Rockwell Collins (COL) Q4 2016 Results - Earnings Call Transcript

| About: Rockwell Collins, (COL)

Rockwell Collins, Inc. (NYSE:COL)

Q4 2016 Earnings Call

October 24, 2016 8:30 am ET

Executives

Ryan D. Miller - Rockwell Collins, Inc.

Kelly Ortberg - Rockwell Collins, Inc.

Amin J. Khoury - BE Aerospace, Inc.

Patrick E. Allen - Rockwell Collins, Inc.

Analysts

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

Peter J. Arment - Robert W. Baird & Co., Inc. (Broker)

Myles Alexander Walton - Deutsche Bank Securities, Inc.

Cai von Rumohr - Cowen & Co. LLC

George D. Shapiro - Shapiro Research LLC

Carter Copeland - Barclays Capital, Inc.

Rajeev Lalwani - Morgan Stanley & Co. LLC

David E. Strauss - UBS Securities LLC

Ronald Jay Epstein - Bank of America Merrill Lynch

Howard Alan Rubel - Jefferies

Samuel J. Pearlstein - Wells Fargo Securities LLC

Operator

Good morning, and welcome to today's Conference Call regarding Rockwell Collins Fourth Quarter Earnings and the Acquisition of B/E Aerospace. This conference call is being webcast at www.rockwellcollins.com.

Today's call is being recorded; an archived replay of this webcast will be available on Investor Relations page after the conference call concludes. For opening remarks and management introductions, I'd like to turn the call over to Rockwell Collins' Vice President of Investor Relations, Ryan Miller.

Ryan D. Miller - Rockwell Collins, Inc.

Thank you, Carol. Good morning, everyone. Thank you for joining us. On the call this morning are Kelly Ortberg, Chairman, President and Chief Executive Officer of Rockwell Collins; Amin Khoury, Founder and Chairman of B/E Aerospace; and Patrick Allen, Senior Vice President and Chief Financial Officer of Rockwell Collins.

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

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

I'd now like to turn the call over to, Kelly.

Kelly Ortberg - Rockwell Collins, Inc.

Well, thanks, Ryan, and good morning, everyone. I am very pleased to be speaking with you, today about the transformative and complementary acquisition of B/E Aerospace. This transaction brings together two industry-leading franchises with significant benefit to Rockwell Collins.

It strengthens our position as a leading supplier of cockpit and cabin solutions, increasing our scale and establishing a new platform of growth for our company. The addition of B/E will also diversify and balance our portfolio across OEM, airline and aftermarket. And as we look to the future, it enhances our ability to integrate cabin equipment using smart technologies and connectivity solutions to significantly enhance the experience of passengers and airline personnel.

From a financial perspective, this combination is very attractive to both company's shareowners. We project run-rate pre-tax cost synergies of $160 million along with meaningful revenue synergies, which I'll discuss later in the call.

Additionally, we expect double-digit accretion to earnings per share in the first full fiscal year, and combined five-year free cash flow generation in excess of $6 billion. The acquisition of B/E Aerospace is consistent with our vision to be the most trusted source of aviation and high-integrity solutions in the world.

Before I ask, Amin, to make a few comments, let me just say a few quick words about our earnings which were also announced yesterday. We had a strong quarter of operational performance highlighted by double-digit earnings per share growth and robust quarterly free cash flow generation. This gives us a great momentum headed in 2017. Over the long-term, we're well-positioned to deliver accelerating top line revenue growth, double-digit earnings per share and strong cash flow growth.

Patrick Allen is going to discuss our fourth quarter earnings results, and our 2017 guidance later on in the call, but let me turn back to the transaction.

I'd like to thank the B/E Aerospace's Founder and Chairman, Amin Khoury for being here with me, today. As you can imagine, to put together a deal like this, we've come to know each other and our respective companies quite well. We could not have found a better partner in B/E Aerospace, and I can tell you that on behalf of the nearly 20,000 employees at Rockwell Collins, we can't wait to bring them to the Rockwell Collins family.

Today is a big day for Amin. As Founder of B/E, he's achieved an extraordinary feat that we should all admire from creating a small business with $3 million in revenues in 1987 to a global powerhouse of almost $3 billion, today, and a leader in the markets, all the markets that they serve, very impressive.

Congratulations, Amin. And I'd like to ask you to say a few words.

Amin J. Khoury - BE Aerospace, Inc.

Thank you, Kelly. Thank you very much for your kind remarks, but obviously it's no longer about me. It's about the wonderful benefit that this combination brings to our customers, and our employees and our shareholders.

Our combination with Rockwell Collins represents an excellent outcome for B/E Aerospace's stockholders who will receive an immediate premium, as well as a substantial equity interest in a strong combined company, broader range of products, customers and the combined expertise and resources to create real and meaningful future value.

We feel confident that this combination delivers significant long-term benefit neither company could realize on its own. We look forward to becoming part of Rockwell Collins, and leveraging their technology to accelerate our long-term growth as we embark on the next chapter in the company's history. The opportunities available to us working together are boundless. We will truly be the premier supplier of front and back of aircraft products, and we'll build on our deep customer relationships.

For me personally, I can retire knowing that B/E Aerospace is in Kelly Ortberg's extremely capable hands; with Werner Lieberherr continuing to run the business, while leveraging the full resources of Rockwell Collins.

This transaction delivers great benefits to all of our constituencies. Our shareholders will realize significant and immediate value in the form of a 23% current premium to B/E's closing stock price on Friday, and expected substantial equity upside in the combined company.

Our customers will enjoy access to a greater breadth of products, technologies and a global scale in combined expertise to continue serving their evolving needs. Our employees will have greater opportunities as part of a larger, more diversified company with enhanced opportunities for professional growth and advancement across Rockwell Collins Global Platform.

Importantly, having worked with, Kelly and his team very closely throughout this process, I can assure you that Rockwell Collins and B/E Aerospace share the same cultural values, commitment to customers, focus on innovation, quality and sustained customer value.

Rockwell Collins is acquiring a company that is in great shape. While I will not spend time on this call discussing earnings, we released our third quarter results yesterday, we recorded another outstanding quarter, and we raised guidance for 2016.

In sum, this is a tremendous opportunity for B/E Aerospace and Rockwell Collins' shareholders to participate in the long-term value-creation opportunity that neither company is able to achieve on its own.

I'd now like to turn the call back over to, Kelly.

Kelly Ortberg - Rockwell Collins, Inc.

Well, thanks, Amin. I'll now talk through the transaction terms on slide number four. Yesterday, we announced that Rockwell Collins plans to purchase B/E Aerospace for $6.4 billion in cash and stock, plus the assumption of $1.9 billion in debt.

B/E Aerospace shareowners will receive consideration of $34.10 per share in cash and $27.90 in shares of Rockwell Collins' common stock for each B/E Aerospace share they own, representing a value of $62 per share, subject to a 7.5% collar. B/E Aerospace shareowners will own approximately 20% of Rockwell Collins following the completion of the transaction.

B/E Aerospace will operate as a new aircraft interior systems segment within Rockwell Collins, and will continue to be run by Werner Lieberherr and B/E's proven management team. The transaction is expected to close in the spring of 2017 upon the completion of regulatory approvals and approval of Rockwell Collins and B/E Aerospace shareowners, as well as other customary closing conditions.

Now, turning to slide five; I want to provide a bit more detail regarding the strategic and financial rationale for this transaction. This acquisition is the result of a multi-year strategic process we undertook to determine how best to grow our company. This included the formation of a new Strategic and Financial Committee of our board. We looked at two major alternatives, one was to take our capabilities into new markets, and the other was to expand our capabilities into our current market channels. And we selected this path and developed some criteria of technical differentiation, long life cycle and market leadership.

B/E Aerospace is a terrific match. The combination solidifies our position as a leading supplier of cockpit and cabin solutions. We'll be able to broaden our offerings to customers through an expansion of our traditional core business, while also strengthening and balancing our portfolio mix.

B/E Aerospace is a leader in nearly all the markets they serve, and similar to Rockwell Collins has a reputation for innovation, quality, and on-time delivery. B/E Aerospace also has a highly-visible, long-cycle backlog. Beyond new aircraft deliveries, their $12 billion of installed base provides a strong flow of aftermarket retrofit opportunities that balances our current cyclical exposure to OEM production rates.

Now, I touched on the combination benefits, but let me just quickly reiterate. We expect to generate approximately $160 million in projected pre-tax run-rate cost synergies. We expect double-digit accretion to earnings per share in the first full fiscal year. I believe there are meaningful revenue synergies that create significant upside to this business case. And we expect five-year free cash flow generation in excess of $6 billion. B/E Aerospace business will fit within Rockwell Collins as a separate segment as we have successfully done with the ARINC acquisition. This will ensure no disruption to our customer commitments.

Now, in addition to the compelling financial aspects that I outlined, the deal is structured to preserve a solid investment grade rating, retain our dividend payout of approximately 25% of net income. It takes advantage of attractive credit markets and generate significantly greater value than alternative uses of capital, including share repurchases.

Moving on to slide six. For those of you who may not be as familiar with the B/E business, I want to give you an overview of B/E Aerospace. B/E is a leading provider of highly-engineered aviation certified interior aircraft products. The company is a leader in all of its major product categories, and has a blue-chip customer base of airlines, commercial and biz jet OEMs, aircraft completion centers and leasing companies.

And as I've mentioned, B/E has a high-quality backlog with multi-year visibility, and a large installed base of over $12 billion that drives aftermarket retrofit demand. The company has about 10,000 employees who directly contribute to B/E Aerospace's success in the market, and will be a great fit at Rockwell Collins as we work together to build on a respective reputation.

Now, looking at the right-hand-side of the chart, you can see B/E Aerospace's breakdown of 2015 revenues by customer, by market and by segment. About 80% of its revenue is from the airline customers, 60% is line fit, and 77% is within the Commercial Aircraft segment.

Now, slide seven and then eight, breakdown B/E's business by its Commercial Aircraft segment and Business Jet segment. Let's start with the Commercial Aircraft on slide seven. You can see B/E's four key products within this segment are seating, galley inserts, oxygen and passenger service units and interior structures. B/E is a product line leader with strong share in first, business, and premium economy and main cabin seating, and has won 40% to 50% of the business class and main cabin awards and orders over the past two years.

B/E is also a product line leader in food and beverage preparation and storage equipment referred to as galley inserts. And they have won 85% of the galley insert awards and orders over the past two years. They are the supplier of passenger oxygen systems for all Airbus and Boeing platforms currently in production. And finally, B/E is the supplier of Spacewall modular lavatory systems for the Boeing 737 aircraft.

Turning now to slide eight, let's take a look at B/E's Business Jet segment. Key products within this segment are super first class suite, business jet seating and interior lighting systems. B/E is a product line leader in bespoke customer (sic) [custom] super first class cabins, there they were recently awarded a $260 million program for high-end suites, which sets a new industry standard. And they have won more than 75% of super first class awards over the past couple of years.

The company is a product line leader in all major seating categories including business jet, VIP aircraft and civilian helicopters. It is the sole source for Boeing 737 and Boeing 737 MAX cabin lighting and does retrofit lighting on a number of aircraft as well.

Turning now to slide nine. You can see the impressive combination of Rockwell Collins and B/E Aerospace offering in the cockpit, cabin and aircraft exterior. The transaction broadens our portfolio with leading products in attractive segments that strengthens and broadens our airline relationships. With the addition of these capabilities, Rockwell Collins will have an increased ability to provide integrated offerings throughout the aircraft.

Turning now to slide 10, as you can see the company will be more diversified, and in different ways than we are today. The combined company will have greater presence in the commercial air transport market. This will strengthen our aftermarket mix with more retrofit opportunities. And you can see in the diagram, our customer mix will be nicely balanced between U.S. and international. This transaction creates more resilient and diversified business with greater earnings power and reduced volatility.

So, with that, I'd like to turn the call over to, Patrick Allen, and he's going to discuss the combined company's financial highlights. Patrick?

Patrick E. Allen - Rockwell Collins, Inc.

Thank you, Kelly, and good morning to everyone. Slide 11 shows the combined company's pro forma financials. As you can see, the combined company would have generated approximately $8.1 billion of revenue and $1.9 billion in EBITDA through the 12 months ended September 30, 2016.

Both companies announced earnings' results yesterday, so these are current numbers, and did not reflect synergies and the combined earnings power of the two companies, which together we expect will create significantly even greater value in the future.

Let's turn to slide 12, and talk about some of those synergies. The transaction is expected to generate run-rate pre-tax cost synergies of approximately $160 million, which translates to $125 million after-tax due to some of the synergies coming from favorable tax jurisdictions.

In addition, we expect to make certain conforming purchase accounting adjustments which will benefit earnings by $60 million to $90 million per year for about six years. The sources of the cost synergies will come from elimination of duplicate, public company costs and headquarters consolidation, low cost country manufacturing, supply chain savings, consolidation of IT systems and rationalization of our sales and customer support organization.

We've a long history of successfully integrating acquisitions and realizing synergies as you saw with our ARINC acquisition. And we've established a very clear path to realizing these savings. Additionally, significant revenue synergies exists, which Kelly will talk about in more detail, but are not included and represent upside to our business case. The cost to achieve these synergies is about $120 million, the bulk of which will be incurred over the next three years.

Slide 13 provides some additional color about our near-term capital deployment. As always, we will continue to invest in organic growth. We will continue investing in research and development, and capital expenditures are expected to be in the range of 3% to 3.5% of sales of the combined organization.

We plan to use a significant portion of our free cash flow to deleverage, and we expect our debt-to-EBITDA ratio will be under 3x within two years. We plan to structure our financing with $1.5 billion three-year pre-payable term loan to facilitate this plan. And we remain focused on shareholder return and plan to maintain a dividend payout ratio of approximately 25% of net income.

We do not expect significant share repurchases over the next couple of years, just enough to offset dilution. Over time, as our leverage normalizes, we expect to resume our normal share repurchase program. And we are committed to maintaining strong liquidity and flexibility and preserving an investment grade rating, which we currently expect to be a solid BBB.

Now, let me quickly summarize our earning results for the fourth quarter and full-year 2016 on the following slides. Turning to slide 15, we reported a strong Q4 with revenue of $1.4 billion, a 4% increase year-over-year.

EPS from continuing operations of $1.58, a 14% increase compared to last year, and income from continuing operations of $208 million, a 13% increase. Our Government Systems business posted its first full-year of growth in six years and closed out the year with fourth quarter sales growth of 14%, and its highest-ever quarterly operating margin.

We continue to see growth in our IMS segment in both the aviation and non-aviation businesses. Commercial Systems air transport aviation electronics portfolio delivered a solid quarter of growth in OEM and aftermarket sales, while the business and regional aviation electronics portfolio continue to see weakness from the challenging business jet market conditions. Our diluted average shares outstanding decreased from $133 million to $131 million due to our share repurchase program.

Now, turning to slide 16, I'd like to review briefly our full-year 2016 results. We reported 2016 revenue of $5.3 billion, approximately flat year-over-year. EPS from continuing operations of $5.50; a 6% increase compared to last year. Income from continuing operations of $727 million, a 5% increase and operating cash flow from continuing operations of $723 million, which is down 3% year-over-year. We are pretty pleased with these results in light of the challenging business jet marketing conditions.

Now, turning to slide 17, I'll walk you through the guidance for 2017. Importantly, this is just for Rockwell Collins' base business. It does not include any impact from our acquisition of B/E Aerospace, which again we plan to close in the spring of 2017. We will update guidance over the coming months as we get a better sense of the timing at close.

With that said, for 2017, we plan to generate total sales of $5.3 billion to $5.4 billion, representing growth of about 2%. This replaced Government Systems sales growing low to mid-single-digits, an accelerating growth rate from 2016. We expect Commercial Systems revenues to be about flat as benefits from market share gains in air transport offset further declines in biz jet OE revenues. And we expect Information Management Services to be up mid to high-single-digits.

Our total segment operating margins are expected to be about 21%. Cash flow from operations is expected to be between $800 million and $900 million. Capital expenditures of approximately $200 million resulting in free cash flow of $600 million to $700 million. Our R&D investment in 2017 is expected to between $900 million and $950 million, and our full-year income tax rate will be between 28% and 29%.

Yesterday, B/E also reported results for the three and nine months ended September 30. As reflected in the release, the company reported strong sales and earnings growth, and continues to build momentum going to 2017.

With that, I'd like to now turn the call back over to, Kelly.

Kelly Ortberg - Rockwell Collins, Inc.

Thanks, Patrick. Now, I want to walk through what, I think, could be the most exciting long-term benefits of the combination of the two companies, and that's our revenue synergies.

As I said before, these all represent upside to our business case. And we see five major areas of synergy. First area, I'll talk about is the business aviation aftermarket.

It will be a prime area of focus for us with more than 20,000 jets we can offer a full complementary of interiors from seating to lighting to electronics, while aircrafts are undergoing avionics modifications. And depending on the size of the aircraft, we could easily see between $200,000 to well over $1 million of opportunity per aircraft.

Rockwell Collins' position on many military aircraft program gives us an important access to customers, and this acquisition will allow us a broader offering to those customers. This is a channel that B/E currently just doesn't serve.

Rockwell Collins has stronger OEM relationships, and that will aid further growth for standard interior sales. And likewise, B/E has stronger airline relationships that we think would generate opportunities for Rockwell Collins to sell more avionics or likewise opportunities where Rockwell Collins has strength to sell more interior equipment. If you think about that, these opportunities represent well over $50 million per opportunity.

And finally, as you think about the transition to the next integrated digital airplane, perhaps, most exciting synergy is our combined portfolio will uniquely position us to integrate cabin products, smart network technologies, and connectivity solutions to significantly enhance aircraft uptime and airline profitability.

In summary, we are thrilled about this acquisition and the opportunities it provides to both company's shareowners.

Together, our company will be a leading supplier with platforms for accelerated growth in new products and markets.

The transaction is financially compelling and will allow a significant cost savings, and will deliver significantly greater value to our stakeholders than either company could on its own; customers, employees, suppliers, and shareowners will all benefit from this exciting combination.

And I'll finish by adding my complements to Amin and his team, who've done a tremendous job of building a leading franchise, and creating value at B/E. We're eager to welcome the talented B/E Aerospace employees and look forward to continuing to grow our business together.

So, let me turn the call back over to, Ryan, and we'll begin the Q&A.

Ryan D. Miller - Rockwell Collins, Inc.

Thank you, Kelly. In order to give everyone the opportunity to ask questions, we ask that you limit your questions to one per caller. If you have further questions, simply reinsert yourself into the queue, and we'll answer those additional questions if time permits.

Operator, we are now ready to open the lines.

Question-and-Answer Session

Operator

And your first question comes from the line of Robert Spingarn from Credit Suisse. Your line is open.

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

Good morning.

Kelly Ortberg - Rockwell Collins, Inc.

Hi, Rob.

Patrick E. Allen - Rockwell Collins, Inc.

Good morning, Rob.

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

Hi, guys. Congratulations on your agreement.

Kelly Ortberg - Rockwell Collins, Inc.

Thank you. Very excited about it.

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

I wanted to ask on – Kelly, you just talked about the revenue synergies, and you noted about $1 million to $2 million in upside per biz jet, I think it was. How would you characterize that in a percentage upside from your current combined revenue? And then the same question for commercial aircraft?

Kelly Ortberg - Rockwell Collins, Inc.

Well, what I said, Rob, was that depending on the size of the aircraft, we could see between $200,000 to well over $1 million per...

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

I'm sorry.

Kelly Ortberg - Rockwell Collins, Inc.

...and let me just explore that opportunity a little bit more to define what that is. Today, when aircraft come in for maintenance actions, that's when we typically will sell them avionics mods or even cabin entertainment equipment mods and updates. And we do that through our pretty expansive dealer network. We've got over 300 dealers in the business aviation channel that help us do that.

B/E currently doesn't have a dealer network, and in many cases, they don't have visibility to know those aircrafts are coming in for mods and upgrades or maintenance actions. And so, there's no point of sale for the interior products to let those customers know what the latest and greatest capabilities are.

And as you can imagine, most of these customers are looking for some of the latest features and amenities that would go in the cabin. And we think, it's going to be a great opportunity for us when we know these folks are coming in for maintenance actions. Their aircrafts are going to be down for either a modification to the cabin systems or an avionics or even an engine overhaul. We can then upsell the cabin interiors to that. So as I look at that, I think that can have a meaningful increase, but almost double our opportunities as we do discretionary mods to – with our current avionics portfolio, so that's a...

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

Double your avionics content or double the current combined content for the two of you?

Kelly Ortberg - Rockwell Collins, Inc.

...it could double our current avionics content on a per aircraft mod basis. So, if you look at our aftermarket...

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

Okay.

Kelly Ortberg - Rockwell Collins, Inc.

...a portion of that is mandate-driven, a portion of that is discretionary mods. I think this can provide a meaningful update to that end market.

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

Okay. And then on a typical commercial aircraft, if you took Collins' content with B/E Aerospace's, do you have thoughts on how much that could rise?

Kelly Ortberg - Rockwell Collins, Inc.

Yeah. So let me give you a couple of figures of merit, because I think they are important as you think about that synergies. If you look at our content on the next-generation wide-body aircraft, if we combine B/E's content, it will triple our position, our content on programs like the 787, the A350, which we know are going to drive the preponderance of the future wide-body market, and it will nearly double our position in the narrow-bodies.

There are airline customers where B/E is extremely strong. We're not so strong, so there's opportunities for us with that expanded footprint to pull some avionics opportunities. And likewise, there are airline customers where they are not as strong, but we do have strong avionics positions that we could provide a broader offering to those customers.

And I think, if you think about that as I talked in my prepared remarks, that's probably about a $50 million-plus opportunity per major BFE selection or aircraft selection; probably more opportunity for the interiors than pulling the avionics because of the relatively larger content that B/E has on an aircraft, but significant opportunities.

And you know that's something that we've actually already seen with our ARINC acquisition, where there were airlines that they had a much stronger position with some of their services, and it just gave us access to better understand the needs and the demands of those customers. And we've been able to pick up some share by doing that.

So I think, that's pretty exciting, and I will tell you, it doesn't require a lot of effort on our part. It's mostly channel management. We're talking about the existing product lines of both companies, so it's great upside for us. And we'll probably be able to prosecute those things pretty quickly.

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

So, just to clarify, can you put that $50 million in percentage terms?

Kelly Ortberg - Rockwell Collins, Inc.

Percentage of what?

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

Content increase. So B/E today plus Collins today, after revenue synergies tomorrow?

Kelly Ortberg - Rockwell Collins, Inc.

Well, I haven't looked at it that way, Rob. I'd probably not answer that question right now. I think, you ought to think of it in terms of – if we pick up three to five customers per year, I gave you the per airplane content. That can give you a good way to think about it.

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

Okay. Thank you.

Kelly Ortberg - Rockwell Collins, Inc.

Thanks, Rob.

Operator

Your next question comes from the line of Peter Arment from Baird. Your line is open.

Peter J. Arment - Robert W. Baird & Co., Inc. (Broker)

Hi, yes. Good morning, everyone; and echo Rob's comments, congratulations everyone.

Kelly Ortberg - Rockwell Collins, Inc.

Thanks, Peter.

Peter J. Arment - Robert W. Baird & Co., Inc. (Broker)

Kelly, I guess, maybe most importantly for me is just, could you focus on the, kind of the synergy roadmap on the cost side, kind of you're spending $120 million to kind of achieve that. But how should we think about that in terms of just kind of how that rolls through over the next couple of years. Just basically some of your thoughts on that would be appreciated?

Kelly Ortberg - Rockwell Collins, Inc.

Sure, Peter. Well, first of all, we're going to see those revenue synergies come pretty quickly. We expect 90% of that $160 million to be achieved by our second full fiscal year, which is our fiscal 2019.

And let me give you the four, what I'll say, major financial drivers to those cost synergies, and it will give you a perspective of the timing. The first is eliminating the duplicate public company costs and headquarters that Patrick outlined. That comes right away. That's pretty quick synergy, and that is pretty straightforward as you can imagine in a transaction like this.

The second area is in supply chain savings both direct supply chain where we're buying materials that go in our end products, as well as indirect where we're buying either consumables or things that we use, as well as services that we both buy externally. We think those savings are going to come pretty quickly as well. We've already got a detailed list of our supply chain overlap, where we expect to see synergies, and we based our synergies on previous supply chain consolidation that we've done.

So I think that's pretty straightforward. And again, that will happen pretty quickly. We've got a plan that we'll be able to hit the ground running on those supply chain synergies.

The third area is consolidation of our IT systems, and especially our manufacturing ERP system. And we'll start that right away, but that will happen on a – really a plant-by-plant basis. So that will feather in over time. The first plants will obviously provide the synergies faster, and that will come in over the first three years to four years.

And then last area is leveraging our low-cost country manufacturing and engineering capability. The engineering side is mostly around design centers in India. We both have India design centers in Hyderabad, which will give us opportunity to have some consolidation, but also further leverage that IDC, India Design Center for low-cost engineering.

And then, as you can imagine, global companies like ours are continually looking at where and how we build our products and how we do that in the most efficient manner. Those will take a little bit more time as we shift to some low-cost country manufacturing.

So, I'd say, kind of up-front, you're going to see the elimination of the public costs, supply chain, start of the IT consolidation, and then, over time, the full IT consolidation, and the low-cost country manufacturing and engineering will drive those synergies.

Peter J. Arment - Robert W. Baird & Co., Inc. (Broker)

Appreciate that.

Kelly Ortberg - Rockwell Collins, Inc.

Now, we've got several others. But I would say, these are the four meaningful areas of cost synergy.

Peter J. Arment - Robert W. Baird & Co., Inc. (Broker)

Thanks, Kelly, for the color.

Kelly Ortberg - Rockwell Collins, Inc.

Yeah. Thanks, Peter.

Operator

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

Myles Alexander Walton - Deutsche Bank Securities, Inc.

Thanks. Good morning.

Kelly Ortberg - Rockwell Collins, Inc.

Hey, Myles. Good morning.

Myles Alexander Walton - Deutsche Bank Securities, Inc.

Kelly, a common question I'm getting, I'll give you a chance to answer it. How do you get comfortable or how do you make investors comfortable that, this largest deal you're doing in the company's history, eight years removed from the (35:52), really, the last significant correction in the Commercial Aerospace segment is the right time to be doing this, and in your level of confidence, and in that Commercial Aerospace segments staying strong for the next couple of years, next, a long time, more than couple of years, and doing the deal now?

Kelly Ortberg - Rockwell Collins, Inc.

Good question, Myles. It's something that we spend a lot of time analyzing as a part of the – our decision, here. First of all, let me just say, this is a through-cycle acquisition. We absolutely believe in the long-term nature of air traffic growth.

B/E's business is much more driven to air traffic growth and airline profitability than what I'll say our core Rockwell Collins business is, which is more geared towards the cyclicality of OEM production. I really like that. I think this acquisition actually balances us and provides us opportunities to go into the retrofit market.

As you know, when aircraft OEMs lower aircraft production rate, the airlines will then look to upgrade their existing aircraft. And I believe, we're coming into a major cycle where a lot of wide-bodies are coming off-lease and will be returned to the lessors.

And with that, we're going to see great opportunities for retrofit of the cabins, because these systems, when the aircraft come back to the lessors, they need to be reconfigured for the new airlines that they're going to. That's just an opportunity we really don't see in our core business, so I really like the nature of the aftermarket revenues here.

The other thing I'll say is we're both well-positioned on the wide-bodies that are going to drive the growth with the A350 and the 787. We have in this plan taken a hard look at the overall cycle of the legacy wide-bodies, factored that into our outlook. I'll also say that we did extraordinarily deep due diligence on the B/E backlog. It's very robust.

And I think that, we feel very comfortable that this acquisition is going to manage its way through what will be a – we will see some softness, no question, in wide-body in near-term, but there's also no question for the long-run to deliver the traffic growth, you have to have wide-body aircraft. And for the long-run, this acquisition will create a lot of value for us.

Myles Alexander Walton - Deutsche Bank Securities, Inc.

Okay. And Patrick, what is the net deal amortization for the deal in the first year you own it, inclusive of that $60 million to $90 million purchase accounting benefit?

Patrick E. Allen - Rockwell Collins, Inc.

Well, we – Myles, we're still working on the intangible valuation. So, I don't want to commit to a specific number, but rest assured it's both the reduction in the engineering amortization and the amortization of intangibles are included in the accretion numbers that, Kelly, indicated.

Myles Alexander Walton - Deutsche Bank Securities, Inc.

Okay. Thanks.

Operator

Your next question comes from the line of Cai von Rumohr from Cowen & Company. Your line is open.

Cai von Rumohr - Cowen & Co. LLC

Yes. Thank you and congratulations. To follow up on Myles' question, you've said 10% double-digit accretion in fiscal 2018. So obviously, you must've had some assumptions regarding that amortization, and some assumptions regarding what does include of the $120 million of kind of integration cost, and some assumptions about the number of shares that you issued. Could you just walk us through the assumptions that get us to double-digits?

Patrick E. Allen - Rockwell Collins, Inc.

Well, double-digits is a pretty wide range of potential outcome. One of the things we need to do over the course of the next few months, Cai, is do things like the purchase accounting valuation that arrives at the precise intangible asset amortization. I would tell you that one of the assumptions we made in terms of interest rates is 3% to 3.5% interest rates, I think, is a pretty reasonable assumption, today. And we've made that assumption. In terms of fleshing out some of the more detailed calculations, I prefer to get farther down the line in terms of the valuation of the intangible assets of B/E.

Cai von Rumohr - Cowen & Co. LLC

But I mean, you've made a statement of 10%. So even if we take the lower-end of that, you must've had some assumptions regarding, are we going to be at the upper or the lower end of the collar on the share count, and those sorts of things. So, just if you could get us the assumptions to get to the low-end of the double-digits?

Patrick E. Allen - Rockwell Collins, Inc.

We assumed in our analysis that there wouldn't be any adjustment to the collar; in other words, that the share price would be unaffected. So there is some variation around that. I want to say, it's probably a couple of points of accretion going either way.

Cai von Rumohr - Cowen & Co. LLC

Okay. Thank you.

Operator

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

George D. Shapiro - Shapiro Research LLC

Yes. I want to just be clear on the double-digit accretion. Does that include the effect of all of the synergies, I mean, or by fiscal 2018 you won't have, you say, 90% within a couple of years. So how much of the synergies is included in that double-digit?

And then on the $60 million to $90 million benefit, I assume that the $60 million, the low-end is what you see over the year or two. So if you could just mention what those specifics were for the double-digit accretion?

Patrick E. Allen - Rockwell Collins, Inc.

Yeah. George, you're absolutely right. The 2018 numbers assume – think of it as a GAAP accretion number relative to what Rockwell Collins would be on a standalone basis. It includes a share of the synergies, so we'll be accelerating from 2018 to 2019 as the synergies lay in, as Kelly had indicated. So, we'll have a portion of the synergies. And also, that amortization starts around $60 million a year. Think of it as $60 million in 2018, which is our first full fiscal year, rising to $90 million over the planning period.

George D. Shapiro - Shapiro Research LLC

Okay. Okay. Thank you. I'll stick with the one question.

Patrick E. Allen - Rockwell Collins, Inc.

Thanks, George.

Operator

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

Carter Copeland - Barclays Capital, Inc.

Hey. Good morning, gentlemen.

Kelly Ortberg - Rockwell Collins, Inc.

Hi, Carter.

Patrick E. Allen - Rockwell Collins, Inc.

Good morning, Carter.

Carter Copeland - Barclays Capital, Inc.

I wondered if you could back up to some of the early comments you made on the transaction, Kelly, related to the multi-year strategic review that you said had been underway. I just – we hadn't heard about that before. I wonder has it helped shape the decision to do this transaction? What did that reveal in terms of growth or profitability or particular challenges or opportunities? What was it about that look at your business that said, this is where we need to go to address X or Y? Any color you can help us with there would be appreciated.

Kelly Ortberg - Rockwell Collins, Inc.

Yeah. Well, the only thing I'd say is, it was a look at how to optimize as opposed to a defensive, any kind of a defensive maneuver. But clearly, there's some things that as you look at our core business that's factored into our thinking, one is that we now have all the cockpits on Boeing's next-generation aircraft, which is providing us great growth between now and when the 777X comes in. But at that point, we aren't going to have as many opportunities to gain share as we already have 100% of that particular market share. Now, there will be some new airplanes, but to continue at the growth rate, we feel we needed a broader portfolio of offerings.

Another factor is the business aviation OEM environment as we all know, and we've seen over the last several years is, it's questionable when that end market is going to recover. And I don't think, as I look at our core business, that we can be assured that that's going to be a growth engine for us going forward.

Now, we're not going to get out of that business. It's very important. We have to get a lot of leverage across our other end markets. We use common product lines; it's a technology incubator for a lot of what we do. But again, as I look at how we're going to optimize the growth of the company, we felt we needed to have more opportunities to do that.

So, we did look at those two alternatives I outlined in my opening remarks. And I think, one of the things about Rockwell Collins, while we've got a great technology base, if you talk to customers about what separates us in the marketplace is the relationship. They know we'll do what we say we're going to do. They trust us. They know we're going to support them and their customers in their long-term business opportunity. So we felt leveraging that capability was the best way to go, and looking at how to broaden our portfolio.

And as I mentioned, one of the important criterias of making sure as we're broadening that portfolio, we broaden that with someone who, first of all, understands that portfolio, is well-positioned in the market, has enough scope and scale that we're assured success. And B/E is just a great fit with all of their product lines being top in the market, well-established. Look, this is not a – they don't need fix-up from Rockwell Collins. This is a well-run business with well-respected positions.

But they're also at a time where they're being challenged by the customers to provide more, what I'll say, smart implementation of their equipment. You can kind of think of the future airplane that all of the galley equipment is going to need to be a node on the network to either provide a better passenger experience, to allow the crew to interact differently with the passengers or for improved maintenance actions. And they're being pressed by their customers to bring up smart devices, smart cabin interior devices that integrate that capability. They don't have that, we do. We don't have the products, they do. So it's a really nice fit for us.

And I think, we're going to be uniquely positioned to work with both the airlines and the OEMs to help shape that and provide a more efficient, effective interior market for them going forward. So, I see a lot of good things about this opportunity here, today.

Carter Copeland - Barclays Capital, Inc.

Great. Thanks, Kelly. I'll stick to the one.

Kelly Ortberg - Rockwell Collins, Inc.

Thanks.

Operator

Your next question comes from the line of Rajeev Lalwani from Morgan Stanley. Your line is open.

Rajeev Lalwani - Morgan Stanley & Co. LLC

Thanks for your time. Just in terms of the transaction and some of the comments you made earlier, can you just talk about how you're shifting your business mix a bit going more towards commercial versus defense? Is that something that you're doing deliberately, or is this more of an opportunistic type transaction? And I asked it for the obvious reasons as sort of investors seem to prefer more sort of safer business just on the defense versus that commercial side? Thanks.

Kelly Ortberg - Rockwell Collins, Inc.

Well, there's no question we have historically been more balanced between commercial and military market, and this shifts that balance more towards commercial. Having said that, I do believe there's opportunities for us to grow this portfolio in the military market. So I'm pretty excited about those opportunities.

If you think about Rockwell Collins, we actually do a lot of work in the cabins of military aircraft. It's mostly mission systems equipment that we put in, either air refueling, signals intelligence, communications, networks, those types of things. But all those aircrafts when they're getting modified, all the interior systems are needed and are being modified.

So I think that the business will present some significant opportunities for us to grow the military market. And as that business recovers, we'll see some increased shift back to a little bit more balance there.

I don't have a view that we need to stay 50/50 commercial and defense. I think that the mix and the balance is much more important at the product line that you need to have the scope and scale there to compete effectively at the product line. And so, I feel quite comfortable with the overall mix shift here going forward. And as I said in my other remark, we are absolutely a believer that air traffic is going to continue to grow at that 4% to 6% historical growth rate.

And so, while I'm sure there will be OEM fluctuations through that, in the long run, in order to deliver that traffic growth, there needs to be aircraft interiors and seats and all the things to deliver that. So, I feel very comfortable with this move. And I think, it diversifies us, as I said, with much more aftermarket opportunities.

I really like the fact that the interiors get modified multiple times in the life of an aircraft. Our avionics typically don't, other than mandate updates, they tend to stay on wing through the full life of the airplanes. So this really gives us a lot more retrofit opportunities, which when the OEM rates are being perturbated (50:18), it gives us other areas to offset that.

Rajeev Lalwani - Morgan Stanley & Co. LLC

Very helpful. Thanks for the time and congrats.

Kelly Ortberg - Rockwell Collins, Inc.

Thanks.

Operator

Your next question comes from the line of David Strauss from UBS. Your line is open.

David E. Strauss - UBS Securities LLC

Thank you. Good morning.

Kelly Ortberg - Rockwell Collins, Inc.

Hi, David. Good morning.

David E. Strauss - UBS Securities LLC

Hey, congratulations. So, you've talked this double-digit accretion. It sounds like it's off of whatever you were expecting for fiscal 2018 on a stand-alone basis. I guess, just to level set us, can you help us what you were actually expecting? I think you've previously been talking about double-digit EPS growth, but if you could just level set us there. And then just quickly on your guidance, the Commercial Systems guidance of flat, a little bit worse than what I was expecting even with business jets being weak. Can you kind of break out the individual components there? Thanks.

Kelly Ortberg - Rockwell Collins, Inc.

Let me hit the top line guide, and then I'll ask Pat, to come back on the EPS accretion. If you look at our biz jet OEM revenues for fiscal 2017, they're actually going to be down a little bit more than the OEM's production rates that you're probably basing your outlook on.

There's a pretty significant amount of inventory in the system that's going to be fleshed out. So we are going to see significant declines year-on-year again in our OEM revenues, that's going to essentially offset the growth that we have in air transport. And then the other factor is that, we've seen all year the parts recycling in the aftermarket – air transport aftermarket, and we factor that in and expect our overall aftermarket to be relatively flat because of that phenomenon.

Patrick E. Allen - Rockwell Collins, Inc.

And as it relates to the accretion, dilution question, I'm going to give you a total unsatisfactory answer, I think David but, it is correct that your – it is the accretion over what we otherwise would be planning as a standalone company. However, we don't typically give individual years out beyond that you were looking at. So I think it's fair to say that we would anticipate growth in the business, but I'm not going to get more specific than that.

David E. Strauss - UBS Securities LLC

Okay, Kelly, on business jets, just to follow up, are you thinking business jets down 15%, 20% for you in 2017, business jet OE?

Kelly Ortberg - Rockwell Collins, Inc.

Well, the biz jet OE will be – but as we reported, it also has regionals. So we'll see some offsetting regionals. So, I'd say down high-single-digit for the combination.

David E. Strauss - UBS Securities LLC

All right. Thank you.

Operator

Your next question comes from the line of Ron Epstein from Bank of America. Your line is open.

Ronald Jay Epstein - Bank of America Merrill Lynch

So, Kelly, just help me get my head around this. This is the part that I don't understand; in terms of the diversification strategy, it seems like a bit of a barbell, at least from a technology point of view, right? When I think about Collins and its core strength in communications and electronics and all that, the really cool stuff you do, how do I sort that out with stepping down the technology ladder, and doing seats, coffee makers, toilets? I mean, I'm having a hard time understanding that?

Kelly Ortberg - Rockwell Collins, Inc.

Yeah, Ron. Well, first of all, let me just say that, I think you underestimate the complexity, the amount of engineering that goes into these pieces of equipment. It's highly engineered, as I mentioned. The whole certification process is extraordinarily complex. And I'd just say go look at how many people are in the markets in these particular commodities, it's a big barrier to entry. So I think your thought that this is not complex is probably a little bit off.

I would also say that, they have historically been standalone systems. There's no question that what we do has more software control content in it than what B/E does today. But I see that as a great opportunity, because that's going to shift over time. Everything is going to become a smart device. We're going to be embedded microprocessors in everything. We're going to be embedding software and software applications across the airplane. I think this is a great opportunity for us to bring these portfolios together and seize that transformation that's going to happen in the market.

So I think, if you look five years, six years ahead, you'll see that this is a much different looking product line with sensors, embedded sensors, controls, Wi-Fi interfaces, secured networks throughout the airplane. Those are all the expertises that Rockwell Collins has, and it's going to bring to the excellent product line that B/E has.

Ronald Jay Epstein - Bank of America Merrill Lynch

And just if I can push back a little bit on one point. Travelling around and visiting a bunch of the air shows at different places in the world, the one area where it does seem there is some traction in the supply chain, for example, in China, would be overhead bins and seats and IFE, right? I mean, it just doesn't seem like the barriers to entry in those markets are as severe as they are in your core electronics market. So, I mean, maybe, I'm understanding that wrong, but it just doesn't seem that way at first glance.

Kelly Ortberg - Rockwell Collins, Inc.

Well, I think you got to go look at the respective market shares by product lines. And there's no question that B/E has a very high market share, a very high win rate in competitions as they're competing for these products and services, and there are not that many competitors.

So I think, we feel very comfortable that this product line, it's highly-differentiated, highly-engineered and create significant barriers to entry for commoditization. These are not commodities in the – particularly in the front of the aircraft. This is what differentiates the airlines from one another and they take these things very, very seriously. And again, I think we'll be able to bring technical capability to B/E's product line in a way that will even further differentiate us going forward.

Ronald Jay Epstein - Bank of America Merrill Lynch

Okay. Great. Well, thank you for answering the questions here. Have a good morning.

Kelly Ortberg - Rockwell Collins, Inc.

Thanks, Ron.

Operator

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

Howard Alan Rubel - Jefferies

Well, thank you very much. Just a couple of high-level deal questions. Can you talk about the break-up fee and some of the regulatory challenges, what agencies do you need to see? And how did you arrive at the spring date? It seems reasonable, but just want to check?

Kelly Ortberg - Rockwell Collins, Inc.

Yeah. So, we don't anticipate any regulatory challenges, but we do have to go through all the regulatory filings. And because of the global nature of our respective companies, we have those filings in a lot of different jurisdictions. We think probably China's approval would just be the long pole in the tent. From an administrative perspective, we don't anticipate any issues there. We've picked spring of 2017; I think that's probably reasonable. I will tell you, if we get through that a little faster, then we'll be ready to go as soon as we get those regulatory approvals going forward.

The break-up fees are – is structured where, if B/E board which has unanimously approved the deal as has Rockwell Collins board. But if they would change their recommendation to approve the deal, then they would have to pay $200 million of break-up fee. And likewise, if Rockwell Collins board changed their approval or recommendation, then we would pay $300 million of break-up fee.

Howard Alan Rubel - Jefferies

I mean then, Kelly, one last item. It stood out in your earnings that you had a notable uptick in some classified business; while I don't want to ask what that is, I'd like to find out whether it's recurring in any nature or can you elaborate on that degree?

Kelly Ortberg - Rockwell Collins, Inc.

Yes, it's recurring for long-term.

Howard Alan Rubel - Jefferies

Thank you very much.

Ryan D. Miller - Rockwell Collins, Inc.

Operator, we have time for one more question.

Operator

And our last question today, comes from the line of Sam Pearlstein from Wells Fargo. Your line is open.

Samuel J. Pearlstein - Wells Fargo Securities LLC

Good morning.

Kelly Ortberg - Rockwell Collins, Inc.

Hi, Sam.

Samuel J. Pearlstein - Wells Fargo Securities LLC

Kelly, if I can just follow-up on the whole discussion around the digital aircraft that you're saying in terms of nodes on the network. Is this a new area of development that we should expect to see, and can you discuss really what the trajectory, what that means in terms of R&D, both customer and company-funded over the next few years in the combined company?

Kelly Ortberg - Rockwell Collins, Inc.

Yeah. I don't think you're going to see us shift our overall combined company R&D focus. What separates us and what separates B/E is the fact that we both invest heavily in technology and next-generation product lines, so we're not going to stop that in any way, shape or form.

B/E is already underway in some areas of their product line moving to the wide-body interface and the smart device and embedding sensors in there, so this is here now. They need some capability, help around integrating that system, creating the applications. We do the secure firewalls, the onboard routers, switches, wireless distribution on the aircraft, so I think we can bring a lot of capability to help accelerate the product line implementation of the smart technology.

Samuel J. Pearlstein - Wells Fargo Securities LLC

Okay. And just a quick one, Patrick, what is the assumption in terms of pre-production engineering change in fiscal 2017 that's embedded in the guidance?

Patrick E. Allen - Rockwell Collins, Inc.

The pre-production engineering change is about $25 million on a net basis.

Samuel J. Pearlstein - Wells Fargo Securities LLC

Up or down?

Patrick E. Allen - Rockwell Collins, Inc.

Up.

Samuel J. Pearlstein - Wells Fargo Securities LLC

Okay.

Patrick E. Allen - Rockwell Collins, Inc.

Sorry. Down.

Samuel J. Pearlstein - Wells Fargo Securities LLC

Thank you.

Patrick E. Allen - Rockwell Collins, Inc.

Down. Down.

Samuel J. Pearlstein - Wells Fargo Securities LLC

Yeah. Okay.

Kelly Ortberg - Rockwell Collins, Inc.

Wait. Wait. Just to clarify, Sam.

Patrick E. Allen - Rockwell Collins, Inc.

$25 million down. I'm sorry, Sam.

Samuel J. Pearlstein - Wells Fargo Securities LLC

Okay. Thank you.

Kelly Ortberg - Rockwell Collins, Inc.

Okay. Well, thanks, everybody, for joining the call with us today, and the insightful questions about the transaction. On behalf of Amin, Patrick and I, we look forward to continuing the dialog. I know many of you will have more questions and we'll be out in the market talking with you in the coming weeks and months.

We cannot be more excited about the combination, and we look forward to providing updates as we progress through this process. We do plan to file our 10-K in about three weeks. So, review that document for additional disclosures. And thanks, everybody, for participating with us in the conference call today.

Operator

This concludes today's conference. You may now disconnect.

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