GKN's (GKNCF) CEO Nigel Stein on Q2 2016 Results - Earnings Call Transcript

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GKN Plc (OTC:GKNCF) Q2 2016 Earnings Conference Call July 26, 2016 3:30 AM ET

Executives

Nigel Stein - Chief Executive

Adam Walker - Group Finance Director

Phil Swash - CEO, Land Systems

Kevin Cummings - CEO GKN Aerospace

Peter Oberparleiter - CEO, Powder Metallurgy

Analysts

Andrew Carter - RBC Capital Markets

Rami Myerson - Investec

Stephen Swanton - Redburn Partners

Andrew Gollan - Berenberg Bank

David Larkam - Numis Securities

Sandy Morris - Jefferies

Alasdair Leslie - Societe Generale

Glen Liddy - JPMorgan Cazenove

Sanjay Jha - Panmure Gordon

Harry Breach - Raymond James

Nigel Stein

Welcome to GKN's 2016 Half Year Results Presentation. Slightly different format this morning; I will start with a short introduction, then Adam will take you through the results and the highlights of first six months. But interesting as that is and it certainly has been an interesting few months here in the UK, the future is more important. So following Adam, I will go through what we're doing now to secure GKN's exciting future.

We'll end with Q&A, when I and my colleagues on the stage, will be delighted to answer your questions. GKN is doing well. The addition of Fokker, continued growth in the automotive businesses and the beneficial effects of currency translation, look set to continue our five-year record of rising profits before tax and help us going into 2017 as well. But we're not satisfied with that.

So now, while sustaining our organic growth, we're sharpening our focus and pushing ahead with increasing productivity and taking out cost. But, at the same time, we're continuing our investment in technology, ensuring GKN remains a leader in its chosen markets. Here are the results in summary, sales up 17%, with 2% organic growth; profit before tax up 12%; growth in earnings per share and an increased dividend. So, good progress.

Turning now to our markets, the aerospace market overall was relatively flat, with TIOR forecasting the same for the full year. Our aerospace sales saw organic growth of 2%, with the rise in commercial more than offsetting a decline in military. That's the pattern we expected, with military passing through a trough and resuming growth when the F-35 build rate steps up. We managed to partially close the gap left from last year's one-offs and had a good contribution from Fokker. The integration is going well and we're delighted that Fokker's part of GKN Aerospace. The global automotive market grew by 2%, with China leading the way.

Production there has been steady this year after last year's quarterly ups and downs. Overall, driveline saw strong organic growth, with sales up 5%, comfortably outperforming the market, this time through a very good performance in Europe. We saw strong sales in SUVs and in premium brands, where our content is high. Globally, the automotive market looks steady, with IHS forecasting growth for the year at just below 3%. Powder metallurgy continued their good run, growing at the same level as the automotive market, with strong growth in China and good margin progression.

You'll see later their very strong order win rate which bodes well for the future. Engines and transmissions are getting smaller; with the design for PM, smaller parts can be just as profitable. Land systems also did well, in line with our expectations in a tough market. You can see from the chart a decline of around 20% in U.S. agricultural equipment, but we were much less down in Europe and, industrial, actually grew our sales. Some think those markets are turning and we shall have to see.

When they do, profitability will recover fast. Overall, although it's hard to measure all our differing markets precisely, I think we can say GKN outperformed, as we expected. But now, we want to speed up by sharpening our focus, by reducing costs across the Group through a series of self-help measures, things we want to do to be better.

At the same time, we will maintain our investment in technology and I will talk more about this after Adam has been through the results. First just a quick word on Brexit, we don't see much impact on GKN's trading. We're a global business, with manufacturing plants in 17 European countries and many more employees inside the EU than the UK. In our UK businesses, two-thirds of sales are invoiced in U.S. dollars or euros, so as our currency hedges progressively roll off, they will benefit from a weaker pound.

With that, over to Adam.

Adam Walker

Thank you, Nigel. Good morning, everyone. I think this has been a good start to the year; growth above our key markets, underlying profits up across the majority of our plants, generating a bit more cash flow and earnings moving forward. FX, of course, has had a positive impact on our earnings, especially post-June 23 and is likely to have an even bigger impact over the rest of the year, if rates stay where they are. But, of course, our hedging strategy means that whilst our dollar cash flows are higher, our dollar debt is, too.

And then, of course, we have the pension deficit to add on top of this, but just as importantly, results day is about looking forward. We're always considering our markets, our portfolio, our cost base and our cash flow. We're doing lots of things right, as evidenced by these numbers, but sharper focus will put us in even better shape in 2017 and beyond. Anyway, let's start with the results.

Sales of £4.5 billion, significantly higher than last year, thanks to Fokker and currency; 2% higher on an organic basis which is an improvement on where we were at the end of Q1. Trading profits up to £390 million; a trading margin of 8.6%, diluted a bit by Fokker, earnings growth of 7%; a tax rate of 25% which remains my guidance for the full year and an interim dividend of 2.95p, up 2%, acknowledging that we're about to start negotiations around the UK pension triennial valuation and reflecting an estimated full-year free cash flow cover of 1.8 times.

The breakdown of the £665 million increase in sales from £3.85 billion to £4.5 billion is shown here. I will talk about the divisions in more detail in a minute. So let's just focus on currency, a £202 million benefit, 90% from the dollar and the euro and Fokker which contributed almost £370 million. Overall, organic growth of 2%.

Turning to the bottom line, a £44 million increase; as you can see, another significant impact from currency here too. In the back of your pack, you can find the currency-by-currency reconciliation. But the rule of thumb is a $0.01 movement in the dollar is a £3 million movement in profits and a €0.01 movement in the euro is around £2 million on a full-year basis. At current rates, we would expect a year-on-year bottom line benefit of around £70 million. This is, of course, translational and can easily move the other way. And before moving to the divisions, the £10 million red column on the right under other primarily reflects the benefit in the first half last year of a pension increase exchange offer we made to our legacy pensioners.

So let's move into the divisions. This slide covers the core aero results alongside the first six-month contribution from Fokker. Let me start with the newest addition to the GKN Group. It has been a good six months. The Fokker team has settled well into GKN and we're already seeing the benefits that each party can bring to each other. We've settled the historic DoJ claim that we talked about at the time of the acquisition. The integration process has been approved by the works council and we remain on track to achieve all of our strategic objectives. Trading has been good, delivering a solid 7.6% margin. Fokker has enhanced our overall technology offering, adding a strong market presence in electrical interconnection systems, expansion across key platforms like the A350 and the F-35 and significantly increasing our global footprint, especially within Asia.

We expect a good year of growth and the margin to improve as the year progresses and the synergy benefits kick in; a good start. And whilst on Fokker, as you've seen in the release, we've taken a charge of £22 million in the first half reported outside our management numbers. And expect the full-year charge to be no more than the €50 million we outlined at the time of the acquisition and the rest of aerospace has done well too, even with the headwind of the reduced rate of the A330 and declining military sales. Commercial growth of 8% in the first half was ahead of our expectations. The A350 production ramp up is on pace and is now generating a strong, profitable revenue stream.

You know that the A380 production rate is coming down, but this was already anticipated in our planning. And our engine portfolio has grown this half, with engines like the V2500 and the CFM56, in their aftermarket profitable stage, balancing the GTF and the Trent XWB in the ramp-up phase. Even with all these moving parts, our underlying aerospace margins are stable and where we expected them to be.

Turning to driveline, we have achieved another period of outperformance versus the global market, 5% organic sales, with growth in all our end markets except Brazil and Japan. Europe was a particular star, thanks to strong programs with Fiat Chrysler, Volvo and Daimler. We achieved double-digit growth and a strong profit conversion. As we've discussed before, in North America a lot of the growth has come from light trucks, where we do not have the same level of exposure. Nevertheless, we grew and we expect the second half to be stronger, with the launch of the successful BSUV program for Fiat Chrysler.

We have, though, had some operational issues in North America. Incremental costs on an all-wheel drive program depressed margins in the first half. We're not quite out of this phase financially but, operationally, we're now achieving customer quality and delivery requirements. Driveline's conversion would have been mid-teens without this impact. China remains a strong market, growing at 6%. As we highlighted in Q1, we're slightly behind that, but expect to outperform in the second half of the year, with the launch of a number of programs for both the domestic OEMs, as well as increasing penetration in the all-wheel drive market. And we continue to develop programs in the eDrive space. Following the continuing success of the Volvo XC90, we're now on the BMW 2 series Active Tourer.

Not to be outshone, powder met had a strong half too, with 2% organic growth, in line with the market once you adjust for the impact of the surcharge. Margins are up again to a record level, boosted by design for PM. With much smaller contract sizes and shorter contract lives, winning new business is critical and we've won more this half than ever before at over £120 million, winning business with Ford, Schaeffler and GM. Although the U.S. remains our largest market, we've achieved good growth in Europe, India and China.

To supplement the latter, we now have a local powder production in China which will significantly boost our powder capacity in Asia and help us grow sales in that region. And in addition, we now have a joint venture arrangement to enhance our titanium powder capability. With enhanced powders, bionic tools and a passionate Italian in charge, there's no stopping us; almost £0.5 billion of sales, £63 million of profit and a 12.6% margin.

Of course, I've saved the best until last. Land systems delivered in the face of continuing tough markets, especially the North American ag market which is down around 20%, fairly brutal for both our global customers and for us. On a brighter note, however, Europe including ag looks a bit more encouraging. And our industrial business did well, growing in Europe and winning new business in China which is being fulfilled from our new facility in Taicang for the first time.

Some commentators are calling the bottom. I have been counseled by colleagues, who have seen a few more years of land systems than me, not to lead with my chin. Let's just say land systems tends to decline for three years and then recovers strongly. Whatever the outcome, we're definitely six months closer to a recovery than we were in December. And with organic sales declining by 6%, we kept close to our costs and delivered £17 million of profit at a slightly improved margin.

Moving to cash flow, it was a good start to the year on cash; increased EBITDA, some investment in working capital, although don't forget, we had to pay the VAT on the advance we received just before the last yearend, pretty consistent levels of net capital expenditure, resulting in operating cash flows increasing over the same period last year. Cash generation remains a focus for the Group. Our inventory turns stand up well to our peers across our different business. On commercial working capital, our customers are not easily persuaded to pay us more quickly; indeed, some try to unilaterally move in the other direction. And on creditors, we operate to fair commercial terms. Improvement in operating cash flow remains a key focus for the Group.

And turning to the bottom half of the cash flow, no great change to last year, our interest costs are, in the main, fixed, our tax payments after years of increasing are stabilizing and we will discuss pensions in a minute. Further down this table, you will see the £85 million relating to net investment hedges and other items. Within this line, there is a £96 million movement which is the translation impact of denominating our two long term sterling bonds in dollars and euros. So we end the period with a reported net debt of £918 million, £149 million higher than at the yearend, but £96 million of this movement relates to the translation of the swaps.

Moving to pensions, the deficit now stands at £2.1 billion, a £540 million increase since December 31, of which a large chunk occurred following June 23. As you know, this is an accounting valuation at a point in time. The principal reason behind the increase is the fall in bond rates since December; around 90 basis points alone on the UK AA corporate bonds. This was around £400 million of the movement. Add in to that the need to translate our European and U.S. deficits back into sterling and you get £100 million more. As you can see from the release, the valuation of our liabilities is extremely sensitive to a movement in discount rates. A 1% increase across all our geographies is worth around £600 million. And do note that these accounting valuation changes do not change the deficit cash contributions of £42 million per annum.

As you know, in the UK, we're in the midst of the triennial valuation which uses a different methodology to IAS 19. The valuation date is April 5, 2016; at least this is before some of the latest movements, although the direction of travel from the last valuation in 2013 is the same. And as we said last year, we would anticipate that the level of contributions for deficit funding will increase. Negotiations are ongoing and, in the meantime, we continue to work on a number of initiatives with a view to reducing the volatility and, ultimately, reducing our long term liabilities. Which way will long term interest rates go in the UK? A lot of respected houses are forecasting inflation next year which would point to a rise in interest rates, but I guess the one thing that last month has taught us is not to predict anything.

And so, in summary, we have grown above the market and expect to do so over the full year; our Group margin is in the range; our ROIC is good but it's down a bit, impacted by the FX impact on our balance sheet. And whilst cash flow has improved a bit this half, I expect more in 2017 and beyond, although the pension headwind should not be ignored when comparing our conversion with peers. And we enter the second half in good shape.

Our principal end markets are holding up and we have the programs and the platforms to deliver for our customers and deliver for our shareholders. The aerospace market outlook has softened a wee bit, but we're doing better than we thought and feel positive about this year and next. Fokker is looking like the acquisition we thought it would be. Across our two automotive divisions, we expect to outperform again over the full year in 2016. And our land systems top-line decline is slowing and maybe things will turn next year. Whatever, we're keeping close to costs and winning new business.

Overall, we expect 2016 to be another year of good growth for GKN; earnings momentum helped by currency and Fokker. And with the steps that we're taking that Nigel will take you through now, we'll be in even better shape in 2017 and beyond. Thank you.

Nigel Stein

Okay. Thanks, Adam. A good six months, slightly frustrating as should have been even better in driveline, but still, lots of good progress. So what's next? Well, the undercurrents driving our markets are strengthening; a rising population which is increasingly urban and Asian and aging and more affluent too; the push for a cleaner environment is driving electrification in both aerospace and automotive. The speed here is definitely picking up; for example, planned European legislation is for 30% of cars produced to be fully electric by 2030 that still leaves 70% which are not, but most of those will be hybrids.

And we expect the widespread application of the new technologies in our industries, including additive manufacturing as well as increased use of digital in manufacturing which is picking up pace as the cost falls. GKN's consistent strategy is defined around those trends, with five key objectives embedded in all our plans. You know them, so I won't repeat them here.

We pay a lot of attention to our financial triangle, with a balance between growth, margin and return on invested capital. Fokker has brought good absolute growth, but today, slightly dilutes our margin, so our focus right now is more towards margin and return on invested capital. To help drive performance, we're looking to sharpen our focus, while continuing to invest in technology, to make sure we enter 2017 at full speed. How will we do that? First, we will step up our already strong drive for productivity by reducing fixed costs by £30 million a year. There will be a £35 million charge to be booked during the second half of this year; the benefits will be seen in 2017.

Second, taking advantage of the new technology now available, we will progressively redirect more of our capital investment into productivity focused projects, reining back somewhat on added capacity. We've been running at a relatively high CapEx to depreciation ratio so, at the same time, we will look to bring that down. And third, we'll ensure we optimize our portfolio to focus the business where we can get the best return. With our selective and disciplined approach to acquisitions, we've built some strong market positions. But across the Group, where we judge there is less opportunity to differentiate ourselves through technology, global footprint or operational excellence, then we will look to manage those businesses in a different way and move our investment to higher-return projects. And importantly, we will continue to invest in technology to keep GKN a market leader.

I will elaborate on that in a moment, but first, let me illustrate productivity opportunity through just a couple of examples. In driveline, most of our CapEx is spent on capacity expansion supporting new programs. As we go forward, we aim to progressively increase the proportion going into projects that are focused on productivity, investing in areas such as automated inspection, robotic assembly and better digital systems; new technology is making those far better and much more affordable. That switch will accelerate the payback.

On average, driveline's productivity investments give a two-year payback, compared to around four to five years for capacity investment. The move will be progressive, because we still want to invest to support driveline's strong new business outlook. And another example where we're already seeing benefits is in powder metallurgy, who have developed their own ingenious tooling made by additive manufacturing. It reduces average setup times from 75 to 25 minutes, a two-thirds saving.

With roughly 8% of our machine time spent on changeover, there's a big opportunity for productivity gains. And powder met also have our most integrated digital network with their key equipment connected and providing real-time data. As a result, they are targeting a 10% efficiency saving in back-office areas which they're well on the way to achieve. So just two examples of how we aim to step up the pace in productivity. And make no mistake, productivity and continuous improvement are already a way of life in GKN. Each year, through our strong lean manufacturing program and continuous improvement activities, we already drive out more than £100 million of costs across the Group which is why we remain so competitive and successful in our markets. But we now aim to do more.

Turning to technology, GKN has a wealth of excellent positions which we're seeking to exploit and are already working on with customers. In aerospace, our structures team are key members of the wing of the future consortium, designing a lightweight, laminar flow wing. Through Fokker, we're now leaders in thermoplastics which can provide 10% to 15% weight saving on selective components. In engine structures, we're working on several projects with Pratt & Whitney and Rolls-Royce to manufacture lightweight turbine cases and blisks, including using some additive manufacturing techniques. And the highly respected Fokker Elmo business is part of United Technologies' electric aircraft initiative.

We're well placed to do more in the electrical space as aircraft progressively electrify. And that's not to mention the new U.S. long-range B21 strike bomber, where we're proud to one of only five main contractors working on the program. The story in driveline is similar. We remain the clear leaders in CVJ with innovative products still being deployed and, as shown, winning prestigious awards. In all-wheel drive, our latest lightweight disconnect system is the market leader, with our recent product also being by far the quietest drive unit on the road with a clever modular design. eDrive is still in its infancy, but growing fast. We're already the market leader in standalone electric axles or eAxles which provide combined all-wheel drive and hybrid capability.

There are more than 300,000 GKN systems on the road, including those on the Volvo XC90 hybrid which is still doing incredibly well and we have more launches coming. We're also working on programs for fully electric vehicles where noise, weight and efficiency have increased importance. GKN has a high level of expertise in those, as well as an unparalleled understanding of the overall vehicle driveline. And remember, eDrive is incremental to GKN; almost all electric cars still have drive shafts, so eDrive brings another opportunity for growth through added content per vehicle. GKN's technology in powder metallurgy is second to none, covering a whole range of applications.

I'll not go through them, but would say we're very well placed to capture growth through innovative powders and parts, including in additive manufacturing where we've established a good capability. You may have seen yesterday we announced a joint venture agreement with TLS, a small German company with leading titanium powder technology and we will jointly offer that to the U.S. aerospace market. When you combine that technology, our global footprint, our focus on operational excellence and continuous improvement, you can see why we're well placed with strong market positions. The slide shows it, with GKN generally number one or number two in the world in what we do. The message is, we're very well positioned to continue our growth.

To conclude, GKN operates in large global and growing markets. In aerospace, the recent Farnborough air show saw a lower level of order announcements, but that should not obscure the huge backlog of commercial aircraft to be built in the coming years. And the appearance of the F-35 is reminder that new military programs are inexorably moving forward. In automotive, global demand for cars remains robust and the quickening pace of change from internal combustion, to hybrid, to pure electric, brings opportunity for GKN.

It's good for us and we have shown how we can go from CVJ drive shaft to all-wheel drive and now pushing in eDrive. In powder metallurgy, the shift towards new technologies, such as additive manufacturing and new powders, offers great opportunity for GKN, already market leader with the widest range of technologies and Land systems is well positioned for recovery in its markets. Although changing markets can bring challenges, they also provide opportunities and by seizing them, with a strong drive to succeed, we're confident we can deliver GKN's exciting future. Thank you.

We now have some time for questions and if you please remember to wait until the microphones come round and say your name and company name and ask your question. Thank you.

Question-and-Answer Session

Q - Andrew Carter

It's Andrew Carter from RBC. Could I just ask you to talk a little bit more about the productivity initiative? I guess there are potentially some financial implications that we should think about that; have you thought, at this stage, about what CapEx guidance might be for 2017? Is the capacity increase that you're still thinking about, is that going to be sufficient to continue to outgrow the markets in driveline like you've done in the past? I guess finally, in terms of the margin impact of this, are we actually going to see depreciation coming slightly less as part of the P&L and might there be a margin impact one way or the other?

Nigel Stein

I'll perhaps start with that and Adam can jump in. CapEx, the main thing is we're switching more towards productivity. As you heard in the presentation, we get a faster payback from new technologies such as automated inspection, robotics, etc. which, as I say, give us a faster payback in the CapEx, that is the main thing to do that switch. We do want to, at the same time, to pull back the high level of CapEx to depreciation that we've seen in recent years, so we will see that ratio coming down.

We don't want to constrain our capacity, but we did say a while ago that we would be being more selective in talking about driveline in CVJ orders. So we'll carry on that strategy and look for our growth through all-wheel drive, where actually the capital need is slightly less. And margin benefits, we're always striving to move our margins up. Depreciation I don't think will come down in the short term, because we've actually been investing at quite a high level in the last few years, so we'll see that depreciation actually slightly tweaking up before it levels off. Adam, do you want to add anything to that?

Adam Walker

No, I think we're looking at positioning ourselves in better shape for 2017 Andrew and the CapEx has run at slightly higher rate to depreciation over the last couple of years as we've been growing. It's not about the overall level of CapEx, it's about where we target that, but I would expect the ratio in terms of the CapEx to depreciation ratio to come down a bit in 2017. They expect the margins to improve because we are going to be taking fixed cost out from the January 1, 2017 and this is largely headcount and so we’re making ourselves a fitter business for 2017, improving the bottom-line, improving our cash flows some of the things have been a bit of focus for us a number of years for us.

Rami Myerson

Rami Myerson from Investec. Two interconnected questions; you've launched a £30 million cost saving program, £35 million costs, can you provide some type of detail about this across the different businesses? And of course, how much of that fixed cost savings do you think you can actually keep, given we're seeing increasing pricing pressures from some of your suppliers. I think most noticeable, of course, is not only on cost, but also on cash, we've heard stories about Boeing changing their terms of payment, a U.S. company called them delinquents yesterday; I would appreciate your thoughts on that.

Nigel Stein

I'm not going to start by calling a customer anything, actually. But I think just to say on sharpening the focus, this is across the Group, it's everywhere in GKN, we just want to push ahead faster, so we haven't set it so much in one division or another. Obviously, we'll have discussions with employees first; this is spread across the Group, so it's the whole of GKN speeding up and taking our fixed costs down. Adam, do you want to say anything about that working capital movement in aerospace?

Adam Walker

I would just say on the charge, you'll see in the press release that driveline is being restructured. So driveline which we traditionally, historically, had run geographically around three geographies, Europe, North America and Asia, is now being run on product lines, so the CVJ operations and then the all-wheel drive and eDrive.

This is a structural change and a lot of the thinking around the restructuring charge and the fixed cost is looking at the structure of the Group and how we run the four divisions and how the Group interacts with those. As we go through the second half of the year, we'll have a clearer indication of where that charge will land and the cost savings will land division by division as we move forward in 2016.

As Nigel said, we won't talk about an individual customer. You know what Boeing have said; they're a big customer to us. Clearly, if they move their payment terms, that has an impact on our working capital, but it's for us to manage that. We have to manage our working capital, as I said just now; we don't get our customers to pay us any quicker. It's a tough industry, but we're used to that; operating cash flow remains a key focus for us and we've got to manage any of those changes.

Stephen Swanton

I've just got a couple of quick cash flow questions and then one on Driveline. On the cash flow - sorry, Stephen Swanton from Redburn - can you just clarify the size of the VAT payment and how it impacted the working capital line I take it? Also, the sale of fixed assets looks quite high at £25 million as well, I'm wondering what you're disposing of to release that cash.

Adam Walker

The VAT was in the region of about £30 million to £40 million. It was in relation to the advance that we talked about the end of last year and was paid in January, so that was a headwind in terms of working capital in the first half of the year to overcome. Fixed assets, we had a contract in aerospace, a piece of technology that we'd invested in the capital, that contract has come to an end and the customer repaid us for the capital we'd invested. It was CapEx that went into 2015 and we got repaid in 2016.

Stephen Swanton

And then on driveline, if I understand correctly you said the conversion rate or the drop through would have been mid-teens in driveline, is that a divisional level?

Nigel Stein

Adam was saying in Europe, a very, very strong performance; it was so nearly a fantastic half. And then, as you heard, we did have some problems in North America which held it back otherwise. But we did see exactly the sort of performance that we thought that we could get from driveline, but working hard to make sure we go forward in the second half and 2017.

Stephen Swanton

If we strip out the launch costs, it's like 8.6% margin that we've got, is that calculation right?

Adam Walker

Yes, probably around about that. I think overall, the Chinese margins have come down a little bit in the first half of the year as we said they would. But the key driver for driveline was getting the wholly owned subsidiary margin up and that's made a lot of progress in this first half. It would have been a little bit better without the issues in North America.

Stephen Swanton

Taking a step back from the more medium term outlook for CapEx, is there a shorter term issue with now production capacity in Europe and do you start shipping from North America over to Europe now?

Nigel Stein

Well, we're shipping stuff from Brazil, so that's the whole thing about driveline; we're even shipping stuff from China I think. Driveline is a very global business and can support other plants around the world. Anything you want to add to that, Phil?

Phil Swash

Not too much. We make maximum use of the footprint. As Nigel said, Brazil has been very depressed; the decline we've seen in Brazil is less than half the market decline because we've been utilizing it to support principally Europe for CVJ systems and we'll continue to do that for the rest of the year.

Andrew Gollan

Andrew Gollan from Berenberg. Two aerospace questions and one on pensions. Firstly, on the commercial side of the business, the program outperformance, in terms of organic, you said that was slightly ahead of your expectations for the period. On military, we're talking about this trough profile; can you just confirm, on a revenue basis, is that 2017, do you see that flattening out, will be flat this year and we start to pick up 2017, just to get a profile of that, please?

And then lastly on pensions; we know you're in negotiations at the moment, but on a scenario analysis, cash impact, if terms don't change so much compared to where we're today, what kind of cash flow impact are we looking at in terms of the step up, please?

Nigel Stein

Okay, we'll start Kevin on the two aerospace questions and then on pensions to Adam. Don't forget, we're in the middle of negotiation with the trustees, so we'll be slightly restricted in what we say. Kevin, do you want to talk about the growth in commercial and then the military trough?

Kevin Cummings

Yes, certainly. Commercial growth, primarily what we're seeing is a good ramp-up on the A350; we're seeing an increase on the A320 and an increase on the B737. Those are driving in the structural areas. In addition to that, we saw a good turn-in on the spares and FHA agreements on our engine programs as well. So we saw an upside on all of that. The military component for 2017, we do believe that 2016 should be the end of our declining sales in military and we expect a stable 2017.

Andrew Gollan

And just one follow-up, are we at the trough of the A330 and when do you start to feel the ramp-up again, given Airbus' new guidance?

Kevin Cummings

We believe we're at the trough for the A330 as announced and we would expect, either towards the very end of 2016 or early in 2017, we should see some slight uptick on that.

Nigel Stein

Adam, is there anything you want to say or can say on the pensions?

Adam Walker

Well, I'm sure you don't want me to start the negotiations the negotiations in open forum Andrew. Clearly, it's not going to be nil; at the moment we paid £42 million and I certainly wouldn't expect it to be at that sort of incremental increase, so it's going to be somewhere in between there. I think one or two people have started putting sensible numbers into their cash flow guidance for 2017, but we'll update you as we go through the year.

Nigel Stein

Okay, any questions for our passionate Italian or anybody else on the stage?

David Larkam

David Larkam from Numis. Three questions, please. Firstly, at GKN hybrid power, can you talk about what's going on there? Secondly, sharper focus, does that mean disposals? And finally, just talk about the A380 and what impact to that is, going forward?

Nigel Stein

Okay, hybrid power, we've had a change of attack on hybrid power. The reason we bought it was for the technology and recovering energy and also the knowhow in terms of management, of energy management and managing of motors. What's happened is the bus market's moved on and they're now doing less of that type of system and more full battery power. So we'll be including that and using that expertise more in the automotive side of the business, rather than focusing on the bus market.

So that's our plans there. Disposals, we've made disposals in GKN. We sold our share in Emitec about two years ago, so we do things; we don't talk about anything we do. But if you look at GKN over the years, we've changed with time, we've moved into new markets, secured market-leading positions. So as and when we think anything is appropriate for disposal, then we would do that. I think it would be impossible to talk about it before we did that sort of thing and then the A380, the question there, Kevin, do you want to pick up on that?

Kevin Cummings

Yes, obviously we have a large content of aircraft on A380 and the decline in the sales over the next three years will have an impact, both the top line and bottom line. But A380, the announcement that Airbus have come out with is right in line with what we had anticipated, so we were not surprised by that.

Sandy Morris

A380 is very big, if we're taking out, whatever it is, 14 aircraft, was it $7-ish-million? No, I think it's--

Kevin Cummings

About $8 million.

Sandy Morris

Yes, but that's a lot. And then we've got Fokker kicking in as well which won't be taking the ship-set up.

Kevin Cummings

Yes, that's what took it from $6.5 million to $8 million, Sandy.

Sandy Morris

Right. So we're $8 million with Fokker, but the content depended on the engine, didn't it?

Kevin Cummings

The total has the engines. The $8 million has the engines in it as well.

Sandy Morris

Right, but it takes a bit of effort to put that back in, doesn't it?

Nigel Stein

We work hard, Sandy; we would love them to be there, but we've always expected, as you heard Kevin say, that the rate would come to this level, so it has.

Sandy Morris

Okay. Yes, I'm very disappointed naturally on things. Just in aerospace, just so that we understand, spares matter, the slight hour agreements matter; the mix was still incredibly adverse, a not dissimilar mix last year, put a really big hole in the profits in aerospace before the one-offs, didn't it really or it seemed to?

Nigel Stein

The military, you're talking the military decline, yes.

Sandy Morris

Yes and commercial last year, there was a big hole in profits which this year we've actually somehow avoided.

Nigel Stein

It's not a big hole. I think I would, perhaps in comparison to others in the market, say we had maybe a slight air pocket, our profits. We're on that, but to say a big hole I think is probably a rather extreme word. It would have slightly reduced our profits; we had some one-offs that actually kept them flat. And we said at the beginning, going into this year, we'll work hard to compensate for some of those one-offs or one-offs not being there and we've made some progress.

Adam Walker

And we're still down half on half in terms of underlying aerospace profits. So overall, with translation impact, the numbers the £133 million plays the £133 million and then you've got Fokker, but underlying we're still down and we had £15 million this time last year. So we've made some progress on getting that back.

Sandy Morris

But are you now the passionate Italian rather than the dour Scot? But just zeroing in on this, we have been investing a lot in intangibles, £80-odd-million last year in terms of the startup costs associated with new programs. They, just looking at the intangible investment, don't look like they've gone down a huge amount just yet. Is there a sort of breakout in 2017 where they begin to come down? In short, I was thinking of A350; that would go down this half, but it hasn't materially gone down.

Adam Walker

No, that's still at a similar level it was 12 months ago. But you're right, the trend now is coming down; that big investment that we've seen, particularly around the A350 and some of the engines that are coming on, starts to go down as we move in 2017 and 2018 onwards.

Nigel Stein

The A350 has been the big driver of that, Sandy and we're now passed the peak and heading down.

Sandy Morris

Right, but if we kept sticking £80 million into intangibles, in terms of your cash flow, the size of that now comes down in halves or something.

Nigel Stein

Absolutely.

Sandy Morris

I hate to labor this thing in North America, but I can't remember us ever running into an issue like that before, not CVJs, not with all-wheel drive, where we must have got to kind of startup and then it all went wrong.

Nigel Stein

It's a complicated story; Phil can perhaps shed a little bit of light. But in a manufacturing business, just in time, you're living with problems every day and everybody in the car industry does. This was one that was much bigger than we'd seen before and it was an engineering problem, something that didn't get picked up, that was designed a couple of years ago.

So it wasn't something that happened now. The consequence of it became clear and then when you're running to catch up and we don't let our customer down, so we were running to catch up, you were having to put an awful lot of extra costs in. And that's basically what happened. We have caught up, but the costs will continue for a few more months, until we've got the whole thing bedded down.

And actually, the product that's been developed is a very, very successful product, but it was a very painful launch process and certainly not one we'd hope to repeat. Phil, do you want to add anything to that?

Phil Swash

Just to say, as with any of these new programs, the more complex they get, engineering specification management becomes more and more important. We probably could have done a better job of that, with our customer. And then the vehicle dynamics, the demands of the vehicle, were extremely challenging, in terms of both performance and critically, noise which was one of the key issues which drove an awful lot of late change and the length of our supply chain means that the cost of that, the implications of that, can be quite severe. And unlike my days in aerospace, we go from zero to 2500 a week, in the blink of an eye and those costs then tend to build up. The positive is, as Nigel said, that having managed through that period, we have got an absolutely world leading piece of rear drive module technology that's the quietest on the market which is already helping the customer involved sell far more vehicles than they anticipated and we see a lot of growth with that.

Sandy Morris

Right, so there's no chance of this being a generic issue across any other models?

Nigel Stein

This issue is not a generic issue across any other model, but I would say don't underestimate when you look at manufacturing. We've always got launch issues and things that we work hard to overcome; everybody in the industry does. There's always a little bit of - a few million here and there where we've had to move fast to push things. This was much bigger than usual and that's why we called it out and it was a shame, because otherwise driveline would have had a really, really good first half which - there we're, but we're on top of it now and moving forward.

Sandy Morris

I don't mean to be mean; it's just the way that I come over.

Nigel Stein

We know you well, Sandy, don't worry.

Sandy Morris

In powder metallurgy, why are the orders now shorter than smaller size?

Nigel Stein

Why are they--?

Sandy Morris

In powder metallurgy, why are the contracts now shorter lived than smaller size?

Nigel Stein

I don't think the contracts are. I did mention, if you're picking it up, the components are getting slightly smaller, because as engines come down in size we're seeing the actual size of the components. And, therefore, the unit selling price often come down in price. So they come down in size and the unit components come down, but no less profitable which is demonstrated by the margins. Peter, do you want to say anything to that?

Peter Oberparleiter

So the engine from eight cylinder to six cylinder to four cylinder that we do, for example, main bearings perhaps we don't need that many. But they get more sophisticated, so more added value and less weight, all the lightweight, so playing an important role there, taking out weight from the cab. But that's where we're strong, with our sophisticated technology, so we see that the trend to differentiate from our competitors.

Sandy Morris

And you're still just as competitive on the small parts as you were on the bigger ones, because you would have thought the energy saving and the materials savings were less.

Nigel Stein

If you want to know a secret, we make more money on the small than we do on the big parts.

Sandy Morris

Good. I know you're not going to go here, but you've never actually got a negative real discount rate in terms of the accounting assumptions. I assume the actuarial assumptions are going to be slightly more sensible, accountants clearly doesn't want it.

Adam Walker

The accounting standards drive you to appoint and you've got to use the set rules. When it comes to the actual triennial evaluation, there is more flexibility, that's why it's a different methodology. And we're looking at the actuarial assumptions that are being applied at the moment, as are the trustees.

Nigel Stein

I think the point there, Sandy, I'd make, because I kind of agree with you; I agree with you on most things, by the way. But what if you look at it from the actuarial point of view, they look at the - not so much the discount rate, but the yield you can get from a government investment, a gilt someone like that and then say well what can you reasonably expect to get above that?

And what they're basically saying is, you cannot expect if expect, if you have savings and the pension scheme is just a big savings organization, you cannot expect to get any return. This is it, you're going to get no return on your money for the next 20 years, 30 years. Actually I'd say, if you look at putting your money in GKN, we think you'd get a great return, because we've demonstrate it in our return investment capital which is why we take the view, we're better off investing in the Company and driving forward and seizing growth opportunities, than we're, frankly, putting our money into gilts.

But the actuarial valuation will happen and I'm sure we'll have to put more cash into it; that's just the way of the world. But we won't be putting any more in than we think is absolutely necessary.

Alasdair Leslie

Alasdair Leslie from Soc Gen. Just a question on driveline; the new program launches that you're looking at, for the second half, in the U.S. and Asia, does that give you a reasonable line of sight now for 2017, in terms of maybe expectations for performing at least in line with the market maybe, in North America and Asia again? And then also, just a follow-up question on driveline, on the reorganization, do you imagine maybe taking some incremental costs above the line in H2, just relating to that reorganization? Thanks.

Nigel Stein

Well, just before I hand on to Phil, volume outgrowing the market. We still think our formula works very well, demonstrated yet again, first half of outgrowing the market and I think we're still very confident of that for 2016 and going into 2017. Although I do keep saying, I think I've been saying it now for about eight years, please don't hold it to us, year in, year out.

Maybe it's only seven years, because there are programs rolling on, but driveline is a very strong position. And the reorganization, all the reorganization we talked about, will be taken above the line in the Group figures, so if there's any clarification in that. Phil, do you want to talk about driveline outgrowing the market?

Phil Swash

Yes, second half we anticipate this year's second half which will clearly position us for next, to be quite a bit stronger, because both in North America and China, we have significant new program launches, General Motors and Ford, in North America, where the C1, E2 platform for GM is doing extremely well. That will eventually be deployed across 15 different vehicle types launched from five countries. So we've got very good position on that. Ford Explorer, Ford RS continue to ramp up. We've got fabulous content on those.

And in China, I think we trailed last year we expected to see more domestic exposure and that starts to come through with Chang-An, Great Wall, all-wheel drive again in the second half of this year. So I think we're well positioned for outperforming North America and China in the second half and that will put us in a good place for next year.

The reorganization I just would say as well, part of the reorganization is to give us, as Adam said, moving from three global regions today to two global product streams which gives us much better alignment of customers. Our strategic plan which is very different for CVJ systems compared to all-wheel drive, any drive and I expect that to give us better performance as we go through next year as well.

Glen Liddy

Glen Liddy from JPMorgan. On China, for both driveline and powder met, are you actually gaining market share in China with the domestic manufacturers or is it just a clutch of new model launches that happen to be bunched that distorts the sequential performance? On powder met, you've opened up new facilities in Asia; are they creating a bit of a drag on the margin for powder met overall? And if we're at the bottom of the cycle for passing through raw material savings and we start to see them rise, will that squeeze the margin down but, in essence, keep the same profit per kilo of product sold?

Nigel Stein

Well, I'll let the guys - because the answer's yes to that, Glen. But it already is and he's still managed to move his margins up. Phil, do you want to talk?

Phil Swash

Yes, briefly. So domestics are about 30% market share in China; we're about 10% and we see that progressively increase to about 20% over the next three years, so it is progressive improvement in terms of that exposure, Glen.

Nigel Stein

Powder met, Peter?

Peter Oberparleiter

Our exposure is more against it; we're second tier so we're exposed against the first tiers and they are still more European, the Schaefflers and TRWs and the highlights, but [indiscernible] works they send more and more to the local OEMs so we're more present there. So not direct contact, less direct contact, but through deals. On the surcharge, we already see it increasing from $160 a tonne to $260 so we went through that from the beginning of the year to this year we had a bit of a benefit in the first half, but that's leveling out during the year, continually staying at the level we're.

Nigel Stein

For those who aren't so much as Glen is into the story, in powder met we pass through material surcharges, but there is a lag, so we absorb it for a bit and we have been absorbing it for a bit. We've managed to do that in the first half and still post our numbers, so it was a good result. Your question though, Glen, on the margin and was the expansion in China helping us or diluting the margin; in the new powder venture, slightly diluting it, it's a very new startup that we're going through there.

But the two plants, sinter metal component plants, doing very, very well. You saw our growth in China; fantastic, very, very good plant. We kept away from China because we had problems to sort out in North America several years ago. The last few years we've been coming in upgrading; we've got a very, very good business going there now. So no, China is actually adding to the margin.

Sanjay Jha

Sanjay Jha from Panmure Gordon. A couple of questions, if I may? You mentioned in your presentation that all-wheel drive is slightly less CapEx intensive; does that also apply to eDrives as you go to more electrified cars?

Nigel Stein

Yes, it is. All-wheel drive is less CapEx intensive, that is a fact; they're bigger programs. The capacity is actually more devoted to a particular program, so it's more specific to a program, but because we buy more components in than we do in a typical CVJ, it uses less CapEx. eDrive today probably uses even less CapEx but, boy, it uses up costs. We're spending a lot of money developing these eDrive products, but we do buy quite a few components in, so yes, they are also less capital intensive.

Sanjay Jha

So is that more going through the P&L as opposed to your balance sheet?

Nigel Stein

It's certainly going to the P&L, yes, but it's not going to the balance sheet.

Sanjay Jha

One more question for Adam, I think. You mentioned I think in your presentation that the dividend - you said 1.8 times cash cover. Can you clarify; that's free cash flow cover?

Adam Walker

Free cash flow cover, yes.

Sanjay Jha

After the pension payments or before?

Adam Walker

Yes which won't change in 2016.

Sanjay Jha

Okay. And that will carry on in 2017 the same target, 1.8 times?

Adam Walker

No, it's not a target. I'm just saying that's roughly where we think we're going to end this year 2016. We'd like the target to be higher than that, we'd like to have two times free cash flow cover, but this year it will be probably a little bit below that.

Harry Breach

Harry Breach from Raymond James. I've just got a couple of easy ones for Kevin. Kevin, this year, I think we've seen perhaps a little bit more on the equipment than the engine side in Aerospace; more interesting dollar aftermarket revenue growth than maybe we've seen for a little while. Can you give us any more of a feel for aftermarket revenue growth, particularly at the Volvo aero business, if we're still allowed to call it that? And the other question was about 777X; can you give us an idea about roughly where Boeing is in terms of letting out structured contracts, where you are with that process?

Kevin Cummings

Yes, related to the spares business, as far as commercial engines and the engine business, a good turn in the first half of the year. We were, between our spares and flight hour agreements, in double digits as far as growth year over year, so it was a strong increase. And then on 777X, Boeing has let out, I would say, most of its major large components and assemblies and they're still in the process of the next tier down, the component elements are still being bid out throughout the cycle, so probably over the next six months to a year.

Harry Breach

Have you any sense of where you're at in terms of wins on that? Or is it a little early in terms of your bidding on that?

Kevin Cummings

I think it's a little early. We're right now consolidating to make sure that what we currently have on the 777, because a lot of airplanes did not change, is extended. And a few packages that are still out there that can be addressed and have not been sourced we're actively pursuing.

Nigel Stein

Okay, anyone else? I think we're pretty much out of time but if there is any other burning questions, well, if you have any questions we'll be here at the end; happy to take them, very good to see you. Thank you very much for coming. With that, we'll end the session. Thank you.

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