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Hexcel (NYSE:HXL)

Q2 2012 Earnings Call

July 24, 2012 10:00 am ET

Executives

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

David E. Berges - Chairman and Chief Executive Officer

Nick L. Stanage - President and Chief Operating Officer

Analysts

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

Abhiram Rajendran - Crédit Suisse AG, Research Division

Amit Mehrotra - Deutsche Bank AG, Research Division

Howard A. Rubel - Jefferies & Company, Inc., Research Division

Michael Lew - Needham & Company, LLC, Research Division

Avinash Kant - D.A. Davidson & Co., Research Division

Peter J. Cozzone - KeyBanc Capital Markets Inc., Research Division

David E. Strauss - UBS Investment Bank, Research Division

Operator

Good day, and welcome to the Hexcel Corporation Second Quarter Earnings Call. Today's conference is being recorded. At this time, I'd like to turn the conference over to Wayne Pensky, Senior Vice President and Chief Financial Officer. Please go ahead, sir.

Wayne C. Pensky

Great. Thank you. Good morning, everyone. Welcome to Hexcel Corporation's 2012 Second Quarter Earnings Conference Call on July 24, 2012.

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 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 2011 10-K, our second quarter 10-Q and last night's press release.

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

With me today are Dave Berges, Hexcel's Chairman and CEO; Nick Stanage, our President and Chief Operating Officer; and Michael Bacal, our Communications and Investor Relations Manager.

The purpose of the call is to review our 2012 second quarter results detailed in our press release issued yesterday. First, Dave will cover the markets, then I will cover some of the financial details, and then we'll take your questions.

David E. Berges

Thanks, Wayne. Good morning, everyone. We had another great quarter, with sales up $399 million, up over last year by about 16% on a constant currency basis, or 13% as reported. Sequentially, second quarter sales looked a lot like the first quarter, but with even better margins. Plus, we had some onetime items that combined to add $0.05 to our EPS. Adjusting out the onetime items from both periods, diluted EPS of $0.42 was 31% better than 2011.

Thanks to our good execution and strong conversion on incremental sales, improved our adjusted operating income to 16.1%. This was a 210-basis-point improvement over the second quarter of 2011, with only 30 basis points coming from favorable currency impacts. We again set company records this quarter for the highest operating income dollars and percents and for adjusted net income.

Now let me cover the markets using constant dollars to describe the trends. Commercial aerospace of $233.5 million for the quarter were up over 14% in constant currency from 2011, with growth in each of our submarkets. Total revenues from new programs increased by more than 30% for the quarter versus the prior year and now account for about 30% of our total commercial aerospace sales.

Sales for legacy platforms at Airbus and Boeing were up modestly from the second quarter of 2011, but lower sequentially as sales rates moved back in line with aircraft production levels.

Sales to other commercial aerospace, which includes regional and business aircraft, were up over 10% compared to the prior year, but also slightly down sequentially.

Space & defense revenues were $88.1 million, up about 10% on a constant currency basis versus the second quarter of 2011 and up almost 4% from the first quarter. Growth in rotorcraft continues to be the primary driver.

In industrial markets, sales for the quarter were $77.6 million, up about 28% year-over-year in constant currency. Wind sales were up significantly over an easy comparison to last year's second quarter, and they have now grown sequentially for the last 6 quarters. While we're encouraged by this growth and the large backlog of turbines on order with our largest customer, our guidance for the year assumes a second half similar to the second half of 2011 due to economic and policy uncertainties.

Now let me turn it back over to Wayne for some additional comments on the financials.

Wayne C. Pensky

Thanks, Dave. Gross margin of $105.5 million for the quarter was 26.4% of sales as compared to 24.6% in the second quarter of 2011, due to good leverage on the strong sales volume and favorable impact of exchange rates.

SG&A and R&T cost grew less than revenues, and that's improved to 10.3% of sales. Our foreign exchange rates contributed about 30 basis points to the higher operating income percentage in the quarter as compared to last year and about 40 basis points to the year-to-date operating income percentage. Our operating leverage continues to be strong. After adjusting for exchange rates, we delivered 28% incremental operating income on the sales growth for the quarter and 26% for the first half of the year.

Additionally, during the quarter, we experienced 3 onetime events that impacted reported operating income as presented in Table C of last night's press release. They netted $9.5 million in income and consisted of $9.6 million in income from settling our business interruption insurance claim arising from the April 2011 tornado that hit our Alabama PAN facility; a gain of $4.9 million from the sale of land in Livermore, California, the site of a previously closed manufacturing facility; and lastly, a $5 million in charges to the environmental reserves, primarily for remediation of a manufacturing facility in Lodi, New Jersey that was sold in 1996 -- excuse me, 1986.

As you may recall, during the second quarter, we redeemed the remaining $73.5 million of our 6.75% senior subordinated notes, which resulted in a $1.1 million charge, or $0.01 per share, from the accelerated amortization of deferred financing costs and expensing of the call premium. The redemption was funded by a $75 million add-on to our senior secured credit facility.

Our year-to-date effective tax rate was 31.8%, which is in line with our guidance and about the same as last year's tax rate, after excluding onetime benefits. Our free cash flow into 2012's first half was a use of $71 million as compared to a source of $9.5 million in 2011. This reflects the increased capital spending for ongoing capacity increases.

In the first half of 2012, we paid cash of $144 million for capital expenditures as compared to $68 million in 2011. We are still targeting to spend between $250 million and $275 million for capital expenditures this year, and we expect our capital spending to be funded by our cash from operating activities and our existing credit facilities. We estimate we'll use between $50 million and $75 million cash for the full year of 2012.

We would now be happy to take your questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Steve Levenson from Stifel, Nicolaus.

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

I'm sure you'll get lots of questions about the margins afterwards, but I figured I'd ask about some of the new products. On A350, do the potential delays like the drilling machine issue that's been widely reported have an impact on your schedule? Or do you think you can stick to what you anticipated at the start of the year?

David E. Berges

Well, as I've said before, I'm not going to front run the customer. But as you may have seen, the whole front fuselage for the first flight aircraft was delivered to Toulouse this month. If you haven't seen it, it's on the Airbus website, a picture of it. And yes, they've had some difficulties with the mounting holes on the wing. But at the Farnborough Airshow last week, the Airbus CEO said that the most critical phase, the assembly, is behind them. Also, at the show, you certainly noticed that Cathay became the launch customer for the A350-1000. The new larger version of the A350 is scheduled to be introduced 2 years behind the -900, so that's great news. But as for timing, also again quoting Fabrice Brégier, the CEO of Airbus, he told the Financial Times that, "The schedule was challenging, but achievable." And then a point that he made that I do want to quote is he said, "Let me put it this way, we'll do better than the market consensus." So I guess the real question is what the markets assumed and how will their performance compare to that. As for us, we're tracking -- paying very close attention to them. We're very tightly intertwined with their program team, and we'd make adjustments that we need to. Right now, I don't see any big changes in what we expected as we came into the year, and we're pretty pleased with what we see and hear.

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

And the second item is something coming out of Rolls-Royce and GKN. I guess, in order to compete, they're looking at making a composite fan blade for some of their new engines, as well as a composite fan case. Is there anything you can tell us about Hexcel's involvement there, please?

David E. Berges

Well, we're involved with all of the engine makers, all of the nacelle makers and all of the airplane makers. So if there's composite work going on, you can put us down for being involved. Rolls-Royce and Pratt & Whitney have long studied the fan and long been interested in increasing composites in the case. GE is obviously taking the lead on that from the early '90s, mid-'90s on the GE-90. Whether that ends up being in fact in the fan, it remains to be seen. But we're working on development programs with all of them.

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

Okay. And do you think you have an edge over the other guys as you're the only ones right now in the engine materials business?

David E. Berges

Well, I always like to think we have an edge, Steve. And the materials are -- composite material systems are about performance of the materials. They're not unique necessarily to what part of the engine or what part of the nacelle, though we have certainly the broadest range of products. So we're more likely to have a range of products that can interest engine and nacelle people when they're trying to reduce weight.

Operator

Our next question comes from John McNulty with Credit Suisse.

Abhiram Rajendran - Crédit Suisse AG, Research Division

This is Abhi Rajendran calling in for John. A couple of quick questions. Your margins are now at record levels, so I was just wondering how we should think about the potential for them to push higher from here. And maybe you could remind us of some of your longer-term goals for margins?

David E. Berges

Well, as you note, we've had some pretty darn good margins. In fact, for 4 quarters in a row, Nick Stanage and his operation team have embarrassed me by delivering more leverage than I expected. Just looking this morning, the LTM leverage is now over 30% operating income on the incremental growth, well above my 20%-plus guidance. In addition to SG&A cost control, we've had over 35% gross margin leverage over the last 12 months. We've had some help from strengthening dollar, lower AN prices and natural gas prices, but factory performance has also been outstanding. So hats off to the operations team. As for taking up the guidance, I still want to stick with the 20%-plus EBIT leverage guidance. We have new line start ups, timing of certain programs that always worry me a little bit, but I guess I could say we can comfortably be over 20% plus. Some of you know I'm a struggling golfer. I kind of feel like I've had 2 birdies in a row and my knees are knocking on the next tee. So we'd like to continue to outperform our 20%-plus expectation.

Abhiram Rajendran - Crédit Suisse AG, Research Division

Got it. And then a quick question on commercial aerospace. So the 12.5% growth that you put up in the quarter was obviously a little bit less than the 20% to 30% growth we've seen over the last several quarters. How should we think about growth in that segment throughout the rest of the year?

David E. Berges

Well, I think new programs will continue to grow as far as the eye can see, as long as there are more programs in the pipeline. So as I've said before, you have A380, 747-8 that are hitting stride now. 787 is starting to climb and really records some nice year-over-year gains. The A350 is growing nicely and certainly will grow dramatically after the 787 does. And then the new engining programs for the A320, followed by the new engining on the 737. So that segment, which is now 30% of commercial aerospace, you can expect darn good growth. And it's, of course, on a bigger and bigger number. The legacy aerospace, we mentioned on the last call, it was running a little hot in the last couple of quarters. It seemed to us that our sales to legacy were higher than line rates would suggest, and we attributed that to inventory restocking after the big downdraft of inventory through the whole supply chain in 2009 and 2010. If this quarter's any indication, we've got that behind us now, and now we think we're properly aligned with the current build rates, and we should start to see line rate-based increases going forward, which look to be in the 10% to -- 6% to 10% per year range, according to the current announced rates. As for the other commercial aerospace, it's always a bit of a wildcard. It seems to have settled in, in the $140 million to $160 million per year run rate. Until there's a pretty strong recovery in the economy, I wouldn't expect that to get back to the $200 million rate that we used to see.

Abhiram Rajendran - Crédit Suisse AG, Research Division

Okay, great. And then one last question, if I may. On the wind side of the business, you're looking for sequentials to slow down in the second half. I guess, beyond general macro uncertainties and some potential financing issues, how should we think about the environment for subsidies and credits for wind projects on a global basis beyond this year?

David E. Berges

Well, I know a lot of people are worried about the U.S. production tax credit, and there's an awful lot of press coming out of all of the wind turbine makers trying to urge Congress and the administration to make a move on the PTC. I'd say, even if the PTC is extended, you're going to have a slowdown in U.S. installations in 2013 just because of the cycle that it takes. I think you shouldn't get too focused on the PTC as far as Hexcel's sales go. Hexcel's sales are principally to Vestas. They're very diverse in their backlog. Their U.S. orders in the last year have been less than 20%, last 2 years, less than 20% of their order backlog. And while I do worry about low natural gas costs or credit in Europe or lower demand or grid problems in China, the fact is, in the last 12 months, Vestas has still kept up an order pace. Their orders, announced orders for motors for the last 12 months are 6.5 gigawatts. That's 25% higher than their 2011 delivery rate. So their book-to-bill must still look pretty good, and they had a backlog coming into it. Now I don't know what goes on with cancellations and push outs underneath the covers, but the fact is, our customer seems to be doing pretty well, and thus we've had 6 quarters of growth. Our outlook for the second half is more a matter of being conservative because of the uncertainties than it is a lack of confidence in the backlog that Vestas has accumulated.

Operator

We'll take our next question from Amit Mehrotra with Deutsche Bank.

Amit Mehrotra - Deutsche Bank AG, Research Division

Dave or Nick, can you comment on the operating leverage in the wind business, specifically on the downside? If wind were to take a step function change down, how should we think about the decremental margins in that business before and after any cost reductions?

David E. Berges

Well, I would say leverage on the way up is always easy, minimizing the leverage on the way down is always hard. But we've been doing it for 11 years. Sadly, we've had a couple of experiences after September 11 and with the electronics meltdown. And, in fact, we had a pretty serious drop in wind 3 or 4 years ago. So if you look at 2009, 2010 -- I mean, we don't break wind out for you, so I can't answer your question specifically, but we got good, favorable leverage this year because we have these new plants in U.S. and China. And as we started to fill them up and use them, we had real good increments on wind, even though it is a lower-margin product line than the rest of our businesses. It's an incremental world. So I think you can count on Nick and his team to manage what cutbacks need to be made, if there is a slowdown. But again, as I say, I don't see -- I really don't see trouble in the next 2 to 4 to 6 quarters in wind.

Amit Mehrotra - Deutsche Bank AG, Research Division

So $1 of sales loss in wind on an incremental profit basis would equal more or less? Or would it be directionally less or directionally more than $1 loss, incremental loss, on the commercial aerospace side of the business?

David E. Berges

Nick, give me a...

Nick L. Stanage

I'll go with less.

David E. Berges

I guess I'll dodge that by saying it sort of depends on what region the sales decline is. It's equally across all regions, and I've got 3 plants then running inefficiently versus a serious slowdown in one where we could shift work and be more efficient. How was that for a dodge?

Amit Mehrotra - Deutsche Bank AG, Research Division

Okay, I'll try another question. Can you just update us on the A380? Are the shipments currently at the run rate of the most recent production slowdown? Or will there be some sequential headwind on that program as you sort of meet the slowdown that Airbus has announced?

David E. Berges

If I had to make a worry list, it's a short list. But I don't think we've seen as much of a slowdown. I do think the step down is proportional to what build rates have happened. What I'm a little bit worried about is if there's going to be an inventory correction because of that slowdown. If there is, we haven't seen that yet. The first and second quarter comparisons would suggest that it's an orderly slowdown in anticipation of going back up. But I'm not sure we've seen all the cards on that. So I think I'd have a better answer for you in another quarter or 2. And then I think we'll certainly be stabilized.

Amit Mehrotra - Deutsche Bank AG, Research Division

Okay. Just one last quick question and then I'll hop off. Just on cash flow, looking in 2013, I know you don't have guidance. But if we just look at the moving parts, earnings should be up $20 million, $25 million, D&A will be up another maybe $10 million, CapEx probably stays where it is for another year. That gets you to about a $20 million to $25 million free cash flow burn for next year, assuming sort of the similar working capital investment for this year. Is that in the ballpark? Or is there something there that will make it materially different than that?

David E. Berges

Wayne would probably always nod at some burn rate and cash and I will always tell you we want to fund our CapEx with operating cash. And I'm looking at Nick and making sure he's nodding with me on that.

Amit Mehrotra - Deutsche Bank AG, Research Division

So 2013, we could see free cash flow break even to positive?

David E. Berges

That's always my target, and I think we could get there. Whether or not that's where our guidance ends up, I don't know.

Operator

[Operator Instructions] Our next question comes from Howard Rubel with Jefferies.

Howard A. Rubel - Jefferies & Company, Inc., Research Division

Dave, just to kind of touch on a couple of operational things, what are you doing with headcount? I mean, on one hand, clearly the business is growing. On the other hand, there's some incremental uncertainties.

David E. Berges

Well, we're going with demand. And the uncertainties that most of you are feeling, with Spanish debt and such, just don't line up with our demand. We struggled a little last year to keep up with demand, so we're -- we want to make sure we stay ahead of it because we get great leverage. So we add less people than our sales go up, and that's why we're delivering these great leverage numbers. I think we're always conservative on it. It is extremely painful and incredibly expensive to have to take people out and retrain when they come back up again, so I think we're being prudent about it. But I'm not making any apologies for the world's difficulties. We've got growth.

Howard A. Rubel - Jefferies & Company, Inc., Research Division

Your adding a little bit of overtime then is -- and a process -- in the process, I would guess?

David E. Berges

We always end up with some overtime, especially if we have frantic growth. So we've had 9 straight quarters of year-over-year orderly double-digit growth. And I say orderly as opposed to frantic growth. I go back to -- you were here, I go back to the first half of 2008, we had a 23% year-over-year growth rate for that half. It was 17% sequentially. The scramble to higher excess set ups, over time, premium shipments resulted in a lousy 9% operating leverage on the growth. It's much easier to make productivity improvements and to get good leverage when it's a steady trend in the teens, as demonstrated in the last 12 months. So -- and just one last factoid, I was looking this morning, the first half of 2008 with that frantic growth, we delivered the best operating income in the history of the company, but we made more EBIT this quarter than that entire half, even though the sales were only at a 13% higher run rate. So orderly double-digit growth is a great way for us to expand our margins and see what Nick is made of.

Howard A. Rubel - Jefferies & Company, Inc., Research Division

No, that's exactly what you seem to be doing, and you seem to have better, I'll call it, touch points into the supply chain than you've ever had. Can you maybe elaborate a little bit on that?

David E. Berges

Can you elaborate on the question?

Howard A. Rubel - Jefferies & Company, Inc., Research Division

Well, I mean, there's always -- you're always pushing back to make sure that there's not too much somewhere or that, in fact, you're managing the business so that...

David E. Berges

Oh, sure. So you're talking about our customers, right, which -- so forward to the supply chain. Yes, we work hard after the A380, the fiasco of the early 2000s when there was so much inventory in there. We ended up figuring out a process to go touch every single user of the materials and try to get and keep an eye on how much they have in their pipeline going forward. So we have a better sense of what either shortages or oversupply might be coming down the road. It helps us plan a little better, plan our staffing, plan our capital. So thanks for noticing.

Howard A. Rubel - Jefferies & Company, Inc., Research Division

And then the last thing, and I'm going to notice this too, is that the GE guys are very excited about what your products are going to do on the MAX or on the Leap-X, and it looks like Boeing has more or less defined what the MAX is going to be. How do you feel about your content today versus maybe 12 months ago on both of those airplanes?

David E. Berges

On the reengines? The planes?

Howard A. Rubel - Jefferies & Company, Inc., Research Division

Yes, sir. Yes. Yes.

David E. Berges

Well, I would love to tell you that it's way, way, way too early to talk about it. But we did, just to get people calibrated, put out sort of a target of a 50% increase per airplane on both of those programs last fall, just because we had people sort of guessing all over the map. I think that's a reasonable target. In fact, I think it's one we could beat. But again, there are lots and lots of decisions to be made on what the engine shares are, who uses our acoustical treatment, what they do on the nacelles, who makes the nacelle, how much is composite. But it's all upside.

Operator

Our next question comes from Michael Lew with Needham & Company.

Michael Lew - Needham & Company, LLC, Research Division

With regard -- a couple of questions -- with regard to the A350 program, when do you expect the secondary structural contracts to be awarded? Do you have a rough estimate on the aggregate amount also?

David E. Berges

We do, but we haven't elected to disclose yet. We just did the primary because of the magnitude of the CapEx. We don't typically announce contract by contract. And in fact, in the case of EADS, we have a big contract with the entire corporation, and things are incorporated in that or not. So we aren't doing these in -- a piece meal in the real world, so we have no announcements yet. I think in the not-too-distant future, maybe by the time the plane flies next summer, we'll give you a better number for what the content will be.

Michael Lew - Needham & Company, LLC, Research Division

Okay, it's good to hear. On the industrial side, what was wind in the second quarter? How much did it comprise of industrials?

David E. Berges

We don't break it out. It's more than half, as usual. And we don't break it out just because we really have one competitor and just a couple of customers. So that's the real reason we don't break it out. It was very strong as it has been for the last 3 or 4 quarters.

Michael Lew - Needham & Company, LLC, Research Division

Right. And you mentioned one primary customer, but how many other customers are you supplying to?

David E. Berges

Well, we are...

Michael Lew - Needham & Company, LLC, Research Division

Kind of the ballpark number.

David E. Berges

We are supplying to a number of customers and working on a number of programs. But materially, it's still a one-customer game, and that's how you ought to think about it.

Michael Lew - Needham & Company, LLC, Research Division

Well, what would some of these other customers potentially -- do you think they would come to -- become larger scale? Is it anything you would say, like over the near term?

David E. Berges

Not sure the definition of near term, but I...

Michael Lew - Needham & Company, LLC, Research Division

Let's say over the next year?

David E. Berges

Now I would say not too significantly. I think if we penetrate, it will be on new blades, larger offshore blades or new spar designs, not existing production, existing tooling, training, expertise. The likelihood of those changing is not too significant. So I think it would be more gradual, but then it could be significant if we are successful on the new blade that begins to sell.

Michael Lew - Needham & Company, LLC, Research Division

Okay. And also, lastly, on the space & defense side, I guess your competitor recently mentioned slower demand related to the joint Strike Fighter program. From a modeling perspective, would that suppress growth in the back half of the year for the S&D segment?

David E. Berges

If that customer does use our carbon fiber, we have other things that go on to the program. And to the extent that customer slows down his orders to us, it would suppress it somewhat. I don't think you're going to see it, though, because the F-35 is really just starting up, and I don't even think it's yet in our top 5.

Nick L. Stanage

Correct.

David E. Berges

Is that right?

Nick L. Stanage

Yes.

David E. Berges

Okay.

Operator

[Operator Instructions] Our next question comes from of Avinash Kant with D.A. Davidson.

Avinash Kant - D.A. Davidson & Co., Research Division

I had just as a quick question on the capacity side. Of course you've been building capacity and putting CapEx out. The question I had was that with 2012 and 2013 spending, which is expected to be kind of at the similar level, what kind of revenue do you think you'll be able to achieve? Or would you be basically done with the spending on most of the key programs that are inside at this point? We should [indiscernible].

David E. Berges

I would think we have a couple of more years of it to get the capacity in place for the growth that we currently see on the 787, the A350. So we haven't gotten specific about it. But I think I said in the last call, we probably have a couple of more years at these high rates to get to where we need to be for full run rate on both those programs.

Avinash Kant - D.A. Davidson & Co., Research Division

So a couple months, that means 2012 till 2014, you mean?

David E. Berges

Right.

Avinash Kant - D.A. Davidson & Co., Research Division

Okay. And also, on the defense side, a little bit further, of course, as you said, JSF is not among the top 5 programs for you, and there's been a lot of discussion about budget cuts and everything else in the defense side, and people are a little bit worried. Do you see any risk to some of the key programs that you have on the defense side for 2013?

David E. Berges

We haven't given 2013 guidance yet. But as we've said before, we have a very broad range of products on a very broad range of programs, and it's not just U.S. So the helicopter blade programs that we have with almost every helicopter manufacturer are upside for us to be able to offset any slowdown. I haven't heard talk of outright sudden-stop program -- on programs in 2013. In fact, I think I just saw that UTC did a 5-year block extension on the Blackhawk helicopter, which is an important program for us. We have the A400M transporter in Europe, which has got an all-composite wing as well as tail, is starting to have some successes and seems to be on a pretty good track. F-35, maybe slower than what was expected years ago. But incrementally, I still expect F-35 is going to continue to grow. So as I've said before, I think we're going to still continue a single-digit growth kind of pattern based on what I know now. Maybe worse case, we -- we're flat. Quarter by quarter, it doesn't necessarily track with that, but the diversity of our applications to customers and the secular penetration and forward penetration of helicopter blades gives us quite a bit of confidence that this is going to be a good market segment for us for some time to come.

Avinash Kant - D.A. Davidson & Co., Research Division

Perfect. Then a final question on the wind side, I think the previous question was trying to ask something similarly. But you have seen the one key customer that you've been exposed to thus far. We've been hearing about another major player, actually, trying to start, or at least thinking about starting to use composites in the turbines. Would you think that another major customer is close to starting to adopt these materials in their design?

David E. Berges

Well, they all use composites. Our technology that we put forward is prepregs. So pre-impregnated glass and pre-impregnated carbon fabrics or fibers. The other process is a more direct process where they buy the glass and they put it in the mold and then they pump in the epoxies. So they're just -- they're 2 different technologies. And Vestas and Gamesa have long believed that prepreg is more highly engineered and better weight and balance controlled, and that's how they design and build their turbines. And some are going to a prepreg-based spar, which is the center structural part of a blade, and that's probably where there'd be penetration, if we were to have some.

Avinash Kant - D.A. Davidson & Co., Research Division

So you see other people adopting prepreg-based spars. Does that put...

David E. Berges

Yes. On the very large blades, there is movement towards prepreg because of the loads that are required and the incredible weight addition there is for incremental lengths on a blade.

Operator

Our next question comes from Peter Cozzone with KeyBanc Capital Markets.

Peter J. Cozzone - KeyBanc Capital Markets Inc., Research Division

Just a couple of quick questions here. On the corporate and other expense line, is that adjusted kind of $13.7 million in 2Q kind of a good quarterly run rate for the back half of the year?

Wayne C. Pensky

Yes, that's close enough. The $13.7 million excludes -- I take it you excluded the environmental charge.

Peter J. Cozzone - KeyBanc Capital Markets Inc., Research Division

The environmental charge, correct.

Wayne C. Pensky

Correct.

Peter J. Cozzone - KeyBanc Capital Markets Inc., Research Division

And then, also, can you maybe just give us an update on where you are in regards to the capacity expansion process? I know we're fairly early in the game here, those won't be coming online for the next couple of years. But just give us an update there. And then have incremental costs roughly stabilized? Or are there any expectations or plans that might bring those up heading into 2013?

David E. Berges

Well, our game plan is to add the capacity in tranches or layers. That's how we mapped it out, it's how we expect it with a -- in particular, the A350 as the program goes down the path to first flight and certification. Everybody in the supply chain is expected to start increasing their build rates gradually. And it allows us to spread out our capacity increases and do it in blocks. So we are well into that. We've done a couple of blocks, if I could just describe them generically. And the next block is under way. We had -- the incremental costs that you referred to do create a headwind. But to the extent we've got top line growth, we're able to cover it. And in fact, even not have to complain about it. So last year, in the second quarter, we had some start-up costs, second and third quarter, and that's one of the reasons the leverage is good now, we will have some start-up costs again late in the year or early next year. We already have started to hire for one of the next lines that we're going to start up because it's a long training process. But at the end of the day, we're committed to this leverage pace over 20%, and capable of doing more than that as we've demonstrated through the start-ups that we've already encountered. So I wouldn't worry too much about it.

Operator

We'll take our next question from David Strauss with UBS.

David E. Strauss - UBS Investment Bank, Research Division

Apologize, because I joined late, if these have already been asked. But Engineered Products, the margins there, do you expect to still get back to the 15% to 16% level in the back half of the year? And then Wayne, what do you estimate your average interest rate is now on your debt, outstanding debt?

David E. Berges

Yes. On the Engineered Products, it's a smaller part of the business, and it's kind of lumpy. We've got some new products and new programs that are in start-up phase. I'm pretty happy actually with the performance that they've had in the first half. As those start to get up to stride, I would think we could easily get back to the 15%, 16% range by the end of the year. And, Wayne?

Wayne C. Pensky

And with respect to that, our average rate is a little under 3%.

David E. Strauss - UBS Investment Bank, Research Division

And Wayne, on depreciation, do you still expect that to pick up in the second half of the year?

Wayne C. Pensky

Yes, we do.

David E. Strauss - UBS Investment Bank, Research Division

Okay. And the -- so $8 million or so higher for the full year?

Wayne C. Pensky

Yes. I think it'll be tough for us to get $8 million higher for the full year. Some of it is just due to translation, but we're probably a little bit behind in terms of that, and we've probably -- more items have fallen off than we thought. But it'll -- we expect it to be higher in the second half.

Operator

It appears there are no further questions at this time. That concludes today's conference. Thank you for your participation.

Wayne C. Pensky

Great.

David E. Berges

Thanks.

Nick L. Stanage

Thank you.

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