Rockwell Collins' (COL) CEO Kelly Ortberg on Q1 2016 Results - Earnings Call Transcript

| About: Rockwell Collins, (COL)

Rockwell Collins, Inc. (NYSE:COL)

Q1 2016 Earnings Conference Call

January 22, 2016 9:00 AM ET

Executives

Ryan Miller – Vice President-Investor Relations

Kelly Ortberg – Chairman, President and Chief Executive Officer

Patrick Allen – Senior Vice President and Chief Financial Officer

Analysts

David Strauss – UBS Securities

Peter Arment – Sterne Agee CRT

Richard Safran – Buckingham Research

Ken Herbert – Canaccord Genuity

Carter Copeland – Barclays Capital

Sam Pearlstein – Wells Fargo

Seth Seifman – JPMorgan

Robert Stallard – Royal Bank of Canada

Pete Skibitski – Drexel Hamilton

Myles Walton – Deutsche Bank

Robert Spingarn – Credit Suisse

Cai von Rumohr – Cowen and Company

George Shapiro – Shapiro Research

Noah Poponak – Goldman Sachs

Michael Ciarmoli – KeyBanc Capital Markets

Jason Gursky – Citi Investment Research

Howard Rubel – Jefferies and Company

Operator

Good morning and welcome to the Rockwell Collins First Quarter Fiscal Year 2016 Earnings Conference Call. Today’s call is being recorded. For opening remarks and management introductions, I would like to turn the call over to Rockwell Collins’ Vice President of Investor Relations, Mr. Ryan Miller. Please go ahead, sir.

Ryan Miller

Thank you, Sean, and good morning to all of you on the call. With me on the line this morning are Rockwell Collins’, Chairman, President and Chief Executive Officer Kelly Ortberg; and Senior Vice President and Chief Financial Officer, Patrick Allen.

Today’s call is being webcast. And you can view the slides we’ll be presenting today on our website at www.rockwellcollins.com under the Investor Relations tab. These slides include certain non-GAAP financial information and a reconciliation to the related GAAP measure.

Please note today’s presentation and webcast will include certain projections and statements that are forward-looking. Actual results may differ materially from those projected as a result of certain risks and uncertainties, including those detailed on Slide 2 of this webcast presentation and from time-to-time in the company’s Securities and Exchange Commission filings. These forward-looking statements are made as of today, and the company assumes no obligation to update any forward-looking statement.

With that, I’ll now turn the call over to Kelly.

Kelly Ortberg

Thanks, Ryan, and good morning, everyone. If you recall on last quarter’s earnings call, we said that we expected first half of fiscal year 2016 to be a slow start to the year, followed by growth in the second half. We expected the first quarter to be the weakest and in fact it was even a little weaker than we anticipated, most notably in Government Systems. So let me take that ahead on and summarize the performance and outlook of each of the businesses. And I’ll start with our Government Systems business.

Due to program timing we expected our Government Systems business to be down mid single-digits in the first half followed by nice growth in the second half resulting in overall low single-digit growth for the year. In the first quarter, we did experience the anticipated headwinds that we outlined on last quarter’s earnings call.

However, we were also impacted by two issues that we did not anticipate. One was a supplier issue that impacted late quarter deliveries of some products. And the other was a delay in some expected follow-on orders. All-in, the supplier issue and the order timing delay caused about 500-basis point impact to our Government Systems for the quarter. The good news is that we’ve already resolved the supplier issue and we have booked one of the delayed orders. And I expect to recover both the order timing and product delivery catch up with in the year.

Now I know that it makes investors nervous when growth is back-end loaded, so I would like to provide some additional color on what we expect to drive that growth in our Government Systems’ second half. Roughly 60% of the back-half growth is either in backlog or annual follow-on business where our customers make annual buys throughout the year. All this looks to be well-funded, so I don’t see much risk here. But 25% of the second half growth is in programs that we have won, but are not yet awarded. The only risk is the timing of the contract action and we’re tracking that very closely and are confident that will close in a timely manner for our year.

And then the last 15% of the second half growth are programs that we have yet to go out and win. And that number is inline with our normal, historical, anticipated sales profile for this point in year. So despite the challenging first quarter, I remain confident in our low single-digit growth for the full year in Government Systems.

Now before I move from Government Systems I do want to make a few comments about the budget outlook. First of all, the new budget is net good news for our government business. If you recall we’ve been forecasting our government business with sequestration as the budget baseline. And as I’m sure you know, the agreement is an improvement from that baseline. I also believe that we’re well positioned to at least get our fair share of the budget increases, given their priorities and the breadth of our portfolio. I would expect that we’ll start seeing some of this improvement as early as next year. In fact I wouldn’t be surprised if we get a little tailwind on short cycle orders by the end of this year. So this is a strong boost to our plan to return Government Systems to sustained growth.

Moving now to Commercial Systems, first-quarter results were inline with our expectations. OEM sales were down, primarily driven by the impact of the previously announced global express rate reductions at Bombardier. But we did see nice growth in our Commercial Systems aftermarket.

We delivered another quarter of strong operating performance, headlined by 22.2% operating margins and our Commercial Systems team did a really great job of controlling their spending to manage the margin impact from the Global 5000 and Global 6000 production cuts at Bombardier.

Fiscal 2016 is an important year of program execution for our Commercial Systems. And we completed a large number of milestones in the first quarter, including the certification to CSeries and ARJ-21 aircraft, first flight of the Mitsubishi Regional Jet, entry into service of the Challenger 650 at Bombardier, entry into service of the fusion-equipped King Air at Cessna, and entry into service of the Legacy 450 at Embraer. All of these programs are important in our long-term growth plan for our Commercial Systems business.

Now finally, let me turn to Information Management Services, where we delivered mid-single digit topline sales growth for the quarter and some really strong operating margin performance, a 130 basis point improvement over the year – over the prior year. Our core aviation business grew at 7% and continues to drive the incremental margin improvement that we expect from that business.

In the year, most – I’m sorry, last year most of our revenue synergies from the business aviation side of the business were leveraging synergies between ARINCDirect services and Rockwell Collins international flight operation service portfolios. And while we anticipate some additional opportunities in this part of the business, we’re now starting to see synergies in other areas of the business. For example, we’ve secured a number of new agreements to fly Global Express connectivity service in the cabin, allowing us to address the broadband connectivity market that we have not previously served. We also signed launch customers for our ARINC MultiLink flight tracking service, which is complaint with the new European mandate that will help airlines keep track of their fleet.

I know I probably sound like a broken record, but I continue to be extremely pleased with the acquisition of ARINC from both a financial perspective and how well the culture of the ARINC team and the Rockwell Collins family. I think we continue to expect more good things to come from this business.

So in summary for the quarter, I feel really good about achieving our full-year plan. We have good line of sight to second-half growth, and we successfully executed our restructuring plan in the first quarter which will deliver benefit going forward. The permanent reinstatement of the federal R&D tax credit and the 2015 government budget deal, are both very positive catalysts for Rockwell Collins’ future. And I continue to believe with strong execution on new programs we have a very optimistic outlook for the long-term growth drivers of our company.

So with that as an overview, let me turn it over to Patrick and have him walk through some financial details.

Patrick Allen

Thanks Kelly and good morning to everyone as well. I’d now like to walk you through today’s presentation slides that summarize our results for the first quarter of fiscal 2016. I’ll begin with Slide 3, where we highlight our total Company first-quarter sales, earnings per share, income from continuing operations and shares outstanding.

Total Company sales for the quarter decreased $57 million or 5%, compared to the first quarter of last year, primarily due to lower Government Systems sales. Income from continuing operations decreased $36 million or 21% and earnings per share from continuing operations decreased $0.26 or 21% compared to the same period last year. Income from continuing operations includes a $28 million after tax or $0.21 per share restructuring charge, primarily related to headcount actions across the company. Which we are taking as a result of challenging market conditions, particularly in business aviation. In addition, of both fiscal 2015 and 2016 includes our retroactive benefit from the federal R&D tax credit of $0.16 and $0.18 respectively.

As we turn to Slide 4, Commercial Systems achieved revenue of $562 million for the quarter, down 1% compared to the same period last year. Sales related to aircraft OEMs decreased $18 million, or 5%, to $313 million, primarily due to lower business jet aircraft OEM production rates, unfavourable airline selectable equipment mix and lower Airbus A330 production rates. All of that was partially offset by higher deliveries in support of the Airbus A350 and Embraer Legacy business jet production ramps.

Aftermarket sales increased $17 million, or 8%, primarily due to higher head-up display retrofit sales in China, higher inorganic sales from the acquisitions of Pacific Avionics and International Communications Group and higher regulatory mandate sales.

Commercial Systems operating earnings were basically flat compared to last year with operating margins improving 20 basis points from 22% to 22.2%. Operating earnings and margin benefited from lower Company-funded research and development expense, partially offset by negative mix, as an increasing customer funded development offset lower business aviation product sales, as well as higher cost from the Pacific Avionics and ICG acquisitions and higher cost from further expansion in international emerging markets.

Now moving onto Slide 5, you’ll see that we reclassified Government Systems sales categories into avionics, and communication and navigation. These sales categories have been consolidated from the previous categories to be consistent with an internal reorganization and are delineated based on the underlying product technologies.

Government Systems overall revenue decreased by 11% or $451 million, driven by lower rotary wing hardware sales, the timing of deliveries for the E-6 program, the wind-down of an international electronic warfare program, lower stimulation and training sales, and lower international targeting system sales. Government Systems first quarter operating earnings decreased $20 million to $86 million, resulting in operating margin of 19.1%, compared to 20.8% in the first quarter of last year. The decreased operating earnings and margin resulted from lower sales volume.

Turning to Slide 6, Information Management Services sales increased 5% over the prior year, as commercial and business aviation services sales increased 7%, while the non-aviation-related businesses were flat compared to last year.

Information Management Services first quarter operating earnings increased $3 million to $24 million, resulting in an operating margin of 15.4% compared to the 14.1% in the first quarter last year. The increase in operating earnings and margin was due to incremental earnings and the higher sales volume.

Slide 7 provides an update of our R&D investment. Total spend decreased from $231 million in the first quarter of fiscal 2015 to $228 million in the first quarter 2016. Company-funded R&D decreased $17 million due to lower development expenditures for the Embraer Legacy 450 and Airbus A350, as well as lower business jet product line development costs.

Customer-funded research and development expense increased $5 million, due to higher development costs for international programs in Commercial Systems. And preproduction engineering investment net increased due to higher cost incurred for certain military transport programs and government systems.

Moving to Slide 8, we show the status of our capital structure as of the end of the first quarter, compared to the end of last year. During the quarter our debt-to-EBITDA ratio increased to 2.0x from 1.7x at year end. The increase is primarily due to an increase in commercial paper, as the first quarter had typically light cash flows. I expect the level of debt to come down over the balance of the year as a larger portion of our cash flow is traditionally generated later in the year and we pay down a portion of that short-term debt.

The updated status of the share repurchase program as of the end of the first quarter is detailed on Slide 9. During the first quarter we repurchased one million shares at an average cost of $87.40. Our repurchase authority remaining at the end of the quarter was about $290 million.

Now on to Slide 10, where we provide a summary of our fiscal year 2016 financial guidance, which has been updated as a result of the permanent reinstatement of federal R&D tax credit, as well as an updated restructuring charge. Total sales in segment operating margins remain unchanged from the previous guidance. The earnings per share range as been increased by $0.25.

The federal R&D tax credit provided about a $0.35 benefit to our fiscal year 2016 earnings per share guidance and is partially offset by higher restructuring expense and higher incentive compensation expense. The cash flow from operations range has been increased by $50 million, primarily due to the benefit of federal R&D tax credit. Fiscal 2016 guidance for research and development investment and capital expenditures remains unchanged.

Our effective tax rate for the fiscal year 2016 is now expected to be in the range of 22% to 23%, down from the previous guidance of about 28%, due again to the retroactive and prospective benefit from the federal R&D tax credit. The second quarter of the year will have an effective tax rate of above 30%, which includes the benefit that tax credit. And the third and fourth quarters will be similar to the second quarter, however, we expect some lumpiness to happen in the quarters, as a benefit from certain tax planning strategies is expected to be realized.

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

Ryan Miller

Thank you, Patrick. In order to give everyone the opportunity to ask questions we ask that you limit your questions to one per caller. If you have further questions, simply reinsert yourself into the Q&A, we’ll answer those additional questions as time permits. Operator we are now ready to open the line.

Question-and-Answer Session

Operator

Thank you, sir. [Operator Instructions] Your first question comes from the line of David Strauss from UBS Securities. Your line is now open.

David Strauss

Good morning.

Kelly Ortberg

Good morning.

Patrick Allen

Good morning, David.

David Strauss

Kelly, maybe touch on business jet, business jet OE, how you're feeling about things. I think since you gave us guidance last time Dassault came out with some pretty weak numbers. Seems like all the indicators on the business jet side continue to weaken. Maybe talk about not only the guidance for this year, but you think the ability of the OEMs to hold at these lower production rates and not have to go down even lower from here. Thanks.

Kelly Ortberg

Yes, David, if you recall we had put a little bit of discount in our forecast associated with anticipated further challenges to OEM production rates. What we normally have happen is – at this time of year all the OEMs really give us a trued-up forecast as to what they are going to do for the year. And in fact, we did see that production rate decline. Really we saw declines for most of the OEMs. And you’ve heard, as you pointed out, you’ve heard some weakness described in the market from those folks. In fact we’ve used up the reserve that, I had allocated for that.

Now they typically hold pretty well through the fiscal year. If there’s another adjustment, it usually comes around the summer furlough work time, time-off period. So we're hopeful that we're trued up for the year and that's why we put that discount there. Unfortunately, it isn't going to be opportunity; we needed that discount to reflect this.

As far as the long-term outlook, it still remains soft, David. And we continue to be fairly conservative in our outlook for business aviation. These rate levels are pretty low. I think they can be sustained, but we do need to continue to watch that market going forward. I don't have a better crystal ball for what production rates are going to look like next year. We'll true that up when we provide our guidance for next year.

Operator

Your next question comes from the line of Peter Arment from Sterne Agee CRT. Your line is open.

Peter Arment

Yes, thank you. Good morning Kelly and Patrick.

Kelly Ortberg

Good morning.

Peter Arment

Patrick, maybe you could remind us in terms of the cadence of how the savings kicks in for the rest of the year, just from a perspective on the EPS front and the restructuring.

Patrick Allen

Peter, I would say we realized very little savings from the restructuring in the first quarter. And I would say the savings is going to pretty much spread out evenly over the next three quarters. So we should see a pretty balanced savings profile over the next three quarters.

Peter Arment

Okay, thank you.

Operator

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

Richard Safran

Hi, good morning.

Kelly Ortberg

Hi, very good morning.

Patrick Allen

Good morning.

Richard Safran

I wanted to ask you a question on the after-market and about Intertrade and demand you're seeing from refurbished parts. There are some indications of increasing demand for refurbished parts. Want to know if you can comment on that, what you're seeing there. Also, given that the inventory of aircraft cannibalized for refurbished parts is finite, just wondering if you're seeing improving demand, how long you might expect that to last.

Kelly Ortberg

Well, so our Intertrade business is seeing improved demand or increasing demand for used components. Richard, that's really not new; we saw that all through last year. We're expecting to be up double-digit in our Intertrade business this year. And I think that's a trend that's here to stay. So I think you just got to look at where that used components – it's going to be a function of what aircraft are being retired and the pace of retirement, and that's what's going to drive that market.

I think it's becoming a best practice in the industry. As I mentioned in the last call, we're seeing it now being used components. Recycling is being utilized in Asia-Pac where we typically they have always bought new spares in the past. So I think it's here to stay. That's why we've kind of factored our after-market to grow a little slower than what you're going to see the traffic grow. Because I think that after-market is going to be impacted by the recycling of the used components.

Now, luckily we have a used component business. Unfortunately, it's not quite big enough to offset the impact that we'll see in our overall MRO. But I think that's here to stay, Richard.

Richard Safran

Excellent.

Operator

Your next question comes from Ken Herbert from Canaccord Genuity. You line is open.

Ken Herbert

Hi, good morning. Thank you.

Kelly Ortberg

Good morning.

Ken Herbert

Kelly, I wondered if I could start off – there’s been obviously a lot of speculation with the announcement yesterday on the 747 cut from Boeing, just about health of the original equipment, commercial cycle. And I just wondered if I could get your thoughts on sort of if you see any incremental risk in the last month or so relative to some of your initial plans on either build rates on the 737, 787. Any particular incremental areas of risk you would highlight beyond what’s been publicly announced? Or any updated thoughts on the sort of the OE outlook on the transport side here this year and into 2017. Thank you.

Kelly Ortberg

Yes. Ken, really nothing new that I would highlight. I don’t think the 747-8 rate change probably surprises any of us. Obviously, all eyes are on the basic 777 backlog and the ability of Boeing to sustain that. And we’re still watching that just like you are. I’ve got nothing to update you on that.

One thing I’ve said is that Boeing would need to give us an updated rate forecast on the existing 777 here pretty soon to have any impact on our fiscal year 2016. And the fact that they came out with rate changes on 747-8 and didn’t do that on 777 tells me that they’re still marching to their plan to sustain the basic 777 rates, at least through the demand for our fiscal 2016. So nothing new really to report on that. Still very healthy backlog for us. And as you know, we’ve got new share gain opportunities coming into the market.

Operator

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

Carter Copeland

Hey, good morning, guys.

Kelly Ortberg

Hi, Carter.

Patrick Allen

Good morning.

Carter Copeland

Just a quick question on the aftermarket. When do you expect to see any material impact from A350 provisioning sales? Is that later this year kind of impact, or does it take fiscal 2017 to really see any material uptick there?

Kelly Ortberg

You’re probably not going to spike out seeing material impact from A350 provisioning. We’ve already seen initial provisioning and you really didn’t see that as a major spike like we saw on 777. It’s a little bit of a function of the commodities that we provide on the two different airplanes. They are different, as well as the fewer number of new airlines taking the A350 as opposed to 87 when it came out, had a lot of different airlines. I think, Carter, the next big provisioning spike for us is really 737 Max. And we’ll start to see that maybe a little bit at the end of this year and certainly into next year, we’ll see some good provisioning input for that.

Carter Copeland

Awesome. Thanks for the color, Kelly.

Operator

Your next question comes from the line of Sam Pearlstein from Wells Fargo. Your line is open.

Sam Pearlstein

Good morning.

Kelly Ortberg

Hi, Sam.

Sam Pearlstein

Hi. Just want to know if you can talk just more about the aftermarket just in general. How much of the 8% overall, the 16% business jet aftermarket was organic versus acquired? Then can you just talk a little bit about the parts, the retrofits, the upgrades, the provisioning just in kind of the different buckets, how they all performed?

Kelly Ortberg

Yes, if you kind of look overall, we were up 8% as we disclosed here. Air transport was up low single-digit. And that was really HUD retrofits, some cabin wireless activity. Mandates are down in air transport. We’re going to see that throughout the year, that the mandate revenue is down there. Interesting enough, mandates overall were up, because mandates were very good for the quarter in business aviation. And finally, we saw a really nice quarter of avionics upgrades where they are putting fans, updates to the Biz Jet avionics. I’m very hopeful but that will continue and actually provide us a little bit of opportunity for the full-year. In terms of inorganic revenue…

Patrick Allen

It’s about $8 million in the aftermarket and almost all of it is in air transport actually.

Kelly Ortberg

So Sam, if I kind of gave you a little bit of an outlook. I think we’re going to increase our growth rate throughout the year in air transport. You’re going to see the business aviation numbers mute a little bit. We’re not going to see quite as high growth rate. But overall, we still feel good about that high single-digit growth in our aftermarket.

Sam Pearlstein

Thanks.

Operator

Your next question comes from the line of Seth Seifman from JPMorgan. Your line is now open.

Seth Seifman

Thanks very much. Good morning. Patrick, I guess historically, with the R&D tax credit, you guys would have a rate of about 30%. But as you said you’ve implemented some tax saving strategies. When we think about going forward but baseline tax rate for you guys with the permanent R&D tax credit and perhaps some tax saving strategies that can be permanent as well, what kind of tax rates do you think about over a longer term?

Patrick Allen

I think over the longer term, Seth, we’re looking at right around 30%. Maybe a little higher, but right around 30%.

Seth Seifman

Okay. Very good. Thanks very much.

Operator

Your next question comes from the line of Robert Stallard from Royal Bank of Canada. Your line is now open.

Robert Stallard

Thanks very much, good morning.

Kelly Ortberg

Good morning.

Robert Stallard

Kelly, you mentioned on the government side about the potential positive impact of the FY2016 DOD budget. I was wondering if you could comment on what you are seeing in the defense export markets, whether there’s been any impact has yet from the decline in the oil price.

Kelly Ortberg

No, none whatsoever. It’s something we keep an eye on, but in fact all the priority funding, our Saudi F-15 program continues to be funded as expected. We’ve got some follow-on business, high priority business in the Middle East in targeting and those all, all of those programs seem to be well funded. So, no, I’m not seeing any – the oil issues seem to be playing through the commercial business much more than the defense business.

Robert Stallard

Yeah, that’s correct, thank you very much.

Operator

Your next question comes from the line of Pete Skibitski from Drexel Hamilton. Your line is open. Mr. Skibitski, your line is open.

Pete Skibitski

Sorry, good morning, guys.

Kelly Ortberg

Hi, Pete.

Pete Skibitski

Yes, guys there’s been a couple questions on air transport aftermarket and I just wanted to get a little bit more color there. It looks like organically was down about 4.5% in the first quarter. And Kelly, you talked about kind of the new trends in that are going on there. So – but on a full-year basis, I think previously you were expecting kind of mid single-digit growth. Is this long-term now, more of kind of a very low single digits, 2%, 3% type of market for you guys, just because of the new trends there and maybe Asia weakness, Asia changes? Can you just add a little more color?

Kelly Ortberg

Yes, I think the basic MRO component of the aftermarket you’re probably about right because of that recycling that I talked about. But then we have the discretionary side that tends to be a little more lumpy. We’ve got mandate driven revenue. We’ve got these retrofits of head-up displays and head-down display systems on 757/767. And then we have the provisioning things that we talked about earlier that tend to spike that. But I think if you strip the discretionary away and look at the fundamental MRO, I think you’re probably about right.

Pete Skibitski

Okay. Okay. And then just any incremental headwinds at all from Asia, given some of the volatility over there?

Kelly Ortberg

Well, we have seen a little bit of incremental headwinds in our flight services business in IMS, where we’re doing international trip support. If you look at our growth rate, it was just a little lower than what we’ve been expecting and almost all of that softness is just international trips. In fact, our international trips for the quarter were down about 6%. We’re gaining customers, but they are flying fewer international legs right now and I think the China, Russia and Brazil are the areas I would spike out that are causing that. Hopefully that stabilizes here going forward.

Pete Skibitski

Okay. That’s helpful. Thanks, guys.

Operator

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

Myles Walton

Thanks, good morning.

Kelly Ortberg

Good morning.

Myles Walton

I was hoping you could touch on the government side. And I know you want to give quarterly guidance, but how quickly can you recover in 2Q back to that down mid single-digit trends you had originally thought about? Are you at a point where you’re kind of back on the recovery profile, or is 2Q trends going to look similar to 1Q?

Kelly Ortberg

Yes, so let me talk about that. First of all, it’s unfortunate that, and disappointing that we had these issues that kind of piled on a soft quarter. The product issue, if it had been any other quarter than the holiday quarter, I think we would have had it resolved and wouldn’t have even had to talk to you about it. So we’ve already got the issues resolved with the customers. We’re making the deliveries. So that will go pretty quickly. We’ve booked one of the major orders that were the Pakistan’s C-130 that we anticipated. So that will move forward. So I’m pretty confident that we’ll be able to recover that in the fiscal year. Maybe not all in the second quarter, but certainly by the end of the year. So we’re still kind of forecasting down mid single-digits for the first half and then growth in the second half.

Myles Walton

Okay, and then just one other, of the dime, Patrick, that you mentioned was being absorbed by higher incentive comp and extra restructuring, how much is extra restructuring of that and where is it going?

Patrick Allen

Think of it as about half and half. And the increase is largely in the voluntary retirement program, which is spread across the businesses.

Myles Walton

Okay. All right, thanks guys.

Operator

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

Robert Spingarn

Hi, good morning everybody. Hopefully, you can hear me.

Kelly Ortberg

Good morning. We can.

Robert Spingarn

Good morning guys.

Kelly Ortberg

Yes.

Robert Spingarn

Kelly, I wanted to go back to ARINC and just ask if you could give us a little more of a window into actually, into what’s going on in that business. Maybe separate the aviation from the non-aviation, and talk about how you’re going to get that higher single-digit growth rate later in the year, and maybe also if you could comment on the relative profitability of the different businesses in there, because it seems like the non-aviation is the lower margin business.

Kelly Ortberg

Yes, it is. And if you look really the economic engine as I mentioned, the incremental margin comes from the growth in the core aviation business. The non-aviation business, we called that lumpy in the past, where we’ve tended to have project-oriented programs. I’ll admit it’s been consistently lumpy down. So if you look at the performance of that business been pretty flat. And it was flat this quarter. I am expecting growth in the non-aviation component of the business. So we’ll see an improved overall growth rate.

And we put some strategies in place to address the growth in that business. So I think this is going to be an important year to see whether those strategies are going to play out. But we are achieving our overall EBITDA growth expectations because of the fact that we are achieving the core aviation growth that we expect and that we are achieving or a little bit exceeding the incremental margin performance that’s coming with that growth. So again, I feel pretty good about it. The only, the only headwind that I see that maybe we didn’t anticipate was this international trip support. I think that’s temporary for us and we’ll be back, with the growth in international trips, but we’re just kind of have to work through the economic issues here that we’ve got in those regions.

Robert Spingarn

So would you say that Q1 was below plan?

Kelly Ortberg

Little bit, yes.

Patrick Allen

Yes. Q1 was maybe a point below what I was expecting.

Robert Spingarn

Okay. But you still feel pretty good about your original guide?

Kelly Ortberg

Yes, I do.

Patrick Allen

Yes.

Robert Spingarn

Okay, thank you.

Kelly Ortberg

And just to be clear, where it was below plan was in the non-aviation business and…

Robert Spingarn

Right.

Kelly Ortberg

And it’s really the timing of some deliveries there.

Robert Spingarn

I guess the question is can the aviation make up for that or can the non-aviation make up for that?

Patrick Allen

Well, look we’ve been able to make up for it from a profit perspective by driving the growth in the aviation. We have got to get this non-aviation business off this flat forecast, and that’s the strategies that team, my team knows that very well. I think we’ve got some plans to do that. If we can just get some average growth of the non-aviation and continue with that really strong growth out of the aviation business, I feel really good about achieving our long-term outlooks.

Robert Spingarn

Right, right. Thank you.

Kelly Ortberg

Thanks.

Operator

Your nextquestion comes from the line of Cai von Rumohr from Cowen and Company. Your line is open.

Cai von Rumohr

Yes. Thank you very much, guys. So you’ve raised your EPS guidance by $0.25. I think the R&D tax credit is plus 30 and you had mentioned on the negative side, the restructuring and incentive comp and then my understanding was the restructuring savings in the last nine months would at least equal the first quarter’s charge. And then I guess I don’t understand why the incentive comp is up when you missed your plan in the first quarter. So if you could explain those issues. Thanks.

Kelly Ortberg

Sure, Cai. Yes, I would say both the restructuring charge and the savings are up from our original estimate. I would say the charge is up a little bit more because we’ve got – we have some need to backfill some of the people who took the voluntary retirement program. So it’s really a disparity between the size of the charge and the size of the savings that’s generating what’s roughly a nickel of headwind to the R&D tax credit. And the impact on incentive compensation, if you remember last time we had a big catch up in R&D, we had EPS as a goal in incentive compensation. We took that out, but we still have a goal associated with cash flow and the R&D tax credit generated incremental cash flow, which is generating higher incentive compensation because we’ve raised our cash flow goal by $50 million. So that’s the other component of the, I’ll say roughly dime that’s offsetting the $0.35 benefit in R&D tax credit.

Cai von Rumohr

Thank you very much.

Operator

Your next question comes from the line of George Shapiro from Shapiro Research. Your line is now open.

George Shapiro

Yes. If I look at the commercial margin ex-R&D, since it clearly benefited, it was dropped to 170 basis points from 30.1% to 28.4%. Now, you mentioned that you had a little impact with higher low margin customer-funded, higher costs from the Pacific Avionics. So my question is, will R&D stay at this lower level throughout the year? Or are there other – some of those other issues I just mentioned one-time items or what’s going on to effectively cause 170 basis points drop in the underlying margin? Thanks.

Kelly Ortberg

George, I think your math is spot-on. And I think you’ve identified the causes of why the margin has been impacted in the first quarter. Now, what’s going to happen going forward is we’re going to see I’ll say a steady shift between company-funded R&D going up and our deferred engineering investment coming down over the course of the quarters. Now, that’s going to be offset by restructuring savings, which as I mentioned earlier in the call, we didn’t get much of any in the first quarter. So we’ll be benefiting from the restructuring savings, plus, we should be getting higher volume and with higher volume getting the incremental flow on that. So I’m confident that we’ll continue to generate good margins on the commercial side of the business. But the dynamics will be as I described.

George Shapiro

Okay. Thank you.

Operator

Your next question comes from the line of Noah Poponak form Goldman Sachs. Your line is open.

Noah Poponak

Hi. Good morning, everyone.

Patrick Allen

Hi, Noah.

Noah Poponak

Wanted to go back to the Government systems growth rate in the quarter. With the supplier quality issue, any incremental detail you can provide on exactly what that was or where it was? And then on the order timing, which sounds like a separate issue, somebody else in defense has brought up the holidays. I guess I’m just wondering if there was a system-wide abnormal end of year issue. And can you quantify what the growth rate would have been in the business without these sort of transitory items?

Patrick Allen

Yes, it was about five points of impact to our Government systems growth rate. So we’re down 11% we would have been down 6% without them. The supplier issue was a nonconforming material issue on a connector that we used in our ARC-210 radio. In fact, we didn’t have to rework. We just needed to go through the quality paperwork and get a waiver in place. Unfortunately, that was at the end of the year and with the holidays, we couldn’t get that waiver approved. So we’ve got that waiver now approved. The products are shipping. So it really was just a blip. You shouldn’t think of that as any kind of systemic issue.

In terms of the order timing, the one that I highlighted, the Pakistan’s C-130, we had expected quite early in the fiscal quarter. We actually got that here early this calendar year but it delayed. And that’s an FMS order. I don’t think that was holiday-related, Noah. I think that was just the normal challenge we have of trying to predict how fast things go through that cycle. I don’t have anything else to highlight in Government systems that was abnormal around the holiday.

Noah Poponak

Okay. And your short cycle defense comment, was that a change? Had that started to firm? And then has maybe turned a little bit? Or is there no change in how you’re seeing that progressing?

Patrick Allen

No, no change…

Noah Poponak

Okay.

Patrick Allen

Short cycle things like radios, munitions, are the types of things we would expect to see. NRE programs would be example, the things that we’ll see out of the benefit of this budget update. And so there’s no change in outlook there.

Noah Poponak

Okay. Thanks very much.

Operator

Your next question comes from the line of Michael Ciarmoli from KeyBanc Capital Markets. Your line is open.

Michael Ciarmoli

Hey, good morning guys. Thanks for taking my questions. Maybe Kelly, just to stay on the Government system, specifically, I think you called out 15% of the back half that you need to go out, get and win. Can you give us some color? Is there a lot of FMS sales in there and maybe on the – also on the FMS topic? Can you touch on any risks related to the KC-390 program, given the kind of current state of the economy in Brazil?

Kelly Ortberg

Yes, so let me walk through each of those categories that I went through. For those of you who are program-specific in government, you’ll understand what programs are driving that. So I talked about 60% being firm in follow-on. If you look at the firm contracts, KC-390, KC-46 some rotary wing at AgustaWestland and Sikorsky, Saudi F-15 are all firm programs that have first half/second half growth. I’m confident that the KC-390 first half/second half growth will be achieved in spite of the economic situation. We are funded by Embraer.

It doesn’t mean they are necessarily funded by their customer, but they are going forward with that. I do think we will probably see some future delays on the KC-390 program. But at this point, nothing in this fiscal year. Then in that, I also talk about follow-on in that 60%. And these are our annual buys, things like the R210, mid data links, our KC-135 Block 45 program, where the customer buys the annual work on a yearly basis. They are all funded, they are in the plan and I don’t see really any risk there.

The 15% that I talked about is really – there’s no real large program drivers. Some of them are international. These are things we’ve either bid on or we’re waiting a decision. And we also have quite a bit of just short cycle stuff, where we get an order and sell it out of finished goods. And so we just track that kind of – it’s a lot of little orders. We track that relative to how do we look firm this year versus historical. And we look pretty good with improving budget environment that maybe actually opportunity for us. But I don’t see anything that’s out of the normal, nor do I see any major one program driver in that 15%.

Michael Ciarmoli

Got it. Very helpful. Thank guys.

Kelly Ortberg

Okay.

Operator

Your next question comes from the line of Jason Gursky from Citi Investment Research. Your line is open.

Jason Gursky

Yes, good morning, thanks.

Kelly Ortberg

Good morning.

Jason Gursky

I just wanted to stick with Government Systems. One last question here. You mentioned in your prepared remarks that you are expecting some level of annual renewals that kind of come through. But one of the things we’ve heard from others is that the annual renewals are beginning to get descoped in size. And so, the government buys 100 one year and buys only 96 or 95 the following year. Can you just give us a sense of what you’re seeing on your annual renewals and whether there’s been any descope occurring for you guys?

Kelly Ortberg

I wouldn’t say – I wouldn’t say across the board descope, I think it depends on what – we do see some descope but we also see some increase in scope. Our JDAM orders are higher than what we expected. We always look at the quantities on the KC-135 Block 45, but that’s more driven by the pace at which the government can take the kits and get the aircraft modified. So we are always dealing with that, but nothing systemic or nothing that I would expect would be across the board and cause us any challenges. Radio quantities, MIDS quantities for tactical data links, all look good going forward. So nothing that I’d be able to say we see that trend.

Jason Gursky

Okay. Then just a clarification question, if I can. On the IMS comment around international flight operations being under a little bit of pressure, can you let us know whether that was for commercial flights or bizjet flights or just kind of what the mix of that weakness is? Thank you.

Kelly Ortberg

Yes, that – I’m sorry, that’s all business aviation. This is where we do trips – international trip support. So when a business aircraft makes an international trip, we provide a service to them for that trip, and that’s where we’re seeing the weakness, has nothing to do with air transport.

Jason Gursky

Perfect. Thank you.

Operator

Your next question comes from the line of Howard Rubel from Jefferies and Company. Your line is open.

Howard Rubel

Thank you very much. I want to talk about implementation for a moment. You’ve got a lot of things that are going on this year, Kelly. And maybe you could address a couple of things, how you are doing in terms of implementing this restructuring program. I mean, you did make a change to the government business unit, the 737 MAX is at the critical point before first flight and you have to balance, what I call cert requirements and production rate. And then you’ve got C Series. And then just to finish on that is the change in the global and weather, in fact you feel like you’ve understand the depth and the magnitude of that challenge.

Kelly Ortberg

Well, Okay, lot in that question. So first of all, I think the restructuring has gone very well. It’s mainly a headcount reduction for us and that has all went out in the first quarter. So, I’m very pleased with where we are. We do have some consolidation and restructuring of our business to run more efficiently with fewer heads and that’s what drove, for example, the change that we made in our Government Systems portfolio.

Our development programs are going very well. We’re in great shape on MAX. I’m very excited about the support and getting that aircraft into first flight and everything looks really good. So development programs are tracking quite well. I mentioned the C Series certification. Now our team’s focused with supporting Bombardier to get to entry into service here, middle of the year. As far as business aviation and the Globals, we saw global impact. As I mentioned this quarter, that impact actually increases a little bit throughout the year. That was an area that we saw some additional truing up from Bombardier here as we went into the fiscal year. So, yes, I think that we’re going to just be challenged with that production rate, but I think we’ve got it well-sized now for the year.

Howard Rubel

Thank you very much.

Operator

[Operator Instructions] Your next question comes from the line of David Strauss from UBS Securities. Your line is open.

David Strauss

Thanks again. Kelly, you had mentioned the upside from the fiscal 2016 budget. Wanted to see if you would care to speculate what that could mean or Government Systems growth looking out 2017, 2018, 2019, I think you previously said getting back to 2%, 3% kind of growth rate? Could you maybe talk about the kind of upside we could see from the 2016 budget out in those years? Thanks.

Kelly Ortberg

Yes. Well, so the team’s still kind of going through the actual program pedes and how that all is going to flow. But I would hope that we’ll see a point or two of higher growth than we had previously had anticipated because that’s what we’re – that’s what we’re seeing out of this budget environment. And again, I think we’re pretty well positioned to at least get our fair share. So, it’s long-term, I think it certainly firms up our ability to get this business back to low to mid single-digit growth.

David Strauss

Thank you.

Operator

Your next question comes from the line of Sam Pearlstein from Wells Fargo. Your line is open.

Sam Pearlstein

Hi. Patrick, can you just talk a little bit about the pre-production engineering. With a $40 million increase, I guess in the first quarter you talked about $100 million for the year. I guess, are you still seeing that kind of an increase? And does that mean it increases more earlier in the year and then it starts to actually reverse? Or is it just…

Patrick Allen

Yes, yes. I would say, yes. What we’re going to see is over the course of the year, the amount that goes into the deferral going to reduce over time. And actually I think I mentioned it with George’s question, you’re going to see company-funded pick up a little bit, company-funded R&D pick up a little bit over the course of the quarter. So you’re going to see a little bit of a mix shift over the course of the year. And we still – and we’re on plan with respect to deferred. So I still feel very, very comfortable with that $100 million net increase.

Sam Pearlstein

Thanks.

Operator

Your next question comes from the line of Seth Seifman from JPMorgan. Your line is open.

Seth Seifman

Thanks very much and thanks for taking the follow-up. Just if we could go back to the commercial aftermarket and you could talk maybe a little bit more about Intertrade. And you’ve talked for a while about the structural factors driving growth there, but just from a cyclical standpoint with low oil prices – a lot of the data that we all have seen shows retirements were down last year, in terms of the – in a environment, maybe we’re not as many aircraft are being retired and maybe older aircraft are flying a little bit more. How does that cyclical dynamic affect Intertrade and play out against the structural dynamic of more airlines looking to harvest used parts?

Kelly Ortberg

I can’t – I don’t think I can point to exactly how much that dynamic would change our Intertrade business. It’s all – the focus of that business is all around making sure you have the right demand for the right asset, and you go buy the right asset that you can turn. And so it really gets down to a program-by-program, aircraft type by aircraft type, a specific dynamic that team works.

In the end, whether they slow the – if they slow the retirement rate, that will mean that there’s probably fewer spares out there. But it also mean there’s probably larger demand for those spares, those used spares. So the trick will be our ability to get to those used parts in the market to continue to grow. And I feel pretty confident that within the business that we’re forecasting, we should be able to grow that, again, double-digit here for the year.

Seth Seifman

Great. Thanks very much.

Operator

Your next question comes from the line of George Shapiro from Shapiro Research. Your line is open.

George Shapiro

Yes. Just wanted to pursue a little bit more, the business jet aftermarket is up 17%. You were saying that the inorganic was all air transport. So what do you look for business jet aftermarket going forward? I mean, last year, I guess it’s a pretty easy comp, but still – that’s a pretty healthy increase.

Patrick Allen

Well, remember, we’ve guided that bizjet aftermarket would be fairly new to – kind of like what we saw last year. Obviously, 17% is the gangbuster start to – I think we saw 2% last year in growth. I don’t – as I mentioned, I don’t think we’re going to continue at that 17% rate because some of the mandate activities will come down in business aviation. But I’m hopeful that if we continue to see like we’ve seen this quarter with good sales of avionics mods that we’ll be able to create some opportunity to our forecast there.

George Shapiro

And Kelly, I don’t know whether you want to forecast or not, but would – based on everything you said with second quarter revenues again be lower than last year’s second quarter? Like the first quarter was lower than last year’s first quarter?

Kelly Ortberg

I think it will be much closer to flat, but yes, maybe down a little bit.

George Shapiro

Okay. Thanks very much again.

Operator

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

Robert Spingarn

Hi, just a follow-up on the comment on the ARINC and the bizjet softness there, if that’s the right characterization. Was that from the service demand or was it from the volume of flights?

Kelly Ortberg

It was from the volume of flights which drives the demand for the services. If you think about that, we get paid to provide trip support for our flight if they don’t take that flight. And by the way it’s by leg. So even if they take a flight, but it’s fewer legs, that means less revenue for us, the more trips, the more legs to the trip, the higher the revenue.

Robert Spingarn

So this non-discretionary service, this isn’t something that they select by flight. This is just tied to the number of trips, as you just said?

Kelly Ortberg

Yes. Generally, anybody who is flying a large bizjet like that has contracted with the flight support services organization or they may do some of it themselves. But it’s things they have to do to support that flight.

Robert Spingarn

So you’re just tying that to George’s question on strong aftermarket in biz jet. I mean, we actually seeing a flight activity decline here that’s worrisome?

Kelly Ortberg

Well, that’s a very small segment. I think if you look at bizjet, overall flight activity…

Patrick Allen

It was up low single-digit growth. And if you look at our commercial MRO, it tracks very closely to that overall flight activity. So, yes, I think we’re – we watch that very carefully. We’ve been – we saw low single-digit in our bizjet MRO here this quarter. And that tracks pretty close to that activity. If the activity ticks up, our revenues will tick up. If the activity slows down, we’ll see headwinds.

Robert Spingarn

Okay. And then just switching gears slightly, commercial OE, last – I don’t know, year or so, you’ve had sort of this – on the air transport side, but $180 million to call it $210 million quarterly sales. But of course, you talked earlier about all this new – these new programs that you’ve won MAX, 777X, A350 so on. When should we start to see that quarterly number really start to move north?

Kelly Ortberg

Well, we’ll seeing this…

Patrick Allen

What we planned is…

Kelly Ortberg

In the second half of this year, we’ll see the production rate increases for – at Airbus for the narrow bodies and we’re seeing A350 consistently ramp up. We will start to see some revenues very late in the fiscal year on MAX, but really it – really ticks up in fiscal 2017.

Robert Spingarn

Okay. And you’ll get the seven, eight benefit at some point here.

Kelly Ortberg

Yes.

Robert Spingarn

Are you already running that at 12?

Kelly Ortberg

No, I think that starts to hit us in our second half?

Patrick Allen

Yes.

Kelly Ortberg

Second half of the year is where we will see the benefit from 87 along with the 320s.

Robert Spingarn

So it sounds like that June or September quarter we could see a meaningful move in that commercial OE air transport figure?

Patrick Allen

You should see much better growth in the second half of the year in air transport OE.

Robert Spingarn

Okay, thank you.

Patrick Allen

Absolutely.

Operator

Your next question comes from the line of Howard Rubel from Jefferies and Company. Your line is open.

Howard Rubel

Well, thank you very much. China Aviation has been a very important driver for the – for your business for quite a while and there is sort of two parts. So one is you articulated the HUD pickup. But also from time to time those carriers also adjust their spares and their demand and other things and then last, growth has been pretty good. And also related you’ve had some R&D programs in there. So Kelly, could you kind of address the market and talk about – provide some color please?

Kelly Ortberg

Well, the market demand for our services for our products and for the aircraft continuous to be very strong. Where we are seeing weakness is the overall things that are related to the economic slowdown, things like flight activity as an example. But I’m not seeing any softness in their demand for aircraft, number of flights they are doing in the air transport market. The aftermarket remains very robust. They are continuing to fund HUD retrofits to meet their mandated service. So, yes, the overall economy is slowing down, but I think it’s still a very robust market for air transport.

Howard Rubel

So you can still see varying anywhere from mid to high to even low double-digit growth? Is that fair?

Kelly Ortberg

In – I’m sorry, in what segment.

Howard Rubel

Well, I mean if you were to characterize it, it still probably ranges somewhere between mid or high single-digit to maybe even low double-digit. Is that correct?

Kelly Ortberg

Yes. For our China business if I put all in, yes, I mean, I don’t have the number in front of me, Howard. But I’d say that’s a double-digit growth business and continues to grow at that rate.

Howard Rubel

No, that’s kind of the read I have and I just…

Kelly Ortberg

Yes.

Howard Rubel

You see it and touch it more than I do. So thank you.

Kelly Ortberg

Yes.

Operator

This concludes the question-and-answer session. I’d now like to turn the call over Ryan Miller for any closing remarks.

Ryan Miller

Thank you, Sean. We plan to file our 10-Q later today. So please review that document for additional disclosures. Thank you for joining us and participating on today’s conference call.

Operator

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

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