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Hexcel Corporation (NYSE:HXL)

Q1 FY08 Earnings Call

April 22, 2008, 10:00 AM ET

Executives

Wayne C. Pensky - Sr. VP and CFO

David E. Berges - Chairman of the Board, CEO

Analysts

Howard A. Rubel - Jefferies

John P. McNulty - Credit Suisse First Boston

Steve Binder - Bear Stearns

Stephen Levenson - Stifel Nicolaus

Nigel Coe - Deutsche Bank

Al Kaschalk - Wedbush Morgan Securities

Operator

Good day, everyone, and welcome to the Hexcel Corporation First Quarter 2008 Earnings Conference Call. As a reminder, today's conference is being recorded. For opening remarks and introductions, I will now turn the call over to 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 2008 first quarter earnings conference call on April 22, 2008.

Before beginning, let me cover the formalities. First, I want 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 results or outcomes to differ materially from our forward-looking statements today. Such factors are detailed in the company's SEC filings including our 2007 10-K and last night's press release.

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

With me today are Dave Berges, Hexcel's Chairman and CEO, and Michael Bacal, our Communications, Investor Relations Manager. Purpose of this call is to review our 2008 first quarter results detailed in our press release issued last night. First, Dave will cover the markets and I will cover the financials before taking questions.

So, let me hand the call over to Dave.

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

Thanks, Wayne.

2008 started out with a bang with top line sales almost 22% higher than last year's first quarter leading to record sales and operating income for the second quarter in a row and a 50% year-over-year increase in net income when adjusted for one-time items.

As importantly, we made good progress on our global capacity expansion programs. Our new prepreg facilities in France and Germany are now engaged in material qualification runs. And next Tuesday is the formal opening ceremony for our new carbon fiber plant in Spain. Our next new fiber line in Salt Lake City has been accelerated into the third quarter of this year when we hope also to begin being wind energy prepreg manufacturing in our new plant in China.

All of these projects have put some short-term stress on our results but are essential to keep pace with the demand profile we see from our customers. We expect the new European plants to at least fully cover their incremental fixed and start-up costs in the second half.

As I am sure you are aware, this quarter we've seen a 14% year-over-year decline in the value of the dollar versus the euro. For reference, our reported top line sales of $344.5 million were 22% higher than last year as reported, but only 16% on a constant currency basis. So the apparent sales growth of $62 million was $47 million in real volume terms.

Commercial aerospace sales were $192 million for the quarter, up almost 30% even in constant dollars from last year. Sales to Airbus and its subcontractors were up over 35% for the quarter principally due to the continued growth in build rates. While sales related to the A380 were up both sequentially and year-over-year, they are still lower than the first quarters of 2005 and 2006.

Sales to Boeing’s regional and business aircraft OEMs and their subcontractors were up over 25% in aggregate for the fifth quarter in a row. It's still too early to comment on the impact of the 787, but as a result of detailed demand reviews with our customers, we are raising our estimated content per plane to $1.3 million to $1.6 million, up from our prior estimates of $1.0 million to $1.3 million. As for the A350, I have nothing new to report. We still expect the primary structural prepreg supplier or suppliers to be defined in the near future, and we still like our chances.

At the macro level, Boeing and Airbus again had year-over-year growth in quarterly aircraft orders in a very positive book-to-bill start for the year. Their combined backlog is approaching 7,300 aircraft, over seven years at current production rates. As I'm sure, you are all aware, most of this backlog is international, a lot of it from oil rich regions who have a different view of the economy. Domestic legacy carriers are certainly being stressed by high fuel costs and increased FAA scrutiny, but this only adds to their need to find a way to renew their fleets with new lightweight aircraft.

Sales to space and defense markets were $74 million for the quarter, up almost 11% in constant currency. Although, sales to this market are often unpredictable quarter-by-quarter, we're off to a strong start, and we’re confident of achieving at least our typical 8% to 10% growth target in this space. For the quarter, strong global demand in helicopters and US military aircraft were again the main drivers of our growth. Rotorcraft sales now amount to almost half of the total segment. We're pleased to see that Bell Boeing received orders for an additional 167 V-22 Ospreys, an important program for Hexcel.

Overall, reported sales for our industrial markets of $78 million were actually down almost 5% in constant currency versus last year. What we call our other industrial applications were again lower than last year's period principally due to carbon fiber availability. As usual, wind energy sales were very strong, up double-digits both sequentially and year-on-year. We now expect revenues from wind to be more than 50% of our industrial sales for the year.

New prepreg capacity coming on line in Austria this quarter will help us to meet near-term demand, and China comes on line in the second-half. We are also reviewing alternatives to add significant wind prepreg capacity in the US to follow our blade making customers.

Now, let me turn the call back over to Wayne to go through the earnings story.

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

Thanks, Dave.

First, let me spend some time discussing currency impact in detail because it affects all of our reported results and one of the items we have to manage. As Dave mentioned, the average dollar to the euro is 14% weaker for the first quarter of 2008 as compared to the first quarter of 2007. In fact, the spot rate at March 31, 2008, was nearly 19% weaker than the spot rate one year earlier.

Our income statement has two different impacts which helped to act as a natural hedge . First, more than one third of our sales are denominated in euros and pounds, so the weakening dollar causes those sales and the related cost and profits to translate higher. A weak dollar helps these sales and this impact is easy to understand. Second, the more complex impact is our European aerospace sales are primarily denominated in dollars but have a significant portion of their costs in euros and pounds .

The net result from these two impacts on our 2008 income statement is that the euros and pounds are an estimated $75 million equivalent net cost position. For the year, we have hedged approximately 75% of that net position. Specifically, the average actual rate for the quarter was about $1.50 per euro. We had about 75% of our net exposure hedged at 1.33 for the quarter and last year's first quarter hedge rate was 1.24. The difference in the hedge rates on the 75% of our exposure was factored into our plans and guidance, but the impact of the run-up to $1.50 per year this quarter on the 25% unhedged was not.

The rule of thumb you can use for 2008 is every 5% weakening of the dollar results in an increase in sales of approximately $25 million on an annual basis, with a reduction on 2008 operating income of less than $1 million. These impacts of course reduce our gross margin and operating income percentages. The difference in exchange rates lowered this quarter's total company gross margin by about 150 basis points and operating income by over 100 basis points as compared to last year. I know this isn’t easy or intuitive, but we thought this discussion might help you better understand our performance.

Gross margins for the quarter increased to slightly more than $80 million or 23.3% of sales as compared to last year's record 25.3% gross margin for the first quarter. As just discussed, exchange rate caused about a 150 basis points of the difference with the rest caused by incremental fixed and start up cost related to our new facilities in Spain, France, Germany and China. While we expect the currency pressures to continue, as Dave said, we do anticipate our new facilities to at least cover their incremental expenses in the second half.

Adjusted operating income increased to $8.7 million, a 28% increase over last year. Our adjusted operating margins increased from 11% in 2007 to 11.5% this quarter. While our incremental operating leverage is about 14%, if you do adjust for exchange rates, it was nearly 23%.

Selling, general, and administrative expenses were up less than 3% and would actually be 2% below last year on a constant currency basis, thanks in great part to the restructuring programs implemented last year. Sales, general, and administrative expenses as a percent of sales was 9.3% of sales compared to 11% last year. As in prior years, the largest portion of stock compensation expense is recorded in the first quarter. The first quarter expense this year was $5.2 million with the expected expense from the remaining quarters to be in the $2 million range.

As previously noted, we completed the termination of our legacy US defined benefit pension plan. The final charge on this item was $2.7 million or about $0.02 per diluted share as we anticipated. Our savings are approximately $2 million per year in pension costs, so we’ve eliminated what was effectively our highest cost of debt.

Our taxes remain somewhat volatile with the quarter’s provision at $9.6 million. This included a $2.5 million benefit from the reversal of valuation allowances against US deferred tax assets. Excluding the benefit, our effective rate was 38.5% for the quarter, a little above our 38% target for the year. We continue to review strategies to improve our tax efficiency.

Our net income from continuing operations was $23.2 million or $0.24 per diluted share on a GAAP basis. If we adjust for the items I just discussed, then our adjusted non-GAAP net income was $0.23 per share as compared to the $0.15 per share for the first quarter of 2007. Our net debt increased by $57.5 million in the quarter to $345 million. Approximately $35 million of the increase came from accounts receivable as a result of higher sales with growth in euro playing a major role in the increase.

Other uses of cash included the previously mentioned pension termination which contributed $6.4 million to the increase and the annual cash incentive awards as well as other working capital needs to fund sales growth. The first quarter historically has been the biggest consumption period for cash for the company and, this year includes almost $44 million in capital spending because of our capacity acceleration program, but we still target year-end net debt to be under $320 million.

So, now let me turn the call over to the operator to take your questions.

Question and Answer

Operator

Thank you. [Operator Instructions]. And we will go first to Howard Rubel with Jefferies.

Howard A. Rubel - Jefferies

I'm going to ask the obvious question, Wayne, if you do the math on this, it would seem to me that you shouldn't be talking about the high end of your guidance, because the deferred tax benefit reversal kind of pushes you a little bit higher than you would have thought three months ago or in December anyhow? So, shouldn't we really have been looking for even a high number for the full-year?

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

Yes, actually our guidance has always been on the non-GAAP basis, excluding both the pension termination cost and any tax-related adjustments.

Howard A. Rubel – Jefferies

And then just one follow-up, Dave. Even though you said we're... even though you are not going to get ahead of your customer on the 350, could you talk about what kind of couponing you are doing for them and what kind of feedback you're getting?

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

As I told you last summer, we were selling materials for development trials and certification, testing, verification or performance even last year. So we had sales to the A350 last year and will again this year in any case and we're very happy with our materials and hope they are too.

Howard A. Rubel – Jefferies

Just a follow-up on that, R&D spending was down and I know you talked about that a bit in the release. What might we see that for the full-year?

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

We've taken up our sort of base run level for R&D spending in recent years as we tried to develop new materials and improve our carbon fiber, but the big step up last year as we pointed out I think at each call was the certification process for HexMC parts. It's a procedure that we had not gone through in the past because it’s a new product range. So we had this pretty significant step up as we had got… as we participated in getting FAA certification for... on a part by part basis for HexMC parts in our engineered products business. We have now left that year and those parts are for the most part defined and cleared for production. So, I think whatever that increment was, I don't know if we pointed it out last year, it'll be down by that amount, but not as low as what it was two years ago.

Howard A. Rubel – Jefferies

Thank you.

Operator

And we will go next to John McNulty of Credit Suisse.

John P. McNulty - Credit Suisse First Boston

Yes, good morning.

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

Hi, John.

John P. McNulty - Credit Suisse First Boston

A few quick questions. The strength in the military business, how much of it is just from lumpiness versus, is there a reason I think that you made you better than your 8% to 10% range this year?

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

Any time we start out ahead of our expectation, we are encouraged; anytime we start up behind, we are cautious. So, of course, we have one quarter under our belt and we are at 11 and we guided to 8% to 10%. That product range as you’ve heard me say before goes to over 80 different programs around the world, and it is… each one of them can be lumpy, so it is a little early to declare on that.

John P. McNulty - Credit Suisse First Boston

Okay, great. On the start-up expenses that you were seeing with some of the plants ramp-ups, what was the impact of that on the first quarter? And again, you said you’d be covering it with the revenue, will you be covering and the profitabilities or the margins will actually kind of bounce back to where they should be, or is there still going to be a little bit of a margin hit on that going forward?

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

We call them start up on occasion but it's incremental fixed costs plus start up. So, the bigger piece of that at the beginning is new facilities with new leases and new depreciation and new supervision, staffing, indirect staffing that are working in the facility and spending money without getting any sales. So, that's the incremental costs… incremental fixed costs, and then there are start-up costs and training and those kinds of things.

The fixed costs, of course, don't go away; the start-up costs would go away, and then we start producing revenues that have margins. All we’ve said so far is that in aggregate those three plants, that is Spain, France and Germany will at least cover all of those increments, so that they won’t pull our margins down. We’ve not yet given you any more detail on whether they will contribute or accelerate margins.

John P. McNulty - Credit Suisse First Boston

Can you give us some color as to how much they pulled you down this quarter so that that part at least won't be pulled down for the next few?

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

Yeah, $3 million.

John P. McNulty - Credit Suisse First Boston

$3 million, okay. And then in terms of the weakness in the industrial business, can you give us some clarity as to how much of its just tied to a weakening of the overall economy versus how much of the weakness, or at least non-wind related weakness is tied to just not having carbon fiber for industrial applications?

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

If there is an economic impact or an economy impact, I wouldn't know about that or it's too far down. It is too far up the supply chain for me to figure out how to assess it. It’s principally availability of carbon fiber either our surplus to be able to sell into those markets or to put into prepregs or the availability of reasonably priced carbon fiber from the industrial markets.

Where we have prepaid capacity, we could conceivably buy carbon fiber if it is available and sell it into those markets if we started those business back up. So, it's principally a carbon fiber tightness. There is a possibility that that will loosen up at least short term as the 787 delay will likely create some excess carbon fiber capacity coming out of Toray. So, it might loosen up a little bit, I would say that's the main driver. There are still those other lesser important things such as the winter recreational market was hit from last year's very warm winter.

So, there is an inventory burn off at most of our European recreation customers. And we did do some pruning after the divestiture of those weaving businesses, some weaving operations that remain such as electronics business in Europe. I think that we start to lap that, those latter few items in the second half, actually a little bit in the second quarter. So, I think in the third quarter we have easier comps. To the extent we have carbon fiber available either from our start-up of our next line in Salt Lake or just from the open market, I think that will ease some of that pressure.

John P. McNulty - Credit Suisse First Boston

Okay. Great. Thanks a lot.

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

Less than 12% of the total company is being impacted by these factors.

Operator

We will go next to Steve Binder with Bear Stearns.

Steve Binder - Bear Stearns

Hi, good morning, Dave.

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

Hi, Steve.

Steve Binder - Bear Stearns

Hi, Wayne. Can you maybe just touch on, you called out kind of the dilution start up costs of overhead absorption issues from the new lines. And you talked about FX, but in the past, you've talked about other headwinds, whether it’s expedite costs, productivity issues, energy costs. When you look at your cost... from cost of operation standpoint, how would you kind of characterize the puts and takes in the business?

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

I thought we had a pretty good quarter. We've still got past dues at certain plants which means we will have money on the table with respect to sales and usually where we have significant past dues, we also have expedite and air freight. I don't think it was as bad as previous quarters.

On the other hand, we had a big increase, have steadily had a big increase in acrylonitrile cost for carbon fiber which is a commodity based price not on long-term contract and it generally tracks with oil. That hurt us a bunch but we just... we have to be able to absorb that, it's not really a mix-up. And transportation costs have definitely gone up significantly with the cost of fuel surcharges and the like.

Steve Binder - Bear Stearns

And also on MRJ and C-Series [ph], can we... maybe just update us, review, or is there… as far as content potential there?

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

I don't really have any detail on that. Yet, I mean the early looks at the C-Series design approach are a little more infusion and a little less prepregs, so it’s sort of a different weight of value and think about things, MRJ representing our wide range of capabilities, but I don't have much of a sense of what the potential is of that. I think it out far early to be able to say much.

Steve Binder - Bear Stearns

Okay, thank you.

Operator

[Operator Instructions]. We will go next to Stephen Levenson with Stifel Nicolaus.

Stephen Levenson - Stifel Nicolaus

Thanks very much. Good morning.

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

Hi, Steve.

Stephen Levenson - Stifel Nicolaus

Can you tell us where the extra 300,000 on each 787 is coming from?

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

Well, I would tell you that we have tens of products that go to tens of customers for hundreds of parts and sub-assemblies.

Stephen Levenson - Stifel Nicolaus

But it's not directly to Boeing then?

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

Well, most don't go to Boeing, correct. Each of these products and customer and sub-assemblies has per aircraft assumptions. We try to monitor it regularly and the reason we give you a range is partly because of different configurations and engine selections, but also because these assumptions at this level of detail keep moving around. So, we always sort of monitor exactly what the range looks like. In this, 787 push out exercise, we've engaged all of our top tier 1, tier 2, tier 3 customers in a detailed review to try to make sure we've got a good deal of what their inventory is and what the build rate change is, well, due to us, because I think you are going to ask me.

Now we haven't got it all totaled up yet because we don't have real good guidance on what the build rates are going to be. But in the process of that review, we also reviewed the actual requirements, the pounds or the yards or whatever per airplane, because you have different scrap rate [ph] assumptions and so forth. When we roll it all up, our low-end of the range was higher than previous guidance and we felt the need to update the market.

Stephen Levenson - Stifel Nicolaus

Okay. You did answer what we're going to ask. Another question, when the new carbon fiber launch come on, do you see that replacing purchased fiber or is that just going to be all incremental fiber sales or used in other products inside the company and how much additional margin can you capture as a result? Which way is better for you replacing purchased fiber or selling it outright as a different product?

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

Well, there is no simple answer, but always at the beginning of a new line start-up, our first priority is to get the line fine tuned and optimized to the point that we can start the qualification, because once you get it qualified, you can't change the settings. So, our first priority is to get the line running at its optimum performance, both in speed and quality of product coming off. In that process, we generate some carbon fiber that is usable in industrial markets and we're always easily able to sell that into industrial markets.

We can also put it into prepreg but because we don't know how long that product is going to run or how much we're going to do, we usually have customers lined up to take that fiber. As we start to run steadily, we now have a steady supply of fiber that can be used or sold into industrial. So, it starts the transition from going into prepreg or going to industrial customers as a straight outright sale.

And as we get our aerospace qualifications, hopefully, in addition to the demand being there, the percentage of the plant, it starts… the line, it starts to go into aerospace products starts to increase. It can be third party sales, but it tends to be a gradual introduction into our aerospace mix. So, at the beginning, if you're not running 100%, the margins are not great. As soon as the plant is running full-time, which is usually two, three months into the start up process, then you've got industrial sales and you get margin from moving in the industrial segment of our... the carbon fiber industry done in the industrial-level has got a sort of supply and demand elasticity that looks a little more like a commodity.

So prices have ranged from a few years ago when there was an excess down in the $6, $7, $8 range and they got as high as 13, 14, 15 last summer. So, it just depends on what the market was appraising us when we sell that into industrial as to what the margin is. Ultimately, though the real purpose for our fiber capacity expansions are to put into our advanced prepregs or to apply to high-end premium fiber markets that require intermediate modulus fiber such as military aircraft and the USEC project and so forth.

Stephen Levenson - Stifel Nicolaus

Thanks for all the details.

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

[inaudible] question.

Stephen Levenson - Stifel Nicolaus

Last thing is, have you seen anything about the 737, 700 light, where some metal components might be replaced with carbon fiber, and do you think that’s something again that would be a sale to Boeing or is that something where you may be have a little bit edge selling to some of the suppliers?

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

I don't see anything that really excites me. They're… both Boeing and Airbus, actually all the aircraft makers are always trying to do upgrades and improvements and upgrade their engines and so forth. Sometimes you get winglets or something that present some good but small incremental opportunity but usually the whole structural composition of an aircraft stays the same. So it's unusual that we get a significant path part out of a fix up of an old airplane unless it's a whole re-engineering kind of a project like the 747-800, so I’d always prefer a brand new airplane to be developed than an old one to be updated.

Stephen Levenson - Stifel Nicolaus

Okay. Thanks very much.

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

Yes.

Operator

And we'll go next to Nigel Coe with Deutsche Bank.

Unidentified Analyst - Deutsche Bank

This is actually Nicole de Blaise [ph] asking question on Nigel's behalf.

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

Sure. Good morning, Nicole..

Unidentified Analyst - Deutsche Bank

Good morning. Good quarter. Congratulations. Couple of things. First of all, can you kind of share some of your current thoughts on the 787 impact you’d have in '08 and 2009?

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

It’s a little early for that. We're comfortable enough with our outlook in total that we left the guidance on the high end. That's factoring in sort of a range of scenarios on the 787. From what I can gather, they haven’t put out much detail on this, but just from listening to the Boeing earnings call, from what I gather they are now talking about a more gradual or more conservative ramp up instead of the big jumpstart that they had in mind.

As they were starting to have appearances of delay some months ago, they were still holding to their commitment to build 109 airplanes by the end of 2009, and obviously aren’t going to do that. Beyond that, they seem to be a little bit unclear or not committed. So, it’s something softer than what we saw a year ago, but it's not radically different from what probably all the suppliers have been anticipating and planning for the last five, six months.

Unidentified Analyst - Deutsche Bank

Okay. Got it. And then, if the euro stays at current rates, what kind of impact can we expect for the full year on gross margins?

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

Yes, in terms of if the euro stays at its current rate, in terms of absolute dollars, we’re probably talking a few million dollars. In terms of the margin percentage, I think you’d still see the same impact that we saw in the first quarter of '08 versus the first quarter of '07.

Unidentified Analyst - Deutsche Bank

Okay, got it. And then how should we model the ramp up in D&A?

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

Of what? I am sorry.

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

I am sorry, is it ramp up of G&A?

Unidentified Analyst - Deutsche Bank

D&A. Depreciation.

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

I'm sorry. Okay. I mean, we've... the earlier guidance we gave was depreciation to be $8 million to $10 million higher for the year versus 2007. I think we're up $1.3 million I believe for the first quarter. We will probably.... you will start to see that ramp up a little bit more in the second and the third quarter.

Unidentified Analyst - Deutsche Bank

Okay. And one more. What growth… you guys had a really strong quarter in commercial aerospace. Can you kind of give some more color on how much growth A380 provided and how much revenue there was from 787?

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

They were both about equal and there are minor part of that explosive growth. That growth has been very strong from everything across the board. Turbo props, something that we hardly even paid attention to because they stopped being popular with fuel prices like they are, turboprop build rates are going great guns. Regional, Embraer and Bombardier are real strong. All of the business aircraft that use composites, though they aren’t a big, big number, business jets are having a booming year, selling to international customers. So, it's just a widespread thing this quarter, and the last, and the one before were strong because of the whole market, not because of the new airplanes.

Unidentified Analyst - Deutsche Bank

Okay. Got it. And one more for you, related to your ramping up in capacity, what does it do to 2008 CapEx?

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

We gave guidance for $150 million for this year and that's… we haven't changed that.

Unidentified Analyst - Deutsche Bank

Okay. Great. Thank you.

Operator

We will go next to Christina Fernandez [ph] with UBS.

Unidentified Analyst - UBS

Good morning. Going back to the capacity question with the acceleration this year, does that change the guidance you’ve given for '09 and beyond of $120 million or $150 million or should we see more capacity expansions?

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

We are.... it depends a little on how successful we are on programs, particularly the A350. We like the 150 pace because, if we are successful, and we need to add carbon fiber, I know this is about carbon fiber expansion. All of the prepregs and other kinds of things we do tend to be in, maintenance CapEx is in the $30 million to $40 million, and if you add prepregs capacity expansion for wind, addition of China and so forth, we would be well under our $100 million. It's really about carbon fiber buildup.

So if, for instance, we want a big position on the A350 or any other new carbon fiber application, the lead times are such that we think we’d be able to lay down a couple of lines per year, which is what we've been doing recently. And so, it's not firm guidance but we like the pace of the 150 a year assuming a win on the A350.

Unidentified Analyst - UBS

Can you talk about the trends in pricing for carbon fiber in the past couple of months and also you spoke about capacity easing up as a result of the 787 delay, does that affect that pricing... I mean do you expect that to affect pricing going forward?

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

I'm not real close to what industrial prices are in the stock market, but the industrial range is clearly… history would show, clearly dependent upon supply and demand equations. And so, starting at about 2002, the prices dropped pretty dramatically maybe even before that, 2000, I think as new capacity came online and the prices stayed low until I am thinking 2003 or 2004. And then, they spiked a lot, and availability became really difficult the last couple of years. Most users of industrial carbon fiber were on allocation. So, prices went up pretty high. I am just speculating. I have no data that if there is a significant 787 delay, there is a lot of capacity that’s in built to support it and there might be some availability that would help us with our industrial sales.

Unidentified Analyst - UBS

And one last one. Your 12% margins in engineered products, is that a new run rate that we should expect going forward?

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

Well, I think that business used to be in the 12, in the low teens. The last year with the start-up of these HexMC and all the certification costs, they all were in that business, and they knocked down below 10. So, I am not surprised to see the 12, not having those incremental cost. As with every product line, I would like to see improvement, but I am happy to see it back to 12 and I would like to see it going north from there.

Unidentified Analyst – UBS

Thanks.

Operator

We will go next to Mary Cross with Bliss Hall Capital [ph].

Unidentified Analyst

Good morning, everyone. Now you are seeing good growth in the wind sector, I was just wondering how the operating margins for your product for the wind sector compared to pricing margins for the other products that Hexcel offers?

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

Well, carbon fibers are highest by far as you would expect with the capital expenditures required, but that's a small part of our sales. And generally aerospace carbon prepregs like for space and defense in particular and commercial aerospace are probably next. All of our other products are good, not as high as those two, but they are good. In wind, we look a lot more to return on our capital because it is a very high volume, very high velocity business. So, it's a very attractive business to us in all respects, but a little lower on average and operating income percentage.

Unidentified Analyst

Okay. That's great. Thank you.

Operator

And we will go to Al Kaschalk with Wedbush Morgan.

Al Kaschalk - Wedbush Morgan Securities

Good morning, guys.

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

Hi, Al.

Al Kaschalk - Wedbush Morgan Securities

I just wanted to follow up on the engineering materials. Yes, it was very strong at 12%. What would maybe push that down in a given quarter as we look out over the next four to six quarters?

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

Hoping nothing. If we were to get into another big HexMC qualification program such as on the A350 for parts, we'd have those incremental R&D expenses which are recovered, generally at least in current contracts recovered through amortization and pricing as the parts are shipped. So just a little different from the historical model and that's why we spell that out, break that out. But the 12% is where it was, so we are really just where we were. I'd really rather see it go up as we go forward. I don't expect to see big drops unless we had a big qualification program.

Al Kaschalk - Wedbush Morgan Securities

Is it fair to say that then, David, most of the catch up in cost, amortization, pricing has been achieved?

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

Most of the… the incremental qualification cost on parts of the 787 is finished. That window sort of closed. Well, there might be incremental parts developed for say -9 or the next variant. Unless Boeing opens up the door for changes on the current configuration, I would expect that to stay stable until we get into HexMC parts for the next program. Now the A350 is out of ways, the spending usually isn't this far ahead of a program for HexMC parts, but this is sort of a new product line and a whole new concept, so I'm not really clear on that yet.

Al Kaschalk - Wedbush Morgan Securities

Okay.

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

I think you should expect margins like that or better as you go forward.

Al Kaschalk - Wedbush Morgan Securities

Okay, we will make sure we put that on the scorecard here. Secondly, and I don't know that from your prepared remarks and previous answer to a question, I would like to ask and see what should we expect over the next three to six months, in terms of a communication from you or the company, as it relates to build rates at Airbus, specifically, on the A380 and then Boeing 787, because I have to believe there is discussions that you've had at least with your customers to get back to production rates, and I realize I don't want to take anything away from the strong performance across the board here, but clearly this is something that continued to help the stock price.

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

I am not sure if I understand the question. The ramp up we started on the A380 a couple of years ago got us up to 10% of the commercial aerospace segment in the first half of 2005 and again in 2006 and we are on our way to ramping up. I mean you can also triangulate and figure out what full run rate would be. If you figure the $3 million or so per airplane, pick your run rate for Airbus; if you believe they are going to get to 40 a year, you can do the math. So, we are just... I mean again it's 10 or 20 different sub-tiers around the world and we are feeding that ramp rate. So, somewhere from where we are to date, full run rate is going to be a path that isn't real clear to us. We’ve tried to give you a little bit of sense of where there was a big pop in the quarter, but it's not going to be a real easily predictable sort of growth path, I don't think.

Al Kaschalk - Wedbush Morgan Securities

Okay. So just that it may not detract any slowdown like it did here in the quarter, it also may not have any material impact necessarily in the near future given the strength and help of the other parts of your business?

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

You said… given that it didn't detract us or the slowdown out or the push out of 787 didn't hold us back, you mean?.

Al Kaschalk - Wedbush Morgan Securities

Yes, I think investors are looking for some type of timeframe in which there is an acceleration in production rates at those two new… the two larger component --

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

Yes, I can’t tell you --

Al Kaschalk - Wedbush Morgan Securities

And I just want to settle the… see if that's really a fair assessment, or if you believe that the health of your other businesses are going to be more than compensate for any detraction there?

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

I can't tell you on the… when the 787 acceleration will look, because I don't have enough information. It was not a detractor this quarter. It was about equal to last quarter and about equal to the quarter before. The A380, I would expect to start seeing some acceleration, assuming we don't have further delays from Airbus as I think we’ve now taken up the slack in the rope and we've had three quarters of growth, they are just not overwhelming numbers. The strength of this quarter was on everything else is my point. As we go forward, I expect continued strength in all of these other markets and then incremental contribution probably first from the A380 and more significantly from the A380 until the 787 gets sorted out. And Al, that’s as far as close as I can get you.

Al Kaschalk - Wedbush Morgan Securities

Very good. And then just finally, with all of the changes on acceleration and CapEx, et cetera, it appears that we are still focusing on free cash flow, positive, at least breakeven for '08, is that fair, Wayne?

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

Right. If we can keep the [inaudible]. (41:29)

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

Yes. When we look at 2007 and 2008 together, we said we’d be basically cash flow neutral and we are still targeting that.

Al Kaschalk - Wedbush Morgan Securities

Great. Thanks, again.

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

Okay.

Operator

And this does conclude today's conference. We do appreciate your participation. At this time, you may now disconnect

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Source: Hexcel Corp. Q1 2008 Earnings Call Transcript
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