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Executives

Douglas R. Wilburne - Vice President of Investor Relations

Scott C. Donnelly - Chairman, Chief Executive Officer, President and Member of Management Committee

Frank T. Connor - Chief Financial Officer and Executive Vice President

Analysts

Heidi R. Wood - Morgan Stanley, Research Division

Carter Copeland - Barclays Capital, Research Division

Jason M. Gursky - Citigroup Inc, Research Division

David E. Strauss - UBS Investment Bank, Research Division

Cai Von Rumohr - Cowen and Company, LLC, Research Division

Julian Mitchell - Crédit Suisse AG, Research Division

George Shapiro

Robert Stallard - RBC Capital Markets, LLC, Research Division

Jeffrey T. Sprague - Vertical Research Partners Inc.

Myles A. Walton - Deutsche Bank AG, Research Division

Stephen E. Levenson - Stifel, Nicolaus & Co., Inc., Research Division

Ronald J. Epstein - BofA Merrill Lynch, Research Division

Charles Stephen Tusa - JP Morgan Chase & Co, Research Division

Samuel J. Pearlstein - Wells Fargo Securities, LLC, Research Division

Textron (TXT) Q1 2012 Earnings Call April 18, 2012 8:00 AM ET

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the Textron First Quarter Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Vice President, Investor Relations, Mr. Doug Wilburne. Please go ahead.

Douglas R. Wilburne

Thanks, Greg, and good morning, everyone. Before we begin, I'd like to mention we will be discussing future estimates and expectations during our call today. These forward-looking statements are subject to various risk factors, which are detailed in our SEC filings and also in today's press release.

On the call today, we have Scott Donnelly, Textron's Chairman and CEO; and Frank Connor, our Chief Financial Officer. Our earnings call presentation can be found in the Investor Relations section of our website.

Moving now to first quarter results, starting with Slide #3. Revenues in the quarter were $2.9 billion, up 15.2% from a year ago. On a GAAP basis, we recorded income from continuing operations of $0.41 per share, which compares to earnings per share of $0.10 in the first quarter of 2011.

Moving to cash flow, first quarter manufacturing cash flow before pension contributions was a $106 million use of cash. First quarter pension contributions were $144 million.

With that, I'll turn the call over to Scott.

Scott C. Donnelly

Thanks, Doug, and good morning, everybody. I believe our first quarter financial results represented a very solid start to the year, reflecting growth in our commercial aircraft and industrial end markets and continued operational execution improvements across all of our businesses. We also secured a number of key program wins and made some important strategic moves in the quarter that should help provide growth in the long term.

Starting with systems, we won 2 important unmanned aerial systems fee-for-service contracts from the U.S. DoD. The business model for these fee-for-service programs is different, and we normally -- in that we will be investing CapEx in the platforms upfront and in turn, we'll be receiving cash over time as we operate the assets to deliver services to our customer. These 2 contracts were important for a number of reasons. First, the addition of what we expect will be meaningful revenue streams over the next several years at Textron Systems. And second, both these awards are based on our Aerosonde unmanned aircraft, which is a smaller air vehicle than our traditional Shadow models. So we'll now have a second product platform deployed with the U.S. military, which should lead to future opportunities. Finally, these contracts provide an opportunity to demonstrate the attractiveness of fee-for-service UAS arrangements for additional U.S. and foreign military applications.

Moving over to our Finance segment, we continue to have success with our non-captive exit strategy as we liquidated $171 million in non-captive finance receivables during the quarter, including $67 million reduction in our Golf portfolio. This included the disposal of 13 golf course mortgages and one owned golf course at favorable prices. Our non-captive portfolio now stands at $780 million. We generated income in the quarter, which reflected profitability in both captive and non-captive portfolios.

Shifting to Industrial. Operating performance was solid, with revenues up at each of the business units. We did see some softness in European auto and tool markets as expected, but this was more than offset by strength in North America.

Moving now to Cessna. We delivered 38 jets in the quarter, up from 31 last year and saw a double-digit growth in our aftermarket business. More importantly, we continue to see improvement in customer activity. New orders were higher than last year's first, second and third quarters combined; and our customer prospect list continues to improve. We had several additional positive developments at Cessna in the quarter, including an improvement in the range specification of the new Citation Latitude from 2,000 nautical miles to 2,300 nautical miles, the first flight of the new Ten, the first flight of the M2, delivery of our 400th Mustang and the announcement of new service capabilities in China.

Expanding our Chinese service capability is part of our accelerated China strategy for which we also announced a very important agreement with AVIC to develop a Chinese general aviation business. We expect that this agreement will lead to a number of business opportunities. We expect to form a JV with AVIC and the Chengdu municipal government, which will focus initially on final assembly and completions of our Sovereign product line for our Chinese customers and will ultimately evolve to include a number of activities, ultimately including the development of a new aircraft. We're obviously very excited about this opportunity and believe this positions Cessna very well to participate in what will be a significant growth market.

To wrap up with Bell, we delivered 10 V-22s, 7 H-1s and 30 commercial helicopters in the first quarter versus 9 V-22s, 4 H-1s and 15 commercial units in last year's first quarter. Solid execution on the ramp up in these deliveries allowed us to post another quarter of excellent financial performance. The commercial demand environment of Bell continues to strengthen and based on order activity underway, we still expect to see a significant increase in deliveries this year.

During the quarter, we also expanded the addressable market of Bell with an important product announcement at Heli-Expo, the 525 Relentless. This new 16-passenger super-medium helicopter will offer best-in-class capabilities, including superior payload, range, cabin, and cargo volumes. The 525 will have a fully integrated glass cockpit featuring the Garmin 5000, integrated avionics suite, a pair of GE CT7 engines and a BAE fly-by-wire flight control system. The Relentless will be especially well suited for deep water offshore applications in oil and gas and will also serve as a great platform for search and rescue, emergency medical services, and VIP and corporate missions. The 525 is a strategic new product for Bell, which we will expect will meaningfully contribute for future commercial growth.

To wrap up the quarter, we are seeing encouraging signs in our commercial aircraft markets at both Bell and Cessna. We posted strong results at Bell and Industrial and much improved results at Cessna.

At systems, we had 2 important program wins in a challenging defense environment. Overall, I think we're focused on continuing to prove our tactical execution, at the same time, we're also investing in making strategic moves to grow our business over the long term.

With that, I'll turn the call over to Frank.

Frank T. Connor

Thank you, Scott, and good morning, everyone. Manufacturing segment profit in the quarter was $247 million, up $80 million from the first quarter of 2011 on a $342 million or a 13.9% increase in manufacturing revenues.

Let's look at how each of the segments contributed, starting with Cessna.

At Cessna, revenues were up $113 million on a year-over-year basis as a result of a $23 million -- or a 23% increase in jet unit deliveries and an 18% increase in aftermarket revenues. We narrowed our operating loss by $32 million from the first quarter of 2011, primarily on higher volume.

At Bell, revenues were up $245 million on increased V-22, H-1 and commercial deliveries. Segment profit increased $54 million, primarily reflecting higher volumes and the mix of commercial aircraft.

At Textron Systems, revenues were down $68 million, reflecting lower volumes. Segment profit decreased $18 million, primarily due to the lower volumes.

Industrial revenues increased $52 million, reflecting higher volumes, partially offset by a $12 million negative impact of foreign exchange. Segment profits increased $12 million, primarily due to the higher volumes.

Moving to Finance. Segment profit was $12 million for the quarter. Finance receivables ended the quarter down $267 million from the end of last year. Credit performance improved during the quarter with non-accruals ending the quarter at $290 million, a decrease of $31 million from the prior quarter. And 60-day delinquencies were $143 million, an improvement of $23 million from the fourth quarter.

Moving to corporate items. Corporate expenses were $47 million, up from $39 million last year, primarily due to the impact of -- that our higher share price had on compensation expense. Interest expense was down $3 million from a year ago.

To conclude, we remain on track for our full year EPS outlook of $1.80 to $2 a share and cash flow from manufacturing operations before pension contributions of $700 million to $750 million.

That concludes our prepared remarks. Greg, we can open the lines for questions.

Question-and-Answer Session

Operator

And our first question will come from Heidi Wood with Morgan Stanley.

Heidi R. Wood - Morgan Stanley, Research Division

Yes. Can you talk us through the puts and takes on Cessna reconciling the 18% increase in aftermarket with -- which should reduce profits with what we saw and why you're so confident in achieving this for your goals for the year?

Scott C. Donnelly

Well, I think, Heidi, if you look at the conversion rates, obviously, I think if you go back to the first quarter of last year to the first quarter of this year, it's quite a bit higher than the 18%, but I do think that if you look at over the course of the year, we still think that given what remains kind of a difficult pricing environment and relatively lower volumes, you kind of get into a laundry list of things that are moving around. I still think that over the course of the year that, that's about the leverage that we'll expect to see. So we had a reasonable conversion versus the previous quarter, but I think as you look through the year, I still feel pretty confident it's going to end up somewhere around that 18-or-so percent.

Heidi R. Wood - Morgan Stanley, Research Division

All right, great. And one last question. Can you -- we want to dig into the Bell margins a little bit more. Talk a little bit about the sustainability of that and what sort of drove that nice margin performance.

Scott C. Donnelly

Well, the Bell margins, as you know, we've talked about the challenges this year of being around significant increases in commercial deliveries. Obviously, even within that there are some mix issues depending on the models. So I think for the quarter, obviously, we saw solid growth in terms of the military side. Certainly, commercial was up from 15 to 30 helicopters, but I think we're going to see even more significant unit growth over the course of the year on the commercial, and most of those are going to be somewhat dilutive in terms of margin rates. We also have increased R&D that's going up. So again, I think the numbers that we've guided over the course of the year is certainty attainable. The guys are doing a nice job in managing the ramp and controlling costs, but we are going to see a much heavier mix through the balance of the course of the year on the -- particularly on the wider commercial helicopter volume.

Operator

And our next question comes from Carter Copeland of Barclays.

Carter Copeland - Barclays Capital, Research Division

Just quickly on systems, I wondered if you might give us a little bit more color about the decliners there. You had mentioned your expectations for flat revenues, although I recall in the last quarter, there was some commentary about conversion of some opportunities on UAVs. Any color you can provide us there on what you saw the decline in the quarter and what surprised you there?

Scott C. Donnelly

I don't know that anything surprised us a whole lot in the quarter. Obviously, the trend that we saw all through last year and that we still see into this year is just things moving relatively slowly in terms of getting contracts let, going through the whole proposal, evaluation and award process. We didn't have any surprises in the quarter, where something that we thought was going to happen either didn't happen or volumes were issued at a lower rate, and I still think that we're feeling like we're going to guide to a flat year. Obviously, what was important in the quarter as we came into the year needing to get a couple of very important wins on the UAS business in particular, and we won both of those. Now those don't generate a lot of revenue in 2012, so we said we'll spend most of the rest of the year building out the systems and getting those deployed per specific task orders with both the Navy and the Marines and SOCOM, but those things will all be out there. And they've got between 3 and 5 years of pretty solid revenue generation beyond that. So I think those were important wins, again, not so much they had a lot of impact or were forecast to have a lot of impact in 2012, but very important for us in the '13 to 'l5-or-so time frame.

Carter Copeland - Barclays Capital, Research Division

Great. And one quick follow-up for Frank. The corporate expense, you noted the step-up due to the higher stock price and relative to the amount, I think it was $145 million, you talked about on the last call for corporate expense for the year. How much should we be assuming that, that steps up as a result of this?

Frank T. Connor

Yes, it probably steps up about $10 million if the share price stays in and around these levels.

Operator

And our next question is from Jason Gursky with Citigroup.

Jason M. Gursky - Citigroup Inc, Research Division

I was wondering if you could talk a little bit about this DoD contract structure that you talked about on the UAS. Is that something unique? And how did this come about?

Scott C. Donnelly

Well, I think this is a trend that you're going to see more of in this sort of a fee-for-service, so particularly these UAV vehicles, how much ISR is required and where is it required both by, in this case, the Navy and Marine Corps is one program and SOCOM being the other program, where instead of having the military tie up a certain number of systems, they're looking for the industry to provide those systems and actually own and operate those systems and be able to deploy as required. So I think it's trying to create -- at least, it's a tool they're looking at and a technique they're looking at, I think, to create a more dynamic, more capital efficient way of utilizing these kinds of assets. So instead of tying it up within the 4 structure in one particular location, by having those resources and that capital owned by the industry, they can simply issue task orders and deploy them as required in a much more capital efficient structure. I think that's the intent. And of course, the difference for us is, I think ultimately from a profitability standpoint, we'll do quite well on this, but it does require that we have that capital because then we're the ones that can turn around and respond to what their needs are and allocate those same resources in different locations at different times over a period of 3 to 5 years.

Jason M. Gursky - Citigroup Inc, Research Division

Right. Okay, that's helpful. And then Frank, you've mentioned that the guidance holistically stays in place. I'm wondering, given the results of this quarter, whether you wouldn't mind walking through the segment level guidance and maybe give us some puts and takes on what you're now expecting for the rest of the year.

Frank T. Connor

Yes, well, we're really the same in terms of that segment level guidance as we've -- there are puts and takes in and around the ranges, but generally within those ranges we're still fine with that. The one change to that being on the Finance segment, given the first quarter results, we had suggested Finance to be kind of breakeven-ish. We think that the captive business will be profitable as we had indicated in our outlook. We think that non-captive, given the performance we're seeing right now, probably is more around breakeven. So overall, we think Finance will be positive for the year versus breakeven, but otherwise, kind of we're in the same ranges on the segments.

Douglas R. Wilburne

And then Jason, just to add to that, I think that when you think of the holistic picture there, Frank mentioned that corporate expense is going to be up a bit, we're looking at a higher share count given the share price as well. So all in, it still comes out into the same range as we're sitting here today.

Operator

Our next question comes from David Strauss with UBS.

David E. Strauss - UBS Investment Bank, Research Division

Back to the margin question at Cessna, you compared it to Q1 of last year. But if you look at it compared to Q2 of last year where deliveries were pretty similar overall but your mix was actually a little bit better this year. Last -- in Q2 last year, you were able to generate a profit. Could you maybe just compare this quarter, the moving pieces this quarter versus Q2 of last year where the deliveries were pretty similar?

Scott C. Donnelly

Yes, I think if you looked at the comparison, and we've obviously done that, David, just to understand sort of the moving parts here, I mean, you're right. We had a few fewer Mustangs than we had back in that quarter. There are some other mix issues pushing around there in terms of just the mix of the different models of aircraft that was -- that worked against us a little bit. But look, there's also some pricing that is still difficult in the marketplace out there. I think ultimately, we got to push to get that better, but it has not been favorable over the past year, so we took a bit of a hit on pricing. And I think really one of the bigger issues here is at the volumes that we're running and the cost structure we have, the numbers are such that things that would normally be sort of lost in the noise around LIFO adjustments and accrual for some severances in our Citation, you get down to sort of a laundry list of numbers that are frankly all relatively small numbers, but when you're talking about small numbers of absolute margin, they make a difference. So I guess, the bottom line is a little bit of unfavorable mix in the numbers of jet deliveries, continued pricing pressure and a bit of one-timers in there that normally I don't think would be something that would move the needle very much that in this environment is making a difference.

David E. Strauss - UBS Investment Bank, Research Division

So R&D wasn't a major factor?

Scott C. Donnelly

It wasn't a huge factor. I mean, again, you get into this saying, well, look, our R&D, absolute spending can go up, but we also had some stuff we wrote off in the quarter which went back to 2011. So at least, in that kind of a causal, if you look between those 2 quarters, not a major factor.

David E. Strauss - UBS Investment Bank, Research Division

Okay. And as a follow-up, moving to Bell on the commercial side, 429 deliveries were a lot lower than where I thought they would come in. Talk about what's going on there, and have you gotten the certification for the 500-mile-range increase in the U.S. yet?

Scott C. Donnelly

So 429, there's no change in terms of our expectation in 429 deliveries this year. There's a bit of timing in there just because of where they're laying in the year, so you're right, there was only a couple in the quarter, but there's no fundamental change in what we're expecting in terms of 429. That's part of the issue that's a pressure for us, obviously, in the next 3 quarters, is we'll see significant increases in things like the 429 models. The regulation issue, that's 500 pounds of capacity, which has gotten through and been approved by the Canadians. It is in with the FAA right now. I feel pretty good about it, and I think it's something that will happen in the fairly near term

Operator

And our next question comes from Cai Von Rumohr with Cowen and Company.

Cai Von Rumohr - Cowen and Company, LLC, Research Division

So kind of moving back to Cessna, could you tell us where is the level of any abnormal preowned losses or forfeiture gains, and maybe give us some color -- the trend in demand and pricing as we went through the quarter. I mean, do we enter the second quarter with any appreciable change, or is it kind of really the same throughout the quarter?

Scott C. Donnelly

I think it's about the same throughout the quarter, Cai, in terms of pricing environment. In terms of the used market, I would say, it continues for the most part to be pretty stable. I mean, we're talking about fairly small numbers in terms of things like write-downs and forfeiture deposits. These numbers have become sort of a couple million here, fairly inconsequential numbers, so fairly significant. I would say, continued stability and when you look at our used available for sale of our kind of in-production models, they're getting lower and lower, right? They're down in the 5%, 6%, 7% of the fleet kind of numbers. So that piece of the market in terms of competition for new orders, which is part of what makes pricing tough when you've got relatively new aircraft out there, does continue to get smaller, but it's not gone.

Cai Von Rumohr - Cowen and Company, LLC, Research Division

Okay. And then to the first question, the preowned losses or forfeiture gains, were they much of a factor?

Frank T. Connor

They are low -- very low single digits and largely offset each other.

Cai Von Rumohr - Cowen and Company, LLC, Research Division

Okay. And then, one of your competitors, Hawker, has asked for -- has a forbearance agreement with its lenders currently. If Hawker were to go into bankruptcy, would you be interested in pursuing any or all of that operation?

Scott C. Donnelly

I guess, Cai, I would say that we keep an eye on that like most people, and there are certainly some assets there that we think would be very interesting.

Operator

Your next question comes from the line of Julian Mitchell from Crédit Suisse.

Julian Mitchell - Crédit Suisse AG, Research Division

Yes. So just firstly on Cessna, I mean, it sounded like from the volume outlook, at least, you are more positive in terms of order trends, what you've seen in Q1. If you could talk a little bit about maybe anything on, by region, what you're seeing and then also the effect that, that might have had on your sort of updated assumptions for things like R&D and CapEx. I mean, I think for overall Textron, you talked 3 months ago about R&D up $110 million, CapEx up about -- to about $450 million. Have you sort of changed any of those outlooks given what's happening with demand in Cessna and in Bell commercial?

Scott C. Donnelly

No. I think, Julian, everything's very consistent with our plan. Obviously, the new product programs at Cessna, driven large part right now with the M2 and the Ten are in-flight test programs. The Latitude, obviously, is in its early stages of detailed design. The 525, as we announced, is also a program now that's in its early stages of detail design. So the CapEx associated with those programs, again primarily around tooling, which is really what's driving most of our CapEx budget there and the R&D numbers that we kind of guided to are all completely within what we expect them to be for the year. So there is no change. And again, in terms of the market, I think if you look at what's going on in the orders and level of customer activity at Cessna, it's where we expected it to be. So I still feel pretty confident about what we are thinking in terms of the total volume of deliveries for the year. And the same is true with Bell. The market's been strong, the backlog is there, the level of activity and order rate is where we expected it so that we should ultimately have the commercial deliveries fall in line with our guidance.

Frank T. Connor

Yes, I'd just add, the only thing that -- on the CapEx side that puts a little pressure on our CapEx number to the upside are these wins at systems. And depending on the volume ultimately of the task orders that are let, the amount of equipment that we would look to field this year. But we don't think that, that's a big number, but that kind of does have some impact on the CapEx number.

Scott C. Donnelly

Right. The only differentiator there is those are revenue-generating numbers as opposed to what we traditionally think of as CapEx, right, which is around the tooling and our infrastructure. Those are assets that would be required to go perform those contracts.

Julian Mitchell - Crédit Suisse AG, Research Division

Sure. And then just a quick follow-up on systems. I mean obviously you had -- in Q4, you had a charge around severance relating to the cost base and so on. You've had a decent sort of revenue drop here, but it sounds like the full year outlook is still flattish. How do you feel about the cost base in systems when you're looking out this year or thereafter? I mean, do you think you've done enough on the costs for the time being given that Q1 was, it sounds like, as you expected?

Scott C. Donnelly

Yes, I think, again, it's pretty consistent with our expectations. When we announced the restructuring and we looked at the costs and in particular, for the most part employees affected by that, where we thought we needed resources and where we thought we needed to do restructuring given the current environment, really remains unchanged. I mean, the reality is for some of these programs, particularly for these fee-for-service, where we actually will be adding resources to go execute those programs. But those are different people in a different skill set than those who've been affected by the restructuring. So again, Julian, I think, pretty consistent with what our expectations were going into the year.

Operator

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

George Shapiro

At Bell, can you tell us what the commercial aftermarket and military aftermarket growth rates were?

Frank T. Connor

Yes. We did see some growth there that -- those are not numbers that kind of we break out separately, but we are seeing growth in those areas -- and on the commercial side, it's at rates that are lower than what we've seen at Cessna, but we are seeing growth.

George Shapiro

Still double-digit numbers or below that?

Frank T. Connor

We don't kind of -- we don't break those numbers out separately.

George Shapiro

Okay. And then one, Scott, maybe if you could give a little more color on the JV with AVIC. I mean, you were talking about potentially a larger cabin jet. I mean, is this something in the Columbus category or even bigger, and if you could give some specifics about timing and development.

Scott C. Donnelly

Well, the timing, George -- as you know, the joint venture kind of goes through a few phases here. We started out by putting a completion center capability in Chengdu so that we can deliver basically a green aircraft out of Wichita and do all of our customizations interior completions, paint, finish and all that for delivery into China out of our Chengdu operation. Ultimately, we'll do some additional manufacturing work in the location and greater levels of assembly around the Sovereign and ultimately, longer term, around the Latitude. The new development program, which I think really, ultimately, will be sort of a highlight of this whole activity, is one where we really start the definition and kind of market research of what's the right product for the market as part of the formation of the JV. So that's usually a year or 2 activity when we look at most of our aircraft to really decide what are the right specifications, how do you really do the concept work and define the right product. Certainly, our expectation is that this is going to be a larger, longer-range aircraft than anything else that's in our portfolio, and that's why this is something that makes an awful lot of sense, both for us and for AVIC to invest in. There is no comparative analysis, I would say, against something like a Columbus -- it's not really working from the Columbus baseline . It's really working from what's the right thing given this timing and our current position in the market and, frankly, other things we've done in our portfolio. So I think any specific discussions or disclosures of technical specifications is probably a couple years downstream.

Operator

Your next question comes from the line of Robert Stallard from Royal Bank of Canada.

Robert Stallard - RBC Capital Markets, LLC, Research Division

Scott, I was wondering if you could comment on the market share situation, to follow up from Cai's question whether the issues at Hawker have had any impact on your market share and also with regard to your comment on pricing.

Scott C. Donnelly

Well, I think the -- you've had historically 4 guys really working pretty hard at most of that market, 5 if you include some of the bits of Gulfstream and even Dassault to some degree at this point. But I think if you look at the market right now, and I'm sure you'll see this as it comes out through the industry data, is that no doubt you're going to see loss of share in the jet business at Hawker Beechcraft and I think that, that share is sort of dispersing itself between Cessna and Embraer and Learjet. I think, understandably, it's pretty hard to have a serious discussion with the customer about buying a $10 million, $15 million , $20 million asset if there's uncertainty about who's going to be there to support that aircraft. I mean, I don't think this is a secret, right? I mean, guys that are buying aircraft are -- buying the aircraft is just the beginning, right? I mean these are very long-life assets, and the support and have the manufacturer behind it is an important part of a purchase decision. And I think it's probably giving them a fair bit of difficulty right now given their financial situation. So I can't tell you or wouldn't guess at this particular point where that share is going, but I would suspect that it's moving amongst the other few big OEMs in those markets.

Robert Stallard - RBC Capital Markets, LLC, Research Division

Okay. And then just a follow-up on the pricing issue. I was wondering what your assumptions are for pricing at Cessna through the rest of this year. Are you assuming they stay pretty flat or that they improve?

Scott C. Donnelly

I think it's going to -- it will vary probably a little bit from model to model and region to region. But we would like to think that as we bring new orders in place at this stage of the game that we're going to try to figure out how to drive pricing back up, but that's going to be a difficult fight on a deal-to-deal basis.

Operator

Your next question comes from the line of Jeff Sprague from Vertical Research.

Jeffrey T. Sprague - Vertical Research Partners Inc.

Just a couple follow-up, a lot of ground covered already. First, just back to the, I believe, the first question that Heidi asked. Scott, I think she was talking about aftermarket, but it sounded like you were kind of talking about contribution margins a little bit. Can you just clarify your comments on what to expect for contribution margins on Cessna? Were you trying to get at that?

Scott C. Donnelly

Yes, I think if you look at -- well, I mean, we're not going to -- I don't think we've ever talked about contribution margins on aftermarket or whatever, I guess maybe I misunderstood it. I think if you look at our guidance for the year at Cessna, you get incremental margins on the additional volume year-over-year of around 18-or-so percent. Now in the first quarter, those incremental margins were considerably higher than that versus the first quarter of 2011. But I don't think that the incremental margins that we saw year-over-year in the first quarter are going to sustain that high. I think we ultimately will be around where we guided, which is about an 18% incremental margin on that additional volume.

Jeffrey T. Sprague - Vertical Research Partners Inc.

Okay. I just wanted to clarify that because that was the same number as the aftermarket growth, and it just sounded like there was some apples and oranges in that.

Scott C. Donnelly

And it could be, Jeff, I'm sorry about that.

Jeffrey T. Sprague - Vertical Research Partners Inc.

No problem. And Frank, can you just give us a little more color on kind of how to think about cash flow? You have this big use and other assets and liabilities in the quarter and some working capital pressure beyond that. What's going on there? And how does that play over the balance of the year?

Frank T. Connor

Yes. There's not anything unusual in the first quarter. First quarter is always a significantly negative cash quarter for us. There was some inventory build, there's receivables build, there was some timing and -- in terms of payments from customers and things like that, particularly on the military side, that can tend to be lumpy. So it was negative. It was a little worse than the prior year. If you go back 2 years, it was kind of pretty much in line with what we did in the 2010 first quarter and consistent with generally how we had planned the thing. And again, we believe for the year, we'll be in the $700 million, $750 million cash flow range, just as we had talked about in our guidance.

Jeffrey T. Sprague - Vertical Research Partners Inc.

And then just on Cessna orders, Scott, I think you said Q1 was better than the first 3 quarters of last year, but maybe that's a little bit of kind of the small numbers on small numbers we've been kind of talking about. But can you give us some sense on where book-to-bill was and how you expect book-to-bill to play out into the second quarter?

Scott C. Donnelly

Well, I think you're right. I mean, it's growth over a small number, but it is growth. So we feel pretty good about that. I think on a book-to-bill basis, you're at like 0.75, right, if you looked at just the -- break out the first quarter numbers. But again, I think that what we've guided, our expectation in terms of what we saw in the order flow in the first quarter, what the customer prospect looks like, that we still feel pretty confident that we're going to see the kind of order flow through the course of the year that we need to get to the year.

Operator

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

Myles A. Walton - Deutsche Bank AG, Research Division

Yes, I was hoping to go back to the China JV for a second. And Scott, if you could talk about some of the coproduction platforms that you would think about moving over there and whether -- and how much that would help demand towards the end of this year, if not into 2013.

Scott C. Donnelly

I think by the time the -- we're doing the finalization right now, kind of the Ts and Cs of getting the joint venture itself, formed. We do have to go through the Chinese business license process, which can take a number of months. So we're trying to work towards a target where all these things will be lined up and ready to go at the end of the year. Obviously, we're already working on putting together the requirements in terms of what we have to do for a facility from a completion center capability in Chengdu so that as soon as we get all the licenses in place, we're ready to get all that stuff rolling and capitalize the business, but I don't think you're going to see any kind of impact really in 2012. I think maybe till late 2013, you'll start to see some flow in local deliveries. Now we already have Chinese deliveries, and I will continue to have Chinese deliveries anyway, but at a relatively small number through '12 and '13. But I think this really is something that will start to have an impact in '13 and become more material in '14 and on.

Myles A. Walton - Deutsche Bank AG, Research Division

Okay. And as you look into '13, Embraer coming out with the Legacy 500, what kind of demand impact do you think that will -- or erosion potential impact that will have on your higher end of your line up, Sovereign in particular?

Scott C. Donnelly

That's kind of a difficult question to answer right now. I mean, obviously, there's things that we have going on. Latitude is a good example, where you look at customers that are looking for the larger cabin and that really addresses more specifically the 450, and I think gives us a much better aircraft, much better performance in that space and, obviously, there's some other things that we have going on that would, I think, address well what will happen in the space that represents the 500, which is obviously a bigger, considerably larger aircraft than a Sovereign, at a considerably higher price point than Sovereign.

Operator

Your next question comes from the line of Steve Levenson from Stifel, Nicolaus.

Stephen E. Levenson - Stifel, Nicolaus & Co., Inc., Research Division

On Textron Systems, you talked about the fee-for-service business for the UAS. And can you discuss what the margins are relative to an outright sale and where you think the additional opportunities might come from?

Scott C. Donnelly

Well, I think the -- you wouldn't expect in a government environment to be able to negotiate a very different profit margin on what's expected versus what you would do if you were just selling these assets. I would say that the upside to this thing is that if the utilization ends up being higher, and we are good at utilizing the capital behind these things and the demand is greater, that, that represents upside to us. So I think on an apples-to-apples basis, you would expect pretty similar levels of profitability for the base case. And if we're able to more effectively use -- utilize the capital and there's a demand that allows us to do that, that I would say we would have upside.

Stephen E. Levenson - Stifel, Nicolaus & Co., Inc., Research Division

Okay. And the other opportunities are...

Scott C. Donnelly

Just higher-level utilization, additional task orders.

Stephen E. Levenson - Stifel, Nicolaus & Co., Inc., Research Division

Not necessarily from other customers though?

Scott C. Donnelly

It can also be other customers, right? I mean, these assets are spoken for on sort of a task-order basis, and so it certainly can give us the opportunity, again, depending on what the demand is on these particular contracts can you also utilize those assets on other contracts over time, which could be with other customers as well.

Stephen E. Levenson - Stifel, Nicolaus & Co., Inc., Research Division

Okay. And again, I'm sorry, domestics such as customs and border patrol, or more likely a European customer, for example.

Scott C. Donnelly

All of the above. I think this is a -- we're sort of in an interesting point right now. This is sort of the beginning of this kind of a concept, right, and so I guess, that's why I say when I think it could lead other opportunities, I think about all those kinds of applications. There's stuff within sort of civil applications like border patrols, monitoring of national or emergency areas or disaster areas. There's a lot foreign military applications, so I mean, obviously we'll be taking this model and trying to utilize it on a pretty broad range of applications.

Operator

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

Ronald J. Epstein - BofA Merrill Lynch, Research Division

I've just got a couple of questions for you, maybe just a quick accounting one. When you look at Textron Financial, what provisions were taken during the quarter?

Frank T. Connor

$4 million, Ron.

Ronald J. Epstein - BofA Merrill Lynch, Research Division

Okay, $4 million. Okay, that's great. And then kind of switching gears to the Chinese JV, how do you think about protecting intellectual property when you go into something like that?

Scott C. Donnelly

Well, I think it's pretty easy for us, Ron. I mean, people talk a lot about intellectual property protection, and I think if you're a consumer goods kind of guy, you probably rightfully should worry about that a lot. On the other hand, I think as you get into some more sophisticated technology, there are sort of national protections. I think when you look at China in particular, I think it bears some understanding. Chinese are also very brand conscious, right? So if you look at -- I think what we're doing is much more akin to what's happened in the automotive market than a lot of other industries, where the Western companies that went in and set up joint ventures with the government and did local manufacturing and really had a footprint in the country are the ones that not only enjoyed the growth of that market and helped make the market, but are still the brands and the products that dominate that market today. You go to China, whether it's Shanghai, Beijing or the smaller cities, it's VWs and Audis and Buicks. I mean, these are the guys that were first movers, and they still have very powerful brand presence. People make a lot about sort of the knockoff car companies, the reality is they haven't done all that well. You don't see very many of those. I think when you look at our business in the aviation space, it's even further sort of down that continuum, if you will. And that if you're in the country and you're finishing your final assembly on Sovereigns, you're not going to see a company down the street all of a sudden and pop out with a Sovereign lookalike. You can't -- aviation is a global industry. You have to have certifications, you have to have the FAA and the CAC. So if anybody is going to try to take our intellectual property and do a knockoff of our products, that's going to be a very, very, very public thing. You're not going to all of a sudden see these things on the market for sale. It's years and years of development, a very, very difficult certification process. So I frankly think that people are, in our case, in our industry, our kind of product, our -- this is not an issue to worry about. And frankly, I think you're much, much better off being in the market and participating in the market than thinking you can avoid that market and somehow not worry about IT by taking that strategy. I mean, you're more susceptible to having intellectual property issues if you're not there and participating in the market.

Ronald J. Epstein - BofA Merrill Lynch, Research Division

Interesting. I guess what the counterargument would be is what happened to some of the rail companies over there, correct?

Scott C. Donnelly

I'm sorry, to who?

Ronald J. Epstein - BofA Merrill Lynch, Research Division

Like Siemens and some of the other companies when they were doing high-speed rail.

Scott C. Donnelly

Yes, and I've heard of some of that, but again, I think when you think about all the certification requirements, and again, people buy aircraft and fly them around the world. There's not a local market or a specific local project, it really has to be a global product.

Ronald J. Epstein - BofA Merrill Lynch, Research Division

Yes. And then maybe just one last question for one of you guys, there's been a lot of discussion on the call both from you guys and from other analysts about pricing. Doesn't it imply, I mean, if pricing is still soft, that there's just too much supply on the market, that either on the used end or on the new end, that there's just too much supply, and that's why we're not seeing pricing get better? That really the only way we'll see pricing get better is we just need less supply somehow.

Scott C. Donnelly

Well, I -- there's absolutely no question there's a supply and demand issue going on here and part of that supply includes those used aircraft. And so I think if you look at sort of competition in the marketplace, that's exactly the dynamic that you have going on. And so everybody -- I don't think anybody wants to short the market, right, as things start to come back, so everybody is doing what we're doing, you're trying to understand what -- where you think the market's going and you're trying to build to a forecast because you can't do it month to month, you've got a fairly long-lead assets here. But I think what we -- we would love pricing to get better tomorrow, I would love pricing to be better yesterday, but I think we are where we are in the cycle. I think the used, as it starts to wind down in, particularly on the stuff that's still in production kind of aircraft, will help get that supply demand back into balance, but you still have at least 3, really 4 competitors out there that are all trying to make sure that they keep their position in the market. So as demand comes back and it is getting stronger, you'll start to see that switch just like it has in -- every time you go through these cycles.

Operator

Your next question comes from the line of Steve Tusa from JPMorgan.

Charles Stephen Tusa - JP Morgan Chase & Co, Research Division

Have any M2 or Latitude orders in the quarter?

Scott C. Donnelly

Yes.

Charles Stephen Tusa - JP Morgan Chase & Co, Research Division

Any numbers?

Scott C. Donnelly

No. But, Steve, I just -- just to put some color, they're not overwhelming numbers, okay? I mean, we're in a position here still in the market where people aren't -- you don't see lots of people lining up that want to place orders for aircraft that aren't going to deliver until 2015, okay? So yes, there are some, there are certainly people that want to be sort of first in line for the aircraft and love the airplane and want to do that. Obviously, we have more entry-level buyers and some current Mustang guys who are already thinking about their step-up and then looking at an M2 and saying, "That's where I want to go." Some of them have gotten to the point where they're putting money down and saying, "Yes, I want one of the first units." But there's not a panic yet in the market of people saying, "Geez, if I don't put an order in here real quick, I won't be able to get an airplane."

Charles Stephen Tusa - JP Morgan Chase & Co, Research Division

Right, right. And then you guys aren't going to give kind of your sold-out position for next year?

Scott C. Donnelly

No. That we're definitely not going to do.

Operator

Your next question comes from the line of Sam Pearlstein from Wells Fargo.

Samuel J. Pearlstein - Wells Fargo Securities, LLC, Research Division

Since there are no questions on Industrial, just I was wondering if you could talk a little bit about that. Just given the growth you've seen in the first quarter, if you're going to have flattish sales, is there any part of that, that you're expecting or worried about weakening as we go through the year?

Scott C. Donnelly

The part I still worry the most about is around the automotive build. I think the first quarter is always strong in the automotive industry, I mean, just the way that cycle tends to work, and it was pretty strong. It was a little softer in Europe, which we expected, but it was also considerably stronger in North America, actually even a little bit stronger than we would have expected. Asia was stronger, but not as strong probably as we would have liked. So I would say in terms of how the quarter went, we're happy with what we saw in terms of volume and the health in the industry. But I'd say we remain still a little concerned about what's going on in the -- what will happen over the course of the year, particularly in the European automotive market. And we have a significant share over there, right? It's about 40% of our automotive business.

Charles Stephen Tusa - JP Morgan Chase & Co, Research Division

And then just on that topic, is Kautex, do they use this nylon, that seems was in the papers today about shortages in their fuel systems? And how does that play out?

Scott C. Donnelly

Well, so they do. All of the major suppliers of full-molded tanks use the, I think it was PA12 was what you're referring to. So there was an explosion at a plant in Germany that manufacturers that material system. So it's too early to say exactly what's going to happen. I mean, it certainly has the potential to have an impact. They represent a significant source of supply for that particular material so there's -- all I can tell you is there's active discussions underway with our customers about material systems, alternate material systems, sort of how to manage and sort of bridge our way through that, given what has been sort of a key supplier that has had a real problem. And that's not unique to us, by the way. I mean, that's material that feeds into everybody that makes this kind of a tank.

Operator

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

David E. Strauss - UBS Investment Bank, Research Division

As a follow-up, I think it's Cessna, I don't think you've talked about regionally. Could you comment, Scott, specifically on North America, what you're seeing? And is North America, if you look specifically at the North America book-to-bill, is that above kind of the Cessna average?

Scott C. Donnelly

So I'm sorry I haven't done a book-to-bill on a per region basis, but I would say that the U.S. continues to be healthy, but I would say as we've gone into the year, we've seen some strengthening internationally as well. So I mean we're looking at order book that comes about, I mean I think over the course of the year and what we certainly see indicative in the first quarter, it's going to look more like a 60% international kind of a number as opposed to last year, which was more like a 30% and 70% U.S.

Operator

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

George Shapiro

Yes, just following up on David's question, Scott, how about demand-wise, you're seeing more for your bigger planes versus the smaller ones?

Scott C. Donnelly

George, the mix continues to be, in terms of the order rates, favorable. So we're seeing sort of stronger demand in the CJ4 and up than say the Mustangs. And again, that's kind of consistent with what we saw in the latter part of last year and what our forecast is based around for this year.

George Shapiro

And then, did you give or will you give how much R&D change from last year at Cessna?

Scott C. Donnelly

Not on a by-business basis, George. But in terms of how you guys think about it, the only thing I would say is that we've talked increased dollars, still putting some pressure probably this year around percent of sales, but our expectation is that even though we'll continue to increase the dollars going forward, that we would start to lose that headwind in terms of percent of sales on R&D.

Douglas R. Wilburne

It appears now that we've exhausted all the questions and follow-ups. So thank you, ladies and gentlemen, for joining us, and we'll talk with you soon. Bye-bye.

Operator

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