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Hexcel Corp. (NYSE:HXL)

Q4 FY07 Earnings Call

January 24, 2008, 11:00 AM ET

Executives

Wayne C. Pensky - Sr. VP and CFO

David E. Berges - Chairman of the Board, CEO

Analysts

Steve Binder - Bear Stearns

Howard Rubel - Jefferies

John McNulty - Credit Suisse

Al Kaschalk - Wedbush

Nigel Coe - Deutsche Bank

Christina Fernandez - UBS

Peter Grondin - OSS Capital Management, L.L.C.

Steve Levinson - Stifel Nicolaus

Operator

Good day and welcome to the Hexcel Corporation’s fourth quarter earnings conference call. As a reminder, today's conference is being recorded. For opening remarks and introductions, I will now turn the conference over to Mr. Wayne Pensky, Chief Financial Officer. Please go ahead sir.

Wayne C. Pensky - Senior Vice President and Chief Financial Officer

Thank you. Good morning everyone. Welcome to Hexcel Corporation's 2007 fourth quarter and full-year review conference call on January 24, 2008. Before beginning, let me cover the formalities. First, I would like to remind everyone about the Safe Harbor provisions related to any forward-looking statements we may make during the course of this call. Certain statements contained in this call may constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. They involve estimates, assumptions, judgments and uncertainties caused by a variety of factors that could cause future actual results or outcomes to differ materially from our forward-looking statements today. Such factors are detailed in the company's SEC filings, including our 2006 10-K and today's press release.

Lastly, this call is being recorded by Hexcel Corporation and is copyrighted material. It cannot be recorded or rebroadcast without our expressed permission. Your participation on this call constitutes your consent to that request.

With me today are David Berges, Hexcel's Chairman and CEO and Michael Bacal, our Communications and Investor Relations Manager. The purpose of the call is to review our fourth quarter and full-year 2007 results detailed in our press release issued last night. First, Dave will cover the markets and I will cover the financials, and Dave will have some strategic points to cover before taking questions. So, like me hand the call over to Dave.

David E. Berges - Chairman of the Board, Chief Executive Officer

Thanks Wayne. Overall, we are very pleased with 2007 financial results, especially the second half. For the year, we met our guidance with constant dollar sales growth of 8%, gross margins over 24%, and adjusted operating income of 11.5%. And at long last, we have moved net debt leverage below two times EBITDA, down from over six times after 9/11l. On the top line, this was a record quarter for the company, with extremely strong growth in all of our target markets. We are fortunate to have a good global balance with almost 60% of our sales outside the US, but unfortunate that the euro was over 12% stronger than last year in the fourth quarter.

So, once again, I will give you the market trends in constant dollar equivalents to give you a better sense of the volume growth. Total sales of $318 million were up almost 21% in actual dollars, $43 million or 15.6% over last year when you factor in currency changes. Commercial aerospace sales were $170 million for the quarter, up 21.6% in constant dollars from last year. Sales to Boeing, engine and nacelle makers, as well as regional and business aircraft OEMs and their related subcontractors, were up over 25% in aggregate for the fourth quarter in a row. Airbus revenues for the quarter were up year-over-year for the first time in 2007, but it was only a modest increase from the A380 sales so far. We are pleased with the continued support for A380s from the airlines, as well as the good orders start for the new A350.

For the full year, constant dollar commercial aerospace sales were up 11.4%, despite a 5% decline in Airbus-related programs. As I mentioned earlier, all other sub-segments in this market were up over 25% for the year. As with the new 787, no details are yet available from Boeing as the schedule impacted much less from the scores of sub-contractors we will be supplying. Nevertheless, we believe sufficient other growth opportunities exist to offset any 2008 impacts to our 787 sales. And we are reaffirming our December earnings guidance for the year.

Boeing and Airbus combined have now reported nearly 3,000 orders for the year of 2007. And their combined backlog stands at over 6,800 aircraft over seven years at current production rates. And remember, our sales are almost exclusively to support new aircraft production. While the slowdown in travel may affect profitable spare part sales for many aerospace companies, this huge aircraft backlog provides Hexcel a significant buffer and visibility that differentiates us. And of course, rising fuel costs make the economics of the lighter aircrafts even more compelling.

Sales to space and defense markets were $72 million for the quarter, up almost 21% in constant currency, bringing the year-to-date growth rate to 12.5%. Last year's uncharacteristically flat S&D sales provided an easy comparison for us this year. But, averaging the last two years, yield is about 8% growth per year, in line with over five years of history. Strong global demand in rotor aircraft and US military aircraft were the main drivers of growth in this quarter. About half of the growth in the period was a result of booking significant tooling sales for a new helicopter program.

The overall outlook for helicopters remains very robust and the major airframers are all reporting strong backlogs. Overall, reported sales for our industrial markets of $76 million were up less than 1% in constant currency versus last year. Sales for recreation and other industrial applications were again lower than last year's period, but were higher sequentially than the third quarter levels. Wind energy sales were very strong, up more than 15% as they were for the full year.

We are now adding prepreg capacity in Europe, the US, and China that will support continued opportunity for growth in this sub-market.

Now, let me have Wayne go through some of the earning story.

Wayne C. Pensky - Senior Vice President and Chief Financial Officer

Thanks, Dave. First, let me remind everyone that while the weak dollar resulted in some of our sales translating into larger dollar amounts, it does not help our bottom line, as we have a fair amount of dollar sales matched with euro and British pound costs. And of course, it hurts margin ratio as a percent of sales. It had an impact of over 30 basis points on our adjusted operating margins for the year as compared to 2006. We're due to hedge our exposure in layers, so our pain of a continuing weak dollar gets averaged in.

As discussed at Investor Day, much of 2008 is hedged, but as we have averaged in a weaker dollar, our 2000 expectations reflect about another 40 basis points drop in margins compared to 2007.

Gross margins for the quarter increased to slightly more than $74 million or 23.4% of sales, 90 basis points higher than our performance in the comparable quarter last year. Operating income of $20.8 million included a number of one-time items, which I'll cover in a minute. So, excluding these one-time items, adjusted margins were 11.5% of sales for the quarter, 170 basis points higher than last year.

For all of 2007, adjusted operating margins were in line with our guidance at 11.5% as compared to 11.1% in 2006 despite the currency compression. Year-over-year, incremental adjusted operating margin was 20% for the quarter and 23% for the second half of 2007, reflecting a strong return to our leverage delivery track record of the years prior to the A380 delay. Exchange rate impact was most notable on the incremental leverage, as we had incremental sales dollars without having operating income. The fourth quarter leverage goes from 20% to 25% when you adjust for exchange rates.

As you've seen in the release, we've had a few one-time items I like to cover. The first two are included in the other operating expense line on our income statement, which totals to $12.6 million for the quarter and for the year. As we announced just over a year ago, we decided to terminate our legacy US defined benefit pension plan as we had replaced it with more predictable and portable contribution plans. The result for the quarter was a $9.4 million charge or about $0.06 per share. Final termination plan resulted in another $0.02 per share of expense in the first quarter of 2008. Hexcel contributed $3.3 million of cash for the plan in the fourth quarter and will contribute almost $8 million more in the first quarter of 2008. So, the total cash outflow to terminate the plan is about $11 million, and we anticipate savings will be approximately $2 million per year in pension costs. So, we have eliminated what was effectively our highest cost of debt.

Also in other operating expense is the one-time non-cash impairment of $3.2 million as part of our portfolio realignment related to certain purchased technology and fixed assets acquired earlier this decade. Our taxes remained somewhat volatile in part because of FIN 48 and part because of our large deferred tax assets created by net operating loss carry-forwards and in part because we are working on ways to improve our tax efficiency.

Our effective tax rate for the quarter was 25.9%, bringing our effective tax rate for the year to 36.1%. This quarter included a $1.9 million benefit from a change in estimates of the state net deferred tax assets. Excluding this benefit, the effective rate for the quarter and the year was around 38%. 2007 cash taxes were $17.9 million for the year as compared to the $33 million tax position that runs through our income statement.

With the changing Hexcel profitability profile and tax policies in the regions we serve, we’re just starting a comprehensive review of our tax strategies. While we hope to identify opportunities for improvement, it's too early to determine benefits from timing. So, we are not changing our 2008 outlook for tax, which assumes a 38% effective rate.

Our net income from continuing operations was $13 million or $0.13 per diluted share on a GAAP basis. If you adjust for the items I just discussed, then our adjusted non-GAAP net income was $0.20 per share. Our fourth quarter 2006 net income from continuing operations of $0.19 per share, included a $0.10 gain on the sale of our investments in a joint venture and the reversal of valuation allowances. So, the comparable adjusted net income numbers for the fourth quarter of 2006 would be $0.08 per share, compared to the $0.20 for 2007. Similar adjustments for the year are delineated in tables F and G of our press release that shows for the year adjusted EPS of $0.72 per share for 2007, 41% improvement over 2006.

The fourth quarter loss from discontinued operations includes a $1.1 million tax provision, which reflects the final estimate of taxes on the sale of EVGI business.

Return to our segment statements. Our operating margins for our Composite Materials segment was 12.8% for the quarter, compared to 9.2% last year. The adjusted operating margin for this segment was 15.3% for the quarter, compared to 12.9% in the fourth quarter of 2006, and for the year it was 15.6%, 100 basis point improvement over 2006. The Engineered Products segment operating margin for the quarter was 10.3% compared to 11% last year. For the year, the operating margin was 9.2%. The impacts of higher R&D spending and start-up cost related to the 787 components from our XMC System in the fourth quarter started to lessen, which helped to improve our margins.

Our net debt decreased by $5.4 million in the quarter to $288 million. In 2007, net debt decreased $99 million, which reflects $84 million from our asset sales. Our working capital for the quarter showed improvement as our accounts receivable did not increase as fast as our sales growth. Our inventories dropped $3 million in the quarter in constant currency, while our accounts payable and accrued liabilities did increase $16 million for the quarter. Our cash used for inventories for the year increased $19 million or about 13% to support our sales increases in the start-up of new facilities.

Capital spending for the quarter was $49 million and for the year it was $121 million, as compared to $118 million in 2006. We expect 2008 spending to be in the $150 million range with the carbon fiber expansion programs being the largest driver.

Now, let me turn it back to Dave for some final comments.

David E. Berges - Chairman of the Board, Chief Executive Officer

Thanks, Wayne. I am pleased we were able to deliver on our financial commitments for the year. But, just as importantly, we hit all five of our non-financial objectives that we presented in our December '06 Investor Day. Number one, our portfolio realignment has resulted in a more focused company with better long-term growth and profitability prospects. Over 80% of our markets and sub-markets delivered double-digit growth this year and have the potential to continue strong for years to come.

In fact, over the last five years, continuing operations have grown at a 12% compounded rate and adjusted operating income has grown at over a 30% rate. Number two, our restructuring programs have resulted in a single lean entity. They helped us offset the unfavorable stranded cost from our divestitures. In fact, we managed to deliver a second half adjusted operating margin higher than the first half rather than the 2 percentage point seasonal decline in the previous three years.

Number three, our capacity expansion programs are all on track, and our confidence in their yield, as well as our outlook, led us to announce another major carbon fiber expansion phase. Number four, our targeting of long-term industrial applications, what we call, looking for our second wind, resulted in a major win for uranium enrichment tubes with USEC that could add over $40 million a year to our run rate at the end of the decade.

And number five, our next-generation prepegs and new products like Acousti-Core, HexMC and HexTOOL are being embraced at a faster pace than any of us had expected, and we're well-positioned for all new programs, five-for-five, not interceptions or fumbles. Each is an important strategic initiative to maximize our prospects in a future that's bright even without them.

And with that we'd be happy to take your questions.

Question and Answer

Operator

[Operator Instructions] We will go first to Steve Binder with Bear Stearns.

Steve Binder - Bear Stearns

Good day. Can you maybe just touch on your comments about the 787, you said that you thought you could digest any slowdown in production, but can you quantify from a delivery stand in 2008, because there is a good chance, I guess, suppliers that have probably been behind schedule, you might see some adjustments with respect to that have been ahead of schedule. So I am just wondering, can you maybe touch on what programs could offset any 787 slowdown and what kind of slowdown could you really digest without having to change your sales forecast for Commercial Aerospace?

David E. Berges - Chairman of the Board, Chief Executive Officer

Well, I wasn't exactly pointing to Commercial Aerospace sales forecast, I am talking about our commitment to make our numbers. Let me say a couple of things. A, I don't think there will be much movement, though I really have almost no information. B, there are opportunities elsewhere whether in commercial aerospace or elsewhere in some lines and some products, we've been capacity constraint and there are other opportunities we had to walk past last year, as you know. And C, after 15 years in GE [inaudible], I have observed that somebody who gets a little bad news in January and says they can't make their year, doesn't have a very long career. So, we've got a full year to anticipate, make up and do what we need to do deliver the earnings that we talked about before. From a size perspective, on the 787, we started shipping well ahead of a program, if we were in primary prepreg, and a lot of the products that we are participating in the 787 is closer to delivery time. But, just a prelim scale, I know you have done this, over the next two years the original schedule was for 100 aircraft roughly of about 2,000 that will be built over the two years. So, it's less than 5% of the build count, even if you consider that it's double the content from what we average. Big aircraft is only 40% of the company. So, it's just hard to imagine that this could create the kind of hold that A380 did when we were so close to going at full production with so much of our product primary prepreg.

Steve Binder - Bear Stearns

A350, do you expect that, the Airbus to make some decisions by the end of the first quarter?

David E. Berges - Chairman of the Board, Chief Executive Officer

We've been giving indications that that sort of how long we think it would take. I'm not really prepared to give an update on that at this stage. Obviously, the further they go into the program, the more likely it is that something will have to be announced. But, there is a lot of detail to be worked through, so I'm just going to pass on that, if you let me.

Steve Binder - Bear Stearns

All right, thanks.

Operator

We will go next to Howard Rubel from Jefferies.

Howard Rubel - Jefferies

Thank you very much.

David E. Berges - Chairman of the Board, Chief Executive Officer

Good morning Howard.

Howard Rubel - Jefferies

Good morning gentlemen. Very nice members. A couple of things. Could you address raw material costs for a moment. Dave or Wayne, it seems that with oil near at near $100 or whatever that, it's have to have some adverse impact on your results?

David E. Berges - Chairman of the Board, Chief Executive Officer

We've told you many times that we try real hard to back to back contracts. In a lot of our purchased raw materials, we are able to do that as our suppliers understand we are making long-term commitments in many cases. We are not always able to do it. Energy costs, oil costs, absolutely have put pressure on a lot of our feedstocks and lot of our supplies. On the other hand, there is some activity on… some pricing power from our respect, both from the obvious impact of cost pressures for all materials going into our end customers, but also has contracts have closed out, we've been able to talk to them about the impact of the euro and the impact of feedstock. So, I think we have kept a pretty good balance on that and I think we are going to be okay.

Howard Rubel - Jefferies

Just a go on one more on gross margins. Sequentially, the fourth quarter is typically stronger than the third and this year that wasn't the case, despite the higher volumes. I know you explained part of it away with FX, but is there anything else tough that held you back from doing a little bit better because it seems to me the operating leverage is there for a fairly clear view of better performance?

David E. Berges - Chairman of the Board, Chief Executive Officer

We might have some impacts of FX or something, but as an operating guy, I'd say there are always opportunities to do better. We have been running at a very, very high stress level in many of our operations with the kind of growth in the 25% range that no one really predicted for this year. So, I am certain there are opportunities for reduced overtime premium freight and all of those kinds of things that I hope when we get a better balance we will be get back out of it. But, I am not uncomfortable with the kind of gross margin we deliver. Wayne, anything to--?

Wayne C. Pensky - Senior Vice President and Chief Financial Officer

Nothing additional to add. I think if you look at our fourth quarter this year, it has been better than fourth quarters in the past, and with all activities we have going on here, we are satisfied where we are at.

David E. Berges - Chairman of the Board, Chief Executive Officer

We do have the things we have talked about before. The Spanish plant we now have operators that were trained from Spain in Salt Lake are now back in Spain, so are our a lot of Salt Lake equipment startup specialists and operators and trainers are living in Spain working on the… checking out of our new line. We've got a line starting up also in Germany, and actually today we are doing the grand opening of a plant in North France, a satellite plant. It’s across the street from Airbus facility. So, there are some incremental costs, but I think we are going to be just fine in gross margins.

Howard Rubel – Jefferies

And then just one last follow-up. I thought you did a really nice job of managing inventories, given the revenue growth in the fourth quarter, was there anything in there that was… can take that across the go-line for the balance of the year?

David E. Berges - Chairman of the Board, Chief Executive Officer

I have been somewhat disappointed with our inventory performance in the last say six quarters. I think we have talked about it on this call a number of times. We did make progress in the fourth quarter. I want to see continued progress month by month and not just it some year-end goals in our factories. So, it is something we are putting a lot of focus on. We do have a bunch of incremental inventory stories or excuses that are valid, trying to build a precursor inventory ahead for our new fiber lines. These new plants, the closure of Livermore Plant required some incremental inventory. Take all of that out of the picture and our inventory still wasn’t as good as it could have been this year.

Howard Rubel – Jefferies

Thank you very much.

Operator

We will go next to John McNulty from Credit Suisse.

John McNulty - Credit Suisse

Good morning. Just a few questions. With regard to the Industrial business, I guess, back in your December Investor Day, you were targeting mid-teens growth with wind being kind of a big upper-teens kind of diver behind it. With the rest of that business, how much of it would you say you have in the bag because there are either new product launches or what have you that you are pretty confident in and how much would you say is exposed to whether or not we have a major recession or not?

David E. Berges - Chairman of the Board, Chief Executive Officer

Out side of wind you mean John?

John McNulty - Credit Suisse

Out side of wind, exactly.

David E. Berges - Chairman of the Board, Chief Executive Officer

Outside of wind is, first, not a very big part of the company and going through a bit of churn as we’ve talked exiting certain weaving business, distribution arrangements that were not a part of the EVGI portfolio sale, but aren’t as interesting to this. We also have had the limits of our capacity, in many cases, our availability of industrial carbon fiber, and then the weak recreational market in Europe. So, those three things caused the problem. So, we don’t have a real clear line of sight on any big chunks that are going to make a difference in that thing. We think the recreational market year-over-year should be an easy comparison, so we expect to see some growth there. We think the portfolio realignment, which mostly took place in the latter three quarters of the year, is behind us so that won’t pull down what otherwise would have some minor growth to it. And then...

Wayne C. Pensky - Senior Vice President and Chief Financial Officer

I can say, John, there's very little of that’s in there that is actually subject to long-term contracts. So, going back to Dave’s earlier point, it’s tough to get good visibility on it.

David E. Berges - Chairman of the Board, Chief Executive Officer

It's hundreds and hundreds and hundreds of customers. This is the 60th year of Hexcel and when we dig down in the other industrial, we find the biggest grouping within that is other. And as we dig down in that file and sub-file, we find the biggest grouping is other. It's a weaning process that some new leadership in US marketing is trying to weight through and get some sense around.

John McNulty - Credit Suisse

I guess my question then is, if you are looking in the Industrial segment for mid-teens growth and wind is less than half of the overall business or we are assuming it is, how do you get comfortable that you can hit that mid-teens number because the rest of Industrial, the non-wind portion really has to put up some pretty solid numbers, maybe not a strong as wind, but still some pretty solid numbers to hit your target?

Wayne C. Pensky - Senior Vice President and Chief Financial Officer

I guess I would admit to you that it is my area of least comfort of all of the various things that we talked about. I'm comfortable that we’ll hit mid-teens on the total Industrial, but whether it's over powered by wind and less performing on the other industrial, I'm not clear at this stage. A little longer term, we will have some sales from the USEC program, some of these other second wind items like HexTool applications, like the flywheels, and some others are getting a little bit of traction in our contributing and again we hope to have some easy comparisons year-over-year on both recreation and distribution parts of the business.

John McNulty - Credit Suisse

Okay. Great. That's helpful. And then the only other question, which is just more of a housekeeping one. On the tooling revenue recognition change, where you got, I guess, $5 million benefit this quarter, what was the profitability on that? Did that impact the margin either positively or negatively in terms of your overall corporate margins?

Wayne C. Pensky - Senior Vice President and Chief Financial Officer

John, I wouldn't think that it would have a material impact on margins either way.

John McNulty - Credit Suisse

Okay, great. Thanks a lot.

Operator

[Operator Instructions] We will go next to Al Kaschalk with Wedbush.

Al Kaschalk - Wedbush

Good morning guys.

David E. Berges - Chairman of the Board, Chief Executive Officer

Hi Al.

Al Kaschalk - Wedbush

Dave, can you comment in terms of what you said on Boeing, can be flipped to Airbus, what do you expect coming forward here related to the A380 program in terms of how we should think about production rates?

David E. Berges - Chairman of the Board, Chief Executive Officer

The final build rates they have published… a schedule have adamantly stuck to it. How it impacts us? All the way down as we have discussed before. It’s a very complex series of models. I think we've talked about this before. We know some of our sub tier suppliers who are building number 45 or 50 aircraft pieces and parts. Some of the bigger ones, of course, are much closer to the Airbus schedule. Very long supply chain that goes all over the world. About the best way we can characterize it is, is a couple of years ago, it was 10% of our aerospace sales and it dropped in the neighborhood of 5% of our aerospace sales after delays, two years in a row, as I recall. Those are the kinds of numbers we were putting up, there were very low in the first half of 2007. So, we have some fairly easy comparisons, so we would expect to be having Airbus growth this year with a significant help from the A380.

Al Kaschalk - Wedbush

If I may try another shot at it. As you work through '08, do you expect each quarter to seize an acceleration and contribution on the top line from the 380 program?

David E. Berges - Chairman of the Board, Chief Executive Officer

I do expect sequential growth in the A380 from now on as long as they stay on schedule, yes.

Al Kaschalk - Wedbush

Okay. And then if we can translate that into capacity which are building out. The CapEx dollars were significant in Q4. It appears to me that you're accelerating this process to build capacity. Is that a fair comment? And if so, what do we expect over the next two quarters in terms of communication on that front?

David E. Berges - Chairman of the Board, Chief Executive Officer

I don't know if I would say accelerating, we stepped up to a significant level of CapEx spending a couple of years at $120 million. We suggested in December that from what we see going forward assuming that these new programs go and we win our fair share or unfair share of them that we could sort of envision a 150 per year pace as being a reasonable expectation. So, we had a big step up, but I think we are kind of comfortable with the visibility of these programs that we have that we’ll be able to layer in the CapEx in a pretty orderly fashion.

Al Kaschalk - Wedbush

And then in terms of the margin questions that have been asked, it seems to me that what you achieved in the quarter was pretty good relative to the revenue number and why we shouldn't see substantially better results as volumes come online? And when do you expect that to come through?

David E. Berges - Chairman of the Board, Chief Executive Officer

We've indicated 50 basis point or 100 basis point margin expansion in 2008. We indicated in our December discussions that we target mid-teens operating income as a total company, and see a way to reasonably expect to get there by 2010, if we continue our leverage story. I'm hopeful that the incremental operating leverage that has historically been 20% can in fact improve as we start to get into higher-end intermediate modulus fiber mix in our output.

Al Kaschalk - Wedbush

Thanks for taking my questions.

David E. Berges - Chairman of the Board, Chief Executive Officer

Sure.

Operator

We'll take your next question from Nigel Coe with Deutsche Bank.

Nigel Coe - Deutsche Bank

Thanks. Good morning.

David E. Berges - Chairman of the Board, Chief Executive Officer

Good morning Nigel.

Nigel Coe - Deutsche Bank

You talked about a little bit about the second winds in an earlier question, how confident do you feel that's… at sometime during the next 12 months, you'd be envisioned [ph] to announce a major USEC type contract. Could this seem that longer term that the potential growth in Industrial [inaudible] ?

David E. Berges - Chairman of the Board, Chief Executive Officer

The ones we are working on, I don't expect a big step function announcement like USEC. That was a project that we've been working on for a long time, but it's sort of reached a no/no-go threshold last year with USEC, and when they flipped the switch, we were the winner. The other step we have are… don't have that sort of a binary character to them. It is an accumulation of a lot of things that have interesting characteristics from a sustainable competitive advantage standpoint that we are working, I think will start to give this sub-segment of Industrial some traction and let it join the double-digit ranks for the long-term like the rest of the markets appear to be.

Nigel Coe - Deutsche Bank

Okay. Is it likely doing bit more incremental and you wouldn’t necessarily, announce that it will just build at the time?

David E. Berges - Chairman of the Board, Chief Executive Officer

Correct. When I first introduced them, I called them long-term as not in a year or two. USEC, actually came out a little quicker than we expected. Otherwise, I still see this as sort of a two-three year thing that will provide good sustainable growth in that sub-segment.

Nigel Coe - Deutsche Bank

Okay, great. And secondly on the carbon fiber in Spain coming up on stream. Can you just remind me where the mix between, kind of, bought [ph] versus built carbon fiber will go now with this plant up and running?

David E. Berges - Chairman of the Board, Chief Executive Officer

I am sorry.

Wayne C. Pensky - Senior Vice President and Chief Financial Officer

I’d say bought versus built.

Nigel Coe - Deutsche Bank

Yes, that’s right.

David E. Berges - Chairman of the Board, Chief Executive Officer

As with all of our fiber lines, when they are running, the fiber is capable of going into industrial applications, and then we begin the process of optimizing and getting it to run well and then we start the… was generally is a year-long process to get it qualified and certified in aerospace. But, remember, when we need the first pound of aerospace fiber off of that new plant, we need to have it up and running and qualified. So we don't have 1.5 million pound un-served demand in aerospace high-grade carbon fiber or we would really be in big trouble and so would the industry. When we get it qualified for aerospace, it will then start to have an increasing mix of aerospace. In some cases, there are some make/buy choice potential, but typically these are fibers that are qualified, certified on certain platforms and don't change. So, the way to think about it is, when new capacity comes on, it will support and help us in our industrial markets for a year or two, and in the second year, it will start to gradually convert the utilization of that capacity to aerospace. So, it's a gradual process.

Nigel Coe - Deutsche Bank

Okay. I'm just thinking that, as you bring on a more capacity and you’ve got the new expansions in progress as well, you are obviously buying a proportion less fiber from [inaudible] for example, and therefore I am just tying to judge what the impact that mix might have as you move between OpEx and CapEx?

CapEx is rising as a proportion of sales, therefore OpEx should fall. Is that the way to think about it?

David E. Berges - Chairman of the Board, Chief Executive Officer

The mix, we would end up with a make versus buy. first and foremost on Industrial products. We would expand margins with that transition. The big margins come when we need that capacity for more premium products like aerospace. So, again it is a gradual, but it is steady gradual improvement. And to the extent we sell it into… sell the fiber into industrial markets, the margin is higher than our average margins because of the capital intensity and that whole pricing structure.

Nigel Coe - Deutsche Bank

Okay, got it. Just one final question on 787. How many ship sets have you delivered so far?

David E. Berges - Chairman of the Board, Chief Executive Officer

We are delivering yards and pounds and not airplane pieces and parts. So, don't have any ways to… we don’t have anyway to think about that.

Nigel Coe - Deutsche Bank

Okay, thanks.

Operator

We will go next to [inaudible].

Unidentified Analyst

Good morning. Just I was wondering if you can talk about leverage, you have increased your CapEx quite a bit, but you have kept leverage that’s pretty low… it’s now below two times. Is there any reason that should change in the near-term or are you guys comfortable with this very low level of leverage?

David E. Berges - Chairman of the Board, Chief Executive Officer

Very low level of leverage, I have been targeting two times since September 11. First of all, take a deep breath. In the fall of 2002, which was the last big credit crunch, we were a company with less than $50 million market cap and over $750 million of debt or $700 million of debt, six time levered in aerospace. We were today's equivalent to a sub-prime borrower, and a tornado alley trailer part needing a second home equity line. So, I feel pretty darn good that we’re below two. I don't think we're going to have big swings off of that for a little while as we expand via CapEx. I mean, the way I think about our capital expending is, it’s our acquisition equipment. We have kept it pretty well balanced for the last two years. We have higher returns in 2008, but little higher spending, I think we will again in 2008. And in 2009, the returns from the investments will start to outpace the capital, I would think so, we’d start expanding cash income and then we’d have to make some decisions about what we are going to do with leverage being too low.

Unidentified Analyst

Okay. That kind of feeds into my second question. Is all the CapEx in building up this capacity, is it simply a case where there aren’t assets to purchase or are the multiples out there are too high? How does that work?

David E. Berges - Chairman of the Board, Chief Executive Officer

You mean as far as acquisitions?

Unidentified Analyst

Yes, are there opportunities to make acquisitions rather than just go out build all this capacity out or there are just no opportunities?

David E. Berges - Chairman of the Board, Chief Executive Officer

I think the kind of capacity that we are talking about putting in place is very specific to our products. The industry is pretty concentrated, so I don't know that there is much consolidation that could go on without a regulator. As for other kinds of businesses, we just went through a lot of pain and agony to try to zero our focus down on these markets that we know and love and have great, great growth prospects. So, again I think of accelerating, maximizing our position on aerospace and wind and these new industrial opportunities as being our acquisition strategy, more than that, hoping to find another leg.

Unidentified Analyst

It makes sense. And lastly, if there are further delays in any of these big programs, would that slow your expansion plans, is there any chance that the CapEx comes in a little bit lighter this year or is that pretty much spent for ‘08?

David E. Berges - Chairman of the Board, Chief Executive Officer

You know the lead times on new programs are long and so are the requirements for putting in carbon fiber capacity. To put in new carbon fiber capacity and get aerospace qualified, it is sort of a three-year step, so that capital that we are putting in place this year and next isn’t for the A380 or the 787, that capital was spent some time ago.

Unidentified Analyst

Great. Thanks very much.

David E. Berges - Chairman of the Board, Chief Executive Officer

Sure.

Operator

We'll take our next question from Christina Fernandez with UBS.

Christina Fernandez – UBS

Going back to the 787, does the delay at all change your forecast for R&D expenses versus what you have planned until the aircraft gets delivered? And also how should we think about the margins on the initial shipments versus your Composite materials segment margin?

David E. Berges - Chairman of the Board, Chief Executive Officer

The R&D spending surge that we had, which wasn’t a big number, but the surge that we had in the recent five or six quarters was mostly focused on 787 qualification. Most of that work is done. So, you have seen a little bit of a tapering off in the fourth quarter. Now, if the 787 delay results in incorporation of more products such as more XMC parts, it is conceivable that we have another little flurry of R&D expansion. But, the result would be more parts on the aircraft… or more materials on the aircraft. So, it sort of a hard to lose situation with respect to that. I think the R&D will now start to move more towards A350, 787-8, A400M, and other programs. But, I think our R&D rates are still pretty low compared to people who are designing and developing equipment. As for margins, we don't have big swings across our aerospace or space and defense products or markets. Again, it is not like an equipment provider who gives very, very attractive pricing to the OEM and then makes it upon the spare parts later, we make our money at the OEM level because we don't have an after-market. So we try to have good margin throughout the program.

Christina Fernandez – UBS

Thanks. And then on your business consolidation and restructuring expenses, those came in just slightly about your guidance of $5 million to $7 million, was there anything different there? And is that still expected to drop off significantly in 2008?

David E. Berges - Chairman of the Board, Chief Executive Officer

Yes. Christiana, we did actually terminate a few more people than we expected and so we were able to actually take more cost out than we originally expected. So, that was part of that cost… part of the higher cost. With respect to 2008, about all that’s really left is soft of a final clean-up and remediation of the soil at our Livermore plant that we are in the process of selling. So, restructuring for next year at the moment shouldn't be a big number.

Christina Fernandez – UBS

Okay, thanks.

Operator

We will take our next question from Peter Grondin with OSS Capital.

Peter Grondin - OSS Capital Management, L.L.C.

Hi guys.

David E. Berges - Chairman of the Board, Chief Executive Officer

Good morning Pete.

Peter Grondin - OSS Capital Management, L.L.C.

Good morning guys. Great quarter. Just a quick question on the gross margin. With some of [inaudible] to the fact that you guys are obviously investing a lot in the build-up in Spain and so forth, and now you probably just started generating revenue there. It is not a CapEx issue, it is now sort of a cost of goods sold issue and you're running stuff through, but not generating a lot of revenues. So, could that have depressed the margin a little bit or just the FX situation?

David E. Berges - Chairman of the Board, Chief Executive Officer

It's a little bit of both, but with respect to Spain, we won’t be generating revenue probability till…say at least second quarter at the earliest. First quarter, I mean, we completed construction at the end of… or just completed the construction. The cost I was referred to earlier, as we had lot of training of the people there. And you're right those are running through the cost of good sold now. In the first quarter we will have cost in terms of starting up a line and getting that ready for production and that includes both training as well as the start-up and running material cost.

Wayne C. Pensky - Senior Vice President and Chief Financial Officer

As for now, looking on gross margin, I do think that the contribution of the capacity that we have added, Spain aside, contribution will start to come through, bear in mind all those capitals is now starting to hit us on depreciation, I think $8 million to $10 million more of incremental depreciation, which is mostly in the gross margin level. So couple of that in the quarter that we got to cover with the additional output or other productivity.

Peter Grondin - OSS Capital Management, L.L.C.

Okay, it is done.

Wayne C. Pensky - Senior Vice President and Chief Financial Officer

Thanks.

Operator

Okay. We’ll go next to Steve Levinson with Stifel Nicolaus.

Steve Levinson - Stifel Nicolaus

Thank you, good morning.

David E. Berges - Chairman of the Board, Chief Executive Officer

Good morning Steve

Steve Levinson - Stifel Nicolaus

Most of the good questions have been asked. You talked about the qualification process and in the past you've mentioned a little bit that you’ve gained a lot of knowledge from what you did at the Salt Lake. Do you think the Spain timetable is going to be that much longer?

David E. Berges - Chairman of the Board, Chief Executive Officer

I, in my mind I am trying to be a little more, expect my expectations a little bit lower on Spain than Salt Lake only because it's a Greenfield and we have very significant infrastructure in Salt Lake and ability to respond if there are maintenance issues. So, if you think about, you have been out there I think, Steve, it's a huge plan with infrastructure and now we are in the corn field with a plan, with some very hard-working dedicated well-intention employees, but less ability to respond. It's always a little bit more of a challenge. So, while I hope we are going to get our customers trained to handle new qualifications in an expeditious manner. I am not as helpful that the start-up issues with the Greenfield and in other countries with only the employees will make it an easy path in Spain.

Steve Levinson - Stifel Nicolaus

And then when it comes to A350 also about, once the materials qualified, could you go through again the testing procedure, the sampling procedure, and where you think it might have advantages over competitors? Do you want a spot there?

David E. Berges - Chairman of the Board, Chief Executive Officer

Well, engineers, as we’ve discussed before, have a long list of attributes that they would like to see in material, before they are willing to change it from the baseline materials. Base line material is usually whatever they were using on the last airplane. And in the case of the A380, the last airplane was based… the primary prepreg was based on our material on a [inaudible] actually. So. I think engineers on a new airplane would typically start there and decide whether they want to change the attributes of material to find some way to design a better, lighter airplane. So, they define what they would like. We do our best to deliver all of the attributes that they want. So does the competition. Then they look at our test results and they take samples and make pieces and parts and develop their test results. They put all those into a supercomputer to see if it actually helps like they thought it would and usually come back with additional changes that they would like to tweak and you start the process all over again. Once we start to get zeroed in on new baseline there is a very long, maybe a year and a half certification process that we have to go through to get all the way through, our proving our equipment then proving that it works on their equipment, proving that it makes the right kind of parts. So, as I said for many years on the A380, it's never really, really over until the airplane is certified. But the primary prepeg decision usually gets narrowed down very early on. So, I am certain they have a baseline in their mind. I am just not prepared to announce what our role in that baseline is.

Steve Levinson - Stifel Nicolaus

Okay, thanks. You mentioned HexMC and I guess it is no secret that they are still trying to take weight out of the 787. What sort of parts opportunities do you see there? Is it mostly interior or other structural parts too?

David E. Berges - Chairman of the Board, Chief Executive Officer

I think the current, the current dash numbers 787 is way well along and I'd be surprised that they… much change that because they are pretty far and long. I mean there might be opportunities if they decide to hold off on assembly substantially. I don't expect that that is going to happen. But we don't really know. I think it is more likely that we will get more places and imparts on the next dash numbers of the aircraft possible retrofits. Not generally the interior, I would say, inside the wing, skins and inside the fuselage, but not inside the interior that you see are thousands, and thousands, and thousands of metal parts that we think could be HexMC.

Steve Levinson - Stifel Nicolaus

Great. Thanks very much.

David E. Berges - Chairman of the Board, Chief Executive Officer

Sure.

Operator

We'll go next to [inaudible].

Unidentified Analyst

I just wondering if I can get some clarification on the impact of foreign exchange on your margins in order for what do you say happened, which is forex reduced margins, have to have some peculiar circumstances, either the expenses equal the revenues or the expenses are in countries growing up faster than in countries where the revenues growing up because of forex? I wonder if you could elaborate a little bit about how your costs are matched to revenues?

David E. Berges - Chairman of the Board, Chief Executive Officer

Sure. So, in the aerospace industry, the sales are in dollars, generally speaking. So, we could have production in a European country where we get… our sales are in dollars, but our costs are in euros or pounds. And so, we have a mismatch and we will have… if you look that P&L by currency, we’ll have actually negative. If you take the sales in local currency and compare them to the costs in local currency, the costs are much higher. The offset is we’ve got sales in dollars. So, we have to translate those sales in dollars to get them in local currency to pay our costs, with the weak dollar we lose on that exchange.

Unidentified Analyst

So, you have more expenses than revenues in foreign exchange in the strong currencies versus last year?

David E. Berges - Chairman of the Board, Chief Executive Officer

Well, by currency, overall don't know… overall we’re profitable, but if you looked at it by currency, we have lots of dollar profits, but partially offset by costs in the local currency. So, for example, between the euros and pounds, we are about $75 million to the negative and we are much more positive in the dollars, but we’ve got to take some of those dollars and covert them. So, we do this as we try to hedge that number until we’ve locked that number in and thus we can.

Unidentified Analyst

Is there any thought about trying to match the currency of doing more closely to the currency in costs?

David E. Berges - Chairman of the Board, Chief Executive Officer

Yes, I mean absolutely. The first priority, I should say… the first priority is to hedge as much of our material costs as we can. We are basically doing the same thing Airbus does. Airbus is selling planes in dollars, so they turn around to their suppliers and ask for them to purchase in dollars, so they have a natural hedge right there. So, we do the same thing. So, for example, most of the carbon fiber and resins are purchased in dollars and that backs as a natural hedge. But it’s our local costs of people and stuff is still in the local currency.

Unidentified Analyst

Thank you very much.

Operator

We’ll take a follow-up question from Howard Rubel with Jefferies.

Howard Rubel – Jefferies

I just wanted to go to cash flow for a moment. When do you think you will be able to get a little more done and sold?

Wayne Pensky - Senior Vice President and Chief Financial Officer

Howard, that probably won’t happen, it will hopefully happen this year. We actually do have it under contract. But we have to deliver a clean piece of land and it’s getting everybody to sign off [inaudible] to the site that’s been in place for our… manufacturing has been there 100 years. So, it is a matter of… I mean, if you drill by it now, it’s a piece of dirt and it’s just a matter of getting the dirt cleaned and then getting everybody to sign off that it’s cleaned.

Howard Rubel – Jefferies

Sounds like a lovely process.

Wayne Pensky - Senior Vice President and Chief Financial Officer

I'm sorry, I missed the final step, the zoning has to be changed until… that actually would take us the time.

Howard Rubel – Jefferies

So, maybe this year?

Wayne Pensky - Senior Vice President and Chief Financial Officer

Yes.

Howard Rubel – Jefferies

Thanks, Wayne.

Operator

This concludes today’s question-and-answer session as well as today's conference. We thank everyone for their participation. You may now disconnect your lines.

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Source: Hexcel Corp. Q4 2007 Earnings Call Transcript
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