Esterline Technologies (ESL) Curtis C. Reusser on Q3 2016 Results - Earnings Call Transcript

| About: Esterline Technologies (ESL)

Esterline Technologies Corp. (NYSE:ESL)

Q3 2016 Earnings Call

August 04, 2016 5:00 pm ET

Executives

Julie Albrecht - Vice President, Finance and Investor Relations & Treasurer

Curtis C. Reusser - Chairman, President & Chief Executive Officer

Robert D. George - Executive Vice President, Chief Financial Officer & Corporate Development

Analysts

Howard Alan Rubel - Jefferies LLC

Robert M. Spingarn - Credit Suisse Securities (NYSE:USA) LLC (Broker)

David E. Strauss - UBS Securities LLC

Samuel J. Pearlstein - Wells Fargo Securities LLC

Kenneth George Herbert - Canaccord Genuity, Inc.

Michael F. Ciarmoli - KeyBanc Capital Markets, Inc.

Peter John Skibitski - Drexel Hamilton LLC

Operator

Good afternoon, and welcome ladies and gentlemen to the Esterline Technologies Third Quarter 2016 Earnings Conference Call. At this time, I'd like to inform you that this call is being recorded. Also, a replay of today's call will be available for one week by calling this toll-free number: 855-859-2056. You will need the following PIN 49084439.

Following our prepared remarks, we will open the conference up for question-and-answers after the presentation. I will repeat these instructions after management completes their prepared remarks. Management has asked that you observe a strict two-question limit on the first round of questions. There will then be an opportunity for follow up questions as time allows.

I will now turn the conference over to Ms. Julie Albrecht, Vice President of Finance and Investor Relations. Please go ahead.

Julie Albrecht - Vice President, Finance and Investor Relations & Treasurer

Thank you, and good afternoon, everyone. Curtis Reusser, Esterline's President and CEO; and Bob George, Chief Financial Officer, are here today to discuss Esterline's 2016 fiscal third quarter performance. Before we begin, I'll remind you that our call today contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are based on management's current expectations, and are not guarantees of future performance. As you know, forward-looking statements always involve risk and uncertainties, which we detail in our public filings with the SEC.

We also will discuss certain financial information on this call that is considered non-GAAP under the SEC's Regulation G. For a reconciliation of non-GAAP financial measures to the most directly comparable GAAP financial measure, please refer to the section in today's press release titled Non-GAAP Financial Information. You can also refer to our supplemental financial information that we provide in PowerPoint presentation format that further supports our earnings release. If you do not have the release or the PowerPoint, they can both be found on our website at www.esterline.com.

I'll now turn the call over to Curtis. Curtis?

Curtis C. Reusser - Chairman, President & Chief Executive Officer

Thank you, Julie, and good afternoon to everyone on the call today. I'm pleased to report that our third quarter results were solid and consistent with the general ramp that we expected to occur throughout this year. We've continued to build a strong backlog, focus on execution and embed the Esterline operating system into our culture. We've also continued to achieve the milestones in our integration and restructuring activities.

The implementation of our E3 operating system is advancing throughout the organization. As we've discussed, our operating platform becomes increasingly powerful with scale, and so we're very pleased that our backlog supports continued growth. We think the company is more flexible, more efficient and more responsive to our customers, and is better positioned to drive margin improvement than ever before. Our efficiency and cost control initiatives are being progressively reflected in our results. The underlying and more important development that enables this strong performance is that a continuous improvement mindset is becoming a natural part of Esterline's culture.

I believe our teams across the company are increasingly able to identify and then pursue new paths to efficiency. We're capturing new business and improving our competitiveness in each segment of the company. Importantly, we're successfully doing so in a challenging environment. The macro backdrop to the quarter was complex. As you know, since the last earnings call, we've had the Brexit vote, a sharpened, heightened global security environment, and continued questions about future trends in certain commercial aerospace markets. So now let's review some numbers for the quarter. We grew third quarter revenues to $117 million, up almost 7% over last year. This is an acceleration over the 5% pace we reported in the second quarter. Our order trends remained strong, and they position us well for our fiscal fourth quarter and for future years.

Our total book-to-bill ratio is 1.1, both for the third quarter and for the first nine months of the fiscal year. Our commercial aerospace business continues to show strength in the third quarter. This is especially reflected in the revenue growth from our Sensors & Systems segment. We have aligned our business for the current OE production rate schedule, and we continue to expect growth in certain key programs as we go forward. Our orders for commercial programs have been broad-based, and our successes are coming across many different products and sub-system categories. We continue to expect improvement in Commercial Aerospace build rates over time, particularly in the single aisle market. And this volume increase, combined with our mix of shipset content are supportive of organic sales growth.

In particular, we see good sales growth opportunities on the new engine option programs with both Boeing and Airbus, as well as at Bombardier on the C Series, the Embraer E2 and the MRJ. With respect to the aftermarket, on the commercial side, as you know, particularly relative to some of our peers, our high-margin aftermarket business is a smaller percentage of total revenues, around 10%. We are tracking to plan in this area and continue to see this as a mid single-digit growth business for the year. The defense environment has been consistent with our expectations, and we had nice third quarter sales growth with Defense products in our Avionics & Controls segment.

We continue to focus on certain key programs that we believe are strong long-term opportunities, although order and sales trends can fluctuate a bit in the short term. We believe that the JSF, the P-8, the A400M and the KC-390 will remain key programs in our mix, and combined with our avionics and displays products, will drive future growth. Also, we continue to have solid order trends in our Defense Technologies business, which in the third quarter had its highest order volume of this fiscal year. The results in our adjacent markets were positive in the third quarter also, particularly in certain industrial markets and in gaming. Our adjacent end markets are diversified and short-cycle, with different factors driving trends in gaming, medical equipment, rail and other categories.

These factors make this market segment challenging to forecast, but this third quarter acceleration in certain areas puts us in a good position as we close out the fiscal year. In this overall challenging end market environment, we have reevaluated and sharpened our approach to sales and marketing. First of all, our platform presidents, who are responsible for executing our sales growth strategy, are energized and motivated to drive results for the overall enterprise. Each platform president is an enterprise point-of-contact for certain key customers. This ensures that the breadth of our Esterline products and technologies are showcased at the highest level in our customer relationships. This is an important lever to capture future sales growth.

This executive level approach is complemented by a more detailed technical relationship at the business unit for our customers. This day-to-day working relationship involves many talented technical engineers on both sides. I really believe this is the right sales structure to best showcase and leverage our product sweep, encourage and delight our customers and create opportunities for additional content. I'll turn now to a deeper update on our strategic initiatives. We continue to push our E3 activities forward. We're still holding continuous improvement academies around the world to train employees on the operating system with 15 more sessions scheduled through the end of the calendar year out of a total of 33 academies that we're holding in 2016.

I'm especially pleased to see the operating system in active use, not only in our production areas but in support functions such as finance, IT, HR, compliance and supply chain. I see tangible improvements in our support function processes and value-add to the enterprise as a result of the E3 tools. All of this certainly shows that the Esterline operating system is becoming more and more embedded in Esterline's overall culture and go forward strategy. With respect to our facility consolidations, the production moves of our Norwich and NMC product lines into Esterline facilities are still on track to finish this fiscal year. In addition to taking better advantage of our Mexico facilities with these production moves, we are also focused on leveraging our presence in India.

A grand opening of our expanded India Design Center took place in the third quarter. This facility will serve all Esterline locations as a center of excellence for engineering and technology, with the capacity to house 300 engineers. These activities in Mexico and India show our focus to drive significant improvements from an enterprise approach towards a more cost effective footprint. With respect to our integration of the acquired DAT business, our teams continue to work diligently and make progress on many fronts. I was very pleased to observe numerous customer meetings at the Farnborough Airshow where we highlighted a broadened Avionics & Controls products technology services that are all part of our DAT business.

We are also realizing synergy savings in R&D, supply chain and in-house manufacturing capabilities. I'll also highlight that we're progressing according to plan with the renovation of the building that we purchased in Belgium during the second quarter. Our engineering team has already moved into the remodeled facility, and we're on schedule to complete the relocation of production and other support functions by the end of calendar 2016. The bottom line, on our third quarter performance and progress is that we're heading down the path that we want to. We are increasingly more efficient and more scalable.

We captured growth in a spotty environment, executed well and enhanced our customer relationships. Our backlog is strong. We're on the right mix of programs, and we expect our growth to continue. We're successfully improving our operations, and we continue to develop and improve our talent. We're pleased to have delivered a strong third quarter, and most importantly, we're in a good position to maintain this momentum going forward.

And with that, I'll turn it over to you, Bob.

Robert D. George - Executive Vice President, Chief Financial Officer & Corporate Development

Thanks, Curtis and good afternoon, everyone. Our third quarter results were solid overall and validate the second half ramp that we've been forecasting. I'm pleased to highlight that in the third quarter we grew sales by 6.7% over last year's third quarter, and by 5.5% sequentially when compared to this year's second quarter. We continued a strong orders trend with a book-to-bill of 1.1 for both the third quarter and on a year-to-date basis, with backlog now at $1.4 billion from $1.2 billion a year ago. And we delivered on the sequentially improving results that we expected when we re-baselined our markets and operations in the first quarter. This includes stronger sales with the related gross margin drop-through and well-managed controllable costs.

With these highlights, let's drop down a level and take a closer look at some details. Now, as a reminder, the transition to the new fiscal year-end continues, and therefore, all fiscal period comparisons are against recast 2015 numbers that align with the new fiscal quarters. Third quarter 2016 sales were $517.1 million, up 6.7% from $484.7 million in the third quarter of 2015. The prime driver of this sales increase was nice organic sales growth across nearly all platforms, with a little help from positive foreign exchange thrown in for good measure. Consolidated gross margin was $173.6 million or 33.6% of sales, compared with $165.3 million or 34.1% of sales in the same period of 2015.

Adjusted to exclude the impact of compliance and integration costs and long-term contract adjustments, consolidated gross profit was $173 million or 33.5% of sales, compared with $169.3 million or 34.9% of sales in 2015. The change in adjusted gross margin compared with the prior year reflects certain challenges in our Advanced Materials segment that I'll describe further as I turn to the segment details. And with that, let's go right to the segments.

Avionics & Controls sales were up a strong 11.2%, from $200.1 million last year to $222.6 million this year. All platforms in this segment demonstrated growth. Key drivers to the strong sales growth are higher volumes for DAT's Defense products, and for certain Interface Technologies industrial products.

The Avionics platform also benefited from a long-term contract revenue recognition event, and benefited from foreign exchange rates. Adjusted operating income in the Avionics & Controls segment was $28.5 million or 12.6% of sales. This compares with $20.3 million or 10.1% of sales in the prior-year period. The primary drivers for this quarter's higher segment earnings were increased sales leading to higher gross margin, while cost controls in R&D and SG&A also contributed. We did benefit from Canadian dollar weakness in our Avionics platform, and I'll note that our adjusted segment earnings for Avionics & Controls exclude the impact from a long-term contract settlement that had a positive impact on our GAAP earnings. This is consistent with our historic treatment of unique long-term contract adjustments.

In our Sensors & Systems segment, sales were $186.3 million, up 6.2% compared with the prior year. The higher sales were driven by strong demand for aerospace products in both Connection Technologies and Advanced Sensors. This reflects the continued positive trend in our aftermarket sales in the Advanced Sensors platform. Adjusted segment level operating profit was $28.5 million, or 15.2% of sales, compared with $24.5 million or 13.9% of sales in the prior year. Higher segment level operating profit reflects the positive impact from higher sales, positive foreign exchange rates, but it is partially offset by higher costs related to inefficiencies associated with the Norwich production transfer to Mexico and California.

In our Advanced Materials segment, our sales decreased by about 1% year-over-year to $108.6 million. Adjusted segment level operating profit was $16.3 million or 15% of sales, and that compares to $25 million or 22.9% of sales last year. Advanced Materials has been experiencing a rollercoaster ride this year due to external market forces as well as internal execution challenges, and this quarter was no exception. There were several specific headwinds for Advanced Materials in this year's third quarter. First, in late May, we experienced an unfortunate incident in one of our Defense Technologies' sites resulting in injuries at the site. We shut down the facility as we completed a thorough evaluation and investigation, and we've been diligent and cautious as we work to restart operations at the impacted site.

Last week, we conducted a review of all training and safety policies with all employees, and this week we have begun restarting operations. The restart will be slow, steady and safe. The Defense platform has had a strong bookings year, and an excellent focus on implementing the Esterline operating systems. With these factors as a strong foundation, for the fiscal third quarter of 2016, we were forecasting sales growth at this site, as well as a continued ramp in Q4 sales above those planned in Q3. Financially, in addition to lost sales and gross margins in the quarter, we incurred approximately $1.6 million of costs directly attributable to the incident. Now, I'll comment in a few minutes about our expectations for the full year of fiscal 2016 related to this event.

Another headwind in the Advanced Materials segment was the immediate foreign exchange effect of the UK vote to leave the EU, popularly referred to as Brexit. Specifically, the impact relates to the weaker pound sterling relative to the U.S. dollar, and resulted in a negative impact to this segment's sales and operating profit from our expectations. In addition, as I reported to you previously, we have been affected by operational execution challenges in one of our California facilities, and this quarter was not an exception. Our team continues to work diligently on activities designed to achieving improved results at this site. Let's transition to our consolidated results.

We reported operating profit of $54 million or 10.5% of sales, compared with $45.7 million or 9.4% of sales in the prior-year third quarter. The key drivers here were the improved operating performance I've just described, and a reduction in our corporate expenses. Adjusting out compliance and integration expenses in both periods, third quarter operating profit was $58.3 million this year or 11.3% of sales, compared with $55.6 million last year or 11.5% of sales. Interest expense during the period was $7.7 million compared with $10.4 million in the prior year, and the lower interest expense in the third quarter is due to lower interest rates as a result of our refinancing activities in 2015.

Our effective tax rate in the third quarter of 2016 was 17.2%. This compares to 19.2% recorded last year. The lower tax rate this year is primarily driven by certain consent agreement expenses that were previously non-deductible for tax purposes in fiscal 2015. Our projected full year tax rate is in the range of 15% to 17%. This rate is slightly lower than previously projected, as the mix of our full year earnings is increasing in lower tax rate jurisdictions. Bottom line, in the third quarter of 2016, GAAP net income from continuing operations was $38 million, or $1.28 per diluted share. This compares with $28.2 million, or $0.90 per diluted share, in the 2015 recast third quarter.

On an adjusted basis, excluding compliance and integration costs and long-term contract adjustments, net income from continuing operations was $40.9 million or $1.38 per diluted share, and this was a nice improvement over $1.15 per diluted share in the prior year period. For the first nine months of fiscal 2016, cash flow from operations was $114.7 million. The recast 2015 cash flow from operations was $117.2 million. Depreciation and amortization in the first nine months of 2016 was $73.3 million. Capital expenditures were $58.5 million, and this includes $15 million for the purchase and subsequent improvements of the primary DAT building in Belgium.

Free cash flow for the first nine months of 2016 was $56 million, compared with $81 million last year. And lower cash flow this year is driven largely by lower earnings and higher capital expenditures. Related to our capital structure, our leverage ratio is approximately 3.3 times on a gross debt basis. And as we've mentioned before, this is higher than our norm, and our focus going forward will be to bring this ratio into the 2.5 times range. During the third quarter, specifically early April, we repurchased approximately 102,000 shares for a total spend of $6.7 million, and after this activity we have $91.5 million still available under our $400 million share repurchase authorization.

Now, looking forward to the balance of the year. With the second quarter and third quarter results behind us, our priorities continue to be execution, execution, execution. We've done well in the second and third quarters to manage through both internal and external instability, including the Brexit vote and the incident in our Defense platform. That said, we're pleased to have ended this quarter demonstrating our ability to make the climb to higher revenues in the second half. Our strong bookings and backlog performance bolster this confidence looking forward. We ended the quarter with $1.39 billion of backlog, which is up from $1.23 billion last year, and we booked new orders of $552.1 million in the third quarter of 2016.

Now, that's an increase of $85 million versus prior-year bookings of $467.4 million. Orders were higher in the third fiscal quarter of 2016 in all segments. The largest driver to the strong orders in this year's Q3 was Avionics & Controls, specifically a nearly $50 million order in our Avionics platform for cockpit upgrade work, and this multi-year program will likely begin generating revenues in the second half of 2017. We expect our full year sales to be near the upper end of our current range, so we are narrowing our sales guidance range to $1.95 billion to $1.975 billion. This revenue strength reflects positive performance and execution at most of our businesses.

Notwithstanding the incident in Defense Technologies, the strength is broad-based, and as I mentioned earlier, our expectation for the Defense Technologies platform was for a strong third quarter, and a continuing ramp in the fourth quarter. The Defense platform has had strong bookings, and importantly it qualified several product lines through rigorous First Article Testing. While we absorbed the Q3 effects from the site shutdown, given our Q4 growth assumptions, we feel it is prudent to narrow our EPS guidance specifically reflecting the estimated Q4 income effect from the accident when compared to our guidance model.

We now expect adjusted EPS to be in the range of $4.40 to $4.60 per diluted share. This change is specifically related to the uncertainty surrounding the restart of the defense facility. We are reiterating our guidance for full year cash flow of $110 million to $130 million. This cash flow guidance is on a GAAP basis and includes approximately $70 million of capital expenditures, a higher amount than our historic spend due to the DAT building purchase and renovations this year. Additionally, we continue to expect our EBITDA, also on a GAAP basis, to be in the range of $230 million to $250 million in fiscal 2016.

Now, back to you Curtis.

Curtis C. Reusser - Chairman, President & Chief Executive Officer

Thanks, Bob. So before we take your questions, I'd just like to comment that at this point, I really think our path forward has fewer obstacles and risks, and more promise than it ever has since I've come on board here. We have more to do, that's for sure, but I'm pleased to see that we've won some hard-won challenges. We've achieved some really good progress on some of the drivers that are positioning us for a very strong future, and that includes the reshaping that we've done on our portfolio, our global footprint optimization and the implementation of our E3 system, as well as the cultural shift that I think promotes a lot stronger accountability and performance throughout all of our operations.

Our views continue to be one of steady organic growth, accompanied by incremental benefits of scale and efficiency. It's working for us, and I think more importantly, for our customers. We're able to respond faster with higher quality levels and more flexibility. We think, as we showcase these attributes, our customers are going to reward us and our shareholders will capture the superior value.

So with that, we'll open it up for questions.

Question-and-Answer Session

Operator

Thank you. And our first question comes from the line of Howard Rubel from Jefferies. Your line is open.

Howard Alan Rubel - Jefferies LLC

Thank you very much. It's nice to see you hitting your numbers, Curtis. I guess, maybe you could add a little more color with respect to this incident. And I mean, I know, Bob, you started on it and you're leaving us with a little bit of, I'll call, vagueness. And then if we interpret what you're providing us with, though, it looks like some of your core businesses are actually doing a little bit better than you thought. Could you comment, please?

Curtis C. Reusser - Chairman, President & Chief Executive Officer

Yeah. I'll have Bob cover some of the numbers, Howard, but thank you. I would agree that the majority – this for me was a very good quarter. We did have this very unfortunate incident and we're being very careful. We've just restarted. We had it shut down for a couple of months. That business has done a really nice job of capturing some new product lines in a tough defense market, and so we did expect it to ramp throughout the year and have a pretty strong Q4. So we're being a little cautious in forecasting, and we don't want to rush in bringing that back up online. Bob, do you want to talk a little bit more about the specific impact?

Robert D. George - Executive Vice President, Chief Financial Officer & Corporate Development

Sure, Curtis. Howard, thanks for the question. So yes, as I'm sure you're aware, we did have the incident at one of our countermeasures facilities in Defense Technologies. It occurred on May 23. And as I mentioned in my prepared remarks, we immediately shut down the facility. From May 23 to the end of the quarter, we incurred $1.6 million of direct costs in the quarter related to the incident itself. And that $1.6 million is about $0.04 per share. But relative to our guidance of more significance really for the full year are the opportunity costs naturally of the foregone sales and the profits associated with the shutdown and then subsequent restart.

And again, as I mentioned, we have a strong backlog there, with a strong shipping schedule. We have just passed a series of aggressive first article, and difficult First Article Testing and our expectations were that we were going to have it from that incident, the impact would be about $0.25 to $0.30 per share for the year. And again, as I commented in my prepared remarks, the situation here is in flux. We are proceeding with the restart with all due care and caution.

Howard Alan Rubel - Jefferies LLC

I understand when you're dealing with energetics. The second question that I'd like to ask then, as a follow up, I mean, the restructuring and one-time items were substantially better than we've seen, and I guess, that reflects partly maturity of some of the programs. Do you care to quantify or address how you see the level of expenses going forward in this category?

Curtis C. Reusser - Chairman, President & Chief Executive Officer

Well, just in general you're right. Howard, they're wrapping up. We're doing production in the two new facilities, so there's no more production. We did have, probably the larger chunk of those two projects finish up. It does tail off through the end of this year. I don't see – those are getting wrapped up. Q3, Q4 will be relatively – probably Q4 will be about the same as Q3 and then we should be done with the two restructuring projects. As we talked about, we're still making some progress on the DAT integration, and hope to be wrapped up with that the first half of 2017. So those should tail off. Again, they're wrapping up very good progress there. We're ramping up at the new sites. We've got the majority of the facilities people. Everything is on track there. So a lot of activity, but doing well.

Howard Alan Rubel - Jefferies LLC

Well, thank you very much, gentlemen.

Curtis C. Reusser - Chairman, President & Chief Executive Officer

Great.

Robert D. George - Executive Vice President, Chief Financial Officer & Corporate Development

Thanks, Howard.

Operator

Thank you. And our next question comes from the line of Robert Spingarn from Credit Suisse. Your line is open.

Robert M. Spingarn - Credit Suisse Securities (USA) LLC (Broker)

Yeah. Hi, everybody.

Robert D. George - Executive Vice President, Chief Financial Officer & Corporate Development

Hi, Rob.

Curtis C. Reusser - Chairman, President & Chief Executive Officer

Hi, Rob.

Robert M. Spingarn - Credit Suisse Securities (USA) LLC (Broker)

So your guidance, I mean there's a few moving pieces. The tax rate there's a range, and I was going to ask you if – how much of the buyback you think you can complete by the end of the year or what's embedded in the guidance? But also, it does imply some continued improvement in margins. And Bob, I was wondering if you could give us some sense by segment of what you're expecting there.

Robert D. George - Executive Vice President, Chief Financial Officer & Corporate Development

Yeah. I'll start with the share buyback question. We have no intentions of buying back shares at this point in time. As we indicated in the second quarter, in our second quarter call, we are focused right now on returning our net debt leverage ratios or gross debt leverage ratios back down to our historic norms of about 2.5 times, and that is our focus point. And our guidance does not assume any additional share buybacks. With respect to going forward, as we've indicated in the call, we are seeing positive performance across the corporation. We're seeing strong results. Our anticipation is that we are going to see some margin improvement as we move from Q3 to Q4. And we're quite pleased with the way the businesses are performing in most cases right now. Curtis, did you want to add anything?

Curtis C. Reusser - Chairman, President & Chief Executive Officer

Well, I was just going to say the Defense – without getting into all the details, if you take the impact of the Defense Technologies, which was pretty much – we had some things that we could button up and ship out the door, but just that volume related cost really did impact negatively the overall margins. And you could see some nice improvement in both the Sensors and the Avionics segments that had really nice contributions going forward. But we're continuing to expect improvement, and I think again with a little bit stronger volume, and with that coming back up on line, you'll see some future improvement.

Robert M. Spingarn - Credit Suisse Securities (USA) LLC (Broker)

Okay. And then Curtis, you talked about some pockets of strength in industrial, I think, earlier. Could you elaborate if there's anything to home in on there?

Curtis C. Reusser - Chairman, President & Chief Executive Officer

Nothing major that – the gaming has been good, our Interface Technologies business has had some good trends. They're making some good progress. We've had good bookings there. Again, I tried to highlight in my comments, we've seen some weaknesses in bookings sales last year, and really it wasn't a knee jerk reaction, but over the last probably three quarters or four quarters we've seen a lot more focus at my senior staff level and the platform president level to really look at both near term and long term bookings, and have a pretty strong process there. So again, it's a pretty wide front, but industrial markets kind of generally have been pretty good. Gaming internationally has been good. U.S. has been a little bit flat to weak. But overall pretty nice trend, and it is nice to see some counterbalance for that. Strong bookings in Q3; we'd anticipate that to continue going forward.

Robert M. Spingarn - Credit Suisse Securities (USA) LLC (Broker)

Okay. And then just lastly, kind of high level. We've talked, you and I, over time about the stability in the business. It sounds like you're kind of there. Do you feel like – obviously, this fourth quarter sounds like it's going to be pretty good. Do you think that stability can carry into next year at this point, and we can start thinking about growth, or is it not yet time to think about that?

Curtis C. Reusser - Chairman, President & Chief Executive Officer

No. I'm cautious. I want to be cautious. I don't want to get ahead of myself, but we've had a lot of balls in the air with the Consent Agreements that's wrapping up, with the facility moves that are all but done, with DAT integration, some lower sales that we're seeing trending the other way. So I do think that there is more stability. I think the team is gelling well together. We've got a pretty clear focus on what we're doing. So I feel like – as I said, I feel better now than I have before, but I don't want to get out over my skis. So I'm cautious.

Robert M. Spingarn - Credit Suisse Securities (USA) LLC (Broker)

Okay. Well, thanks very much. Nice quarter.

Curtis C. Reusser - Chairman, President & Chief Executive Officer

Thank you.

Robert D. George - Executive Vice President, Chief Financial Officer & Corporate Development

Thanks, Rob.

Operator

Thank you. And our next question comes from the line of David Strauss from UBS. Your line is open.

David E. Strauss - UBS Securities LLC

Thanks. Good afternoon.

Curtis C. Reusser - Chairman, President & Chief Executive Officer

Hi, David.

Robert D. George - Executive Vice President, Chief Financial Officer & Corporate Development

Hi, David.

David E. Strauss - UBS Securities LLC

Just back to the guidance, if I were to compare it to last year's Q4 on an adjusted basis, even if I take into account the cushion you obviously have in the numbers, or the contingency you have in the numbers for the countermeasures facility coming back on line, it still looks – and adjusting for the tax rate differences, it still looks to me like you're forecasting a down year-over-year quarter. Can you point to exactly what's driving that – the forecast for the fourth quarter being lower this year?

Robert D. George - Executive Vice President, Chief Financial Officer & Corporate Development

Yeah, David. There's one answer to that, and that's last year's fourth quarter's recast, and it essentially includes, effectively, an extraordinarily strong year-end. So you basically have like two quarter ends.

David E. Strauss - UBS Securities LLC

And you're...

Robert D. George - Executive Vice President, Chief Financial Officer & Corporate Development

(39:43).

David E. Strauss - UBS Securities LLC

Okay. And you're talking about the $2.20 number, Bob.

Robert D. George - Executive Vice President, Chief Financial Officer & Corporate Development

Yes.

David E. Strauss - UBS Securities LLC

The $2.20 EPS number.

Robert D. George - Executive Vice President, Chief Financial Officer & Corporate Development

That's correct. Absolutely.

David E. Strauss - UBS Securities LLC

Okay. I wanted to ask about the cash and capital structure. So your comment about not looking to buy back stock but to de-lever, year-to-date, I think you've built – from a growth standpoint, you haven't de-levered at all, yet you've built cash on the balance sheet. Obviously, the fourth quarter you're forecasting, a pretty good cash flow quarter. Should we expect to see you de-lever from a gross standpoint a fair amount in the fourth quarter?

Robert D. George - Executive Vice President, Chief Financial Officer & Corporate Development

Well, actually, so I've got to answer that a little cautiously. So the answer is yes, we will be de-levering from our free cash flow, without a doubt. As you know, however, we do have a fair amount of cash flow that's generated in our European facilities, and so that is going to remain offshore. The other effect that is also going to benefit us on the de-levering is the improvement in our EBITDA as we go forward. So we've got the beneficial effect of both portions of the equation. We are going to be paying down our debt from free cash flow, and we're going to be having strength in the EBITDA going forward.

David E. Strauss - UBS Securities LLC

Okay. Last one from me. Obviously, you have the excess compliance costs and integration costs, everything you're pulling out of the adjusted numbers. I guess, Curtis or Bob, do you want to hazard a guess in terms of how much in terms of the unadjusted numbers, how much is running through there today that you think is kind of one-time or non-recurring in nature, and what could potentially go away over time? Thanks.

Robert D. George - Executive Vice President, Chief Financial Officer & Corporate Development

So again, David, similar to the response that Curtis gave to Howard, we're expecting similar effects in Q4 that we had in Q3 relative to compliance. We are moving into our second directed audit, and moving into what hopefully is the final innings of the ballgame on that one. But that is going to continue into the first half, the first fiscal half of next year. And we do report in – and I don't have a copy of the release here in front of me. We do report the dollars we expended in compliance in the third quarter, in the earnings release and also in the Q.

Curtis C. Reusser - Chairman, President & Chief Executive Officer

I'd just add to that, David, I think what you're trying to get to is, of the stuff that we don't carve out, there still is activity going on in the businesses, especially as we're gearing up for the second audit, and again, we don't carve that out or try to. So there is probably some incremental costs that are impacting our business units, especially as we get ready for the second audit, which kicks off – we have an audit schedule that's been agreed to with the State Department. It kicks off at the end of August. It'll go through probably December timeframe as we work through the different sites. So we feel good about that.

We've also had some, I would say, things that we don't carve out in our accelerated integration targets as we close down the two facilities, we're down to the expected headcounts. We did most of those changes in the third quarter, and now we're down to the levels that we anticipated. And again, as we had two factories going up and a lot of activity to get the first article inspections through a couple of our key customers, that those activities were hitting gross margins in the specific businesses. So some of that flows through inventory. We'll have to see some of that weed off in the fourth quarter. But we feel good about the progress that we're making there. There is a lower level of head count. We've built up the right levels in the new sites. So some of that should start to flow off in the fourth quarter, and into definitely some improvement in 2017.

David E. Strauss - UBS Securities LLC

Thanks.

Robert D. George - Executive Vice President, Chief Financial Officer & Corporate Development

Thanks, David.

Operator

Thank you. And our next question comes from the line of Sam Pearlstein from Wells Fargo. Your line is open.

Samuel J. Pearlstein - Wells Fargo Securities LLC

Good afternoon.

Robert D. George - Executive Vice President, Chief Financial Officer & Corporate Development

Hi, Sam.

Curtis C. Reusser - Chairman, President & Chief Executive Officer

Good afternoon, Sam.

Samuel J. Pearlstein - Wells Fargo Securities LLC

I guess really, Bob, I'm looking at the cash flow guidance for the year, and it implies a pretty big step up from Q3 to Q4. And I know that it is probably, your guidance would suggest $10 million or so higher net income. But what are the other moving pieces that are driving from Q3 to Q4 that's going to help the cash flow?

Robert D. George - Executive Vice President, Chief Financial Officer & Corporate Development

Well, obviously, income is a big part. One of the reasons why cash flow is a little softer year-to-date is because of the significant capital expenditures that we've incurred relative to our norm. We're anticipating that we're not going to see that level of CapEx in Q4. So we've got higher income, and we've got lower CapEx. When looking at our working capital, because obviously that's another significant factor there, we are expecting obviously, receivables are probably going to move up because of the higher sales that we're looking at, but fundamentally the sales that we're looking at in Q4 are not going to be that dramatically different than we've had in Q3. So in our model we're looking at some level of inventory reduction in Q4. The combination of those factors is what leads us to believe that we're pretty comfortable with that cash flow forecast.

Samuel J. Pearlstein - Wells Fargo Securities LLC

Okay. And if I just think about 2016 going into 2017, and I know you're not giving 2017 guidance, but just what are the big items that hurt cash flow this year that aren't going to recur? I mean, is capital spending, should we think of that as significantly lower next year? Obviously, income is going to be higher for a variety of reasons, but just trying to think about year-over-year cash flow from 2016 to 2017.

Robert D. George - Executive Vice President, Chief Financial Officer & Corporate Development

Well, I mean – and frankly, Sam, you've nailed it. I mean, our expectations are that the capital expenditures are going to come back to our more historic norms next year. We certainly are not buying another building. We're not renovating the building associated there, and then we are looking for improvements as we move forward in operating performance.

Curtis C. Reusser - Chairman, President & Chief Executive Officer

And one other I'll mention is, Sam, it's just with some of the product moves that we've had, so we moved the products from Duluth to up to Everett. We had some product moves, obviously, we've talked a lot about NMC and the Sensors move. We did have to build up some buffer stock there to make sure that we did those moves. NMC was another one where we built up some buffer stock, again, to kind of work through with our customers. So we're not – we're anticipating bleeding those down, which I think were kind of a little bit one-offs. Another small one that did had some buildup was, we've talked about this connector issue that we had an opportunity to go win some new connector business because of a competitor that had some export issues, and we built ahead on that.

And lastly, in Racal, which is typically has that business model, to position for some sales in the fourth quarter, working with our customer we anticipated an order we didn't have it yet, so we did do some build-ahead there. So I'm not saying we won't have those things next year, but those should probably be a little bit less next year.

Samuel J. Pearlstein - Wells Fargo Securities LLC

Okay. And Curtis, I don't know if you can talk a little bit about you mentioned the team is starting to gel. You did have a change in the Defense Technologies management, and we talked about, I guess, the Arkansas facility and then the California facility. Just, I guess, I'm assuming that business is not tracking to plan outside of the event in that one facility, but could you talk a little bit about that?

Curtis C. Reusser - Chairman, President & Chief Executive Officer

Yeah. No, so we brought Scott Kuechle on board. That was a normal retirement. Jim Brandt is working overlapping with Scott, but really excited about Scott coming on board. In a very difficult environment in Defense Technologies, we've won a lot of business. California has done better than expected this year. Arkansas has had some challenges because they've won more new programs this year than they've won, I think, it's in five years or six years. So it's ramping up, having to set up mixed model sales, doing small batch sizing. So all of that's gone very well. We had the incident in Arkansas, which wasn't – it was an engineering change that probably wasn't understood as well, but that's being improved, and we're working through that, so we feel good about that situation.

Samuel J. Pearlstein - Wells Fargo Securities LLC

Thank you.

Curtis C. Reusser - Chairman, President & Chief Executive Officer

Thanks, Sam.

Operator

Thank you. And our next question comes from the line of Ken Herbert from Canaccord. Your line is open.

Kenneth George Herbert - Canaccord Genuity, Inc.

Hi. Good afternoon.

Curtis C. Reusser - Chairman, President & Chief Executive Officer

Hi, Ken.

Kenneth George Herbert - Canaccord Genuity, Inc.

Hey, Bob and Curtis. I just wanted to ask about the guidance one final way, this time looking at the revenues. I mean, you've got a 5%, 6% drop in the fourth quarter, and I can appreciate that the fourth quarter of the comp last year was abnormally high. But is there anything else, considering the backdrop, it sounds like the third quarter has clearly gone maybe a little better, and you're talking about the upper end of the guidance. But is there anything else you can point to that's either weak, maybe a little weaker than expected, aside from the one facility, or better than expected to help sort of circle the guidance from a revenue standpoint?

Curtis C. Reusser - Chairman, President & Chief Executive Officer

I think, again, I think we're a little bit hung up on the compare with that one year. We think it's going to be equal to or slightly up. There's a number of things we're still chasing, but overall sequentially. So we still think it's pretty – it should be a solid quarter. There are some things that we're still out pursuing, but feel good about the backlog that we have right now. So broadly it looks pretty good.

Kenneth George Herbert - Canaccord Genuity, Inc.

Okay. No, that's helpful. And then if you could, I can appreciate, Avionics & Controls, you talked about sort of broad-brushed strength, and obviously a very good quarter in that segment. But can you provide any more granularity again in that segment in the third quarter on any specific programs, or anything else either from a margin standpoint that particularly stood out, or from the top line?

Robert D. George - Executive Vice President, Chief Financial Officer & Corporate Development

Well, I think maybe two or three things. Some nice wins; the Antonov program that we've gone out with, that was a nice win, a long-term contract. And the thing I'll highlight there is that was a relationship that our DAT folks had with Antonov, and they were able to pull along the CMC side. As you know, we've talked about the sales lead at CMC is from DAT. So I'm very excited about that opportunity, and saw some more of that type of activity at the Airshow. So that was really nice. DAT had some nice sales increases. So again their breadth of products, we saw some nice increases there. And lastly EIT, the Interface Technologies group again, had some good growth there. So kind of broadly, some nice broad-based improvements.

Kenneth George Herbert - Canaccord Genuity, Inc.

Great. Thank you very much.

Robert D. George - Executive Vice President, Chief Financial Officer & Corporate Development

Thanks Ken.

Operator

Thank you. And our next question comes from the line of Michael Ciarmoli from KeyBanc Capital. Your line is open.

Michael F. Ciarmoli - KeyBanc Capital Markets, Inc.

Hey. Good afternoon, guys. Thanks for taking my question.

Curtis C. Reusser - Chairman, President & Chief Executive Officer

Sure. Thanks, Mike.

Michael F. Ciarmoli - KeyBanc Capital Markets, Inc.

Maybe, Bob or Curtis, just to stay on the guidance one more time here. So the low end of revenue actually implies that you could be down sequentially, but it just sounds like conservatism. But given the challenges in the restart, in the Materials segment, should we expect maybe a further decline in those revenues as you guys sort of take your time to start the facility up, or is that facility and that division still going to be able to generate some revenue growth – or revenues actually?

Robert D. George - Executive Vice President, Chief Financial Officer & Corporate Development

So Mike, let me start with the Defense platform. Given the state we're at, we're still in flux. And so I'll give you what I know, which is similar to what I said. So we've done a detailed evaluation of the site. We've done a thorough investigation of the events leading up to the incident. We've taken some corrective actions. We've worked with the employee workforce, and last week reviewed all of our training and safety policies. And this week, as we speak right now, we are in the process of restarting the facility. So, there's a couple of things that have yet to be determined as we're working through this.

One is, when are we going to be back up to ramp speed, which is going to take us a little bit of time; and then the second is, as I mentioned in my comments, we had just passed a number of first article inspections on some new products. And depending on how quickly we come back up, we may have to go through those first article tests again. So that's a long way of saying that we are being conservative, we are factoring that in, and we are factoring a slow and steady startup. And relative to our expectations, sales in that platform could be impacted by $15 million to $20 million.

Michael F. Ciarmoli - KeyBanc Capital Markets, Inc.

Okay. And that's in the fourth quarter?

Robert D. George - Executive Vice President, Chief Financial Officer & Corporate Development

Yes.

Michael F. Ciarmoli - KeyBanc Capital Markets, Inc.

Okay. Perfect. And then maybe just one last one. Some of your top programs have been in the news recently: A400, A380. Just given your sizeable content on those platforms, how are you sort of managing the uncertainty and what does that do from a – do we see any impact near term, or is that still in flux to some extent?

Curtis C. Reusser - Chairman, President & Chief Executive Officer

It's still in flux. We obviously, on certain of those programs, we hear about it a little bit earlier than maybe it's out in the press, and are working with current orders and work in process, and working with the customer. You're right, those are big programs for us; those are very important. They're important customers. We've made good investments. I think A400M, it's timing – a matter of time. There's relatively – they are large programs, but our exposure to any one specific program is fairly small. And so we think we're building that into our forecast as we look forward. I think we've talked about this. We do go through some upside/downside planning and are trying to be, again, a little more conservative in the way that we look, and try to take into account fluctuations like this. And I think we're trying to show that we're being a little more steady-state there.

Michael F. Ciarmoli - KeyBanc Capital Markets, Inc.

Got it. Thanks a lot, guys. I appreciate it.

Curtis C. Reusser - Chairman, President & Chief Executive Officer

You bet. Thank you.

Robert D. George - Executive Vice President, Chief Financial Officer & Corporate Development

Thanks, Mike.

Operator

Thank you. And our next question comes from the line of Pete Skibitski from Drexel Hamilton. Your line is open.

Peter John Skibitski - Drexel Hamilton LLC

Hi, guys. Nice quarter.

Curtis C. Reusser - Chairman, President & Chief Executive Officer

Thanks, Pete.

Robert D. George - Executive Vice President, Chief Financial Officer & Corporate Development

Thanks, Pete.

Peter John Skibitski - Drexel Hamilton LLC

Sure. Hey, Curtis, just a follow up on Mike's question. I'm struggling with the fiscal 2017 top line for some of those same reasons. You've got the A400M gear box issue. We know rates coming down on the A380. I don't know what's going on with the Superjet or the T-6; biz jets and helicopters are kind of weak. And then you've got this continuing resolution that's probably going to impact your first quarter at the least. So I mean, how does it feel to you guys? Does it feel like a flat year from a top-line perspective, or – you have built some nice backlog here this year. Can you give us some more color on – I think before you were thinking about maybe 2% top-line growth? Can you stick to that or is it just too hard to tell right now?

Curtis C. Reusser - Chairman, President & Chief Executive Officer

Well, we're still working with the businesses to take a look at that, so it's a little premature. But I feel – I'm cautious because of those things, but again, our breadth it's pretty diverse. I feel very encouraged about the bookings that we're having in some of the diverse markets. I'm cautious about it. We're not ready to show something, but I would – I'm not going to see big, giant, double-digit gains next year. I will say that. But it's a little bit early for us to give a specific number.

Robert D. George - Executive Vice President, Chief Financial Officer & Corporate Development

Yeah, Pete, we're right now – as you would expect, we're right now working with our platforms and our segments, and looking at our detailed planning for next year. And there is, as both you and Mike have clearly pointed out, there's a lot of uncertainty on some programs that we're deep into, and we are developing and working on with our engineering staff, developing programs that will begin kicking in a little bit later. So right now, it's early.

Peter John Skibitski - Drexel Hamilton LLC

Okay. And just one follow up. I'm just wondering kind of post-Farnborough, if you can kind of give us an update on the cockpit avionics market. I'm just wondering kind of how many chunky opportunities that you've actually won this year there. Is the unit kind of growing? Do you see that market is kind of improving as you go into fiscal 2017, or are there any competitions we should maybe look out for there? I'm just curious how that unit is doing.

Robert D. George - Executive Vice President, Chief Financial Officer & Corporate Development

I'm very pleased with how the unit is doing. I think our senior team here Michel Potvin and his sales team there, along with Al, really I have much more visibility on what they're working on. It is a long list of singles and doubles that they're working on. So again, we're not trying to go bank underneath any big one-time wins, but the combination with DAT has been really good. I will say that when we briefed the board on this, we do talk about, hey, this is working like we planned. There are here's two or three or four pretty significant opportunities where CMC is getting their foot in the door and more wins, and we're also seeing the same thing going the other way where we're able to pull through some DAT volumes. So it's going well. They've got a long list of things that they're working out. We just got to go make sure we execute on them, but so far some nice wins. They had a long list of things for this year. They've been successful on some. They've lost out on some others, so it's still early days.

Peter John Skibitski - Drexel Hamilton LLC

Got it. Thanks so much.

Robert D. George - Executive Vice President, Chief Financial Officer & Corporate Development

You bet.

Operator

Thank you. At this time I'm showing no further questions. I would like to turn the call back over to Julie Albrecht for closing remarks.

Julie Albrecht - Vice President, Finance and Investor Relations & Treasurer

Thank you. And thanks to everyone for being on our call today. I will note that Curtis will be attending a couple of conferences on the East Coast next week. So if possible, it'll be great to see you there. And in the meantime if you have any questions about our third quarter results feel free to get in touch with me. So thanks again and have a great evening.

Operator

Ladies and gentlemen, thank you for participation in today's conference. This concludes the program and you may now disconnect. Everyone, have a great day.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!