and get some of the challenges with new acquisitions in fiscal '13 behind us. We're maintaining our fiscal '14 full-year margin forecast at 9.1%, and for fiscal '15 we're forecasting further margin improvements to 10.3%.

Now to Industrial Systems. Q3; sales in the quarter of $148 million were flat with last year but the mix was quite different. We had higher wind energy sales as our new applications in Brazil for our AC system continue to ramp up. Overall, the wind business had stabilized this year at between $18 million and $19 million of sales each quarter.

The non-wind energy business was up in the quarter as we shipped fewer products of steam and gas turbines. In industrial automation, we had another good quarter with sales up 9% from last year. We continue to see modest improvements in almost every submarket within this category.

Finally, simulation and test sales continue to be relatively weak compared to last year as our major simulation customers complete out their inventory adjustment process. We anticipate these sales would start to improve in the coming quarters.

Industrial Systems fiscal '14; we're keeping our forecast for the full-year unchanged at $590 million. We're changing the mix slightly however increasing our industrial automation sales by $5 million, by reducing our simulation sales by the same amount.

Fiscal '15; looking to next year, we are anticipating 3% sales growth to $608 million. Wind energy sales should be up on sales growth in South America. Industrial automation sales would be about flat with this year. And finally we're anticipating a recovery in our sales to the simulation markets as our customers return with a more normal buying pattern after their periods of inventory adjustments in fiscal '14.

Industrial Systems margins; margins in the quarter were up nicely to 11.4%. We continue to see the benefits of the restructuring actions we took in fiscal '13 as well as an improving mix in the business. We're anticipating further margin improvement in the fourth quarter to yield full-year margins of 10.5%. We believe we'll see further margin improvement in fiscal '15 to 12% on slightly higher sales.

Now to the Components segment; Q3, sales in the quarter were down 2% from last year. In the A&D arena, we continue to see weakness in both the aircraft and space and defense markets relative to last year. In general, the reductions were across a wide range of platforms reflecting the general slowdown in military spending. On a more positive note, over the first three quarters of fiscal '14, our A&D sales have stabilized at a run rate of $45 million per quarter.

In the non-A&D markets, sales into the energy sector were 12% higher than last year. This is by continued strength in offshore exploration applications. In this energy sector, our Tritech acquisition which we completed in August 2012 had a very nice quarter and is performing ahead of original expectations. Sales into the medical and general industrial markets were within $1 million of last year.

Component's fiscal '14; we're moderating our sales forecast a little this quarter as we include the results of Q3. We think both our A&D and non-A&D markets will be weaker than our April forecast. The net impact is a downward sales revision of $9 million. This result in full-year sales of $429 million, a 3% increase over last year.

Fiscal '15; we're projecting a modest sales increase of 3% in fiscal '15 to $440 million. Component sales into the A&D markets will be up slightly from fiscal '14 based on slightly higher sales in the space market and an improved foreign military vehicle business. Sales into industrial applications should also be slightly higher as the U.S. economy continues to improve.

Components margins; margins in the quarter were 15.3%, up nicely from Q2. The margin shift in this business quarter to quarter is primarily a function of the sales mix. Given the stronger third quarter, we're increasing our margin forecast for the full-year to 15%. For fiscal '15 we're projecting margins of 14.8%.

Medical Devices; sales in the third quarter of $29 million were down $9 million from last year. About $3 million of the difference is due to the sale of the Buffalo Ethox operations at the end of the third quarter last year. The other $6 million is due to lower sales into the enteral feeding market.

In Q2 fiscal '13 we entered into a new distribution agreement with a large distributor of enteral products in the U.S. The agreement results in lower average selling prices for Moog but also lower selling and overhead costs. Since the agreement has come into place, we've experienced some sales volatility quarter to quarter as our partner wants to size their inventory correctly. Looking past this volatility, there is the opportunity for significant volume increases as we look out to the future.

Medical fiscal '14; given the weak sales in the third quarter, we're revising our full-year forecast down by $10 million to $117 million. The reduction is across all our sub-segments. The intensive divestiture exercise we went through during the first six months of this year resulted in significant management distraction that has taken its toll on the sales outlook for the year.

Medical fiscal '15; full-year sales of fiscal '15 are projected to be $120 million, up slightly from fiscal '14. We should see improving pump and set sales balanced by slightly lower component sales n our Other category.

Medical margins; margins in the quarter were 8.2%. Given the low level of sales in the quarter, this margin performance is particularly encouraging. We continue to manage our cost prudently and focus our attention on positioning the business for sale. Given the strong third quarter, we're increasing our full year margin forecast from 6.9% to 8.3%. For fiscal '15 we're projecting full-year margins of 8.8%.

Before leaving our Medical segment, let me reiterate what I said last quarter about our strategic direction. We have determined that the medical pump business is not core long-term. As we move forward, we're continuing our process of seeking a suitable buyer for the full segment but also broadening our process to consider options for each of the product lines as appropriate. We'll provide the market with updates as events unfold.

So let me provide a summary. After all the various tweaks, our fiscal '14 sales forecast is now $9 million higher than our forecast from 90 days ago. Total sales for fiscal '14 should be $2.65 billion, up 2% from last year. The change in the forecast is the combination of higher Aircraft sales and by lower Space and Defense, Components and Medical sales.

Our operating margin for the full year will be 11.2% and earnings per share $3.65. Our share buyback program will contribute an additional $0.07 per share to this total but will be canceled out by $0.07 per share in restructuring costs which we anticipate in the fourth quarter.

In fiscal '15, we're projecting a small sales increase and a double digit increase in earnings per share. Sales in fiscal '15 will be $2.69 billion or 1% higher than this year. Aircraft sales are projected to be flat with fiscal '14 but with the continuing shift in the mix from military to commercial. Sales in each of the other four segments would be up between 2% and 3%. We're projecting earnings per share of $4.25, net earnings would be $181 million, net margins will improve to 6.7%, and earnings per share will be up 16% over fiscal '14.

So what we see as the risks and opportunities associated with our forecast for fiscal '15? I look at the events in fiscal '14 as perhaps the best guide. On the risk side, slowing Defense spending combined with cost challenges in the early stages of new commercial aircraft programs remain the major concern. On the opportunity side, we're assuming very modest growth in our industrial businesses and that our Space business will be soft next year. Both of these assumptions could prove to be conservative. As always, we try to provide a forecast which balances the pluses and minuses.

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

Donald R. Fishback

Thanks, John, and good morning everyone. As John noted, free cash flow in our third quarter was $72 million. This compares with an increase in our net debt over the last 90 days of $53 million. The difference relates to $121 million of cash used to repurchase Company stock during the quarter. On a year-to-date basis, free cash flow was $152 million reflecting a 129% cash conversion ratio.

Free cash flow has been strong this year. A number of variants when added together are contributing to this progress. We're having some success with more favorable contract terms including milestone payments, improved inventory turns, and lower spending on capital expenditures. As a result, we've seen our working capital excluding cash and debt as a percentage of trailing 12 month sales decline by about 150 basis points in the last 12 months.

Because of our performance to-date, we're increasing our free cash flow outlook for full-year 2014 to $185 million, compared to our last forecast of $165 million, reflecting a cash conversion ratio of 110%. For 2015, our initial forecast for free cash flow is $190 million or a cash conversion ratio of about 105%.

Our 4 million share repurchase program that we announced in January of this year continued in earnest during the third quarter. Year-to-date through the end of June we repurchased approximately 2.1 million shares representing about 4.5% of our average weighted shares outstanding, at an average price per share of about $67. Our plan is to complete this buyback program by the end of the calendar year.

Capital expenditures in the quarter were $22 million and depreciation and amortization totaled $27 million. For the nine months ended June, CapEx is $58 million while D&A was $82 million. We're reducing our 2014 forecast for CapEx to $90 million which compares with projected D&A of $109 million. For 2015, we're forecasting CapEx of $100 million and depreciation and amortization of $112 million.

Cash contributions to our defined benefit pension plans totaled $18 million in the quarter. We've increased our projected contributions for all of 2014 by $15 million to $70 million. We're now planning to contribute $14 million to our German defined benefit plan putting some of our excess overseas cash to work. For 2015, we're planning to increase the pace of contributions into our U.S. defined benefit plan as a result of the persistence of low discount rates. As a result, our contributions to our global DB plan will be approximately $80 million in 2015.

Despite the increased contributions to our DB plans over the last few years, we've been able to show strong and improving free cash flow results. Global pension expense for our DB plans in 2015 is projected to be $46 million compared with $36 million in 2014. This $10 million increase is equivalent to a $0.15 per share drag on 2015 EPS compared to 2014.

Our effective tax rate in the third quarter was a very favorable 25.6% compared with last year's 28.1%. The low tax rate in the quarter resulted from a tax-deductible loss associated with the sale of the Ethox Medical operations in June of last year 2013. As a result, we've lowered our projected effective tax rate for all of 2014 to 29.6%. For 2015, we're forecasting an effective tax rate of 31.0%.

Our financial ratios at the end of the quarter are solid, even after considering the effects of the stock repurchase program. Net debt as a percentage of total cap was 26.9%, down from 30.8% in last year's third quarter. Our leverage ratio is 1.6 times.

During our third quarter, we announced that we amended and extended our revolving credit facility. We increased the total bank commitment by $200 million to $1.1 billion with our existing 13 banks and we refreshed the five-year term to mature now in May of 2019. We also have an accordion option for an additional $200 million. All other terms of the credit agreement are materially the same and at quarter end we had $416 million of unused borrowing capacity on this revolver.

So in summary as John described, we're projecting 2014 EPS of $3.65 including the effects of our share buyback program and we're forecasting 2015 EPS to increase 16% to $4.25 and 1% sales growth. So with that, I'd like to turn it back to John for any questions you may have and we'll ask Ann to help us out with that. Ann?

Question-and-Answer Session


(Operator Instructions) We'll take our first question from Cai von Rumohr.

Cai von Rumohr - Cowen and Company

Great performance on the cash flow. So could you give us a little more color on the Aircraft R&D, where it was, where you expect it to go and some of the Aircraft challenges, is this the A350, where are you seeing the bigger challenges?

John R. Scannell

Let me just clarify your question. Is the question related to '14, '15 or both?

Cai von Rumohr - Cowen and Company


John R. Scannell

Okay. So the broad story in Aircraft is that the R&D remains elevated. Now the quarter R&D came-in in the Aircraft segment, it's down sequentially, it's down at about $20 million, and for the year we're forecasting it to come in at about $90 million. For next year, we anticipate that the R&D will be down about $8 million or $9 million off of that, so you will have that tailwind. But on the other hand you have three headwinds, you've got the military business continues to soften and we're seeing some margin compression that we hadn't anticipated, the commercial ramp-up on the 87 and then particularly next year the 350 gets into gear, is more expensive than we were anticipating, and next year the commercial aftermarket in particular will be down fairly significantly because we had a very unusual year of IP provisioning on the 787 this year which won't repeat the next year. So it's a combination of all of those factors that's leading to compressed margins in the second half of this year and therefore the reduction for the full-year and we're seeing that continue into the next year. The combination of all of those things is how that plays together.

Cai von Rumohr - Cowen and Company

Thanks a lot. So, you have the aftermarket in your forecast down below fiscal '13 and yet Boeing is saying they expect to have 16 to 18 new customer intros this year and the same number next year and the A350 presumably also will be generating some initial provisioning. So help me understand why you have such a sharp decline projected for Aircraft commercial aftermarket?

John R. Scannell

So if I do '14 to '15, the big shift is in the 87 initial provisioning. This year we are forecasting it to be in the $27 million to $28 million range, the next year we're thinking that will be in the $8 million to $9 million range. That is slightly below what we saw in '12 and '13, but given that the initial provisioning is an accumulation based on the fleet size, the outsized results in fiscal '14 we think that that will have a negative impact on fiscal '15.

Now, when we came into this year we had no idea that the IP would be as strong as it turned out to be and perhaps that's a little bit conservative. I'm not sure, as I say, if you get a boom year, it's like there's an inventory buildup and I think we feel that it would be a little imprudent to assume that anything like that would happen again.

So if you take that out, Cai, it's down significantly from '14, it's down even a little bit from '12 and '13, but if you look a run rate across the four years it's probably in line with the growth of the fleet size. And the A350 next year, it's only a couple of million dollars, it's not a big number, so it doesn't really drive it next year.

Cai von Rumohr - Cowen and Company

Okay, great. And then you mentioned the restructuring. How do you [indiscernible] what's that for, and it's all in corporate expense, is that correct?

John R. Scannell

What we've done is we've put a placeholder in corporate expense, Cai, and we've reserved a number, $4 million to $5 million, in that area. We have not gone through all of that internally yet. There's a lot of discussion that's still have to happen, nothing has been announced, so we would prefer not to go into it at this stage because there needs to be some internal discussion before that happens. Normally we wouldn't mention this type of thing on a call until it was after the event, but given that part of meeting the 2015 numbers, we wanted to make sure that we weren't surprising the market at the end of next quarter if we had a number for it.

Cai von Rumohr - Cowen and Company

And two quick ones. Your R&D, what assumption if any are you making regarding R&D on the 777X is the first question?

John R. Scannell

The 777X, we have not yet got into the bidding process in that. Our packages are later coming out than some of the other packages and we have some possibility of some money reserved in next year's numbers for what I might call as new programs or unplanned activities, but it's not a significant number and even if we were to win something on the 777X typically in the first year it's not a very large number. But given that we haven't seen the details of it et cetera, I can't be exact on that, Cai. I think if we were to win in fact under 777X, I'm guessing there will be a slight revision in the R&D spend one way or another, I'm not sure that it would be a very significant revision.

Cai von Rumohr - Cowen and Company

Okay, and then the last one. You mentioned still having a mid-teens margin target. Is that just for the Aircraft sector or the total Company, and approximately when might we hope that you might reach that target?

John R. Scannell

That's our target for the whole Company. It's also the target for the Aircraft business. And as I said, I said a couple of years ago that our objective was to get to mid-teens by mid-teens, and clearly that's now not what we are achieving, and that is a disappointment for us internally. If I go back a couple of years and if I look at what assumptions – and we had models out five years at the time that supported that type of margin growth – but what assumptions were in those versus to what actually happened, I would say there's a couple of things.

One is that the higher investment in R&D which as I mentioned on the call is $20 million to $30 million higher in '15 than what we had projected a couple of years ago, and that's completing out the work that we have on the 350 in particular but also the addition of the Embraer program, so it's an investment decision that we made, plus higher costs from some of the other programs. It's higher cost associated with the initial ramp-up as programs move from development into production, the 87 and now the 350 coming on behind us, and behind that we will have the E2 jet. It's [indiscernible] slowing down I think a little bit more than we had anticipated. And then the fact that there is no real growth on the industrial side of our business.

So you take all of those together and if you look back a couple of years versus where we are now, those are the things that have actually been headwinds versus what we originally felt. Given the reset I would say in the Aircraft margins and that we don't anticipate that the headwinds there will change for the next couple of years, we're probably out a few years, and I would say [indiscernible] probably work towards the backend of the late teens before we will see those mid-teens margins. I'm hesitant to say it, Cai, because I said something before and now I can explain all the reasons that it didn't quite work out, but based on what we look at now, that's the outlook that we see.

Cai von Rumohr - Cowen and Company

Terrific. Thank you very much.


And we'll go next to Tyler Hojo.

Tyler Hojo - Sidoti and Company

So first question just relates to the fiscal '15 guidance, I guess what I'm wondering is, what is the assumption in regards to share count? Are you assuming that the remainder of the share repurchase authorization gets filled by the end of the year?

Donald R. Fishback

Tyler, this is Don Fishback. Yes, we are expecting that the remaining – I think I mentioned in the call about 2.1 million shares were purchased in the third quarter or through the third quarter. So we've got a little under 2 million left to go. We're forecasting that by the end of the calendar year, there's a little bit of a [indiscernible] in the answer to your question, so by the end of the calendar year we'll have finished the 4 million buyback.

Tyler Hojo - Sidoti and Company

Okay, got it. Alright, that's helpful. And then just to follow-up to Cai's question on 777X, maybe you could share with us what your thoughts are in terms of timing on some of those supplier decisions that you're going after?

John R. Scannell

I wish I could, Tyler, but we don't know that yet. We've been [indiscernible] RFIs, request for information and stuff, but my last information as of a couple of days ago is that we haven't fully, we haven't received RFPs and details and schedules associated with that. So I'm afraid that's a question that you'd have to ask Boeing. We don't know exactly what their schedule is.

Tyler Hojo - Sidoti and Company

Okay, fair enough. And maybe just kind of a broader question as it relates to the wind market, nice to see kind of some of the progress there but I guess what I'm curious about is just, I know part of your strategy is to move from DC to AC power within kind of the wind product line, how is that going and is there any sort of timeframe associated with kind of transitioning there?

John R. Scannell

I would say that's a transition that's happening, it's the customer base that's determining how quickly they want to do that. So some new customers like our business in South America is on the new system, in Europe we're focused and in China we're focused on selling the newer system, but the adoption rate is really based on the consumers, and I think as we look to the future, customers will, the vast majority of them will take the AC system. There are both cost and reliability benefits associated with it. But each customer will be in a different phase of their development cycle and if they have an existing turbine, it's highly unlikely that they will change the pitch system on an existing kind of approved or certified turbine. So they'll probably wait until they come out with their next generation.

So typically the technology shifts like this in any of our markets is something that probably takes two, three, four years depending on what the adoption rate will be. So it's not an overnight, we're shipping you a DC system yesterday, I'll ship you an AC system tomorrow, a lot of it is you introduce to the customer, they do some tests, then they get it into their development cycle, and typically it's a couple of year process before there is a full transition.

Tyler Hojo - Sidoti and Company

Okay thanks for that color. And just lastly for me, just in regards to simulation and test, you've talked now for I guess the last couple of quarters about seeing some inventory adjustments with customers. I guess you're a little bit more optimistic over the next several quarters that that starts to rebound. I guess what I'm wondering is, what gives you that confidence?

John R. Scannell

That is correct, we have seen a significant inventory adjustment this year. The reason for that is, a couple of our customers, one in particular, went through an ERP system conversion and I think they did, like many companies do, they built up some inventory in advance of that in anticipation that they might have some challenges if they went through the conversion, they've done that and they are kind of coming up the far side of that. And the confidence is just based on the conversations with our customers and starting to receive some orders for some new products from them. So we think the fourth quarter will probably be, it won't be a big recovery but we're anticipating that next year we'll see a little bit, we will see some recovery on that as those inventory levels have come down and they start to re-order in line with their production rooms. So it's based on detailed discussions with the customers.

Tyler Hojo - Sidoti and Company

Great. That's all I had. I really appreciate all the color.


We'll take our next question from Steven Cahall.

Steven Cahall - RBC Capital Markets

I think that's me from Royal Bank of Canada. My first question is just on the Aircraft programs. You talked a little bit about the new programs coming in with higher cost. Can you maybe give us some more color of what some of those cost buckets are, is it a little bit more challenges on the learning curve, is this supply or input cost, and as you look forward to the E2, are there things that you've learned from 787 and A350 that will allow you to maybe keep the cost a bit more in line as you get further down in your development trajectory?

John R. Scannell

So there are two questions, let me answer the second one first which is have we learned something. I sure hope so. As you go through any of these, you learn a lot of things and you try to apply it on the next one. These are, particularly the 87 and the 350, these are very, very large systems jobs, and as I described in my text, we've gone from being a components, a second-tier components supplier to a first tier large integrated systems supplier and that has proven to be of course a very large challenge over the last decade. On the 87, we learnt a lot on the 87, we're applying it on the 350 and the E-Jets will be the next one after that, and hopefully we'll have learnt each step along the way so that we get better.

The way we do our costs for these programs is we have an estimate for the initial production and then we have ramp down cost curves for the cost as the production increases as we get down the learning curve, but also as we transition from low rates initial production, typically we will be doing that perhaps in the West where we've got the engineering staff, all of the product engineering folks, and then we start to transition that out of our facilities in the West and ramp up production in our Asian facilities and also ramp up production with our Asian supply chain. And there are a lot of assumptions associated with that that go with the transfer, how the transfer will work, and particularly how suppliers in the supply chain, how their cost will turn out.

As we've gone through some of the programs, what we've learned is that it's taken, the learning curve has taken longer to come down the learning curve, the supply-chain response has been a little bit slower, it hasn't, the cost haven't all come in exactly where you had anticipated, and therefore that cost curve moves out to the right. In the end, there's still plans in place that get us to the cost levels that we want to get at but there's just a shift that takes longer to get there and more volume has to go through before you actually achieve that. And that's what's happened. It's a combination of supplier challenges and transition challenges and just the fact that these are very large jobs that are new to us as a company.

Now I'd also point out that although there is clearly learnings from the large, one large systems jobs to the next, the technology and some of the manufacturing challenges with each job are different because the flight control systems of an A350 are different from the flight control systems on a 787 which is different from an E2. So it's not that they are more of the same, it's just make more of them, there are unique challenges associated with each one.

So there's all with that challenge, yes you learn about the systems job but there are individual challenges because they're different piece parts, perhaps some of them are different suppliers, and each thing brings a new challenge with us.

Steven Cahall - RBC Capital Markets

That's great color. So on the 787, have you fully made that transition from the low rate production in the West to the factory and then where are you in that transition on the A350 here?

John R. Scannell

On the 787, all of our manufacturing is done. We have a facility in the Philippines, which by the way we've had since 1984, so this is not a new facility for us, and all of the 787, essentially all of it is now coming out of our operations in the Philippines. So that transition happened over the last couple of years but we've also of course ramped the 787 at the same time from 20, 30, 40 units to where we are doing 10 a month now, 120 a year, and continuing to look at potentially ramping up from there.

We're building up the supply-chain associated with that but there is the challenge as you bring new suppliers onboard that if for some reason the supplier hiccups you end up going back to your higher cost Western supplier in order to make sure that you're guaranteeing your supply and you put that, you buy from them, that stuff goes into inventory and of course you have to work down your way down through that inventory and that stays in the cost once you get past that and you bring the other supplier onboard. So I'd say the 787 from an internal factory perspective is in Asia, in terms of the supply-chain that's maturing, and we'll probably, we then continue down that learning curve.

The A350 is in the transition process, it's essentially very early production we've done. In order to minimize risks, we do those early production units, goes to the engineering design teams in the West, that's obviously a lot more expensive, new volume, Western rates, and then we start moving it to Asia and it is in the process of moving. Next year as we ramp up, we will see a lot of that ramp-up happening in Asia. But typically to do that, it's one to two-year transition process because you have to do it very carefully that you're making sure that you are maintaining the quality, meeting all of the certifications. We've done it very successfully, we've never announced there's been a major hiccup, we can deliver products. So we have done it very successfully. The challenge always is, do the costs come-in in line with what we had anticipated.

Steven Cahall - RBC Capital Markets

Okay, that's very helpful. And then just a final one maybe on cash. You talked a lot about having more inward investment focus, maybe a little bit less focus on M&A. With such strong free cash flow, is there any directional change there, and I know you're not going to talk specifically on what you are doing with Medical, but if you were to find a buyer for something does maybe the cash that comes in from that gets sorted out differently than the free cash flow that you are generating on an ongoing basis in terms of deployment?

John R. Scannell

So we are engaged in the buyback program, that's new for us as a company, that's not something that we've done in the past, and is a reflection of the fact that we find ourselves in an environment where we've got strong cash flow and there are fewer interesting acquisition opportunities than in the past. Now we still see ourselves definitely in the acquisition game, we just haven't seen opportunities that we found compelling enough and we wanted to make sure that we were giving cash back to shareholders in a way that was rewarding them for long-term holding of the stock.

What I'd like to suggest is let's get past that share buyback program. We are conscious of the fact that we are relative to our history under-levered and then we get through this share buyback program and then we look at, so what will be the next step in terms of returning, either returning capital to shareholders or reinvesting capital to provide for long-term shareholder growth. So we'd like to get through the present buyback which as Don said is probably going to take us another quarter or two and then we'd like to address that again.

And in terms of the Medical, if there are receipts for Medical, I think that probably weighs out. I don't know if that's something that we – given how long it took us to get the process underway and the fact that we've had to take a little bit of a reset in it, I don't think that's something that we have to worry about too soon. If we manage to sell some or all of the Medical business, we'll obviously come back and we can answer that question at that time.


We'll go next to Julie Yates.

Julie Yates Stewart - Credit Suisse Securities

Organic growth for next year is a little bit below where most of us were expecting and you did a nice job of explaining why, but just thinking big picture beyond FY '15, how should we think about the pace of organic growth as some of these new programs ramp up?

John R. Scannell

I think maybe there's two questions in there, one is new programs which are an Aircraft phenomenon and it's the commercial side of aircraft and that's just based, Julie, on the quantities of airplanes that they're going to actually make. And the new programs that will be, we can see the A350, if you assume ballpark it's a $1 million of the content, you can run that out, 87 you can assume roughly the same, you can run that out, if Boeing's rates go up we'll see that go up. And then the rest of the book of business you can kind of look at that versus the average rates that Boeing and Airbus are predicting.

So I think in terms of looking at the growth rate on the commercial OEM side, that's literally program by program driven and I'm thinking you probably have a better outlook or at least as good an outlook of what Boeing and Airbus are going to do as we do, and therefore I think you can bake that in. So there will definitely continue to be growth on the commercial side unless the cycle slows down and Boeing and Airbus were to slow down production rates, but I don't think anybody's predicting that just year-end.

So we'll see growth on the OEM side. We said that the aftermarket next year was down, but as I said that's really a reflection of the fact that we had an enormous IP year this year on the 87 and we think that's going to tail off next year. I hope that we start to see that aftermarket grow after that as the 87 comes back after a more normal level, and clearly we will see the 350 kicking in after that and then the E-Jets after that again. And then as the fleet size grows, you move from IP into the normal aftermarket. So over the next decade we should definitely see that aftermarket stock to ramp up and continue to ramp up.

The rest of the business is – obviously the headwind is on the Defense side of the business and we're not projecting any significant differences from the military budget except for the F-35 where we have a big position on the F-35 and we would see that obviously ramping up. So that's clearly the growth program over the next few years and the hope is that that will compensate at least in part for the wind-down of some of the other V-22 Black Hawk, all of the other programs, the vehicle programs that we've already talked about.

And then on the industrial side, we've seen some nice steady albeit very small improvement in the industrial automation business, which for us really is comparable with GDP growth. As you see GDP growth, it's the capacity utilizations going up, eventually the capital investment cycle kicks up and you start to see that in our business. But until you really see GDP picking up and big investment in capital, we won't see our business shoot up, and I don't think we've seen any evidence in Europe or Asia or the U.S. that says, yes, we are really now – now the consumer is really bound to pick up and we're really going to see that capital investment, the folks retool and try to drive productivity. So we're forecasting a little bit of an improvement next year but nothing too spectacular, and the out years, again just looking at the organic side of it, it really is based on how you get back into a significant growth cycle on the industrial automation business.

And in the Space business, relatively speaking that's relatively small, it's only about 10% of our business. We think that's got good long-term growth opportunities particularly on the commercial space side but that will go up and down year-to-year as you get involved in new development programs, move into production, you get through this, six or eight or 10 satellites, that winds down, the next development. So there's a little bit of a cycle up and down in that that's hard to predict.

So I'd love to see significant organic growth opportunities outside of commercial but that's the big one right now and I don't think there's another huge driver. The one other one that I would mention is the Marine business, the whole energy business. That has the upside potential. The Marine business has continued to be very strong, we've acquired some additional businesses there to broaden our footprint and we think that continues that up opportunity.

And wind business, we said we're sticking with the wind business despite the challenges we've had because we believe that we can develop products that offer superior performance at a better price point and offer significant growth if we can re-establish a very strong position in that market. So that should be a growth market. If it turns out not to be, then I think we're going to have to take a step back and decide whether or not we think we can be as successful as we thought. So we clearly have an organic investment strategy around wind right now that we would like to see pay off over the next three to four to five years but it will take a couple of years to get the new products established in the market and then start to see the growth. That's a long answer to a short question, Julie.

Julie Yates Stewart - Credit Suisse Securities

Okay, thank you. And one for you, Don, what are the assumptions for equity based comp and for corporate in '15?

Donald R. Fishback

Equity based comp is around $8 million, let me just double check here. Yes, $8 million in 2015. And what was the other, corporate expense?

Julie Yates Stewart - Credit Suisse Securities


Donald R. Fishback

Corporate expenses we've got going up to about $29 million in 2015 from about $27.5 million in 2014.

Julie Yates Stewart - Credit Suisse Securities

Okay. And then is there any risk that some of the restructuring charges anticipated in the fourth quarter bleed over into FY '15 as you're still in early stages in shaping that program?

Donald R. Fishback

Yes, that's definitely a possibility, Julie.

Julie Yates Stewart - Credit Suisse Securities

Okay, is that embedded in guidance?

Donald R. Fishback

No, the way we've done it at the moment is we've said that we reserve some restructuring bucket in the fourth quarter, but whether or not that will all – whether or not we'll be able to work our way through all of that or not in the fourth quarter we don't know at this stage, but the '15 guidance assumes this, assumes that we'll hit it, what we're going to do in 4Q and get that behind us.

Julie Yates Stewart - Credit Suisse Securities

Okay. And then just one last one. I think historically you guys have given some color on the cadence of EPS throughout the year. I didn't see that in the supplemental data. Is there any color on EPS by quarter?

John R. Scannell

Typically we do that in our fourth quarter, Julie, but the assumption is that like most of the years it tends to be a little bit lower in the first half of the year and then pick up a little bit more in the second half of the year, but $4.25, you're probably in kind of high $0.90s or $1 in the first half of the year and then you get a little bit better in the second half, but we'll be a little bit more specific in 90 days.

Julie Yates Stewart - Credit Suisse Securities

Okay, understood. Thank you very much.


We have time for one more question from Kristine Liwag.

Kristine Tan Liwag - Merrill Lynch, Pierce, Fenner & Smith,

John, you mentioned earlier that quality and on-time delivery issues you're facing when you're bringing new suppliers to your system is part of the reason for the margin headwind. Should we think of this shift to lower cost suppliers as part of your strategy in going partnering for success?

John R. Scannell

Let me caution you a little bit, Kristine. I think what I said is that there are challenges, there's all those challenges with bringing on new suppliers, and I think the way you phrased it is that new suppliers have quality and delivery problems, and I wouldn't put it like that. I think with each new supplier, there's always a learning curve, there's an initial getting to know each other, some pep talk and all that type of stuff. So there are all those challenges as you go through that. I wouldn't like somebody to feel like I said new suppliers deliver poor quality and they don't come in on time.

But in terms of the broader question, we've been working to develop a low-cost supply-chain for the last five years or so in anticipation of the 787 ramp-up and of course the A350 and the other programs after that and it is the key part of our internal strategy. It was not something that was specifically triggered by the Boeing partners for success because that's a more recent program, this was something that we anticipated when we originally got into the 787 back a decade ago and as I say we've been working intensely on it over the last five or more years as the 787 has moved into production and started to ramp up. So it's not new, it's an ongoing process, it's a key element of our overall ability to compete in the commercial aircraft business is having that Asian supply-chain.

Kristine Tan Liwag - Merrill Lynch, Pierce, Fenner & Smith,

Great, thank you.

John R. Scannell

Ann, we can take one or two more questions. If there's still some folks on the line then maybe we can take another couple of questions.


(Operator Instructions) We'll go to Michael Ciarmoli.

Mike Ciarmoli - KeyBanc Capital Markets

I guess one thing I'm struggling with here, you brought down the aircraft control margins I guess by 100 basis points in the second half of the year. What really changed between last quarter and this quarter? I mean is it military being under pressure, commercial ramping, the R&D? It seems like all that was really known. So I'm just struggling with what really surprised you or what happened that was entirely new that wasn't in your plan?

John R. Scannell

Michael, that's a great question because that's the question of when do you actually recognize something, when does it go from – with the value of hindsight you could always say, and we've said it internally, couldn't we have known, shouldn't we have known, was there something, what are the signs there. So it's one of those where each quarter we go through a detailed review, we look at how are the costs, again on the early production, how are the costs coming in versus what we had anticipated versus what we had modelled. And then the other thing that's happened is that the rates on those programs are higher than we had anticipated.

So the difference in the second half of the year, the margin adjustment that I said is two things. It's about, 30 basis points of it is higher R&D than we had forecasted and we've seen this phenomenon before where it takes a little bit more cost than we had anticipated. So that's about 30 basis points of it. And the other 60 to 70 basis points are higher costs on initial production runs than we had been anticipating. As I say, you forecast out what those are going to be and then when you look back in the quarter, turned out that we didn't quite meet the targets that we had set for ourselves, and when we roll that forward into the fourth quarter, we say it's going to continue to be a challenge in the fourth quarter. And on top of that, the rates on those commercial ramp-up are higher, so you've got more sales on those things with lower margin than you had anticipated.

So it's all or one of those, yet with our signs could we have known, and you say, yes, with the value of hindsight we should have, could have, we didn't, you wake up one day you go through it all again and you say, oh I get it, it's a little bit different from what we thought and we're going to have to do a little bit of a reset on the margin outlook. I'm afraid that's all I can tell you.

Mike Ciarmoli - KeyBanc Capital Markets

No, that's helpful, that's helpful, I get it. And with your experience with the Neo and with the Max, do you anticipate any spending related to the A330 new engine option?

John R. Scannell

We don't have any position on the Neo or the Max, Michael.

Mike Ciarmoli - KeyBanc Capital Markets

Okay. I'm just trying to think given that the A330 should really have much of an impact than neither.

John R. Scannell

I don't think we know a lot about the A330neo yet, I think my understanding is they are going to re-engine it and they're probably going to try and minimize everything else. We have ailerons on the A330 and we've got some other valve component stuff on it but not a lot of content on an A330. If they keep all the flight controls the same, the chances are we could hopefully keep our position with the aileron but it's not – it's just a single actuation position on the airplane. If they decided to change [indiscernible] of the actuation, of course that opens up the market for all of us to re-bid stuff, but that seems like that would be a challenge to do that, that would be a big job, it means changing a lot on the wing and for the volumes that they are anticipating it seems like it would be hard to justify the [indiscernible] for anybody to do including Airbus. So I don't think we think of the A330neo as a big move one way or the other for us at this stage.

Mike Ciarmoli - KeyBanc Capital Markets

Okay perfect. And then just the last one, I know you guys talked about the F-35 aftermarket given flight hours, I know there's obviously been a brief pause here in flying hours there but what are kind of the expectations, any changes for F-35 aftermarket provisioning content given where that fleet is trending?

John R. Scannell

So again I just have to put it into perspective though. I mean what I said in the text was there was a little bit of improvement on the F-35 aftermarket. This year it's about $5 million, $6 million piece of business. Next year it's actually up into the $7 million, $8 million size. So we're not talking huge numbers yet. That will be in time as the fleet grows, a very interesting piece of business for us, but we are anticipating kind of a slow ramp for the next couple of years.

Mike Ciarmoli - KeyBanc Capital Markets

Okay, perfect. Thanks a lot.


And there are no questions in the queue at this time.

John R. Scannell

Thank you very much. Thank you to everybody for listening in and we look forward to meet again in 90 days. Thank you.


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