Rockwell Collins, Inc. F1Q08 (Qtr. End 12/31/07) Earnings Call Transcript

Jan.24.08 | About: Rockwell Collins, (COL)

Rockwell Collins, Inc. (NYSE:COL)

Q1 FY08 Earnings Call

January 24, 2008, 10:00 AM ET

Executives

Dan Crookshank - VP, IR

Clayton M. Jones - Chairman, President and CEO

Patrick E. Allen - Sr. VP and CFO

Analysts

Howard Rubel - Jefferies & Company

Heidi Wood - Morgan Stanley

Joe Nadol - JP Morgan

Joe Campbell - Lehman Brothers

Robert Spingarn - Credit Suisse

Steve Binder - Bear Stearns

George Shapiro - Citigroup

David Strauss - UBS

Ronald Epstein - Merrill Lynch

Cai von Rumohr - Cowen and Company

Robert Stallard - Banc Of America

Myles Walton - Oppenheimer

Alex Hamilton - Jesup & Lamont

David Gremmels - Thomas Weisel

Operator

Good morning everyone and welcome to the Rockwell Collins first quarter fiscal year 2008 earnings conference call. Today's call is being recorded. For opening remarks and senior management introduction, I would like to turn the call over to Rockwell Collins' Vice President of Investor Relations, Mr. Dan Crookshank, please go ahead sir.

Dan Crookshank - Vice President, Investor Relations

Good morning everyone. With me on the line this morning, I have Rockwell Collins' Chairman, President and Chief Executive Officer, Clay Jones, and Senior Vice President and Chief Financial Officer, Patrick Allen. Today's call is being webcast and you can view the slides we will be presenting today on our website at www.rockwellcollins.com under the Investor Relations tab. Please note that today's presentation and webcast will include certain projections and statements that are forward-looking as defined in the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those projected as a result of certain risks and uncertainties, including but not limited to those detailed on slide 2 of this webcast presentation and from time to time in the company's Securities and Exchange Commission filings. These forward statements are made as of the date hereof and the company assumes no obligation to update any forward-looking statement. With that I will now turn the call over to Clay.

Clayton M. Jones - Chairman, President and Chief Executive Officer

Thanks Dan and good morning everybody. Well, I don't know about you but this is one quarterly earnings call that I've, actually really been looking forward to. Let me begin by stating that despite the macro issues faced in the general economy and their impact on the stock market, I really believe that the precipitous decline we have seen in the market value of this company over the last few weeks is inconsistent with our past performance, our market position, and our future growth prospects. Instead I think it's more likely reflects an overreaction to potential US recessionary impacts on worldwide commercial aviation combined with the recent news of a second delay in the Boeing 787 aircraft program.

All of which occurred without regard for the overall strength that we see in both of our served markets. So let me start by commenting on how I see those markets.

With respect to the Commercial Systems business, we continue to experience strong market conditions worldwide and a cycle that looks to have plenty of legs left in. On the OEM side where visibility is very good, several years of record new aircraft orders have created record level backlogs at both of our air transport OEMs. And the order books of the business jet OEMs are exceptionally strong as well and show no sign of abating as you probably already heard from Gulfstream and Cessna just this week.

In addition to this stimulus being provided from the introduction of new aircraft model both of these market areas are being bolstered by significant demand from outside the United States, a new phenomena that gives this cycle the added punch of being fueled by demand from parts of the world where a new class of air travelers is beginning to emerge. And regional jets, where we saw the market bottom out about year ago are coming back with higher production rates of more fuel-efficient turboprop aircraft, as well as the introduction of new models out of China, Russia, and Japan. This gives us a high level of confidence we will continue to see higher year-over-year new aircraft production rates in each of these three market areas for several more years.

On the aftermarket side, global airlines are projected to be profitable for a second consecutive year as historically high load factors and increased ticket pricing help them offset rising fuel cost. This combined with another year of forecasted growth in flight hours bodes very well for aftermarket service, support, and retrofit activities.

And in the market of what appears to be the forgotten half of our company, the Defense business, 2008 will be another year of robust growth in global defense spending. The recently signed FY 2008 Defense Appropriations Bill calls for a 13% year-over-year increase in military investment accounts with another mid-single digit or better rate of year-over-year growth expected for 2009. And fortunately pressure continues to be taken off baseline defense budget due to supplemental funds being made available to specifically pay for the war effort.

Beyond 2009, I believe that global threats will be a catalyst for growth in defense budgets for several more years although at a reduced pace and that's regardless of which party controls the White House or Congress over the next four years. And against this overall positive backdrop, our specific areas of focus that include providing enhanced situation awareness and enabling interoperability and net enablement of both new and existing weapons platforms remain as high military priorities, and should enable us to capture more than our fair share of the spending we expect to see in these specific areas over the long-term.

So in total, our Commercial and Government Systems businesses are looking at very healthy market conditions in which to operate. This coupled with the impact of share gains many of which are already in the barn, some of which we continue to pursue gives me a high level of confidence and our ability to grow the organic revenues of this company by about 8% over the next several years, a rate of growth that is in line with our long-term average annual organic revenue growth targets. And as I sit here today, I see the same market conditions and the same opportunities as I did three to six months ago and nothing that alters my opinion regarding the direction of this company and its ability to continue to perform at a very high level.

As you read in our earnings release this morning, we delivered excellent results for the quarter highlighted by better than expected revenue performance from both businesses. And as an early indicator of the continued strength of the commercial aerospace market, we took Commercial Systems better than expected performance to the bank, as well as raised our expectations for their projected revenues for the remainder of the year. And we did this despite the uncertainty that has been injected into the commercial aerospace market with respect to the status of the 787 aircraft program.

Now as I'm sure everybody on this call is aware just last week, Boeing delayed the 787 program for a second time moving first customer deliveries out to early 2009 announcing that some number less than a 109 aircraft will be delivered by the end of calendar year 2009 and leading to a later an additional update that will contain the details of the reassessed aircraft program delivery schedules going forward. Although we're still waiting for the details as you are, one determinable impact of this announcement is that we will feel an additional pinch on our R&D budget in fiscal year 2008 as we keep our teams engaged in support of the program for an additional two months or so.

Now we've estimated this impact to be about an incremental $2 million to $3 million. And as you can tell from our revised financial guidance, we expect we can absorb this additional cost as part of our previously established and unchanged fiscal year 2008 R&D guidance range. As a result of the good progress we continue to make on qualifying our systems and the fact that we're not throwing additional performance-related spending at the program, our cost of staying with it for longer period of time is manageable.

Now turning back to the issue of aircraft production and delivery schedules going forward. Although we don't know the outcome of Boeing assessment... we won't know the outcome of Boeing's assessment for a couple of months, my expectation is that you will not see the production of aircraft or the acceptance of supplier systems brought to a halt. What I do expect is that Boeing will want to avoid introducing any additional risk to the program. And as you know, they've consistently stated their intentions to be fair and equitable to the supplier partners that have performed well and are on schedule, which is our situation.

So in my estimation any action taken will likely be some sort of a slowdown that will allow ramp-up efficiencies to continue to be captured throughout most of the supply chain while lagging suppliers get into a position to be able to deliver assembly ready systems to Boeing as the problem pacing issues of travel work gets resolved. With that being our best guess, I am assuming your next question is, so what is the impact of a slowdown in aircraft production on Rockwell Collins. Now, while this question remains highly hypothetical and I would assure you I have no insight as to what Boeing's ultimate decisions are going to be, to give you some sense of the impact, let's assume for a moment a slowdown would entail the reduction of production shipset deliveries from us to Boeing by say an even 50 shipsets over the remainder of 2008, almost half of their expectations previously and that extends over the entirety of 2009.

In this case, we would expect a negative impact to our EPS over the same time frame of only $0.03 to $0.04 per share, all of which would be attributable to fiscal year 2009. Now my guess is this impact is surprisingly low to most of you. But due to the structure of the commercial arrangements we have in place with Boeing, as well as realizing that our manufacturing processes will be operating at a lower efficiency rate at this early stage of the program, we believe a less than 1% underlying potential impact to EPS is just not that bigger deal. So, although this program is extremely important to Rockwell Collins, in the whole scheme of things another three-month delay is simply insignificant relative to the ultimate value of the program we look forward to enjoying over the next several decades.

Boeing has a lot of smart and talented people working on this program with the objective of bringing a truly revolutionary airplane to the market. And I would tell you I have unwavering confidence in their ability to get the job done. In my opinion, it's way too early to head to the exits both on this program and on Rockwell Collins as a solid long-term investment opportunity.

Well, that concludes my opening remarks. Now I would like to turn the call over to Patrick for review of our financial results for the quarter and updated financial guidance. Pat?

Patrick E. Allen - Senior Vice President & CFO

Thanks Clay, and good morning to everyone as well. Let's get started by first reviewing our results for the total company that are shown on slides 3 and 4. Sales increased 12% to $1.12 billion, our first time clearing the $1 billion sales threshold for a fiscal year first quarter and our reported net income and earnings per share increased by 8% and 11% respectively as EPS growth outpaced net income growth due to our ongoing share repurchase program. Both our net income and earnings per share growth rates were held back by a non-recurring $0.08 per share favorable R&D tax credit adjustment recognized in last year's first quarter. So on an apple-to-apple basis, excluding the impact of that tax credit adjustment, our net income and earnings per share growth rates would have been 19% and 22% respectively. And our total company profitability metrics continue to remain high as we converted our sales to after-tax profits at a rate of 13.8%.

As our press release pointed out, the federal R&D tax credit legislation was once again allowed to expire and it did so right at the end of our first quarter. As we previously communicated this event created approximately 1.5 percentage points of headwind to our forecasted effect of income tax rate including in the first quarter. Our effective tax rate for the quarter was 33.6%, all of being equal, a rate just above the high-end of our expectations going into the quarter, as we were able to offset a good portion of the negative impact from the expiration of the R&D tax credit with additional tax benefits from negotiated state tax and severance related to our ongoing facility expansions and job creation activities, as well as several other discrete tax items.

Looking at our cash flow results for the first quarter, in what is normally our slowest cash flow generating quarter of the year, our operating cash flow came in at $32 million, $49 million lower than last year. The main driver here was approximately $50 million in higher employee incentive compensation payments in this year's first quarter. In addition, a higher amount of inventory growth in the current year first quarter due largely to the timing of progress payments we received both related to certain Government Systems programs was essentially offset by lower income tax payments and our higher net income.

Turning to slides 5 and 6, we take a look at the first quarter results of our Commercial and Government Systems businesses. In Commercial Systems, operating earnings improved 20% and a 15% increase in total revenues. OEM revenues increased 23% due to higher air transport and business aircraft to OEM production rates coupled with the impact of market share gains. Aftermarket revenues improved 7% driven by another quarter of initial equipment sales to 787 simulator manufacturers, as well as higher revenues from service and support activities. Business and regional retrofits and spares revenues were slightly lower, primarily due to a difficult year-over-year comparable as a result of the very strong sales we experienced in this area than last year's first quarter.

Looking at Commercial Systems operating earnings and margins, earnings improved 20% and operating margins were 100 basis points higher than last year at 24.2%. The current year operating margin benefited from a favorable impact of an adjustment related to contract option exercise, which was significantly more than offset by a $21 million as planned year-over-year increase in company funded R&D costs. This once again points to our ability to continue to expand operating margins even as a higher proportion of our revenue growth is generated by relatively lower margins of OEM revenues.

Turning to Government Systems, first quarter operating earnings improved 13% on a 9% increase in revenues. Government Systems revenue growth for the quarter was higher than expected, as a portion of our growth came from higher sales of Defense Advanced GPS Receivers, ARC-210 radios and international C-130 aircraft upgrade programs that were planned for a second quarter. Also contributing to the revenue growth was a United Kingdom Ministry of Defense Precision Targeting System program and $6 million of new revenues from the information technology and Applications Corporation acquisition we completed this past August. Due in part to the proportion of our revenue growth that related to relatively higher margin hardware sales, our operating margin improved 60-basis points to 21%.

Moving to slide 7, we show the status of our capital structure as of the end of the first quarter compared to the end of last year. You’ll note we opened up the [inaudible] a little and put a bit of our balance sheet flexibility and borrowing capacity to work this quarter. In addition to 228 million of long-term debt we had a $190 million of short-term commercial paper borrowings outstanding at the end of the quarter which enabled us to continue to make progress on the execution of our share repurchase program while meeting our other first quarter cash flow requirements. This increased our debt-to-total capital ratio to 22%.

And speaking of our share repurchase program, the updated status of the program through the end of the first quarter is detailed on slide 8. In the first quarter, we repurchased a total of 3.1 million shares, which represents the initial 224 million purchase of 3 million shares under the accelerated share repurchase agreement we executed earlier in the quarter plus an additional 100,000 shares we received upon final settlement of that agreement in November. This reduced the average cost of the shares from initial purchase value of 74, 77 per share to 73,19 per share. I would also like to point out that in November, our Board of Directors authorized us to repurchase an additional $500 million of company stock under our share repurchase program. And that as of the end of the quarter our outstanding share balance was about 5 million shares lower than it was just a year ago reflecting our ongoing commitment to enhance shareholder value through maintaining an active share repurchase program.

Now on to our final slide, slide 9, which contains the updated [inaudible] of our financial guidance for the full fiscal year. Starting with the changes, first, due to the elevating our expectations for the full year Commercial Systems sales, we raised our projection for total company sales to be about $4.75 billion from the previous range of $4.7 billion to $4.75 billion. As such, Commercial Systems sales are now expected to represent slightly more than half of total company revenues versus our prior guidance of roughly half of total company sales.

Second, as a result of increasing our sales expectations, we boosted our EPS range by a nickel and now stand at $3.85 to $4. This EPS range continues to incorporate a projected effective income tax rate in the range of 32.5% to 33.5%. Although our ability to achieve this effective income tax rate range is no longer dependent upon the enactment of legislation extending the availability of R&D tax credits beyond December 31, 2007. Our projected full-year effective tax rate now reflects a recognition of estimated tax payments... tax benefits from the anticipated resolution of certain tax matters, as well as our higher level of state income tax credits and incentives.

The favorable impact of these items effectively offsets the negative impact resulting from the expiration of the federal R&D tax credit legislation. As to timing, our expectations to be far enough along to recognize the benefit from the tax matter resolutions in the second quarter. If it plays out this way our second quarter tax rate would be about 28% with the back half of the year looking to be about 34%. One last note on the projected full-year effective income tax rate, if legislation is enacted sometime during the remainder of our fiscal year and it provides R&D tax credits for the last nine months of the fiscal year our full year effective income tax rate would be favorably impacted by about 1.5 percentage points.

Our guidance for the total segment operating margins, cash flow from operating activities, total R&D expenditures, and capital expenditures each remained unchanged. Our cash flow from operating activities guidance still accommodates a pension contribution of up to $75 million and is still at risk with a potential shift of $70 million to $80 million of our Boeing 787 program related receivable collections into our 2009 fiscal year. As part of our total segment operating margin guidance of about 22%, we still expect full year segment operating margins of Commercial Systems to increase over last year and full year segment operating margins of Government Systems to be slightly lower than last year. And with respect to our total R&D expense guidance of about $925 million to $950 million, the current range is expected to be able to accommodate small amount of additional 787 program investments that Clay mentioned earlier.

That concludes my comments on the financial results and updated full year financial guidance. And so with that I'll turn the call back over to Dan.

Dan Crookshank - Vice President, Investor Relations

Thank you very much Patrick. In order to give everyone the opportunity to ask questions on the call we ask that you limit your questions to two per caller. If you have any further questions you can simply reinsert yourself into the queue and we will attempt to answer those additional questions as time permits. So Dana we are now ready to open the line for questions.

Question and Answer

Operator

Thank you, sir. [Operator Instructions]. And we will take our first question today from Howard Rubel of Jefferies.

Howard Rubel - Jefferies & Co.

Thank you very much. Just two things on Clay. First we saw Thales won part of the A350 XWB. I suspect you are still in the hunt for part of it, could you give us a little bit of color on that?

Clayton M. Jones - Chairman, President and Chief Executive Officer

Yes, I'll be glad to. We are still in the hunt. As we've been talking about on some of these calls, we had actually expected that most of the A350 sourcing decisions would have been made by about this time but the process is going a bit more slower than we had anticipated and so there is not as many decisions to this point as we had originally thought there would be. We are competing for about nine separate packages. Of those nine packages at least we are competed... competitive for, four have been awarded to date. We have won three out of the four. The one that I think was recently talked about that we did, we are not successful on the displays package is the one that was that Thales was successful on. But we have won the THSA, the Horizontal Trim Actuator. We won the AFDX Ethernet switches continuing our very strong market position in that technology and we've won a couple of navigation landing systems, the Multi-mode Receiver and the digital radar altimeter where we had incumbent positions.

Obviously, we are disappointed on the displays position, that's strategically important area that we had… we thought attractive technology offered to Airbus because of our experience on 787. But we knew all along that was going to be tough going up against an incumbent that had literally every display in every Airbus airplane for the history of the company. And so when you take on somebody like that obviously you're going to have to fight pretty hard and we thought they would do just about everything they could do to win it and obviously they did, because they were successful. But also to give you a sense of where we are in that program, of the roughly total nine packages we're going after, those four that have been awarded only represent about 30% of the total content on the airplane that would be available.

So there’s a lot more runway in front of us and we think we are going to be competitive on NAV sensors, communications information management we're particularly strong, pilot controls, surveillance equipment is all yet to go. So we are going to run at it hard. My guess is we won't win them all but I am very confident that when all the dust settles we will end up having more share of this new airplane and more content than we had on its replacement, the A330 and A340 and perhaps even more than we've ever had on Airbus airplane, which marks our continued interest in trying to strengthen our position at that OEM.

Howard Rubel - Jefferies & Co.

That makes... that really is very is helpful. And then just as a slight follow-up, I think you mentioned in the press release that some of the aftermarket RJ… the RJ business and maybe the bizjet, I call it overhaul market was a little bit soft. I mean was that just a geographic item or was it timing or could you address that a little bit?

Clayton M. Jones - Chairman, President and Chief Executive Officer

Well, it’s a little bit of all of that. First of all, I would say that our service revenue continues to be consistent and strong in the aftermarket. As we've always said on these calls Howard, the most difficult to predict and the time are the major aircraft retrofits when they actually have to take the aircraft down and put something newer. There is so much demand for these aircrafts right now that not a lot of people want to take them down and to put these retrofits in there. The other… and so the timing tends to be very lumpy.

The other interesting phenomena we're seeing especially in business jets is, the market is so good that we are getting capacity constraint. There only so many of the completion centers that we typically broker our retrofits through that they have so much business that get them [inaudible] tough and so if you are not already there you have to kind of wait your turn and that's going to even make it more lumpy. But I think it also speaks to the strength of these more underlying markets that we're seeing out there.

Operator

And we will take our next question from Heidi Wood of Morgan Stanley.

Heidi Wood - Morgan Stanley

Good morning. Nice quarter.

Clayton M. Jones - Chairman, President and Chief Executive Officer

Thanks, Heidi.

Heidi Wood - Morgan Stanley

A question how long Clay, are you expecting this 787 simulator equipment sales? Give us an idea of when that runs off as airlines gets fully provisioned there.

Clayton M. Jones - Chairman, President and Chief Executive Officer

Well, my guess is that simulator sales are going to go on for years and years and years. What we're seeing right now is the initial provisioning of the simulators that will go to the initial companies that are going to be operating this aircraft. So, couple of interesting phenomena’s. First of all, you're starting from a market of zero and any increment you get is a nice increment to your previous sales. Second thing that I think is positive is that there are so many different airlines that are buying 787. Some of those airlines, the smaller ones will probably go to training centers but many of the larger airlines will operate their own simulator equipment.

And so as they look at providing training for their pilots, as they begin to equip with these aircrafts my sense is that we are going to have actually several years of opportunity to sell equipment to simulator manufacturers for this system. Now my guess is this delay we'd experienced right here, it might delay some RFPs that we are going to see coming in over the next few months but those simulators that are in production or that have been committed to I full well expect will continue because historically one of the problems airlines have had sufficient simulators to train the number of pilots for the quality of airplanes they get and so this actually gives them some breathing room.

Heidi Wood - Morgan Stanley

Okay. Is it a fair characterization Clay that the aftermarket revenues were down ex [ph] to 787 business? I am wondering if you could expand a little about what you are seeing in the overall aftermarket outlook in '08 and compare that to 2007.

Clayton M. Jones - Chairman, President and Chief Executive Officer

No, I wouldn't say that it is down ex to 787, a bit lower ex to 787, but not down. I would say that in general if you look at all of our aftermarket revenues for the balance of the year, you will see them generally in the neighborhood of where they were first quarter. And where you will see that broken out as you'll see very strong air transport aftermarket sales, you'll probably see slightly slower business and regional retrofit sales for the conditions I described earlier and then the big impact we're going to have is the IFE, wide-body IFE that are going to hit us particularly hard at the end of the year.

As we said we expect about $50 million increment... I mean a determent of revenues year-over-year as a result of our strategic decision there. Let me correct the record. I would say mid-single digits for the balance of the year if you were to take IFE out, they would be about where they are now.

Operator

And we will take our next question from Joe Nadol of JP Morgan.

Joseph Nadol – JP Morgan

Good morning. Clay, I'd like to start just on the commercial margins and I was wondering if you could, a) quantify the contract adjustment and b) may be just help out with what the underlying incremental margins are, you've told us in the past they've been 40% there, did you do that? And how much R&D impact versus may be mix which was more OEM this quarter?

Patrick E. Allen - Senior Vice President and Chief Financial Officer

Joe, let me try to take that. First of all with respect to the contract adjustment, it was about $5 million of positive adjustment for Commercial Systems. As for the R&D headwind, the R&D headwind was about 130 basis points year-over-year in the Commercial Systems business and so if you sort through the map of everything, our underlying, I'd say pre-R&D incremental operating margins were over 40% for the quarter.

Joseph Nadol – JP Morgan

Okay, that's great. Thanks for that. And then secondly, just any signs of progress on C-series, Clay?

Clayton M. Jones - Chairman, President and Chief Executive Officer

Well, we see a lot of activity going on, yes. We are in discussions with Bombardier and we are waiting on their decision process as they go through their Board authority to offer and I think... I would say I think it's more probable than not.

Operator

And we will take our next question from Joe Campbell of Lehman Brothers.

Joseph Campbell - Lehman Brothers

Good morning, Clay and thank you for the overview, which I think was much needed not only for your stock [ph] but several others have really been worried about the outlook for all the commercial and defense products.

Clayton M. Jones - Chairman, President and Chief Executive Officer

Let's hope it helps.

Joseph Campbell - Lehman Brothers

Well, it seems to be all the stocks are green on my screen. I wondered if you thought that the prices though which are down for your company and just about all the other commercial companies both here and around the world, we are providing that [inaudible] being frustrating for your own stock whether there are any opportunities that you saw or whether you thought that these scares were filtering over to the M&A markets or whether they were not having that impact on opportunities to find things to add to Collins?

Clayton M. Jones - Chairman, President and Chief Executive Officer

Well, I may make two comments about that, Joe. First of all, I think this drop has been so precipitous and so wide ranging and although I think we took more than our fare share fairly, evenly distributed but everybody understands that the underlying value of these companies is not reflective of the current price. So, my guess is you are not going to buy any aircraft... any air company is on the cheap now just because their stock has dipped down like this and any I think company that's worth its salt and has a good Board that understands the underlying fundamentals would resist that happening.

So, I don't see that at least at this point changing the underlying fundamentals of the M&A market other than it probably makes people kind of stand around and wait for things to stabilize. I guess the other thing I would say is the interesting thing to me is as you all know we have been a public company for about 6.5 years and notwithstanding the turbulence of our first six or nine months, which was post 9/11 and we were beaten down pretty hard at that time too but literally for the last five of those 6.5 years the most frequently... the most frequent response I have gotten to investors I talk to is, boy, I wish I would have bought Rockwell Collins, but you are too darn expensive, I am going to wait for an opening.

Joseph Campbell - Lehman Brothers

Well here it is.

Clayton M. Jones - Chairman, President and Chief Executive Officer

Your day has come, because I believe the underlying fundamental is, the company has not changed. I think our commitment to shareholder value has not changed and we all know the way the markets react in times of fear and uncertainty and I would at least opine that’s what you are seeing. So I am not trouble them [ph] in long-term although, yes, great things highly for me and all other CEOs when we see this stuff happen in short-term but there’s certain things I can control and certain I can’t and I am going to control the hell out of the ones I can.

Joseph Campbell - Lehman Brothers

Amen. Thank you for that answer.

Clayton M. Jones - Chairman, President and Chief Executive Officer

You’re welcome.

Operator

And we will take our next question from Robert Spingarn of Credit Suisse.

Robert Spingarn - Credit Suisse

Good morning. Two questions, Clay one on the 787 and then the other on the aftermarket pricing. Maybe I will start with the latter, what are you seeing regionally in terms of commercial air transport pricing and also with regard you talked about flight hour growth. I think there is general concern that you are going to see US capacity contract a bit here, certainly slow but globally it seems quite healthy, could you comment a bit on that? And then I have question on 787.

Clayton M. Jones - Chairman, President and Chief Executive Officer

I'll try to. I assume by air transport pricing, you’re talking about our pricing.

Robert Spingarn - Credit Suisse

You’re pricing on your parts and generally on the aftermarket side, because I guess it’s where it fluctuates the most.

Clayton M. Jones - Chairman, President and Chief Executive Officer

Well, a lot of our OEM pricing is fixed Rob, and so we have long-term contracts with almost all the OEMs and so that tends to be what it is. The part that sort of not fixed if you will, which is our BFE equipments we are doing very well out there in the market and pricing right now I would say is not a big issue in terms of our ability to win nor our ability to have reasonable returns on the equipment because there is so much demand for this equipment right now and just getting things… getting airlift right now is most airlines’ biggest issues driven by things like the price of fuel.

The interesting thing we forget is, one of the phenomena's that's driving new aircraft equipage is to get rid of the older less fuel efficient aircrafts and they really want this new lift because it's becoming more and more of an operating cost. And in the aftermarket I would say the answer is the same. We are not increasing our margins 100 basis points year-over-year for the last several years because the market is less good and so I would say that's a pretty good indicator of the fact that although it’s very highly competitive, our operating efficiencies are allowing us to price at a rate where we can make good money.

Robert Spingarn - Credit Suisse

Do you see any change in behavior from the US airlines?

Clayton M. Jones - Chairman, President and Chief Executive Officer

The behavior in that I see more discipline and times past the airlines would do anything to maintain market share or route structure and just the fact that you mentioned is if they are reducing capacity not only seasonally but as the demand occurs that's good news because that means they are going for yields and they going to try to optimize their routes rather than basically pay a great price just to maintain market share. I think that's the... one of the bigger changes I have seen in this cycle and in the cycle's past. That's why I said and they’re also being reasonable of our price raises to cover the operating cost of fuel. You are seeing more of that go through where in the past that was near impossible when there was high levels of hedging and there was imbalance between the airlines.

Operator

And we will go next to Steve Binder of Bear Stearns.

Steve Binder - Bear Stearns

Yes, good morning. Clay, can you may be just touch, I know you have talked about before, Boeing has talked about they are going to have, try to conclude discussions with a lot of suppliers by the end of the first quarter. Just wondering you have issues of cash, obviously cash payments but two, there is always equitable relief or non-recurring and recurring issues. I am just wondering where do you stand right now on those discussions?

Clayton M. Jones - Chairman, President and Chief Executive Officer

Well, we are having all those discussions Steve and this could be pre-mature for me to talk about where we are on those discussions but I would assure you we are having discussion on both subjects.

Steve Binder - Bear Stearns

I imagine from a R&D standpoint and also from a cash standpoint those discussions, there’s only upside from those discussions fair to say relative to, especially with respect to R&D?

Clayton M. Jones - Chairman, President and Chief Executive Officer

I think that's fair to say.

Steve Binder - Bear Stearns

And we saw looking at 40% company sponsored R&D for the year, I don't know if you touched on that before?

Clayton M. Jones - Chairman, President and Chief Executive Officer

That’s about right, yes.

Patrick E. Allen - Senior Vice President and Chief Financial Officer

We haven’t really come off the guidance.

Steve Binder - Bear Stearns

Okay, great. You touched in the release about geographic diversity, better balance geographically in the aerospace market, increasingly becoming more geographically balanced. Is that... are you touching on that from a OEM standpoint or is that from an aftermarket perspective?

Clayton M. Jones - Chairman, President and Chief Executive Officer

Well, it’s a little bit of both. As the non-US geographies grow that creates more aftermarket opportunity. We have I think around 11 or 12 service centers and half of them are outside the United States and many of them like Singapore and China and Australia are doing very well indeed, even the European service centers are doing great because they fuel… as they fuel and support to Middle East. So yes, that's the balance. I think it's no more indicative, we can easily see and track the big air transport OEMs Boeing and Airbus and where they are selling airplanes, you all know that probably better than I.

But I think the really interesting thing is where business jets are going. Most business jet OEMs would tell you that, probably the first time in their history they are selling more business jets outside the United States than inside the United States. And that’s at a new class of wealth that’s being created, new corporations growing and opportunities as airspaces begin to free up and they see the advantage of using business aircraft as a tool and that to me is even more indicative of that global market.

Operator

And we'll take our next question from George Shapiro, with Citigroup.

George Shapiro - Citigroup

Hi good morning.

Clayton M. Jones - Chairman, President and Chief Executive Officer

Good morning.

George Shapiro - Citigroup

Well, if you take a look at the aftermarket growth of only 7%, it was also sequentially down from the last quarter versus last year when this quarter was slightly up sequentially. So, can you just go through what actually changed the most on a sequential basis?

Clayton M. Jones - Chairman, President and Chief Executive Officer

Well I think in my previous answer probably is the best answer I can give you George is it's just seasonal and lumpy for the retrofits that we have and we include in the aftermarket some of those simulator sales that I talked about. And at the end of last year we had a very high level of incremental simulator sales that they are not recurring at exactly the same rate every quarter. So that’s as good as we can rationalize it. Again I would tell you in the aftermarket there is a very solid and consistent aftermarket in our service and spares revenue and then there is this major retrofit area that comes and goes as we get programs and we complete those programs.

Patrick E. Allen - Senior Vice President and Chief Financial Officer

It is pretty typical for the total Commercial Systems revenues to be sequentially lower Q4 to Q1 as well. So I think it’s…

George Shapiro - Citigroup

But it wasn’t last year Patrick, if you look at Q4 of last year which 250 versus 255 so...

Patrick E. Allen - Senior Vice President and Chief Financial Officer

Yes, I think last year we had a real blockbuster aftermarket revenues. We had a couple of things going there. We had some sparing with the business Jet OEM and we also had completion of several major retrofit programs on the business jet side and so Q1 of last year I would say was very anomalous.

Clayton M. Jones - Chairman, President and Chief Executive Officer

And especially with our IFE business George, I would defy you to go back over two or three years and track a trend in aftermarket revenue, it kind of goes up and goes down but we think over the long-term we can suggest a rate and a trend that is relatively consistent. The other thing we would say is also traditionally in area of era of high OEM sales you have relatively lower aftermarket sales, and then they reverse itself when you see the OEM sales decline because now our airlines are putting more effort and time, our operators putting more of their cash and money into fixing the house.

George Shapiro - Citigroup

I guess, I just ask one other thing. Since this stimulator business is lumpy and to me it's really... I would look at it as a more OE rather than aftermarket, why not just take it out and show straight aftermarket?

Clayton M. Jones - Chairman, President and Chief Executive Officer

Because that's the way we've chosen to do it George. We will look at it, but that's what we are doing right now.

Operator

And we will take our next question from David Strauss of UBS.

David Strauss - UBS

Good morning.

Clayton M. Jones - Chairman, President and Chief Executive Officer

Good morning.

Patrick E. Allen - Senior Vice President and Chief Financial Officer

Good morning.

David Strauss - UBS

Clay and Patrick, in thinking about share repurchased, in the past, what you have done is typically let cash built throughout the year and then go about executing share repurchase, your big share repurchases in the back half of the year. Given the decline in the stock price, would you be, in the terms of thinking about going forward, you potentially be looking at being more aggressive on share repurchase early in the year and putting your balance sheet more to work?

Patrick E. Allen - Senior Vice President and Chief Financial Officer

Well David, you know that I don't like to talk too much about quarter-to-quarter plans with respect to share repurchases, but I would say that this will be a very unusual time for us to be out of the market in terms of share repurchases given our history. So, I would anticipate continued share repurchases overtime and in terms of the timing within year, I wouldn’t want to speculate.

David Strauss - UBS

Okay and then, Clay, can you give us an update on JTRS and then Patrick could you just may be comment on corporate expenses was a little bit lower in the quarter, what kind of run rate are we looking up for rest of year? Thanks.

Clayton M. Jones - Chairman, President and Chief Executive Officer

Sure, well first thing, JTRS is going extremely well and it’s probably the best indicator to everybody is you are not hearing very much about it. We see that as an example when you break it down our, searching for the name...

Patrick E. Allen - Senior Vice President and Chief Financial Officer

GMR.

Clayton M. Jones - Chairman, President and Chief Executive Officer

GMR thank you. The GMR program has passed its critical [inaudible], we think we are going to be through with most of the development activity about the end of this year, it is progressing very well, we will go into development test activity and over the next year 2009 and then we will be ready for low rate initial production as we have currently projected it to be in 2010. In the mean time, our Mid-J program that is a big part of us is also proceeding very well and we are expecting [inaudible] of that to go in 2009 that appears to be on schedule making good progress, and then the HMS, the Handheld/Manpack and Small Form Factor, again it's about a year behind the GMR and that also is making good progress.

And so I think we for that redesign that we agonized our way through about a year or so go has really paid dividends. We have got the program on a good track, the team is working well together, it's making progress and I am very confident that we are going to not only complete the technical aspect of this, but we are going to see the distinct advantages of JTRS getting into the war fighters hands here as we turn the decade.

Patrick E. Allen - Senior Vice President and Chief Financial Officer

And in terms of corporate expenses, it was lower year-over-year, I think about $3 million that was due largely to benefit expenses and I would expect that trend to continue may be not be quite as heavy decline over the course of the balance of the year.

Operator

And we'll take our next question from Ronald Epstein of Merrill Lynch.

Ronald Epstein - Merrill Lynch

Yes. Good morning guys.

Clayton M. Jones - Chairman, President and Chief Executive Officer

Hi Ron.

Ronald Epstein - Merrill Lynch

This morning Textron announced that they're going to launch the LCC aircraft. What would you expect that they had actually come out and announce some of the sub suppliers for example for Collins, Avionics and so on and so forth?

Clayton M. Jones - Chairman, President and Chief Executive Officer

My understanding is that, they're planning to have a fairly substantial press launch of that in early February and my guess is that would be a real good opportunity to do that if they chose to.

Ronald Epstein - Merrill Lynch

Okay. Very good, and then just may be another follow-on question. When… Clay when you're looking at the opportunities in the defense market, kind of on the horizon, the laundry [ph] list of stuff that could happen maybe in the next 6 to 12 months, what kind of is foremost in your mind?

Clayton M. Jones - Chairman, President and Chief Executive Officer

Yes, we are actually, there are number of procurements coming up later in this year, which we are very interested in and very watchful off. Things like KCX, the long-awaited CSRX [ph] final decision, the JTRS, AMF component, the Navy C-130 upgrade and the Joint Precision Ports and Landing system or JPAL programs are all programs of very large import to us and that we'll be watching very closely and we're all contributing to that either on someone’s else team or bidding them directly.

Ronald Epstein - Merrill Lynch

Great. And then, just one last follow on. On the Dagger program where do you expect production for that to go over the next year or so?

Clayton M. Jones - Chairman, President and Chief Executive Officer

Well, we have suggested that the dagger production is really about at its max rate, and we'll continue even though we had a strong quarter here of Dagger sales, some of those were actually pulled forward from what's -- from this current quarter because of the strong demand for that product to get to a war fighter’s hands. But in general we believe that Dagger sales are going to be at about the level they are right now so, essentially flat.

Operator

And we'll take our next question from Cai von Rumohr with Cowen and Company.

Cai von Rumohr - Cowen and Company

Thank you very much. You've mentioned R&D up $21 million year-over-year. If I do the math on your guidance on R&D, 40% for company funded, it’s going to be up $35 million to $40 million, which would say you're saying that R&D is going to be up $15 million to $20 million over the rest of the year. Is that right and can you give us some sense of the flows of R&D sequentially from here?

Patrick E. Allen - Senior Vice President and Chief Financial Officer

Yes, Cai, that is about right. What we're going to see this year is a far flatter R&D curve particularly the Commercial Systems business. I would attribute that two things, one is our staffing ramp this year is much less. And also, we’re transitioning some programs from what I call expense R&D to some of our deferred programs towards the back half of the year. And so, what you're going to see sequentially is some growth but much slower than last year.

Cai von Rumohr - Cowen and Company

Which would say we should see more sequential incremental margin left if sales grow?

Patrick E. Allen - Senior Vice President and Chief Financial Officer

That's correct.

Cai von Rumohr - Cowen and Company

And the other one is, if you bought 3.1 million shares at $73 million… at $73 a share in the first quarter and we are selling here at basically under $61 today, is there any thought that you could kind of go out and be more aggressive do another accelerated repo or something more dramatic?

Patrick E. Allen - Senior Vice President and Chief Financial Officer

Yes I'd say anything is possible. I would say that we don't try to time the market. We try to stay in the market overtime and we look at share repurchase as an opportunity to return capital to shareholders not necessarily… again not necessarily time the market. So the acceleration share repurchase program is a tool we've used in the past and I would suspect we’ll use it in the future whether it'll be this quarter or somewhere else in the future, I don’t want to speculate.

Operator

And I'll take our next question from Robert Stallard of Banc Of America.

Robert Stallard - Banc Of America

Morning.

Clayton M. Jones - Chairman, President and Chief Executive Officer

Hi Rob.

Robert Stallard - Banc Of America

First of all, one on the operating margin you had really a good quarter in Q1. Your guidance for the year suggests things are going to ease off subsequent quarter, do you expect this could be fairly evenly distributed across the next three quarters or is there going to be some lumpiness as we move down?

Patrick E. Allen - Senior Vice President and Chief Financial Officer

I would say, with respect to that, it would probably be lower in the second half of the year for the Government Systems side.

Clayton M. Jones - Chairman, President and Chief Executive Officer

Lot of those programs coming in that I talked about that will add some sales volume are all developmental which just naturally have a dilutive effect on margins. So that's a prime cause of that lower margin in Government Systems as we go through the rest of the year.

Robert Stallard - Banc Of America

Anything unusual in Commercial because I think Q1 last year was very strong and eased off?

Clayton M. Jones - Chairman, President and Chief Executive Officer

Well I think in the Q1, actually Commercial side should be the opposite. We should see expanding margins over the course of the year in commercial largely due to the R&D phenomena I discussed earlier.

Operator

And I'll take our next question from of Myles Walton of Oppenheimer.

Myles Walton - Oppenheimer

Thanks good morning.

Clayton M. Jones - Chairman, President and Chief Executive Officer

Morning Myles.

Myles Walton - Oppenheimer

Hey Clay a high level question for you. In the past, into the up cycle, you talked about the three stages that you think of, non-discretionary spend moving to discretionary spend, moving to actual orders what is your thinking in terms of the stages of a down cycle? On what part of your business would you see some of those leading indicators in?

Clayton M. Jones - Chairman, President and Chief Executive Officer

I like the other theory. Well it depends on what kind of cycle it is Myles. I mean interestingly enough if you go back and look at the post 9/11 period, which really stopped the last big commercial up cycle, which I would suggest they did in a draconian way I don't know if my facts are entirely correct here but the order rate of aircraft for 2001 was almost as strong as it was 2000... I mean for 2002 it was strong as it was for 2001. And so when you get the machine churning and you get all those work-in-process, it's very difficult to shut it down at the... outside the air transport OEM rate. And so I think you see sort of lagging effect.

And typically what people have looked at in the past are orders. And I think this sort of shuddering effect we've seen here over the last little bit very predictably is the fact, that we’ve had three such extraordinarily strong quarters in orders that historically the beginning of the end was when the order rate turned down and now you can see where it's going to go. The only caution I would make to that is we've never had I think a backlog the way it's right now and a sector that is under participated in it which is the US carriers. And so let’s just remember back one year ago we all predicted that 2007 was going to be an extraordinarily slower year and it was the strongest [inaudible]. So I think orders are an indicator but I think you got to wait and give that a little time to develop and than I think you'll see a downturn in deliveries and then you would see actually a pick up in aftermarket and then that would slide into phase one if you will, of the recovery.

Myles Walton - Oppenheimer

All right that's fair. And then for the… I guess a more detail question, you decided to change the group break down in the Government Systems section between airborne and surface versus defense electronics and com. It looks like airborne solutions is more or less defense electronics and defense com is more or less surface solutions, is that right?

Clayton M. Jones - Chairman, President and Chief Executive Officer

I wouldn't exactly say there is one to one. We re-did that because we had a very major re-organization in our Government Systems business to focus a lot more on customers and customer demands, rather than the technology structure we’ve had in the past and so that's just a process of going through our very rich port-folio of products and trying to re-organize them into these two I think more descriptive components. So in essence the surface solution products are the ones that we provide to soldiers in ground or to ships and to Navy and than the airborne solutions you can say are more air force oriented and/or the airborne elements of, let’s say the Marine Core or the Army.

A few anomalies like that might be things like JTRS. There is so much synergy with all of our development in JTRS, we chose not to break that apart, so we would likely report, let’s say AMF component of JTRS under the surface solutions because it’s the other ones, the GMR and the HMS are such a huge portion of business and we don't want to break that up. So with just those few anomalies you can basically look at the application of our product and then sort them into one of those two categories.

Operator

And will take our next question from Alex Hamilton of Jesup & Lamont.

Alex Hamilton - Jesup & Lamont

Actually all of my questions have been answered thank you.

Clayton M. Jones - Chairman, President and Chief Executive Officer

Thank you Alex.

Operator

We'll go to next to David Gremmels of Thomas Weisel.

David Gremmels - Thomas Weisel Partners

My question is also answered thanks.

Clayton M. Jones - Chairman, President and Chief Executive Officer

Dana, I think we have one more caller on the line, I think Rob Spingarn didn’t get to ask his second question, so if he's there why don’t you put him on.

Operator

Thank you sir. We will go to Mr. Spingarn.

Robert Spingarn - Credit Suisse

Thanks very much. Clay you gave us a lot of information on 787 and that is much appreciated. We are starting to get at with some folks is pacing and whether the focus at this point is on those first six airplanes, those test aircraft and getting things to spack [ph] or getting into the ramp for airplanes 7 and beyond, and that's the question I have for you? You talked about extended R&D of a couple million dollars, in this latest scenario, what is it that your are actually working on, you've done developing product or is that on the ramp and are you producing production units yet?

Clayton M. Jones - Chairman, President and Chief Executive Officer

The answer is both of those things Rob. We are still working on the finalization, what we call moving from red label to black label and the vernacular of moving from sort of the initial production element and than black label is the certified element as we look at the last few changes and upgrades that we have to do in every product, it is always a process we use and based in electronics development. And we are still… we are finishing that up and we are on schedule.

Now, let’s go back to the original schedule.

Original schedule would suggest we would have all that done by this summer and we believe we will. And now the only issue is got to become what support we need to make to Boeing for the certification of that equipment. We think we did most of it right the first place but there is always things you pick up that you need to tweak in certification. There is also a need to keep at least some level of engineering support and on the ground operational support at Boeing field so that we can support Boeing. And so, our view is by the time we get through the summer almost all of the development process will be completed and now what we will do is we will have a small cadre that will be supporting Boeing in the final ramp certification and test of that airplane. And so, that's what I meant in my representation by not adding more problems or through spending a development problem but just adding support.

Robert Spingarn - Credit Suisse

Well, does that mean Clay that you really don't start building shipset seven and beyond until this summer?

Clayton M. Jones - Chairman, President and Chief Executive Officer

No, not at all. In fact we probably delivered in the order of 15 shipsets already.

Robert Spingarn - Credit Suisse

Okay. Thank you very much.

Clayton M. Jones - Chairman, President and Chief Executive Officer

And we will again, depending on what Boeing says continue to build those shipsets so long as they will except that so that they don’t have any ramp down inefficiencies and the hypothetical scenario I gave you would be consistent with Boeing's direction to us to slowdown our rates of production for that period of time.

Robert Spingarn - Credit Suisse

Are you capable of a rate of seven per month at this point?

Clayton M. Jones - Chairman, President and Chief Executive Officer

I tell you what, I can build them as fast as they can order them. I am not the limiting factor in any production rate Boeing would ever choose. I mean we are producing at much greater than that on established airplanes and we can ramp as fast as they used to.

Operator

And that does conclude the question-and-answer session. I would now like to turn the call back over to Mr. Dan Crookshank for any closing remarks.

Dan Crookshank - Vice President, Investor Relations

Thank you, Dana. I would just like everybody to know that there will be a… the 10-Q will be out there some time later today for review and I will be available for calls rest of the day. Thanks Dana back to you, to close it off.

Operator

Thank you, sir. And that does concludes today's conference call. Thank you for your participation and you may disconnect at this time.

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