Rockwell Collins' (COL) CEO Kelly Ortberg On Q2 2016 Results - Earnings Call Transcript

| About: Rockwell Collins, (COL)

Rockwell Collins, Inc. (NYSE:COL)

Q2 2016 Earnings Conference Call

April 21, 2016 09:00 AM ET

Executives

Ryan D. Miller - IR

Kelly Ortberg - Chairman, President and CEO

Patrick Allen - Senior Vice President and CFO

Analysts

Howard A. Rubel - Jefferies

Myles A. Walton - Deutsche Bank

Samuel J. Pearlstein - Wells Fargo

Seth M. Seifman - J.P. Morgan Securities

Peter J. Arment - Sterne Agee

Jason M. Gursky - Citigroup

George D. Shapiro - Shapiro Research

David E. Strauss - UBS Securities

Ronald J. Epstein - Bank of America Merrill Lynch

Cai von Rumohr - Cowen and Company

Noah Poponak - Goldman Sachs

Richard T. Safran - Buckingham Research Group

Carter Copeland - Barclays

Robert Spingarn - Credit Suisse

Robert Stallard - RBC Capital Markets

Kenneth Herbert - Canaccord Genuity

Michael F. Ciarmoli - KeyBanc Capital Markets

Operator

Good morning and welcome to the Rockwell Collins Second 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, Ryan Miller. Please go ahead, sir.

Ryan D. Miller

Thank you, Chris, 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 at our Web-site 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. With two quarters down, our fiscal year 2016 is progressing directionally as we expected. As we indicated in October and again in our last quarterly call, this is definitely a first half/second half story. And because we saw it coming, we've been very transparent about the business aviation production rates as well as the Government Systems program timing and the impact on our top line sales profile for the year.

We also, as you know, initiated a restructuring program to help sustain our bottom line performance. This restructuring was essentially complete in the first quarter, and I'm pleased to report that it's now delivering the savings that we expected.

Now, the largest shift in growth from the first half to the second half of the year is in our Government Systems business, so let me start here and give you an update on the metrics I outlined last quarter relative to that growth. In the last call, I said that about 60% of the back half growth was already in backlog or coming from annual buys of follow-on business. This category has now grown from 60% last quarter to 77% at the end of the second quarter. Again, this is all funded activity. So I don't see much risk here and I'm pleased that we're making the progress in firming this up.

Now, the second category of growth is in programs that we have won but have yet to be awarded, and this has decreased from 25% last quarter to 17% this quarter. The only risk in this area is moving these programs through the contracting action into firm backlog, and at this point I don't see anything that would keep us from firming up this 17%.

And then the third category, which is the balance of the second half growth, is coming from programs that we have yet to go out and win. This category has decreased from 15% last quarter to now making up only 6% of our planned growth.

As I look at all these metrics, we're right in line with our historical anticipated sales for this time of the year. So despite the challenging first half, we have good line of sight to the second-half growth for Government Systems. And as a reminder, the fourth quarter is always the biggest in terms of sales and margins and I do expect our growth rate to be the highest in the fourth quarter as well.

Now, turning to Commercial Systems, the first half went about as expected but the aftermarket components are a little different from what we originally anticipated. The business aviation has performed better than expected and the air transport aftermarket has been softer. As this turned out, the two have essentially offset each other for the first half of the year, so our overall aftermarket performance remains on track.

The strength in the business aviation aftermarket has been driven by mandates, which we expected, but also by stronger-than-expected cockpit retrofits. We introduced some new avionics aftermarket products late last year and they are selling quite well.

The weaker air transport aftermarket is being driven by the impacts of recycling, and we're also dealing with the impacts of more aggregators in the service market. I believe these are indicative of structural changes in how the airlines are managing their MRO needs and we should no longer be expecting MRO to grow at traffic rates, at least for the foreseeable future.

Now, air transport OEM rates are progressing as planned with production ramping for the 787, the A350, and the Airbus narrow-bodies. These increases are partially offset by rate reductions on the A330.

Now, business jet OEM rates remain consistent with last quarter, and if you recall I said in the last call that the summer shutdown period is when we would likely see business jet reductions if there are going to be any more that happened this year. So that remains a watch area for us for the next quarter.

Finally, let me turn to our Information Management Services business. This past quarter we delivered 5% sales growth and really strong operating performance with margins improving by 370 basis points. Our core aviation business grew 8% for the quarter, driving the profitability for that business.

While this was great performance, our top line to date is a bit lower than I expected. We are seeing weaker demand for business aviation international trip support which has been hit pretty hard in Russia, China, and in oil-producing countries.

Without a pickup here, we'll probably see our IMS business grow a bit slower for the full year than originally expected. We are expecting though to see growth in the second half from the non-aviation portion of the business and I do want to point out that the better-than-expected profitability should more than offset any top line weakness in our IMS portfolio for the year.

So having walked through the three business segments, let me now turn to our longer-term outlook. We achieved several very important milestones on programs that drive our long-term growth. These include the first flight of the Boeing 737 MAX with our new standard equipment, all delivered on time and working very well. The first refueling flight was performed on the KC-46 tanker, validating both our avionics and the refueling mission package which is a first using 3-D image technology.

And we were also selected as one of the suppliers on the U.S. Army's Manpack radio program, which is a key step towards bringing this large growth opportunity to reality. Also in March, we were recognized by Ethisphere Institute as one of 2016's most ethical companies, and this is the seventh year in a row receiving this award.

So these achievements all demonstrate how we're striving to be the most trusted source of aviation and high integrity solutions in the world, and it's really some good reasons to be optimistic about the future of our Company.

Now, before I turn it over to Patrick, I do want to address an administrative item. For years, we've issued our next fiscal year financial guidance in September and I've received feedback from many of you that it would make a lot more sense for us to issue the guidance when we announce our fourth quarter results, which typically happens at the end of October.

So this is exactly what we plan to do for this coming year. Hopefully, this will make things more efficient for the investment community as well as for Rockwell Collins and it will allow us to better align with the OEMs, our production rates, and we'll be able to discuss year on year financial guidance because our full-year results for fiscal 2016 will be complete at that time.

So with that out of the way, let me turn the call over to Patrick to walk us through the quarterly 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 second quarter of fiscal 2016. I'd like to begin on Slide 3 where we highlight our total Company second quarter sales, earnings per share, income from continuing operations, and shares outstanding.

Total Company sales for the quarter decreased $30 million or 2%, compared to the second quarter of last year, primarily due to lower Government Systems sales. Income from continuing operations increased $9 million or 6% and earnings per share from continuing operations increased $0.08 or 7% compared to the same period last year. The increase in income from continuing operations and earnings per share from continuing operations was primarily due to lower income tax expense due to the permanent extension of the Federal Research and Development Tax Credit.

As we turn to Slide 4, Commercial Systems achieved revenue of $611 million in the quarter, down 1% compared to the same period last year. Sales related to aircraft OEMs decreased $17 million or 5% to $353 million, primarily due to lower business aircraft OEM production rates, unfavourable airline selectable equipment mix and lower Airbus A330 production rates, all partially offset by higher customer-funded development program sales, higher deliveries in support of the Airbus A350 and Boeing 787 production rate ramps and higher Bombardier CSeries sales in support of its entry into service later this year.

Aftermarket sales increased $14 million, or 6%, primarily due to higher business jet avionics retrofit mandate sales and higher inorganic sales from the acquisition of the International Communications Group.

Commercial Systems operating earnings decreased $7 million with operating margins declining 80 basis points from 22.9% to 22.1%. Operating earnings and margins decreased from the prior year primarily due to sales mix as lower margin customer-funded development sales increased and higher-margin business jet OEM sales decreased. In addition, SG&A cost increased from higher cost associated with recent acquisitions. These items were partially offset by lower Company-funded research and development expense and cost savings initiatives from previously announced restructuring plans.

Moving now to Slide 5, Government Systems overall revenue decreased by 5% to $538 million, driven by lower rotary wing hardware sales, lower sales from simulation and training programs, the wind-down of an international electronic warfare program and lower international targeting system deliveries.

Government Systems second quarter operating earnings decreased $6 million to $108 million, resulting in an operating margin that was flat with the second quarter of the prior year at 20.1%. The decreased operating earnings resulted from a lower sales volume, partially offset by lower Company-funded research and development expense and cost saving initiatives from previously announced restructuring plans.

Turning to Slide 6, Information Management Services sales increased 5% over the prior year, as commercial and business aviation services sales increased 8%, while the non-aviation-related businesses were slightly down compared to last year.

Information Management Services second quarter operating earnings increased $7 million to $29 million, resulting in an operating margin of 17.9%, compared to 14.2% in the second quarter of the last year. The increase in operating earnings and margin was due to incremental earnings on the higher sales volume as well as a favorable resolution of some certain prior year claims associated with international business jet support services.

Looking next to Slide 7, we show year-to-date results for revenue, income from continuing operations, earnings per share and operating cash flow. Through the second quarter, we generated $45 million of operating cash flow compared to $132 million last year. The decrease in cash generation resulted from the lower pre-tax earnings and net unfavorable changes to working capital which were primarily due to the timing of sales related to advance payments from customers. These items were partially offset by lower tax payments.

Slide 8 provides an update of our total R&D investment. Total spend decreased from $489 million in the first six months of fiscal 2015 to $470 million in the first six months of FY 2016. Company-funded R&D decreased $43 million due to lower business jet development cost in Commercial Systems and lower software-defined radio development cost in Government Systems.

Customer-funded research and development expense increased $15 million due to higher development costs for regional jet development programs in Commercial Systems, partially offset by the wind-down of an international electronic warfare program in Government Systems. Pre-production engineering investment, net, increased due to higher costs incurred for a military program in Government Systems.

Moving to Slide 9, we show the status of our capital structure as of the end of the second quarter compared to the end of last year. During the first six months of FY 2016, our debt-to-EBITDA ratio increased to 2.1x from 1.7x at year end. The increase is primarily due to an increase in commercial paper, as the first half of the year had typically light cash flows. I expect this 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 second quarter is detailed on Slide 10. During the second quarter, we repurchased 1.2 million shares at an average cost of $85.03. Our repurchase authority remaining at the end of the quarter was $192 million.

Now on to Slide 11, where we provide a summary of our fiscal year 2016 financial guidance, which remains unchanged from the guidance we provided last quarter. We do now have some clarity on when we expect to benefit from the tax planning strategies that we initially guided would benefit the second half of fiscal '16. These tax planning strategies which entail utilizing capital loss carryforwards from prior years is now expected to benefit our third fiscal quarter.

Our tax rate for the third quarter will likely be in the mid-teens and the tax rate for the fourth quarter will likely be in the neighborhood of about 30%. We still expect the full year tax rate to be between 22% and 23%.

I also wanted to talk about the trajectory of our operating margins over the last half of the year. I'm expecting operating margins to be about flat sequentially from the second quarter to the third quarter. We do expect the overall business will return to growth in the third quarter and that growth will drive incremental earnings. But we will also be shifting our engineering spend from deferred engineering to Company-funded engineering, resulting in a fairly flat sequential total operating margins.

As we look to the fourth quarter, we should expect to see more incremental margin growth due to the higher growth rate in sales that Kelly talked about a little earlier.

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

Ryan D. 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 queue and we'll answer those additional questions as time permits. Operator, we are now ready to open the line.

Question-and-Answer Session

Operator

[Operator Instructions] The first question is from Howard Rubel with Jefferies. Your line is open.

Howard A. Rubel

Kelly, you talked a little bit about bizjet aftermarket and some of the positives and also some of the concerns or change in dynamics in commercial. Specifically with bizjets, can you talk about whether it was categories and what kind of visibility you might have, and then also the same for the commercial market?

Kelly Ortberg

If you look at those two, the commercial and bizjet aftermarket, I recognize this is kind of counter-intuitive to the health of those underlying markets, but in business aviation, we’ve continued to see very strong mandate growth this quarter, which we did expect as I said in the opening remarks, but we also introduced some fans upgrades, avionics upgrades into the market, and again that is selling very well and I'm hopeful that that will continue to sell and maybe give us some upside opportunity here in the balance of the year.

In air transport, it's kind of the opposite story. We had mandate headwinds in air transport. Last year, we had a big engine sale which didn't repeat. So we had a little bit of a comparable issue on that. If I strip all of the one-time activities as well as our Intertrade used business sales out of air transport and just look at the fundamental MRO, we've been roughly flat the first two quarters in fundamental MRO, and I think that's about what we're going to see there, flat to very low-single-digit growth in that underlying MRO business as we deal with the new recycling phenomenon that's here to stay.

Howard A. Rubel

And then just as one follow-up, a little bit different, you talked about LRSB and you had some other military wins. Is there a change in focus and can you add anything with respect to the LRSB opportunity?

Kelly Ortberg

No, I can't add anything on that other than we're pleased to be on the Northrop Grumman team. That's about all I can say there. I wouldn't say, Howard, there's a change in our focus. I just think it's a change in the opportunities. The market dynamics are getting better. We're certainly seeing lift in things like JDAM production rates associated with what's going on in the world. We are still struggling with the timing of getting things through the contracting action. That didn't improved. And as you look at our Government business for the first half of the year, we guided that at down mid-single-digit, we ended up at 8% down. So we are a little behind where we wanted to be, and it's mostly getting some of these selected programs through the contracting action, a few for military sale specific programs, but we've got good visibility to that. I'm pretty confident we'll be able to get that done by the end of the fiscal year.

Operator

The next question is from Myles Walton with Deutsche Bank. Your line is open.

Myles A. Walton

I was wondering if you could comment a bit on the business jet OEM business, regional jet OEM end market, and the declines there you saw were I guess inclusive of some offset from growth in the CSeries, so as you look at those and you kind of bifurcate them, could you talk about is the business regional, I know you have gone through your contingency as it relates to business jets, but are you now below that contingency given the current run rate, and also what's the level of CSeries growth you're actually experiencing?

Kelly Ortberg

I think I said this in the last quarter, we used up our contingency and a little more as everybody trued up their production rates at the beginning of the calendar year, and I would say that was kind of across the board. We saw little bit additional reduction in Globals from what we originally planned. So I haven't seen any changes since then, Myles. We just cut in our Fusion flight deck on the King Air if you recall and I think we're getting pretty good vibes from Cessna in the end market that just got certified in Europe, so we're hopeful that that will continue to do what it needs to do to sustain rates there. And we'll watch the furlough summer timeframe, as I talked about. That's where we get any kind of tweaking of rates. Now, recognize that if they do change the rates, that's pretty late in our fiscal year. So I'm not anticipating a heck of a lot of movement here yet, but I think there's still a little bit of risk of adjustments here with the summer timeframe.

Myles A. Walton

And is the CSeries growing sequentially or is it growth rate year on year that's helping that end market a little bit in terms of comps year-on-year?

Kelly Ortberg

The CSeries is growing both sequentially and year-over-year fairly substantially. The issue there is the business jet market for us is so much larger than the regional market.

Myles A. Walton

Okay. And then the other one, Patrick, on R&D, I guess I'm stripping out everything or trying to strip everything inclusive of R&D and all the other adjustments, and the underlying margin at Commercial, it just seems pretty low, and I understand the mix on drivers of it, so maybe the question is really about the run rate of IRAD, obviously lowest I've seen in a long time in the quarter, and it sounds like you swapped back from customer funded to Company funded, can you give us some sense year on year will R&D be about flat for Company-funded R&D or is it going to be down?

Patrick Allen

Within Commercial Systems, it's going to be down year-over-year in total, but we will see that transition in the back half of the year. And I'd say back half of the year, 2016 to 2015, it's going to be about flat from an R&D perspective. One thing I wanted to make sure that we're all focused on though is a fair chunk of our savings from the restructuring program is manifesting itself through the research and development expense line because a fair number of the people who took the voluntary retirement program were engineers.

Operator

The next question is from Sam Pearlstein with Wells Fargo. Your line is open.

Samuel J. Pearlstein

Can you talk about do you still expect pre-production engineering to be up 100 million, and that only leaves about 26 million for the last two quarters? So I'm just saying, will we see growth in Q3 and then it turns a decrease in Q4? How does that play out for the year?

Patrick Allen

We're still forecasting deferred engineering to be in the neighborhood of 100 million. I think there's maybe a little bit of risk that it will tick slightly higher than that due largely to the two things. One is I'll say a decrease in the amortization associated with the timing of some programs in the Government Systems side, but the bigger piece is accelerated spend on the 737 MAX program as we continue to get closer to entering the service there.

Samuel J. Pearlstein

So we'll grow in both the remaining quarters?

Patrick Allen

Yes.

Samuel J. Pearlstein

There will be some contribution I guess. And then just last quarter you talked about 5 percentage point impact on the Government Systems for a supplier issue and the order timing. Were both of those resolved in the quarter and did you recover all those sales?

Kelly Ortberg

We recovered all of the product issue and we recovered that real quickly in the quarter. We did not recover the sales timing issue. In fact, it's one big FMS contract. We've received the contract now but we received it late enough that we didn't get the conversion of the sales. So that's still in our second half to go to catch up.

Samuel J. Pearlstein

Okay, great. Thank you.

Operator

The next question is from Seth Seifman with J.P. Morgan. Your line is open.

Seth M. Seifman

I was wondering if you could talk a little bit more about the commercial aftermarket in air transport and sort of we have talked in the past about the impact of retirement and some of the structural changes, but what's sort of the offset there from Intertrade first of all? Second of all, what was the contribution there from inorganic sales in the quarter from the acquisitions? And then third, just kind of more qualitatively, is there something, I mean this is an issue that has affected various companies in the aftermarket in a couple of different – at different time periods and for a couple of different ways, is there anything specific you see about your products that makes this kind of better or worse or longer lasting than elsewhere?

Kelly Ortberg

I think there's a couple of things that you have to watch. First of all, the retirement rate does impact the business. If there's fewer retirements, it's harder to find the used parts to turn. On the other hand, we continue to operate those platforms and drive MRO growth. For our portfolio, it's very wide-body driven. So if you look this year, the retirements have abated but most of that has been in the narrow-body. Some of the 75, 76 and 747-8 retirements are very high content aftermarket platforms for us. So if you want to look at that, I'd look more at the wide-body which may not be typical to other peer company portfolios.

What we said all along is the aftermarket MRO is going to be again pretty flat to very low single-digit. The offset to that is these part sales out of our Intertrade. That comes very lumpy. This past quarter we were down because we had an engine a year ago. We do have another engine sale in the back half of our fiscal year. So we have some things that are going to create a lumpy overall environment because it's really going to be driven more by our Intertrade sales than the underlying MRO.

Seth M. Seifman

Great. And then on the inorganic side, the contribution in the quarter?

Patrick Allen

It came mostly in the air transport aftermarket and it was about 3% or 4% of growth in the – so it offset let's say 3% to 4% decline in the air transport aftermarket.

Kelly Ortberg

The only thing I do want to add, Seth, is remember, we knew mandates were coming down, so we did see again mandates comparable on the engineering sale as headwinds for the quarter in air transport. That mandate headwind is really related to TCAS changes. The next uptick in mandates we'll start getting will be the ADS-B. We are starting to book some ADS-B orders out to 2020 mandate, probably will drive some increases more in the 2017 and probably peak in the 2018-2019 timeframe.

Seth M. Seifman

Okay, thanks. And I guess maybe since we're talking about the topic, would it be in the first half of your fiscal 2017 that we'd see provisioning for the MAX start to pick up?

Kelly Ortberg

Yes, I think a material provisioning, that's when you'll start to see a pickup. We may actually see a little bit of provisioning with the initial customer here by the end of the year. We're working that right now.

Operator

The next question is from Peter Arment with Sterne Agee. Your line is open.

Peter J. Arment

Kelly, could you give us a little more color on what you're seeing on the A350, kind of the run rates? You've historically, Rockwell has always been kind of ahead of the OEMs in terms of the run rates. What are you seeing in that program right now?

Kelly Ortberg

For this year, we're still fully aligned with Airbus. I think we have 30 airplanes in the year. That's up almost double from last year. So I think we're pretty well aligned with what Airbus is delivering. I think the thing we got to watch is their delivery rate and continued production ramp-up. I'm not anticipating any change for this year. Actually let me correct that, I said that wrong. 30 deliveries last year, it's 60 this year. I'm a year behind.

Peter J. Arment

If I could ask, just to sneak in one follow-up, just unrelated but Kelly you mentioned kind of, you gave us a lot of color on the Government Systems line of sight of growth for the back half of the year. What are you seeing from an international defense perspective? Are you seeing any change in like the pacing of awards just given the reset in the oil price deck, are you seeing any impact there?

Kelly Ortberg

No, not really, nothing out of the Middle East and everything continues to track pretty much to plan. Where we're seeing delays is actually getting through the foreign military sale process, which is really a U.S. issue and less the end customer issue in getting through that contracting action.

Operator

The next question is from Jason Gursky with Citi. Your line is open.

Jason M. Gursky

Just wanted to go back really quickly on the aftermarket for both bizjet and air transport. On the bizjet side, can you talk a little bit about the retrofit work that you're seeing? It suggests it's being spurred by new products that you've come out with, but are you seeing retrofits across the entire cabins of these aircraft or just for the parts of these new products that you've come up with?

And then on the air transport side, maybe give us your initial thoughts on the initial steering activity with regard to the MAX, is the MAX going to be less robust from the initial steering perspective than we would see given all new aircraft? I'm just trying to get a sense of whether initial steering on the MAX would be anything like what we saw with the 87?

Kelly Ortberg

It won't per airplane be anything like the 87. First of all the amount of equipment on a narrow-body versus a wide-body is much less, but the number of aircraft is much higher. So we do expect a meaningful provisioning. And I think that's product line specific. Remember we don't have the display system on the next-generation, the NGs. We do have that. That's where the display system will be a big part of what the new provisioning. If they are using a common VHF radio to an existing fleet, then we won't see provisioning for that. So I think it is going to be very product specific to what's changed between NG and a MAX, but for us that's a lot and it's pretty attractive for the provisioning. The first part of your question I'm sorry was…

Patrick Allen

Business jet retrofits.

Kelly Ortberg

Business jet retrofits, we are continuing to see cabin retrofits that fuelled a lot of our growth last year. I think the cabin retrofits remain solid but aren't probably growing as much as they are last year. What we are seeing the growth driven by are these new fans updates to things like Falcon 50s, we've got a new Pro Line Fusion upgrade for King Air is out in the market and we're again seeing those sell. So we didn't have those products in the market last year. So it's hard for me to tell whether that's product driven or market driven, probably a little bit of both.

Operator

The next question is from George Shapiro with Shapiro Research. Your line is open.

George D. Shapiro

I wanted to pursue the Commercial margin a little bit more. If I look at the Commercial margin ex-R&D, it went down like 500 basis points to 29.6% from 34.6%. Now clearly some of that is affected by the higher sales of the customer funded lower margin business, but if you can explain a little bit more what's going on there? And then also when you go to the third quarter, Patrick, it sounds like you're implying the R&D will be flat with Q3 of last year as opposed to declining 22 million like it did this quarter. So what changes to enable that margin to even stay close to what it is this quarter for Commercial?

Patrick Allen

George, I think you've hit on the biggest margin impact in Commercial Systems, that is the mix shift, and it was pretty significant. We've always said business jet OEM is very good margin for us and customer-funded R&D comes at little to no margin. So that was the biggest shift in margin for us.

Now, included in that is also a few million dollars associated with I'll call it acquisition related SG&A cost that the Commercial Systems is absorbing as well. So you've got a compounding effect of those acquisition related SG&A costs.

And as we progress further, we're going to see sequential growth in Commercial Systems. That growth is going to be coming from higher-margin product. And so we should see I'll say incremental earnings to offset that lift in Company funded R&D.

George D. Shapiro

Okay. And then just one quick other one. I'm assuming or guessing, Patrick, that the gain in the IMS business was maybe $3 million or $4 million.

Patrick Allen

I think it was around $3 million.

Operator

The next question is from David Strauss with UBS. Your line is open.

David E. Strauss

Kelly, I know it's a little bit early to think about 2017, but you've had this target out there for high single digit growth at Commercial Systems down the future. Based on everything you know today, given the pressure on business jets, we've had a 777 rate cut announced, do we get somewhere close to that or is that out of the question, just trying to think about maul in Commercial Systems on a go forward basis?

Kelly Ortberg

It is a little early to make that call. We're certainly seeing lower business aviation production rates than what we anticipated when we put that guidance out. But I'll also say there's been good stuff. We've seen increased rates in air transport. We've seen increased content on some new aircraft coming into the market. It looks like CSeries is now going to move from the development phase into the production phase. So I don't want to tell you what our rate is right now because I'm still waiting to see the final detail from my team, but there has been puts and takes and I think over the long run they should be able to balance each other out.

David E. Strauss

Okay. Patrick, a follow-up on working capital, you talked about it trending better in the second half of the year. Can you just give a little bit more detail there, what are you expecting, what we should see from advances and I guess production inventory? I think you've already touched on pre-production.

Patrick Allen

We did see a bit of a buildup in the production inventory, and I would say it was in anticipation of a strong second half for Government Systems in terms of sales. So this buildup in inventory, that was part of the working capital. I expect that to normalize over the course of the balance of the year. And I think the customer payment, the customer advances, I think we view it as being a headwind for the year, when we came into the year. I think it's probably going to abate a little bit in the second half but not a lot. I think the improvement you're going to see in working capital is going to be largely the production inventory.

Now, if I was to point to a risk to our cash flow, it is the fact that we are so backend loaded on sales that making sure that we get the sales booked and cash collected by the end of the fourth quarter is going to be the challenge that we're all focused on.

Operator

The next question is from Ron Epstein with Bank of America. Your line is open.

Ronald J. Epstein

Big picture question for you, Kelly. One of the themes that seemed to emerge at Homburg this year, even more so than previous years, was the connected airplane and so on and so forth. Can you just wax a little bit on that opportunity for Collins when you think about high-bandwidth connectivity to the airplane and how ARINC is positioned for that, because it seems like they are positioned pretty well but I just wanted to get your take on it?

Kelly Ortberg

We are positioned well and we are – I mean we are seeing growth in the connectivity today. We've booked our first four customers, two in business aviation and two in the air transport market, for Global Xpress which is the new broadband Inmarsat capability and we are working a lot of proposals now. We do see this as a big growth opportunity. And recognize Ron that today we really don't provide much cabin-based broadband connectivity in the market. So that's all growth opportunity for us.

We're very strong in the flight deck connectivity but less so in the cabin and GX will present a big opportunity for us, and we're also working with OneWeb for a next-generation broadband capability where we're the exclusive supplier of the radio equipment and also a value-added reseller and we're going to be bringing that onto the Airbus platforms in the future.

So I'm excited about it. It's happening. There is no question there's going to be strong demand for broadband and connectivity. The connectivity solutions that are out there today that aren't broadband just aren't meeting the connected world needs that we all have. And once that happens, it opens the door to applications and services and we're also focused at providing those kinds of capabilities where once you have broadband connectivity, you can move information easier on and off the airplane and provide additional services for either maintenance or operation improvements for the airlines going forward.

So it's one of the drivers as to why we think the ARINC acquisition is a great value driver for the long term for our Company and I'm excited about the growth of our Information Management Services portfolio and the opportunities going forward.

Ronald J. Epstein

So maybe just one natural follow-on, if you can even speculate or maybe even know, what's the required investment kind of to grow in that area? I mean is it, how would you quantify that?

Kelly Ortberg

Look, I would put it in – let me just put it in categories. There's new radios, so you've got to develop a radio equipment that's compatible with these new broadband satellites. A lot of investment in antenna technology associated again with these new satellites and be an efficient integration. There is new certification cost both in forward fit as well as retrofit, so we have to go get STCs. So for example for these four launch customers that I've talked about, we are investing now in getting the STCs done, getting the certification baseline to retrofit those aircrafts. So those are the categories of investment and they are very similar to what investments we do with other radio systems in the market. So I think we know what those investments are and they are plunged in our R&D plans as we look forward.

Operator

The next question is from Cai von Rumohr with Cowen and Company. Your line is open.

Cai von Rumohr

So to follow up to George's question, the biggest decline I think I've ever seen in your margin before are into Company funded R&D and deferred engineering amortization. To what extent was that also impacted by the fact that it sounds like most of your Commercial revenue gain came in new program, 787, A350, CSeries, is that lower margin business? And then as you look at the second half, I mean you're going to have higher deferred engineering amortization, higher Company funded R&D, kind of looks to me like the mix continues to shift toward those newer programs. Can the Commercial margins improve over this 21%?

Patrick Allen

I think what I'll say is I think Commercial Systems margin in the back half of the year is going to be pretty close to what it was for the first half of the year. I don't see it changing significantly, Cai. Now I do want to I guess clarify a couple of points. The margin headwind that we had from this mix shift was significant and we're talking about going from very high margin product sales to lower margin customer funded R&D, and that was a big impact, and I think going forward we'll still see some of that mix issue but it won't be quite as dramatic and I think we feel pretty comfortable with the margin targets that we've laid out for Commercial Systems are achievable.

Kelly Ortberg

Just to add to that, Cai, the margin mix issue is what Patrick said, it's losing the bizjet revenue and increasing the RE or engineering revenues, it's not a mix of new products coming to the market. We have very good profitability with the new products coming into market. It's part of our common product line strategy where we're reusing. So you shouldn't view 787 anymore as a new product. We've been in rate manufacturing for that, we're now at 12 month rate. So that's very, very good performance from us and I'm not worried about new product versus old product mix looking forward.

Cai von Rumohr

Right, but if the Company R&D is flat year-over-year, deferred engineering is going to be up, you've got to be up 200 to 300 basis points in your margin before those items in Commercial just to hold relatively flat. So what happens in the second half to kind of give you that margin lift pre those expense items that you're talking about versus the second quarter?

Patrick Allen

First of all, I didn't say that the Company-funded R&D is going to be flat. It's going to be down a little bit. It will be closer to flat for the third quarter. So that's part of the answer. And then the other answer is continued cost reductions, we're continuing to see benefit from the retirement program flowing through the numbers. If you think about it from an operations perspective, that benefit gets deferred by a quarter because it's an inventory. So we'll see that benefit flow through as well.

Operator

The next question is from Noah Poponak with Goldman Sachs. Your line is open.

Noah Poponak

Patrick, maybe just sort of hopefully round that out on the margins, you also mentioned I think looking for a sequentially roughly flat total segment margin. Maybe if you could just talk about that by segment and even if you discussed the progression through the end of the year by segment just given there are a bunch of moving pieces in the Commercial segment, sounds like you gained 200 basis points or so at IMS which I would assume doesn't repeat and the Government growth rate changes a lot, so maybe it would be helpful to just discuss it by segment?

Patrick Allen

I think what you're going to see, you're right, the IMS segment margins were higher than they normally would be. So I think what you'll see is the IMS I'll say more normalizing in that 15% to 16% range. I think Commercial Systems as I mentioned is going to be pretty flat quarter to quarter Q3 and Q4. And what you'll see in Government Systems is that the margin is going to maybe tick up a little bit in the third quarter, not much, and the bulk of the margin expansion is going to be in the fourth quarter.

Noah Poponak

Okay. Sorry, did you say Commercial flat 3Q and then flat again 4Q?

Patrick Allen

Yes, pretty much.

Noah Poponak

Okay. And how 4Q loaded is the free cash outlook just given the year-to-date number there and what you said about the collection risks?

Patrick Allen

Unfortunately every year it seems like our cash flow is fourth quarter loaded and it continues to be, and I'd say, if anything, probably a little bit more, little heavier than normal just because of the sales profile we're looking at. So, yes, very heavily weighted toward the fourth quarter.

Operator

The next question is from Richard Safran with Buckingham Research. Your line is open.

Richard T. Safran

I'll just switch topics here. I was interested in this HMS Manpack contract. Can you tell me, it's bit of a multipart question, when you deliver the 30 radios, if [forward] [ph] production is supposed to commence in 2017, does that imply a down select this year? And to the best you can, if you could discuss your view of the competition and how much of an incremental impact this program could have this fiscal year assuming a win? And is this a winner take all type of thing, meaning if you did win, would the $12.7 billion over 10 years all go to Collins?

Kelly Ortberg

Okay, a lot of questions there, so let me kind of walk through the program. First of all, we've won the initial award with two other suppliers. We'll be delivering roughly 30 radios I think into the Army. They'll take those through two test regimes, a development test regime and a contract test regime, to validate those radios against the overall requirement. So there will be no revenues in fiscal 2016 associated with that program because these are free of charge radios, we're just providing them to the Army to go through the test.

From the results of the test, then they will go to what I would call a call for improvement for the participants who pass the test to then providing an updated price for the next fiscal year buy. So I would say, Richard, it will probably be this time next year before they make that decision. Their current plan is that they would down-select from three – if there are still three viable suppliers through the test phase, they would down select from three to two for that annual buy. Obviously at this time next year, there's actually very little revenue opportunity next year either because the revenue will go when the radios are delivered. So it really has moved to an 2018, really an 2018 growth item.

The other thing I'll say is that $12.7 billion, while I like the top line numbers, what that is, is that's the max quantities in every case under the IDIQ contract. So think of this contract as a huge matrix with max quantities all priced and they are all added together. This is not going to be a $12.7 billion contract in my mind. However, it will be very significant, maybe more like $4 billion to $5 billion of revenue. How much comes to us depends on how many contractors, what percentage that we win. We said, look, we can easily see $100 million a year kind of revenue stream from this program, if not more.

Richard T. Safran

Okay, that helps. Thanks a lot.

Operator

The next question is from Carter Copeland with Barclays. Your line is open.

Carter Copeland

Just couple of clarifications. On the aftermarket numbers, just if we talk organically here, it looks like organically it was sort of down high single digits in air transport. That was Intertrade down, MRO flat and I guess your sort of regular spares and [indiscernible] use up. Is that correct?

Kelly Ortberg

No. In air transport, it was Intertrade down because…

Carter Copeland

Intertrade down on the engine sale.

Kelly Ortberg

Right. Mandates down, you didn't say mandates, pretty substantial headwind in mandates, MRO roughly flat and Intertrade down.

Carter Copeland

Can you give us a sense of just roughly how big MRO and Intertrade are in the whole mix? And I know Intertrade has been growing a lot.

Patrick Allen

Yes, we've said Intertrade is I'd say between $100 million and $150 million sales a year. Most of that is in the air transport market.

Carter Copeland

Okay. And then just quickly another clarification, on the mix impact that you mentioned, Patrick, should we think about as primarily Globals or was there a good chunk of that that was BFE on things like the A330?

Patrick Allen

There was a little bit of both but I'd say primarily Global.

Operator

The next question is from Robert Spingarn with Credit Suisse. Your line is open.

Robert Spingarn

Patrick, on the margins again, on the second half ramp, if I'm understanding this correctly, Commercial is not kind of consistent with the first half and that most of the ramp is at Government, is that what you're saying?

Patrick Allen

That's correct, yes.

Robert Spingarn

And most of that…

Patrick Allen

I'm sorry, most of that is in the fourth quarter, yes.

Robert Spingarn

And most of that is in the fourth quarter. But it looks like it's fairly substantial when baked into your guidance here. In other words, could you be a little more specific with how the Government segment margin trends here from a ramp perspective?

Patrick Allen

I guess I think it's going to be relatively flat from second quarter to the third quarter, then we're going to see a large significant increase in the fourth quarter. That's driven just by the sales volume. The fourth quarter is always the highest sales volume for Government Systems and it's going to be especially so this year. And a lot of those sales are these international programs that Kelly referred to earlier and those international programs are kind of very, very good margins relative to the average Government Systems margin.

Robert Spingarn

Could we be talking about a few hundred basis points?

Patrick Allen

Yes. In terms of third quarter to fourth quarter expansion, yes.

Robert Spingarn

Okay. And then, Kelly, just quickly on bizjet OE, you've talked about some weakness there, we've been seeing it everywhere all along, little bit disappointing relative to expectations. I'm thinking the Challenger numbers may be a little bit high, at a 100 a year, I think they may even have gone down quietly on the last guidance out of Bombardier though they didn't quantify the number. Are you prepared for lower Challengers?

Kelly Ortberg

I think we're pretty aligned with what the market demand is for Challengers going forward.

Robert Spingarn

How does that differ from what the Bombardier plan is?

Kelly Ortberg

When we deliver the airplanes versus when they are delivering. I'm going to let them comment on that.

Robert Spingarn

They've already guided down without essentially specifying a number, and I just wanted what's baked into your number.

Kelly Ortberg

Again, I'm not going to get ahead of Bombardier here. I think we're pretty well aligned with again what we expect the market to be on those. I don't want to project Bombardier's…

Robert Spingarn

Okay. Let me ask you the question a little differently. What do you see the downside risk as in your bizjet OE for this year, do you feel like there's some risk there?

Kelly Ortberg

Again, I think it's the furlough time. I'm certainly watching what's going on at Gulfstream. That would probably be the area I would highlight.

Robert Spingarn

Right, and you think that couldn't impact some of your product lines [indiscernible]?

Kelly Ortberg

We don't have a lot of content on the Gulfstream programs. The G650 is a good content aircraft for us. So, again, we'll just watch what they do there. I think we're pretty well aligned at Bombardier.

Robert Spingarn

Okay. Thanks guys.

Operator

The next question is from Robert Stallard with RBC Capital Markets. Your line is open.

Robert Stallard

Kelly, thanks for all the detail on Government Systems and [indiscernible] the backlog and the pipeline you have for the second half. I was wondering how much of this work is sustainable into fiscal 2017.

Kelly Ortberg

That's a program specific question. Most of that work is sustainable into 2016. I'd say very little of it is orders that we can completely convert to sales throughout the year. So think of even the product sales where we get orders for ARC-210 or our MIDS product line, we'll make some sales this year but we won't sell all that backlog out next year. So while this is a second half loaded year, it also gives us opportunity for next year as well as long as we book these orders.

Robert Stallard

Okay. And then Patrick, just on the tax situation, you've got these one-off gains in fiscal 2016. What should we think of as sort of the run rate for tax going forward into next year and beyond?

Patrick Allen

I'd target probably around 30%. We've always been trying to beat that goal but with the R&D tax credit I'm thinking around 30%.

Operator

The next question is from Ken Herbert with Canaccord Genuity. Your line is open.

Kenneth Herbert

Just two clarification questions on the Government Systems. I mean it sounds like with the margin commentary that the sales volume flattish in the third quarter perhaps, maybe down a little, maybe up a little, which implies a very significant fourth quarter on the top line, potentially up close to 20%, and I can appreciate the detail you provided on the backlog and confidence, but are there a couple of programs you'd highlight as swing factors and does that sort of cadence from the third to the fourth quarter make sense?

Patrick Allen

I would say, if I heard your question right, we're planning on having growth, year-over-year growth from Government Systems in the third quarter. Now it will be higher in the fourth quarter on a year-over-year basis, but we're going to have growth both in the third and the fourth quarter. And the things that are going to drive the fourth quarter growth higher are again some of the international programs that we're in the process of closing out right now.

Kenneth Herbert

Okay, so expect some growth in the third quarter, so that's helpful. But then the mix obviously is what's driving the margin commentary it sounds like.

Patrick Allen

Yes, the mix, and I had mentioned also the transition to increased Company funded R&D and that's going to happen on the Government side as well.

Kenneth Herbert

Okay, great. Thank you very much.

Kelly Ortberg

Operator, we have time for one more question.

Operator

The final question is from Michael Ciarmoli with KeyBanc Capital Markets. Your line is open.

Michael F. Ciarmoli

Kelly, maybe if we could just go back to Ron's line of questioning around the connected airplane, we obviously see some of these structural headwinds in the aftermarket. How are you guys positioning yourself with IMS to take advantage of some of the predictive maintenance or real-time monitoring and should we expect not near-term but over time that to be an aftermarket sort of growth engine as there is more of this monitoring of systems in flight and predictive maintenance?

Kelly Ortberg

Yes, absolutely, and that will come to us in a couple of different ways. We'll provide – in cases we'll be providing services to the airlines, we're also working with engine OEMs where we're providing service to deliver the data to them, then they provide a service to the airline around the predictive maintenance. It depends on where the intellectual property resides. We'll be able to do that for the things that we have the intellectual property. We'll be a – think of us as a data delivery source to other companies who own the intellectual property going forward. So there's great opportunities. We'll be able to put apps in our aircraft and the ground, we'll be able to drive services and support that again to the OEMs, to the product OEMs, as well as the airlines.

Michael F. Ciarmoli

Perfect. Thanks a lot, guys. That's all I have.

Operator

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

Ryan D. Miller

Thank you. So we plan to file our Form 10-Q later today, so please review that document for additional disclosures, and thank you for joining us and participating on today's conference call.

Operator

Ladies and gentlemen, this concludes today's conference call and you may now disconnect. Thank you.

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