Meggitt Plc (OTCPK:MEGGF) Q2 2016 Earnings Conference Call August 2, 2016 4:00 AM ET
Stephen Young – Chief Executive Officer & Executive Director
Douglas Webb – Chief Financial Officer & Executive Director
Sanjay Jha – Panmure Gordon
Jamie Rollo – Morgan Stanley
Benjamin Fidler – Deutsche
David Perry – JPMorgan
Rami Myerson – Investec
Harry Breach – Raymond James
Okay. Good morning, ladies and gentlemen, and welcome to the 2016 Interim Results for Meggitt Plc. We'll stick with the usual format. So, I'll introduce the results. Doug will talk through the numbers in more detail, and then I'll run through our current view of the end markets, update you on our key priorities, our progress with the recent acquisitions, and then finally, I'll summarize the outlook.
Trading in the first six months of the year has been in line with our expectations, and our healthy order intake supports the stronger second half as previously guided. Reported revenues increased by 11% in the first half with a growth coming from currency movements and M&A partially offset by a 2% organic decline. And this modest organic decline included 4% growth in civil aerospace, split evenly between OE and aftermarket, which was more than offset by lower military revenue on the back of a tough comp last year and continued weakness in energy.
Underlying EPS was up 1% to £0.154 with benefits from currency and M&A, offset by the phasing of revenues and margin into the second half of this year. The balance sheet remains robust. Net debt to EBITDA on a covenant basis increased to 2.6 times reflecting our normal seasonal cash flow and the phasing of profit. And we'll be back within our target range of 1.2 to 2.5 times by the end of the year. We're reconfirming the full year guidance we gave you in February. And finally, the 4.3% increase in the interim dividend demonstrates our confidence in the growth prospects for the group.
The first half saw a very high level of activity in the business as we focused on delivering the many programs in development and some of our more important initiatives. As you know, we've had a good win rate on these new programs, and this has driven historically high levels of R&D in recent years.
As we said previously, we expect 2015 and 2016 to represent the peak in R&D as a percentage of revenues and we're now starting to see this number come down as some of the new aircraft enter service. This is a trend which should continue absent significant new platform launches.
As we've moved into the industrialization phase on these programs, we're putting new parts into our factories that three times the historical rate. As such, our spend on new product introduction remains fairly high and this will continue for another couple of years. And while this investment creates a short-term drag on margin and inventory, it underpins many decades of revenues on these new programs.
We're making good progress on rolling out the Meggitt production system. Two of our facilities have just entered the fourth phase of the program where we should start to see tangible financial benefits at the site level, and we're also rolling out MPS at the recently acquired composites facilities.
I'm very pleased about what's going on in CSS. You heard a lot about CSS at our Investor Day, and since then, it's continued to go well. They're achieving the targets we set them and there's lots of ideas coming from the team as to how they can make things better in the coming years.
The integration of the composites acquisition is going very well and we're very confident we'll achieve our targets for these businesses. And we continue to focus on making the business more efficient. Since October, we've reduced head count by 400 on schedule and with a lower-than-expected cost, and the cost base of the business is now much better matched to demand levels.
This is particularly true at Heatric where we've reduced the workforce by nearly 50% and the breakeven point of the business to circa £30 million of annual revenues. And we've announced plans to close two manufacturing facilities in early 2017 as part of our footprint optimization plan. And there'll be further consolidations after we get through the production ramp-ups on the new programs.
And now, I'll hand you to Doug to talk about the numbers in more detail.
Thank you, Stephen, and good morning, everyone. So, as normal, I'm going to focus on the underlying numbers that are shown on the slide. The adjustments between these and the statutory numbers are described in the press release. The nature of the adjustment is consistent with previous years although the quantum of the difference is much larger in this period due to mark-to-market adjustment of our financial instruments, principally, our currency hedges, as a result of the recent weakening of sterling. I think like many others, we do not hedge account for this. And as a result, we booked a £51 million mark-to-market loss in our statutory figures against some £8 million profit last year.
As we hold the currency contracts, the maturity, the loss on this does not actually represent an economic loss to us although we offset by stronger future operating cash flows from the currency benefits.
So, returning to the underlying numbers on the slide, I've also shown the organic growth rates, which exclude the impact of acquisitions and, in particular, in this period, the positive effect of the largely pre-Brexit currency fluctuations.
So, looking at the numbers, orders grew strongly, up 18%. They were up 6% on an organic basis with strong civil after-market and military orders more than offsetting weaker civil OE against the strong comp from last year and a further decline in energy. Revenue increased 11% to £883 million and operating profit increased 2% to £163 million resulting on operating margin of 18.5%. I'll come back to both revenue and operating profit in a minute.
Finance costs were £3 million higher than last year due to the increased in debt from FX as our debt is largely dollar denominated. And last year's acquisitions, and partially offset by a lower average interest rate.
Our underlying tax charge was 22%, higher than last year when we closed out some historical tax uncertainties. This rate, of course, is our current best estimate for the full year rate for 2016. Our longer term planning rate remains 23%, but with a higher level of uncertainty than normal due to the evolving developments in tax globally, in particular as a result of the BEPS initiative. And with underlying PBT flat year-on-year, underlying EPS was up 1% as a result of a lower average share count, offsetting the higher tax rate.
So, turning to the details starting with the revenue. This chart highlights the major drivers behind the reported performance for the year. Firstly, FX contributed an uplift of £43 million, primarily from the translation of the results of our overseas businesses. The breakdown by currency is on the slide, and obviously based on today's rates, we'd expect a further benefit in the second half. Our largest single exposure is dollar sterling, and the average rate for the first half was 1.43, as compared to the current rate which I think is around 1.32 today. As usual, sensitivity guidance around FX is contained in the appendix to the slides.
The next slide on the bridge represents a £60 million contribution from the two composites acquisitions, and that's very much in line with our expectations. And the following four bars then represent the organic performance in our end markets. You can see that the positive effect of growth in civil aerospace was more than offset by reductions in elsewhere, giving rise to the 2% organic decline for the period.
As we previously commented, this reflects the strong comps from last year when revenue and profit were more first half weighted than usual. We expect 2016 to be a more normal year in that regard.
So, looking in more detail at these end markets, the table on the right breaks down the organic orders and revenue growth in the period, and as usual, focus on the organic numbers. Orders show the normal variations that we see as multi-year contracts of booked and shipped. This year, we've caught up in the civil aftermarket following a relatively weak H1 in 2015, while the reduction in civil OE compares to 28% increase in the same period last year. Military orders have shown a strong recovery with all divisions seeing a pickup. Our overall group book-to-bill ratio was encouraging at 1.03.
Moving on to revenue. Civil OE was up 4%. The primary organic growth platforms for us with the Airbus A320 and A350 and the Boeing 737 as well as some initial revenue from the C-Series reported OE revenue was also benefiting from last year's composites acquisitions as well as the FX. 4% growth in civil aftermarket was a decent performance, although monthly variability remains a feature. Within the overall outturn, we saw a very strong growth in large jets and regionals, offset by a 21% decline in bizjets against a very demanding comparator and relatively weak market. A reduction in bizjet aftermarket was not a surprise to us, the quantum was a little larger that we've anticipated.
Military revenue declined by 5% in the period, against 6% growth this time last year when we benefited from a catch up from prior shipment issues and a large order for T-50 brakes for the Korean Air Force. In the context of our guidance from modest growth in 2016, with more normal revenue phasing, this performance was in line with our expectations. And as with civil OE, the reported revenue benefit from the composites acquisitions as well as FX.
And Energy show a further 19% revenue decline with both Heatric and the power generation businesses contributing to the weakness. We expect the rate to decline to moderate in the second half of the year.
So, moving on to operating profit, I thought it most helpful this period to bridge the 170-basis-point margin decline. Start on the left of the chart, I pulled out the mix effect in the first six months. Heatric contributed 30 basis points, reflecting the loss in the year-to-date. The larger impact from the effect of surplus parts, the younger age of the fleet, and weak biz jet performance on aftermarket margins.
As you know, the cost reduction activities completed in the first half are designed to largely mitigate the full year effect of these headwinds. The next red bar relates to the phasing of production, particularly within MABS where production rates in our carbon facilities were moderated to respond to some overstocking particularly in regional jets. Similarly, the revenue in our training business is significantly more H2-weighted this year adversely affecting H1 overhead recovery. This will reverse in the second half.
And then the final red bar is the impact of the acquisitions on the overall group margin. As I've said previously, any M&A that we do is likely to be margin dilutive unless we are to buy another wheels and brakes business due to that division's particular to business model. But of course, the new composites businesses will have lower capital requirements over time.
Moving in the right direction then, we have the operational improvements year-to-date from price increases, more low cost sourcing, and manufacturing efficiencies partly offset by increased depreciation and amortization, collectively contributing 50 basis points.
And finally, foreign exchange benefited margin by 30 basis points, reflecting the small positive movement in our U.S. dollar hedge rate from $1.57 to $1.56 on a largely hedged transaction flows and a bigger benefit from the small unhedged element. The effect of foreign exchange translation is largely margin neutral. So, turning to performance by division, this slide shows reported revenue and underlying profit with growth rate shown on an organic basis to eliminate the foreign exchange and acquisition effects.
As I mentioned previously, we expect revenue and profit phasing to be more normal in 2016 with a great awaiting in favor of the second half. Organic growth and margin will both mirror this trend, particularly compared to last year where both metrics were skewed in favor of H1 and this pretty much affects all of the divisions.
There are three specific items I would pick out on divisional performance in the first half. Within Aircraft Braking Systems, the reduction in margin versus last year reflects the adverse production phasing I mentioned earlier and the mix impact of a decline in the traditionally good margin bizjet aftermarket revenue stream.
In Polymers & Composites, you can start to see margin accretion coming through with a 180 basis points improvement on last year, which includes the benefit from the acquired businesses. The base business also saw a year-on-year improvement with better overhead absorption in the fuel tanks facility as volumes picked up.
And finally, the Equipment Group margin, while disappointing, reflects two contrasting factors. Firstly, the phasing of revenue and therefore profitability within the training business is significantly second-half-weighted this year. So, this will benefit the H2 numbers. An element of the strong military order, as I referred to earlier, is in this business.
And secondly, as we have mentioned, we have dramatically reduced the cost in the Heatric business, the full effect of which will start to come through in the second half. As a reminder, the target of the cost reduction was to stabilize profitability at Heatric on a lower revenue base and we think we're in a good position to deliver this target absent the further letdown in revenue.
Turning now to cash flow, the usual seasonality of cash flow is evident here with a £33 million free cash outflow in the period. A £103 million working capital outflow was driven principally by further inventory build at some sites ahead of production ramp-up on new aircraft platforms, and the second half weighted revenue phasing, along with the timing of the supply payments affecting working capital.
As normal, we expect positive cash flow from working capital in the second half, which based on last year would recover roughly half of the H1 increase. CapEx of £29 million was up modestly on last year, as we continue to invest in additional capacity to support new program wins in both the base and acquired businesses. This will accelerate in the second half, as activity increases around ramp-up investment, particularly in the new composite sites.
We're also in the process of doubling the capacity of our low-cost operation in Vietnam, and spend on this program is weighted towards H2. Taking together, capitalized development costs and PPCs were flat year-on-year. Within that low, capitalized development costs were down 11% organically, as spend moderates with more platforms moving towards entry into service, contributing to a 100 basis point reduction in total R&D as a proportion of revenue, 8.9% in this period.
In cash terms, this was offset by increasing PPCs, as deliveries ramp up on a number of the new platforms on which we provide the wheels and brakes, notably the Bombardier C-Series and bizjets such as the G650. As normal, we've updated our forward guidance on the key investment categories in the appendix to the slides.
Engine deficit reduction payments reduced by – reduced to £11 million as expected, reflecting changes in legislation funding requirements in the U.S., offset by an increase in cash funding on UK schemes from – in conclusion of last year's tri-annual evaluation. Again, guidance for the likely full-year cash payment is provided in the appendix.
An interest in tax increased to £30 million, largely driven by higher debt related to last year's acquisitions. We expect our interest expense to increase further in the second half as we've increased the proportion of our debt held at longer term fixed rates.
So, on the balance sheet, it remains in good shape. Our net debt has increased to just under £1.3 billion to include the £108 million increase from currency movements and £76 million in dividend payments in addition to the free cash outflow.
Our gearing that's measured on a covenant basis is at 2.6 times net debt to EBITDA. This reflects the seasonality of the cash flows but also the lower 12-month trading EBITDA due to the weaker H2 phasing last year that we back into the target range of 1.5 to 2.5 times at the end of the year. And interest cover remains very strong at over 18 times. We successfully executed a $600 million U.S. private placement in the first half to refinance the acquisition bridge financing. This new debt is split equally between 7 and 10-year maturities, has an average all in interest rate of 3.67%, and was drawn down on the 6th of July.
We had over £290 million of bank facility headroom at the end of June with no significant refinancing required before 2020. Given the current environment, it's perhaps worth reminding you that our facilities are dollar-denominated while our covenants use average exchange rates for both debt and EBITDA. These factors significant reduce the potential impact on the business from short sharp falls in the value of sterling.
And finally, our retirement scheme deficits increased this period to £374 million driven by the decrease in the AA corporate bond yields used to discount UK scheme liabilities and the impact of currency movements. The next UK actuarial valuation is not due until 2018. And so, this will not have any immediate impact on cash funding.
And so, with that, let me hand back to Stephen to look at the end markets and the key areas of focus for the rest of the year.
Thank you, Doug. Before we get into the end markets, here's a quick reminder of where we are in a very important cycle, and that's the development cycle. This somewhat complicated but important slide shows new aircraft programs over time since 2006 and demonstrates the unprecedented development bubble that we're right in the middle of now. And we've talked previously about our healthy win rate on these new programs. All of these has driven R&D investment up to unprecedented levels, circa 10% of sales last year as you can see from the solid blue line on the slide.
As some of the bigger programs and to service though, we can already see R&D moving back towards more normal levels of 6% to 8% of revenues. And a small number of programs beyond 2018 suggest that we should be at the lower end of that range in a few years. New product introduction or NPI costs have been putting pressure on margins recently. And having passed the peak of the R&D cycle in the first half of 2016, we should pass the peak of the NPI cycle in the next couple of years, leading to improved margins and cash conversion. At around the same time of course we'll be seeing the benefits of MPS and CSS coming through in the numbers.
This chart is a reminder of the aerospace investment cycle and the decades of strong cash flows that will accrue as a result of the investments that we're making now. More programs, better content, more investment in R&D now will drive more cash later. The bar chart in the top-left-hand corner is a reminder as to what stage of revenue generation our capitalized development costs are currently at. And the chart shows the £477 million of development costs currently on the balance sheet. The various shades of gray on the chart totaled to 32% of the spend which is currently in service and generating revenue in some form. The key thing to note therefore is the 68% of this development cost that will generate increasing revenues over the next few years as the new programs enter into service.
And one of the bigger programs in that 68%, the C Series entered service in July, of course. This is another familiar slide with a couple of key messages. The top two pies show how the fleet of commercial aircraft has got bigger and younger over the years. The bottom two pies show our aftermarket revenues by age of program. Our success on new programs is clearly demonstrated as a proportion of our revenues from younger aircraft has grown much faster than the proportion of this aircraft in the fleet. And this trend will continue due to a higher ship set values on many of the programs about to enter service.
And also worth noting is that the proportion of our revenues coming from very old aircraft is relatively small and stable. Of course, percentage margins increase as you work your way up the age profile. And so, the effect of the fleet getting younger has been a drag on margin over the last couple of years. But if you believe, as we do, that the reducing average age of the fleet is at least partly cyclical, then margins will improve as the fleet starts to age again.
Looking at the civil market more broadly then, we have equipment on more than 45,000 aircraft, and this number is growing as is our content on the newer programs. Traffic growth as measured by available seat kilometers was 5.7% in the first half and above the long-term trend rate. Our key priorities in this end market remained broadly unchanged and as I talked about in February. Firstly, the focus on execution to get the many new platforms successfully into service, and particularly that the re-engined narrow-bodies where the ramp-ups are very steep. This will be a significant focus for us over the next couple of years.
Secondly, CSS is very important and we've talked to you about the objectives for this new aftermarket organization at the Investor Day in April. Three months on, it's going well and they continue to hit the targets we set for them. They're aiming to capture biggest slice of the alternatives revenue shown in the chart on the right here, where we currently do very little.
And in that context, we've actively engaged in conversations with a number of parties to secure more MRO work. We're now buying surplus parts in the market. We're working on a number of retrofit opportunities and repair schemes. But as their agreements come up for renewal, we'll move to fewer, bigger distributors on better terms. For all of these reasons, we believe we should grow ahead of the end-market over the medium term.
On the military side of the business, we have equipment on over 22,000 aircraft, as well as a wide range of equipment in ground vehicles and in training installations worldwide. Military budgets have recently started growing again and our broad aerospace platform exposure, in particular, puts us in a great position to benefit from this. We have a growing fleet and good content on the major growth platforms.
Those of you that remember this chart from the full-year results will notice a subtle change, which is that the percentage of our military revenue generated by the top 20 aerospace programs listed on the right has gone up from 43% to 50%. This is driven mainly by our revenue on growth platforms increasing significantly. The best example of this is on the F-35 where a 250% increase in revenue versus the first half of last year moved this aircraft from ninth to third in the table. This is partly due to increased deliveries and partly due to higher ship set values as a result of the composites acquisitions.
We continue to believe that there'll be good opportunities for retrofit and reset work on the existing fleet of aircraft and the FY 2016 budget in the U.S. suggests that the amount of money set aside for this kind of work has increased significantly. And this fleet breadth and growth bias leaves us to think that we can outgrow the overall military market over the medium term. As previously highlighted, we would expect growth in H2 to pick up as the tough comps rolled off and we start to deliver some of the new training systems products on the back of good orders in the first half.
Moving on to energy which continues to be a very tough end market, looking at the two principle elements of our energy exposure, Heatric, which was 30% of energy revenue in the first half, has suffered badly from the downturn in oil and gas prices. Longer term, this remains a fantastic business with great technology and a bright future. Meanwhile, we've taken the right actions to weather the current storm with head count reduced by nearly 50% and the breakeven point of the business reduced to circa £30 million of annual revenues.
Crucially, though, we've retained the critical design in manufacturing capabilities, we'll need to respond to the upturn when it comes, although we have limited visibility on when that might be. In power generation, we saw the same technology that we sell through our aerospace customers. The products are generally manufactured at the same sites by the same workforce. And while we saw some cyclical weakness in the first half, this sort of fluctuation can typically be absorbed by diverting resources towards aerospace production instead.
We gave you a detailed overview of the capabilities of our new composites businesses at the Investor Day in April. So, today, I'll give you a quick update on how the integration is progressing and how we're tracking against our targets for these businesses. Firstly, H1 organic revenue growth of 5% was in line with our expectations, and both businesses are incredibly well positioned on new engine programs that will ramp significantly in the next few years.
The integration is going very well. All of our composites businesses are now managed as one value stream headed by Don Hairston who joined the MPC as part of the Cobham acquisition. MPS is being rolled out at the new sites already as many of you have seen. And the customer feedback has been universally positive. And we now have detailed plans in place which we're confident will deliver the synergy down at the top of this slide.
And as the integration process progresses, we're starting to find opportunities which weren't factored into our original business plan. For example, we plan to accommodate significant growth in the radome business by expanding one of the acquired sites, but we'll now do this in spare space at our Rockmart facility where they're already producing the first radomes for GoGo. We're also in a good position to increase our share on some of the new engine programs over time due to the technical complexity of some of the manufacturing processes required, and our ability to deliver those.
In summary, we had a very busy first half and one that turned out very much as we expected, apart from, possibly, Brexit. And the main Brexit impact for us is currency, as you know. Other than that, it's fairly neutral. Orders were up 18%, which supports our second half growth expectations. Revenues were up 11% with good organic growth in civil, pegged back by weakness in military and energy. We're continuing to build a better business through investments in NPI, MPS and R&D, with the latter now starting to trend down as a percentage of revenues.
The implementation of CSS is tracking on plan, and we're encouraged by the scale of what we see as the opportunity in the market. Integration of the composites businesses is going well, our balance sheet is healthy, and the dividend is up 4.3%.
Looking forward, as I've said earlier, we're reconfirming the guidance we gave you in February. Civil aircraft deliveries are still increasing. Our ship set value increases should drive OE revenue growth ahead of the market over the medium term, and we still expect organic growth in the low to mid-single digits in 2016. Based on strong industry fundamentals, including on-trend ASK growth and load factors at record levels, we expect aftermarket revenues to continue to recover and reaffirm our guidance of low- to mid-single-digit organic growth for this year.
Military revenue should grow modestly in the medium term, and with some good training orders by low-single digits organically in 2016. And whilst we believe our energy business will return to good growth in the future, a lack of short-term orders at Heatric and signs of weakness in power generation will lead to lower energy revenues for this year as a whole.
As a result of all of the above, we continue to expect organic growth for the group to be in the low-single digits for the full year. Revenues and earnings in 2016 will also benefit of course from the acquisitions and currency movements, and these positives will be partially offset in the earnings level by higher interest charge and tax rate. And most importantly, the investments we're making in new products, CSS, and continuous improvement processes will enhance the Meggitt annuity for many years to come.
And with that, we'll open it up to Q&A.
Q - Sanjay Jha
Morning. Sanjay Jha, Panmure Gordon. Three questions, if I may. First of all, the 18% decline in business jets in MABS, is that sort of declining market or is that still – are you losing share to recycling? Secondly, on the acquisitions, the organic growth of 5%, that seems below the sort of general growth in that marketplace. And secondly, could you give us the EBIT margin on the acquisitions?
I couldn't hear the questions. Sorry.
So, I think your first question was around the biz jet growth in MABS.
That was minus 18%?
Minus 21%, I think, was the number we quoted for biz jet overall.
[Indiscernible] the decline in market or...
No. No. So, yeah, we talked before about how some of the dynamics work in the wheels and brakes business when we sell a lot of our biz jet aftermarket through the biz jet OEs rather than direct to the end markets. And we do get cyclical stocking and destocking events from them. Now obviously, the biz jet market itself hasn't been particularly strong, I think.
Operations in biz jet were just down marginally and in the first half in terms of takeoffs and landings. So, it's not a particularly strong market, and then we saw some of these sort of cyclical destocking. So, it's not about the market share, in fact, quite the opposite. I mean, our market share continues to grow in biz jets, and you sort of see that through the comments I made around PPCs, which are continuing to rise as we shift increasing volumes of wheels and brakes onto the new biz jets that are being produced again in a biz jet market that's not growing fast in itself. So, our market share dynamics remains strong in the market that itself is a bit soft.
And just to demonstrate that lumpiness in the first half last year, I think our biz jet revenues were up 28% which is exactly the big OEs ordering a year, 18 months’ worth at a time and then not ordering for a while.
Good morning. Jamie Rollo from Morgan Stanley. Just two for me to begin with, in military, the 2Q implied organic rev growth looks quite weak I think, we can imply like minus 11 or something. And you're sticking with the low growth in the full year. Can you just remind us what gives you the confidence there? I think the comps got a bit easier. And also, to what extent does that very strong order intake in the first half in military actually applied to work you will do in the second half of the year?
The second question is just on working capital. Doug, I don't know if you could expand a bit on the headwinds that you think will unwind on working capital in the second half, please. Thanks.
Yeah. In terms of the military, you're right. Thing number one is we have a tough comp last year. I think Doug mentioned on the way through. The H2 comp is somewhat easier. Our book-to-bill on military in the first half was greater than one. Order intake on military was very, very good as I think Doug mentioned on the way through.
And a particular feature is, excuse me, our training business. One, a couple of IDIQ contracts a couple of years ago to develop new training products. And those new training products will make the first sales of those in the second half of this year. And we have some quite good orders specifically for training in the first half of the year. So, it's a combination of all of those.
Yeah, a new deal. Let met pick up on that because it sort of plays a little bit into the working capital as well. So, I mean, the training business last year was one of those that was stronger in the first half, weaker in the second half than normal. So, it's normally a stronger second half business because a good element of it, the revenue comes out of the U.S. government in it. And it's a classic one where you can use up end of year money on buying a few more bits for your just sort of training range, it often has a strong H2. And Stephen says, put that together with these strong orders that we've been taking in that business, that's what where predicting for this year.
And so, when you look at the inventory increase that I talked about, for instance, in the first half, about a third of our inventory increase is actually in the equipment group and particularly around the military businesses because you do need to build ahead of shipments both in there and the targets business, for instance. So, we've got pretty decent visibility we think as to where that revenue will come through. So, the business have been building ahead of it and that's one of the reasons why we've got some decent confidence that that element of the inventory will unwind as that product ships out. And there one or two other businesses where we can see the same sort of dynamics playing out.
For sure, on inventory, we are seeing a bit of a drag still from the new product introduction, so particularly around the narrow bodies, the new engines for those, the derisking that's going on throughout the supply chain. Our customers are, how should I put out? Encouraging to hold more finished goods inventory to sort of derisk then. And then, as our guys focus specifically on the ramp-ups, but also on the broader sort of quality and delivery agenda that we're running. One way you do risk that in the short run is to hold a bit more inventory actually from your supply base as well, as that what challenges can come through.
Now, is that a long-term structural change? No. We don't believe so because once you get through the ramp-up and the programs have stabilized you can then work that inventory back out. But that element would probably won't happen this year, which is why I'm sort of indicating that we'll certainly a reversal of the first-half building working capital but probably not all of it in the second half.
Thank you very much. Two questions. One, R&D is trending down. Do you have a concept of what a normalized R&D rate is? And would you expect to, if you like, go below that in a kind of mean reversion basis per period? And within that, the amount that's capitalized, is that – what's the phasing like on that in terms of new programs?
And so, I'll let Doug respond on the phasing. As you know, the vast majority of our R&D is D and its spent when we won a program. So, high degree of certainty of return. And the level of R&D is driven absolutely by a number of programs and our content on them. And that's been good, and that's what's been driving the 10%. I think I said on the R&D slide on a way through that we're definitely heading back into the normal range of 6% to 8%. And because we've had so many programs come at once, the likelihood is will be towards the bottom end of that range within a couple of years. So, will it go below 6%? Probably not, but could do. But definitely a few percentage points lower than it is now.
Yeah. And on the phasing on slide 35 [indiscernible] is the guidance for the rest of this year and next on R&D spend. You'll see that the guidance for capitalized is sort of broadly flat, 2016 and 2017 in absolute terms, but we'll see. We're guiding to growth on revenue, and on top of that, you get the currency benefits on that. So, you'd see that coming down as a percentage if you just sort of play those numbers out.
Could I possibly – can I follow up with another different question? And I apologize for asking this, but IFRS 15, your colleagues at Rolls Royce raised it somewhat last week with apparently quite a literal interpretation to standard or even conservative if you like sort of somewhat aligned with what GE and Safran coming from which would suggest an inability to capitalize costs going forward and – but also accompanying write-off of capitalize so far so that you no longer have to amortize. Is that the way that you see it shaping up? Is it too early to say?
Can I talk perhaps about sort of three buckets of capitalization costs that you see in the industry? One of which we don't do which I think is one of the ones that you might not be able to do in the future. So, the program accounting, I believe that might be a change for that. That that doesn't apply to us because we don't deploy program accounting. So, the two buckets of capitalized costs that we have are obviously capitalized development costs under R&D. They are not subject to IFRS 15. They're subject to R&D standard. So, no change on that.
So, I think probably, as I said six months ago, the one that looks as though it will affect us, but like everybody else, [indiscernible] absolutely drawn a line under this yet, but the one that looks that would affect is the capitalization of program participation cost. So, the build cost of the three wheels and brakes if you like because the contract with the OE is different from the contract with the aftermarket provided you probably can't capitalize. There's a bit of a funny nuance there because sometimes we do have the same counterparty, but it looks as though that will probably have to come off the balance sheet, and we will capitalize those costs going forward. That looks like the biggest impact for us at the moment.
Thank you. Ben Fidler from Deutsche. A few questions, please. Firstly, just looking in your slide 10 on the margin bridge for the first half, and just thinking through sort of the elements that reverse out in the second half, and I know you don't give margin guidance. Only this question sounds like it is margin guidance probably because that's what it is. But just you got the production phasing 70 basis points clearly by using the word phasing, we can assume that reverses out. The M&A continues operating efficiencies presumably continue as positive. So, is it really just the production phasing element that comes out plus a little bit of Heatric improvement? That's the way we should think about things panning out through the second half or are there other bits I'm missing?
Well, I think you answered your own question in a way, Ben, because we don't give guidance on margin. But I think I did say the production phase and particularly around the training business because of the way that revenue is loaded and how the overheads get absorbed. I certainly expect that will reverse out. And then I think our broader comment was obviously we've been taking action on costs. That program essentially completed towards the end of the first half, so you'll see the benefit of that coming through in the second half. That's obviously designed to offset many of the headwinds that we've got in the broader business.
Thank you. The second question was just around Heatric. You talked about you're getting breakeven to £30 million of sales. It looks like the first half had about £21 million of sales. So, should we – on a run rate basis, clearly, in profit next year, even if there's a top-line deterioration, depends how much the top-line obviously folds more.
So, Heatric have a mix of long-term and short-term orders. When we set the breakeven at £30 million target, clearly, if you go back over history before the FLNG-related boom in Heatric, their revenues typically were in the £20 million to £30 million per annum range. They've got certain amount of recurring aftermarket or service revenues. So, we get – right here, right now, we're kind of saying £30 million is where we think it might go to. So, we've got further decline in the second half, then, hopefully, some stabilization next year. But this far out, that is still subject to a certain amount of guesswork.
The £21 million you quoted is a bit [indiscernible] a good topic for actually what I did in the first half is more around £18 million in the first half.
And the final question I had was just NPI costs. Are you able to share in some way to help us understand what headwind came from those in the first half? And I guess, I'll say that what are those as a percentage of sales? So, running at this moment in time, the issue behind the question is, as you think about the group margin going forward, you're telling us R&D is going to be a 2-percentage-point tailwind over the next couple of years. NPI costs kind of have been continuing to go up rather than come down. I just wondered I have – scoping those, what disappears from NPI costs? And when do they actually peak? Should we think it peaks in two years’ time from now?
We're kind of hinting it in two years’ time. Have we put a quantum on it?
We sort of gave an indication, I think, I lose track of my time. I think it was the second half of the previous year and the first half of last year with the two halves you're really seeing the NPI impacts coming through. And I think at the time, we were sort of indicating it was around 70 or 80 basis points impact in each half.
You'll notice then on the bridge, NPI doesn't feature in the words this time. And that's because we're not seeing it as sort of big up and down at the moment. I mean, clearly, as individual programs roll through, you'll start getting some of the efficiency that you need to reverse the NPI, but we've got other new programs coming into manufacturing all the time at the moment. So, this looks sort of a pooling effect that's sort of keeping the NPI sort of drag at broadly the same levels at the moment.
So, as Stephen says, we need to look out a couple of years once we've got the vast bulk of the programs into service and you got through the first year or two of production. Some programs will get to run rate efficiency quicker than others. But it will always take a year or two past the IS.
So, at the moment, you're saying – you shared that they were 70 basis points up for a couple of – the half and the second half? So, do I take that [indiscernible] this morning, so that we could think they're running about 150 basis points of absolute drag at this point in time.
It's that sort – it was that sort of area we were indicating. Yeah. Yeah.
Thank you very much.
Thanks. It's David Perry of JPMorgan. I had two questions, but actually a third, just to follow up on next question, can you – does that mean you're right off the PPCs currently on the balance sheet when you made the transition?
Well, whenever you do an accounting change, you restate your comparatives. So you basically reverse everything out as if it would've been – never been there in the first place.
And [indiscernible] are talking about introducing it in 2018, but giving us a restate of 2017. Is that your current plan as well?
You're required to introduce it in 2018 [indiscernible] to restate your 2017 comparisons in your 2018 reporting. That's what the standard requires.
Is that your plan or...
That's what the standard requires.
Okay. There's no option to do it earlier?
You could do, but I would be surprised if anyone goes early simply because we all want to make sure that we've got certainty, if you like, as to how the industry is going to do this, make sure we've got all the big four, given the same views as to what's acceptable. So, I think it will just take that length of time, and for some of the changes, not PPCs, actually. There will be system changes required and that sort of thing. So, there's a degree of practice required.
Okay. Thanks. And then the two I was planning. The first one is, when you look at the full-year guidance and full-year consensus for earnings, you clearly got quite a lot to do in terms of turning around the organic growth and the margin jump and sort of being mindful of last year when you have to lower the guidance in November. I just wonder what you think is the biggest risk, maybe talking to that chart, figure 23 there, to the full-year guidance. And the second question is, given where we are in July, it just seems your range for net debt to EBITDA for the full year, 1.5 to 2.5, is very wide. Just wondering why you didn't feel inclined to narrow that.
On the second half, I mean, thing number one is the phasing of revenues and profit last year was somewhat unusual. If you look at what we've done historically, this year is much more typical. Thing number one. If you look at the orders in the first half and the book-to-bill, all of that supports a stronger second half, the kind of numbers we're talking about. But as you also know, probably 50% of our spares are ordered in the month for shipment in the month.
So, we've got good visibility on a lot of the OE stuff and some of the aftermarket stuff. But a lot of the aftermarket stuff is short-term visibility. So, I would have to say, whilst the orders are looking very good, it would be around the short-term spares.
And on the covenant, David, sorry if we sort of gave you the wrong end of the stick. The 1.5 to 2.5 is our target range for the business and from a sort of structural perspective. So, the comment is just that although we're slightly after that range at the moment, we would expect to be back within our overall target. I'm not saying it's going to be somewhere between 1.5 and 2.5. I mean, in reality, it would be more towards the upper end of that. But as I said, the 1.5 to 2.5 is just our structural guidance range for where we're comfortable with our gearing in the business.
Rami Myerson from Investec. A few questions on cash flow. So, working capital, we're three or four years into MPS and we have seen a gradual improvement in working capital and H1 seems to be a little bit disappointing. Maybe if you could provide even a little more color on why we've seen...
I'll throw a couple of comments and then Doug I'm sure will likewise. The first couple of phases of MPS were really all about improving quality and delivery and improving our long-term rate of organic growth. And the fourth phase is where we set we expect to see P&L and cash benefits kicking in. Two businesses are now in the fourth phase.
If I look at inventory terms and margin in those two businesses, I can see that they're moving. So, I think it's working. But most of our businesses are of course are in phases 1, 2 and 3. In terms of inventory numbers specifically. If you work out the implied second half from the guidance we've given you, you will see that the second half in production – in sales terms is double-digit percentage bigger than the first which is not untypical for us.
But of course you build ahead. You smooth out your production. And the final thing is I've talked about new product introduction particularly the narrow-bodies where the ramp-up is very aggressive as you all know. Where I set the business is, look do not get behind that curve if it means buying more inventory – buy more inventory which will – and that piece will reverse over time as I think Doug said.
So, I think Stephen sort of covered the inventory piece there, Rami. I mean the two other elements within working capital of collecting from your customers and you all have seen there's a bit of increase in receivables in the first half. I think it's fair to say there's quite a lot of pressure in the market generally from customers on stretching terms. You will get that at the half year. It is no less intense, I think it's fair to say at the end of the first half this year. And many – you'll also have seen that actually our payables came down a quite a bit now. Part of that is timing. If you happen to buy stuff in April instead of May that can make a difference is to whether you pay it or not in the half, so it's a bit of that. But payables always tends to come down in the first half anyway because you've got a number of annual payments to get made in the first half. For the things that you accrue throughout the whole of the year, variable comp being the obvious one.
And second comment on the, always useful page 27, where you provide the future cash guidance, and the two things that struck me is it seems like this lower CapEx in 2016 a little to where you started the year and a little bit higher CapEx in 2017. Any color on why you're deferring or why do you think there should be more CapEx next year?
One of the things, one of the pleasant surprises, as you know, the acquisitions come with a lot of CapEx in the short term because of the new engine programs, because of the massive ramp-up in the ship set values, but a piece of the CapEx that we expect to expand which is expanding the rate end capacity in one of the acquired businesses we've managed to avoid most of that by actually putting the expansion into one of our existing facilities, so that will be a small piece of it.
Yeah. And just generally, I mean, I think it's fair to say businesses always tend to have their eyes are bigger than mouths if you like in terms of things they'd like to do versus what they can actually do, and you get a little bit more of a reality as you go through the years, so sometimes it's just stuff, it's slipping because it's starting a bit later and the cash flow from that will slip into the following year. And so, part from what seems so I wouldn't say there's any sort of big that's moving around. It's just a little bit of that that sort of general slippage.
Thanks. And just the last one also on that. The PPCs also, you tweaked it up for next year as well. Is that C Series of any particular programs sort of going better than expected?
I think the increase on PPCs for next year is almost entirely currency, so we've updated the currency to 1.37 which was sort of the – sort of an average rate for this year when we did it, whereas, I think, we were at £145 million six months ago. So, that just tends to move over the map a little bit.
Can I ask a quick one? It's Harry Breach from Raymond James. Maybe one more Stephen. Stephen, with the aftermarket orders growth in the first half, can you give us some sense of the extent to which this was, longer term, lumpy orders getting placed versus underlying sort of run rate picking up, and any sort of color on particular areas?
And then, secondly, with the biz jet aftermarket weakness at the negative 21%, can you again just give us some sort of feel about where you think the underlying run rate sort of absent lumpy comps might be going?
Well, I think we sort of stirred it all together and sort of said low mid-single digit for this year and continuing to improve. But within that, I mean, if you look at the first half of last year and the first half of this year, the individual components are, to be honest, all over the place, very lumpy.
With biz jets, in particular, absent OEM ordering patterns, which were a huge factor, at the moment, you've got utilization fairly flat. You've got still continuing market share gains. Our fleet is getting bigger. Our share is getting bigger. And you've got pricing. And even with flat utilization, that sort of suggests at least mid-single digit, I would have thought.
But what we are – as Doug said earlier, we're finding still quite considerable volatility between large jets, regional jets and biz jets, and from month to month. So, it's – with most of our spares ordered in the month, it's really quite difficult to be any more specific than that.
Actually, just where I was going to kind of go, which is into what the aftermarket does month-to-month. Because in my tiny little mind, these jets, if it's done through the OE, would be the most volatile month to month to month whereas regional, which is airlines, and we've got loads of WBs out there flying around, you would think it would be less volatile month to month to month. Yes, no, maybe?
Yeah. I mean, one or two OEMs in particular operate this max/min stock policy and seemed to move between the two as Doug has mentioned. I wouldn't say it's all of them. But, yeah, you would have thought that. But I think even those people that repair large jets just seem to order spares in lumps rather than a set of brake pads for a DC-10. So, I mean, we mentioned the figure for the first half of last year. [Indiscernible] I mentioned that.
No. You can but we haven't mentioned it.
So, large jets in the first half – we know the fleet is declining 12%. Where did that come from? I mean, it clearly doesn't reflect utilization. So, there must be stock up, stock down factors in there. I wish it was more predictable. I'll settle for very profitable. It's...
Yeah. I mean, it's weird, isn't it?
It is weird, yeah.
And if we just went into biz jets, so I know this is one thing. I never know whether we get this initial provisioning thing, which, I must admit, I've never heard of until Rockwell Collins used it as an excuse when the aircraft stocks kind of delivered. Is there any of that noise around G650 or something?
I mean, you get initial provisioning because people take a block of spares when they order initial aircraft. I think this came up a year or so ago when it became flavor of the month with one or two people. And I think at the time, we said, yes, we get initial provisioning, but is it a significant factor to us that's going to swing things around in a way that seem to other people not particularly.
So, again, if we got that as an individual program, we're here to see it. But because of the breadth and spread of what we do, because any one program is unlikely to move and even in the short run, you tend not to see it bubbling up to group numbers. But, yeah, we do IP.
And I think the particular thing that's been happening is that as maintenance is consolidated into fewer and fewer hands, so away from the airlines into the OEMs and specialist repair shops, all those little pools of IP that you would have around the world, you need less of them because the repairs are more concentrated into fewer hands. So, I think there's been a bit of netting down of pools of inventory across the piece, but that's more a large jet, regional jet kind of comment. And the big spare for us, of course, is brakes and a lot of that is biz jets where they still take plenty of IP.
And then this is getting a bit detailed. Presumably the largest stuff capitalized in R&D is C Series.
It's our biggest single program there.
Sort of handy to that civil life. And when you have that step-up in the free-of-charge stuff, you said some was FX. Are we through all the participation fees which was about 15% of it? Is that now all actually just volume, free issue parts or have we got any participation fees to pay next year?
I haven't done the math for a while, [ph] Stanley, but I don't think our cash participation fees are as much as 15% of our PPCs for a start. So, there may be odd small bits left but there's nothing, nothing significant on the horizon. I mean, we're mainly into shipping free, free stuff.
So, it's a broad proxy for volume.
Well, it's tied to bill rates for us, obviously, on the wheels and brakes side.
All right. And then just one thing overnight, just as you've mentioned it, Boeing got this spanking great contract for F-18 maintenance, which may be a sign of it finally flowing through, I thought. You mentioned it. So, I mean, you mentioned it in passing £640 million and then another hundred orders or something. I know it's five years, but...
Yeah. I mean, yeah, [indiscernible] we have great content on that aircraft. Any huge maintenance order in the long run will be a good thing for us. Not aware we're seeing anything from that yet.
Thanks. I hope you don't mind. Just coming back to IFRS 15 because it's important, it's interesting as well. Can I just ask two questions? The first one is just – maybe you don't know yet, but the current policy, I think, is you literally give away the wheels and brakes for zero...
...and you just capitalized the cost. But there is a sort of like, in theory, that could be a [indiscernible] price. So, I'm just wondering when we come to IFRS 15, will you put revenue of zero and take the cost of the P&L or would you take a revenue of one and a cost of two? So, will it affect revenue or will it just affect EBITA is what I'm asking?
I would just affect cost. I mean, there is no revenue. I mean, free wheels and brakes means free. I mean, there is no revenue, no stick-up price to that. So, we don't book any revenue for that today. We weren't booking any revenue subsequent for IFRS 15. But the manufacturing cost, which is what we currently take to the balance sheet, will get expensed immediately.
Again second, philosophical one, just really interested in your view, my experience watching IFRS unfold over slightly over a decade, it's incredibly advisory rather than prescriptive if you look how everyone interprets, for example, the R&D rules differently. I'm just wondering. Is it the auditors are coming out and being much more prescriptive on this, or is it you, the companies, have chatted and decided to do this? It's just interesting to know.
Well, I think the whole premise behind IFRS 15 from [indiscernible] was to be more prescriptive on revenue recognition. So, it is the standard that is driving a more prescriptive approach. But as always with any standard, I mean the more prescriptive it tries to get translating that across into the real world of contracts with customers can be quite complex.
They're actually – as I think the PPC is probably the easy ones to interpret. But if you get into whether where you've got to break up contracts into multiple parts to recognize revenue separately from each part. That is done in the devil of the detail of commercial terms. So, I think that's why it's taking everybody a while just to get the mind around it.
And so there's a lot of conversation going on across the industry, controllers of the various businesses to try and make sure we will come up with the same answer. But obviously it will depend on individual company circumstances as well.
Got a couple of questions from the webcast. First of all Christian from Bernstein. People like to know where are things with CSS. And can you quantify the contribution you mentioned early days in the press release but also referencing civil that is tracking modestly ahead of expectations? Can you elaborate on what this means and quantify the contribution i.e. how negative? And where your expectations have evolved for the future?
We haven't published separate figures for CSS. But they've got pretty clear set of KPIs. And there's a both financial and nonfinancial. Some of the nonfinancial one's, for example, include building a hopper of retrofit and upgrade ideas. And they have several tens of such opportunities already identified which is ahead of target. I referred in my script, too, they'd be hitting the targets we set them. Actually, the financial targets, they're ever so slightly ahead. But I'm really cautious about publishing numbers for CSS, particularly because we're only a few months in. But it's – in terms of every KPI that we've set them, they're meeting it or beating it. Their challenge is really almost too many ideas.
And we've got a question from Phil Buller at Barclays as well. Two questions, actually. H1 CapEx was low and expected at around £30 million. Is the full year guidance of £95 million to £110 maintained? And also, organic growth for the acquisitions at 5% looks lower than the double-digit growth guidance for these businesses. Is the outlook for these acquisitions still in the double digits medium term?
While Doug is thinking about the CapEx one, it's very clear where the growth in the composites businesses are coming from. 5% in the first half was pretty good. The real growth comes from the new engine programs where basically on the old engine programs there was little or no composite. And on the new engine programs, there's a lot of composites. So, that double-digit growth was kind of a medium-term number, and really, it's there in the ship set values on the new engines.
I think as I said actually in my comments, I mean, what those businesses delivered in the first half was absolutely in line with our expectations for the first half. So, as Stephen says, the growth will accelerate. Now, I think on the CapEx guidance, I think I've covered that a little bit earlier, mainly about just bits and pieces slipping to the right, and the updated guidance on CapEx is in the Appendix.
I think we're done. Thank you very much, ladies and gentlemen.
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