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Executives

Steve Buesing - Vice President of Investor Relations

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

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

Analysts

Robert Stallard - RBC Capital Markets, LLC, Research Division

Heidi Rolande Wood - Morgan Stanley, Research Division

Joseph Nadol - JP Morgan Chase & Co, Research Division

Richard Tobie Safran - The Buckingham Research Group Incorporated

Carter Copeland - Barclays Capital, Research Division

David E. Strauss - UBS Investment Bank, Research Division

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

Amit Mehrotra - Deutsche Bank AG, Research Division

Robert Spingarn - Crédit Suisse AG, Research Division

Noah Poponak - Goldman Sachs Group Inc., Research Division

George Shapiro

Jason M. Gursky - Citigroup Inc, Research Division

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

Ronald J. Epstein - BofA Merrill Lynch, Research Division

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

Michael F. Ciarmoli - KeyBanc Capital Markets Inc., Research Division

Rockwell Collins (COL) Q3 2012 Earnings Call July 24, 2012 9:00 AM ET

Operator

Good morning and welcome to the Rockwell Collins' Third Quarter Fiscal Year 2012 Earnings Conference Call. Today's call is being recorded. For opening remarks and management introduction, I would like to turn the call over to Rockwell Collins' Vice President of Investor Relations, Steve Buesing. Please go ahead, sir.

Steve Buesing

Thank you, Bonnie, and good morning to all of you on the call. With me on the line this morning are Rockwell Collins' Chairman, President and Chief Executive Officer, Clay Jones; and Senior Vice President and Chief Financial Officer, Patrick Allen. Today's call is being webcast, and you can view the slides we will be presenting today at our website at www.rockwellcollins.com, under the Investor Relations tab.

Please note that today's presentation and webcast will include certain projections and statements that are forward-looking. Actual results may differ materially from those projected as a result of certain risks and uncertainties, including those detailed on Slide 2 of this webcast presentation, and from time to time, in the company's Securities and Exchange Commission filings. These forward-looking statements are made as of today and the company assumes no obligation to update any forward-looking statement.

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

Clayton M. Jones

Thanks, Steve, and good morning, everybody.

Of the 3 primary markets we address, government, air transports and business jets, 2 of them have followed a relatively predictable course so far this year. We felt government was going to be weak and following a decline in first half with growth in the second half. Results this quarter indicate that's exactly what's happened. We forecast its strong growth in the air transport sectors, Boeing and Airbus increased production rates, no backlog. And despite a slower aftermarket growth this quarter, air transport is up across the board in double-digits for the year-to-date. However, the market that has proven to be the most unpredictable for a variety of reasons is business jets. Our original guidance for Commercial Systems at the beginning of the year was low double-digit growth. We now expect high single-digit growth with all of the reduction resulting from the Hawker Beechcraft bankruptcy and the slowdown in the business jet aftermarket. Neither of which was expected when we set guidance for the year last September.

Most of this market is in a recovery mode. And we continue to expect deliveries -- increased deliveries at all of the OEMs except Hawker. That said, the recovery is not as robust as we and the OEMs thought it would be at this point, which I believe is a reflection of the state of the global economy. This has had a particularly significant impact at the light end of the market where OEMs are still struggling to fill orders and build backlog. As a result, we are revising our guidance for the year to reflect the updated realities of this market. First, we are lowering our cash flow from operations to about $600 million due to lower collections of accounts receivable from Hawker Beechcraft and higher expected tax payments. Second, we're revising our revenue guidance to about $4.8 billion, which incorporates the updated outlook for business jets. This includes a $25 million reduction to OEM revenue for the Hawker Beechcraft temporary production shutdown and revised build rate, which I disclosed earlier this quarter, and lower expectations for aftermarket growth by $25 million, driven by a slower global economic recovery that has limited discretionary spending and business jet utilization.

Even with those revisions to revenue, we continue to forecast completing the year within our original EPS guidance range but have narrowed our expectations toward the lower end of that range to $4.40 to $4.50 per share. I should note that I am very pleased with how our company has managed things within our control and taken appropriate actions to maintain this high level of profitability.

As you can see in our Commercial Systems results, much of the impact that led to revised guidance I just discussed was realized in the third fiscal quarter. However, to give you a better look in context of our ongoing Commercial Systems business, if I exclude from our revenue, the impacts of the Hawker bankruptcy and some onetime benefits we experienced last year, Commercial Systems would have experienced high single-digit revenue growth this quarter. That level of growth is the same as the second quarter and similar to what we expect in the fourth quarter.

By now, you've all had a chance to review our press release, so I'll let Patrick cover the details of the third quarter results in just a few minutes. However, I do want to point out a few key aspects of the quarter that I think are particularly noteworthy.

In Government Systems, some of the headwinds affecting our first half results have diminished and we're now beginning to see the benefits of previous market share gains. Avionics grew 11% this quarter, on the strength of the 3 Tanker Programs we captured last year, the KC-46, the KC-10 and the KC-390, as well as increased revenue from Saudi F-15 fighters.

We've had great success over the past couple of years, winning positions and are now beginning to drive some meaningful growth in this business. Additionally, we saw a 9% increase in Communications Products based on increased deliveries of our networking and data link products.

Another notable aspect of our results this quarter was strengthening growth in our air transport OEM sales, which increased 19%. Finally, I would note that despite modest sales growth, we expanded total corporate operating margins by 20 basis points to 21%, and reported Government Systems margins above 20% for the 15th consecutive quarter. The previous 4 of which had negative revenue growth.

Over time, I believe we have consistently demonstrated our ability to deliver strong operating performance by managing our cost structure in the face of some very dynamic market conditions.

Now as we begin to look forward to 2013, I expect many of the difficult market conditions we've experienced recently to continue.

For Government Systems, the threat of sequestration has created uncertainty and will challenge our ability to accurately forecast the market and our performance in it. In any case, we fully expect U.S. Defense investment budgets to continue declining next year. While defense will slow in the U.S., numerous international opportunities exist and should become an increasing contributor to the business. This includes recent wins on the KC-390 transport in Brazil, the F-15 fighters in Saudi Arabia, and just this quarter, we expanded our FireStorm product in Australia, with a $70 million contract award.

In Commercial Systems, we're forecasting double-digit growth over the longer term, but that growth will not be linear. Next year, we expect the air transport market to remain strong, with additional production rate increases. However, for the 787 program, it's important to remind everyone that we will be delivering at a rate of 4 ship sets per month well into next year. As Boeing increases their production rates, they will begin to burn off existing inventory of our products and eventually synchronize our deliveries to their rates. We just don't expect that to happen until the latter part of next year.

The business jet market has been difficult to predict and any recovery next year will be dependent on the trajectory of the global economy. Over the past few years, we've had a number of market share gains, which have provided above market rates of growth to offset the false starts in the economic recovery we've experienced the last couple of years. As I look into next year, there are no new aircraft entering service that will materially drive revenue growth above the market rate of growth. However, beyond 2013, the benefits of market share gains should, again, contribute and allow us to grow at beyond market rates.

Commercial Systems aftermarket will again benefit from demand for spares as airlines take initial deliveries of the 787. All of the growth will be a bit less now that we have this year's deliveries in the base. The remainder of the aftermarket will be highly dependent on the pace of economic recovery, which drive discretionary purchases and increased aircraft utilization. This is likely to be as difficult to predict next year as it's been for the previous 3.

While it's a sober picture in the near term, there is a lot to get excited about when I look just a bit further out. We have the ramp of 787 deliveries, which will substantially benefit our business, followed by the entry into the service of the A350 and the CSeries. The 2 new international jets, the MRJ and the ARJ21 will bring new products to the Regional Jet segment over the next few years. And finally, we have the continuation of our business jet market share capture as the Embraer 500 and 450, the Lear 85 and the Global 7000 and 8000 of Bombardier enter into service. With any stabilization in our government business along the way, which I believe will happen, Rockwell Collins is very well-positioned to generate strong revenue, profit and cash flow performance. Meanwhile, we will remain focused on operating our business as efficiently as possible, generating high returns on invested capital and position the company and its share owners for future success.

So with that, let me now turn the call over to Patrick.

Patrick E. Allen

Thanks, Clay, and good morning to everyone as well.

Let's get started by first reviewing our results for the total company that are shown on Slides 3 and 4.

Total company sales for the quarter came in at $1.21 billion, a 1% increase from last year. Income and earnings per share from continuing operations increased 6% and 13%, respectively. The greater increase in earnings per share when compared with net income was due to the share repurchases.

Income from continuing operations included a $7 million benefit from lower tax rate, primarily driven by the remeasurement of certain tax reserves. This benefit only partially offsets the adverse impacts from the Hawker Beechcraft bankruptcy and temporary production shutdown which totaled $8 million after tax. The increased operating performance this quarter was mostly due to continued strength in the air transport OEM deliveries and lower discretionary spending in Government Systems.

Turning to Slides 5 and 6, we have the third quarter results of our Commercial Systems business which reported revenues of $526 million, up 1% from the second quarter last year. Sales related to aircraft OEMs increased $10 million or 4%, to $295 million, driven by increased sales to Boeing and Airbus resulting from higher production rates across their product lines, partially offset by lower deliveries to Hawker Beechcraft due to a temporary production shutdown.

Aftermarket sales declined $1 million to $208 million, driven by lower spare sales which tend to be lumpy across the year.

Commercial Systems operating earnings decreased to $105 million or 20% of sales compared to the operating earnings of $107 million or 20.5% of sales in the third quarter last year. The decrease in operating earnings is primarily due to a bad debt charge related to the bankruptcy at Hawker Beechcraft.

On Slide 7, Government Systems revenue grew 2% this quarter to $679 million. Avionics sales increased $40 million or 11%, to $393 million from increased sales for Saudi F-15 fighters, and the KC-46, KC-10 and KC-390 Tanker programs. Sales in communication products were also strong, with an increase of 9% to $178 million due to increased sales of network communication and data link products.

Surface Solutions sales decreased 39% to $50 million, principally driven by 2 programs which were previously terminated for convenience, also, lower sales on the Joint Precision Approach and Landing System or JPALS program as it transitions for development to production, and reduced deliveries of optical products for surface-based programs.

Finally, Navigation Products sales were down 16% to $58 million, driven by fewer deliveries of our GPS receivers.

Slide 8 shows Government Systems third quarter operating earnings which were $148 million or 21.8% of sales compared to $141 million or 21.1% last year. The improved operating performance is primarily due to lower discretionary spending, partially offset by the absence of favorable warranty reserve adjustment recorded last year. Additionally, a less favorable hardware sales mix offset a $6 million benefit from a favorable EAC adjustment.

On Slide 9, we have our 9-month year-to-date total company financial results for sales, EPS from continuing operations, income from continuing operations and operating cash flow. So far this year, sales have decreased by 1% as the headwinds in Government Systems have been mostly offset with growth in Commercial Systems. Our year-to-date operating cash flow of $192 million is behind last year due to increased payments for employee incentive compensation and higher income tax payments, partially offset by higher receipts for customer advances.

Moving to Slide 10, we show the status of our capital structure. As of the end of the third quarter, we had $778 million of long-term debt and $201 million of short-term debt outstanding compared to $528 million of long-term debt at the end of fiscal 2011. We believe our debt to total capital ratio of 43%, in combination with our investment-grade credit ratings, provides us access to liquidity in a cost-effective manner.

If you turn to Slide 11, we provide details related to the updated status of the share repurchase program as of the end of the third quarter. During the quarter, we repurchased 3.8 million shares of stock at an average cost of $52.24 per share. This brings our total repurchase activity since 2002 to 76 million shares or $3.7 billion return to share owners through maintaining an active share repurchase program. Additionally, the Board of Directors recently approved an incremental $500 million increase to the share repurchase authorization. That brings our currently available authorization up to $502 million. In addition to returning capital to share owners through share repurchases, we also increased our quarterly dividend by 25% to $0.30 per share.

Now onto our final slide, Slide 12, where we provide the details of our updated fiscal year 2012 financial guidance. As Clay mentioned in his opening remarks, we have made some revisions and tightened our guidance ranges. We now expect sales to be about $4.8 billion for the year. Government Systems revenue expectations are unchanged but we now expect Commercial Systems sales growth for the year to be in the high single-digits after incorporating the impacts of the Hawker Beechcraft bankruptcy and the more moderated business jet aftermarket outlook. Even though we've incorporated substantial market-driven revenue headwind this year, we are still expecting to finish within our original EPS guidance range, currently at $4.40, to $4.50. I feel that is a testament to our continued focus on operational performance and execution.

We also adjusted our tax rate expectations to about 29% for the full year and our cash flow guidance to about $600 million, reflecting a reduction of about $30 million in collections from Hawker Beechcraft and higher tax payments related to changes in future expected pension contributions.

Just this last quarter, Congress passed the Transportation Bill, which included provisions providing companies some relief on required pension contributions. Prior to that legislation, we have been expecting mandatory contributions of about $220 million next year compared to our $110 million contribution this year.

Now while we have not fully determined what level of pension funding we'll make next year, the new regulation provides us with much more flexibility relative to capital deployment.

That completes the final review of the financial results and projections, so Steve, back to you to kick off the Q&A session.

Steve Buesing

Thanks, Patrick. In order to get everyone an opportunity to ask questions, we ask that you limit to 1 question per caller. If you have further questions, simply reinsert yourself into the queue and we'll answer those additional questions as time permits.

Bonnie, we're now ready to open the lines.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Robert Stallard of RBC.

Robert Stallard - RBC Capital Markets, LLC, Research Division

Sorry, I don't mean to kick off on the aftermarket and the $1 million decline year-on-year. I was wondering if you can you give any more color on perhaps what sort of aircraft have been most impacted by this decline, if there's any regional variances here or if you see any share loss to contribute to this?

Clayton M. Jones

Well, certainly, we don't see any share loss contributing to it at all, Rob. What I would say is you could take the aftermarket and split it into the 2 pieces, the air transport business and regional, and there are slightly different dynamics between the 2. In the air transport side, I believe that the basic MRO, it actually grew this quarter in low single-digits, about with the pace of traffic growth, which is what you would expect. So that was relatively predictable. And then if you look at the retrofit side, which is making up a greater portion now of it, of recent -- in this year at least because of the large group of 787 spares that we've experienced in the first half of the years, the size of that abated this quarter and then there was a significant lumpiness in the sale of spares to legacy aircraft. I attribute that to primary, just timing. We have always said, since we've been talking about the retrofit side of the aftermarket, that it comes and goes, it's lumpy, it happens when the airlines have cash and decided to do it. We do not at this time think that, that is a result of any tightening of discretionary spending specifically, but it's a timing issue. And in fact, if you look in the next quarter, we're projecting that to return to a high single-digit type growth rate for air transport. So I don't view anything in the aftermarket relative to air transport is a systemic change or a big difference, it was a timing issue more than anything else. In the business jet though, I think you have different dynamics. In this case, we did see a reduction, a very slight reduction in the MRO market, and I do think that is a result of the slowdown in business jet utilization. We talked here recently over the last couple of months that what we were seeing against our projections at the beginning of the year of a 2% to 3% growth in utilization is that year-to-date, it's been flat and we've seen nothing to indicate that, that's going to increase for the balance of the year. And I would say that was the primary determinant of us dropping the revenue forecast by $25 million in the business jet aftermarket part. Contributing to that, I believe, is a lowering in discretionary retrofits, and I believe that's directly proportional to a lot of belt tightening that's going on around the world, especially in Europe relative to upgrades and improvements to business jets. And so that dynamic, I think, in business jets is more focused on the economy and what we might see as a slowing. If that helps.

Robert Stallard - RBC Capital Markets, LLC, Research Division

Okay. Just a clarification on the business jet, are you seeing any differences between smaller or midsized-cabin jets and the large jets?

Clayton M. Jones

Not in the aftermarket. We're actually seeing -- and actually, we contract the long-range pretty well through our Air Routing acquisition that tracks light travels. And what we're seeing is just less use of those aircraft on international trips.

Operator

Our next question comes from Heidi Wood of Morgan Stanley.

Heidi Rolande Wood - Morgan Stanley, Research Division

Clay, I think your margin guidance at the top of the range in this environment is impressive, and can you talk about things that you are doing in terms on the cost side? What are your additional opportunities on the cost side? How far along are you?

Patrick E. Allen

Well, we've taken a lot of actions, actually took another restructuring charge this quarter reflecting a reduction of headcount, and that headcount has come principally out of our Government Systems business but we're also adjusting our shared service spending to continue to manage margins. Another impact is our incentive compensation program, which is designed to reduce the payout as our performance comes down with the market. And so we've seen some benefit from the incentive compensation part as well. I would say this, Heidi, I think we're going to continue to manage our cost structure the way we have in the past and I would say we're right in the middle of that process right now.

Clayton M. Jones

Yes. What I would also add to that is this is kind of unfortunately not our first rodeo. I was counting the other day, this is the 6th cyclical change we've seen in the roughly 11 years we've been a public company. And so I think our guys are getting very good at anticipating these changes and acting very quickly to do that. As Patrick -- I'd reinforce what Patrick said, if revenues were going up, then we'd be talking about a drag of incentive compensation as we add it to that, as we shared that with our employees, but when it goes down, we realized that, that's another lever that we built into our system that allows us to continue to deliver this kind of profitability performance.

Heidi Rolande Wood - Morgan Stanley, Research Division

But oftentimes, Clay and Patrick, the managements can be tempted to shave their R&D in these periods of time. Can you talk about how we should think about expectations for R&D going forward?

Clayton M. Jones

Well, we did suggest in the guidance here that R&D expectation for the year is going down. But I would say that's a combination of 2 things. One is that the government, the customer-funded R&D has been reduced to a certain extent over the year, and the second thing is that we've taken some of the R&D that, frankly, we don't need anymore. I think most specifically, out of something like public safety, which we started the year thinking that was going to be a totally discretionary investment and we've now eliminated that as part of this restructuring I've been talking about in Government Systems. We're continuing to look at what we really need to look like and what is core to our business going forward. And some of the decisions we've made not to invest in ground vehicle systems, not to invest in soldier systems, not to invest in public safety, has allowed us to reduce some of the R&D, but it's in the areas that we don't think are core to the business. In the meantime, we're spending very robustly in the commercial side of our business, for the instantiations of all the Pro Line Fusion, cockpits are going to be going in, the CSeries that I mentioned is still an investment, the A350 we're still investing in as we bring that closer to certification. And so none of that has been reduced as we look at what's core to the company.

Operator

Our next question comes from Joe Nadol of JPMorgan.

Joseph Nadol - JP Morgan Chase & Co, Research Division

My question is on share repurchase. You guys continue to buy back a lot of stock. You did issue -- or the Board did issue a lower authorization than the last one during the quarter, I noticed though and your balance sheet is up to 43% debt to cap. So my question is what, if anything, can we read into those in terms of our restraints on future activity?

Patrick E. Allen

I wouldn't read anything into the size of the reauthorization. What I would say is though we are going to continue to be active in the share repurchase program, both this -- for the remainder of this year and going into next year, I would also comment that the guidance does not assume a significant benefit from fourth quarter share repurchases. So I think you'll see that the activity be somewhat less in the fourth quarter than you've seen over the course of the balance of the year. But Joe, we still remain committed to returning value to share owners through dividends and share repurchases.

Joseph Nadol - JP Morgan Chase & Co, Research Division

Patrick, what's your -- in terms of the rating, what is your understanding of how high you can go on the debt to total capital metric to maintain your rating and how important is maintaining that rating?

Patrick E. Allen

We haven't had any discrete discussions with respect to the rating agencies -- with the rating agencies with respect to that metric, so I'd hate to speculate on that. As a matter of fact, they don't like to do that with us. So I do believe we have some room in the current rating to increase debt to total capital.

Operator

Our next question comes from Richard Safran of Buckingham Research.

Richard Tobie Safran - The Buckingham Research Group Incorporated

I just have a quick question here on the dispatch services contract you've signed with China. I think you have 6 airlines signed up so far. I just wanted to know if you could provide any color on how you see 787 services trending, what your expectations are for just service solutions in general there?

Clayton M. Jones

Well, we have long said that our -- at least, planning guideline is that roughly half of the 787 customers will choose to dispatch power by the hour approach to service and the other half will buy the spares outright. With a relatively limited sample size today, that's about how it's playing out. Now we have had a recent number of selections that we announced at Farnborough, that have chosen the dispatch approach, which if I had to shave it one way or the other, for the long-term health of the business, that would be our preference. We just feel that, that being a new product in the avionics field, it would be unwise to suggest more than half would be doing it and I think we'll wait and see it play out to see if we're off on those percentages. But that's what our expectation is. I think, for the decisions in China, where there is perhaps more acceptance of that, it's why we've been particularly successful in that dispatch 100 product.

Operator

Our next question comes from Carter Copeland of Barclays.

Carter Copeland - Barclays Capital, Research Division

Just one quick clarification and then a question on R&D. Pat, can you size the benefit from incentive comp in the second half due to the lower accruals?

Patrick E. Allen

Well, I would say this, it's probably in the range of about $45 million. [indiscernible] 2 quarters.

Carter Copeland - Barclays Capital, Research Division

Okay. And on the R&D, you're going to exit in the fourth quarter with obviously a much lower run rate in R&D than what you were thinking before. It looked like you were expecting quite a bit ramp up in the fourth quarter. How should we think about what that means for how R&D trends in 2013? It looks like the run rate is going to look more flattish sequentially. Is that something that will remain in 2013, in fiscal '13, or is it going to re-ramp just later?

Clayton M. Jones

Well, the unfortunate way that we disclose the R&D amount, I think, is not very transparent to the actual amount of R&D we're spending. And we've tried to, over the course of a host of conversations, talk about the deferred engineering rate that we have on our balance sheet that, that is an inventory item that confuses a lot of people, but that's the way you account for it. That is going to total about $130 million this year. So even with this reduction, we'll spend about $1 billion a year and we'll be up year-over-year in R&D. I would expect as we go into next year, that we'll probably be up again. I can't remember a year in my history here at Rockwell Collins we're we've not increased R&D year-over-year. So even though the run rate is changing a little bit for reasons I just described to Heidi's question, I would expect that our move into new product lines, our success in the market, and I would say in both sides, both government and commercial, should allow us to continue to increase that R&D expenditures as we are winning new programs.

Operator

Our next question comes from David Strauss of UBS.

David E. Strauss - UBS Investment Bank, Research Division

Clay, at Government Systems, I know you're facing some headwinds, some specific program headwinds next year, could you walk us through those and maybe give some color if whether Government Systems is down? Assuming the sequester doesn't happen, if Government Systems is down in the same range next year or could it potentially be down even more than what we're seeing in '12?

Clayton M. Jones

Well, I think the specific things we've said before, David, is we have a continuation of the DAGR reductions that have plagued us this year, I think will continue into next year, primarily as a function of the up-tempo, in this case, in Afghanistan, as well as Iraq, coming down and they have plenty of inventory of that. So we had forecast a fairly dramatic couple of year reduction in DAGR and that will continue into '13. That would be one large one. The largest one of the bunch is the E6 program that we have. It'll be transitioning next year from development into production and as is typically the case, we saw that in KC-135, we mentioned it in JPALS this quarter, you're going to see a reduction in spending as they test the airplane and get the approvals to move into production. And that will probably be the largest one and I think that's -- we've actually quantified that to about $50 million of headwind there. And I think programmatically, those are probably the 2 largest one that we have. To the second part of your question, that's such a hard question to answer there, David. When we think -- when we're thinking through our budgetary process this year, we're probably going to do it in scenarios with and without sequestration. I would say that Kelly Ortberg and his team are still working on that, and for me to give you a order of magnitude would probably be premature today, but coming to a theater near you.

David E. Strauss - UBS Investment Bank, Research Division

Okay. And then on FireStorm, I know you're expecting some upside there, is the contract signed or when should we expect that?

Clayton M. Jones

The contract is not signed. We would hope we would be able to be in a position to announce it this quarter but that is largely dependent on the pace of the procurement chain in the Middle East. If we've learned anything over time, one must exercise patience. But we do know this, the contract is moving through the process. We have people in-country that have validated that and now it's just a matter of getting it on the right desk with the right signature and we're hopeful that will happen this quarter.

Operator

Our next question comes from Cai Von Rumohr of Cowen and Company.

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

So Patrick, you said that you're down $45 million in incentive comp, so my recollection is that was set at $90 million, so are we to believe that it's now $45 million? And could you give us a little color how that...

Patrick E. Allen

Yes. As I reflect on that, Cai, I may have overstated that a little bit. It's probably closer to $35 million to $40 million, and what I'd say is that the incentive compensation right now is set around 60%.

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

Okay. And then so, how should we think, I mean, just notionally, you always reset it to 100%, which is $100 million, so that's going to be a headwind next year, and your tax rate is lower in this quarter, where is it going to be for the year and isn't that going to be a headwind for next year also?

Patrick E. Allen

Certainly, if the Congress does not pass the R&D tax credit, it will be a headwind for next year. The tax rate, I would suggest, will probably be somewhere in the 31%, 32% range for next year. And obviously, incentive compensation will be a headwind as well, because you're right, we do reset it to $100 million.

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

And where is the tax rate this year?

Patrick E. Allen

We are forecasting it to be about 29% for the full year.

Operator

Our next question comes from Myles Walton of Deutsche Bank.

Amit Mehrotra - Deutsche Bank AG, Research Division

It's Amit Mehrotra here for Myles Walton. Clay, can you comment on the cadence of activity in the discretionary aftermarket during the quarter, specifically on the large transport side? Was activity fairly constant throughout the quarter or was there any dropoff as the quarter progressed from the tail end?

Clayton M. Jones

Well, as I mentioned before, the big dropoff was in the amount of spare sales that we delivered this quarter in the big air transport side. A couple of things going on there, a deceleration in 787 spares. So sequentially, we were down although we still deliver a few 787 spares. In terms of year-over-year, that wasn't a big contributor, but the biggest one was in some of the legacy programs. And again, I attribute that more to timing than I believe there's any systemic change in buying behavior because we expect the discretionary side to be up in the fourth quarter and we have reasonably good visibility at this close range of what we're talking to airlines about right now. So I think that's just a lumpy quarter perturbation, again, that we've always said exists in that market.

Amit Mehrotra - Deutsche Bank AG, Research Division

Okay. And then, Clay, even with the revised free cash flow guidance, the company looks to be in a pretty nice cash position, I think, in the next 6 to 9 months. So would that -- how do you think about using cash to buy back shares versus maybe making acquisitions to more quickly increase the commercial mix in the business?

Patrick E. Allen

We've always talked about our cash deployment philosophy, and really, it hasn't changed here. Our first priority is acquisitions, but it's a pretty sparse environment right now. We haven't seen a lot of acquisition activity over the course of the last year or so. So in the event that we don't see acquisitions, we'll continue to return value to share owners through share repurchases and dividends.

Operator

Our next question comes from Robert Spingarn of Crédit Suisse.

Robert Spingarn - Crédit Suisse AG, Research Division

Clay, just going back to your comments in the monologue on '13. With Defense down in fiscal '13, budget investment accounts are down, you talked about some of the pressures there. And commercial not up meaningfully until '14, and then Patrick just acknowledged you might have a higher tax rate, is it fair to assume that any earnings growth in '13 has to be fully derived from the buyback?

Clayton M. Jones

Well, I don't want to really respond to that until we finish putting our budgets together, Rob. What I've tried to do is give you some of the macro dynamics that we're facing as we put our budgets together. Obviously, there's a host of things that we're still trying to settle in on the budget that could affect what that earnings power is going to be next year. And so without question, we've used the share buyback this year as an accelerant while we're going through a period of relatively flat growth. And so if we go into next year with those same set of circumstances, then obviously, that -- you can reasonably intuit that, that would be a source of growth next year as well. But whether that's the only or major or how a proportion that is, I think it would be premature for me to comment on that at this time.

Robert Spingarn - Crédit Suisse AG, Research Division

Do you think you'll be able to guide mid -- is mid-September as you usually do?

Clayton M. Jones

We're still thinking pretty deeply about that. I would say, right now, we haven't absolutely made our mind up but I would say that we're now tending to guide probably with scenario ranges around what happens with or without sequestration to give people a sense of that very anomalous overhang to our business. But again, I'm going to wait to see what confidence we have when -- especially our Government Systems people put their budgets together and if I can, with some degree of confidence, give you that range of results or give you that look at what we expect to have under those conditions then I would -- it would be my preference to give guidance.

Operator

Our next question comes from Noah Poponak of Goldman Sachs.

Noah Poponak - Goldman Sachs Group Inc., Research Division

Just on the aftermarket, the outlook there at one point was for low double-digit growth for the year. You're trending below that and the rate of growth appears to be slowing, I just wondered if you could update us on where you expect the full year to come in. And then for next year, if you could, without giving a number but just maybe talk about some of the puts and takes, it seems like, again, the core business rate of growth is just getting tougher in terms of comparisons. And then on the 787 initial sparing, I'm assuming that's a pretty big -- a pretty tough comparison next year?

Clayton M. Jones

Well, first, I would say that we're probably talking about high single-digit aftermarket growth now all-in, specifically impacted by this business jet aftermarket reduction that we're taking now, so that's the answer to your first question. For the second question, what I would say is, yes, I think I painted a picture that we are still going to continue on a tough market environment next year. The venture's going to be down. We think air transport's going to be up but with, again, increasingly difficult comparables. And then business jets is going to be the swinger as to what happens in that area, depending on the economy. So that's the landscape we do see right now. Relative to the 787 spares, I think it will be a more difficult comparable but again, they're delivering to more airlines next year, so I'd still think that, that will be a nice upper to our business next year, it just won't be the same rate of upper that we saw specifically in the first half when we're reporting mid- to high-teens aftermarket growth in the air transport side. So I don't think you'll see those levels but I still think you'll see that being a nice tailwind.

Noah Poponak - Goldman Sachs Group Inc., Research Division

Understood. Okay. And then just one other one. Maybe this is for Patrick. I'm just wondering if you could sort of speak to the sustainability of these government margins. They've been fairly resilient in the face of, clearly, a tough top line environment then what appears to be tougher terms of trade coming out of the Pentagon. If the government top line continues to decline, what should we be looking for in terms of the sustainability of these government margins going forward?

Patrick E. Allen

That's a tough question to answer, Noah, because it depends upon the rate of decline and where we see that decline. I think, over the course of the last couple of years, we've managed the decline very well through restructuring action, through aggressive cost reductions in the government side of the business, obviously benefiting a little bit from mix because most of the revenues that came out have been relatively lower-margin development-type programs. However, I think, over time, we're going to continue to see some pressure from the volume being a negative headwind. But if we continue to see a higher hardware mix and greater international sales, that should be a tailwind. So I'm thinking over the course of the next few years, if we see a moderation of the reduction in government revenues, we should be able to maintain that 20% to 22% margin.

Operator

Our next question comes from George Shapiro of Shapiro Research.

George Shapiro

Just a follow-up on the government margin. If you look sequentially and take out the benefit last quarter, it went from 19.4% to the 21.8% we saw this quarter. Patrick, if you could kind of walk through what the benefits were to that? I mean, was the lower R&D for the year that you provided a part of that? Any warranty benefit, and if there's step down, any incentive comps that you were talking about for the corporation overall?

Patrick E. Allen

I think, probably from a sequential perspective, George, I'd highlight 2 things. One is we are continuing to manage our discretionary spending, so that's coming down. The benefit from our incentive compensation adjustment would be a sequential benefit as well, and sequentially, our volume is up and that also provides margin tailwind. So those will be the 3 major contributors.

George Shapiro

Could you just quantify the ballpark, say, the decline in R&D and the incentive comp benefit or just ratio it according to the -- or do I just ratio it according to the sales of the sectors?

Patrick E. Allen

Well, I would say that the company-funded R&D is just a couple of million dollars. The incentive compensation is probably in the range of about $10 million sequentially.

Operator

Our next question comes from Jason Gursky of Citi Investment Research.

Jason M. Gursky - Citigroup Inc, Research Division

Clay, in the past, you've spoken about what you viewed to be the long-term growth rate of the business jet market. I'm just wondering if you could update us with your current thoughts given the last couple of years and the way things have played out?

Clayton M. Jones

I'm still bullish on double-digit growth in the long-term. I think, what we're experiencing now is a very unusually slow recovery as compared against any previous cyclical recovery where we have had now, what would be almost 3 years of negative or no growth in that market. And there is inevitably pent-up demand that occurs during that period of time that will be satiated at some point. I think the causals for the relatively slow recovery are all around us, and it's called the global economy. And it's the same reason capital spending and a variety of industries is much lower than any of us would have expected at this time and why this industry is being impacted. I still believe that the fundamental drivers of business aviation are in place. I think the long-term growth prospects of business aviation, especially in developing markets, is going to be very good. It's just that we're working our way through a period where people aren't spending much money on capital improvements, much less transportation capital improvements. And so I don't know what to say as to what the shape of the global economy is going to be over the next 2 to 3 years. You guys could call that as well as I can. But I can tell you once we get some economic improvement, I think you'll see a direct and proportional improvement in business aviation. And my hope, and that's what it is at this point in time is that, that hits at, or before the time when we get this big inflow of market share gains that should start kicking in, in 2014, as we begin to deliver those litany of new airplanes, which are always better sellers than the existing fleet that will be coming out over the next 4, 5 years. So I mean, I think, it's going to be a great growth story for this company and others in that business. But we've got to work our way through the economy before we get there.

Jason M. Gursky - Citigroup Inc, Research Division

Okay, that's helpful. And then just a follow-up on the fiscal '13 comments, you've spoken in the past about trying to generate double-digit earnings per share growth. Given all of the moving pieces, is that still a legitimate goal for investors to expect at this point given what you know today about fiscal '13?

Clayton M. Jones

I believe that -- well, judge us by this year, Jason. We're going to be basically flat in sales and up double-digits in EPS. And I have not given up on that goal. And I would say this, the revenue that we're able to generate is somewhat in my control but largely out of it. I can't control bankruptcies. I can't control European recoveries. I can't control defense spending or sequestration, and I've just got to take what I get there. But the thing I can control is my spending and my rates of profitability and my efficiency in the company and my returns on invested capital. And ultimately, I have some ability to lever and control my earnings per share. And we're going to be focused like a laser beam on doing that. So yes, I do believe, to answer your question, that is a reasonable goal and we will be working very diligently over the course of the next couple of months preceding guidance to try to deliver on that goal.

Operator

Our next question comes from Sam Perlstein of Wells Fargo.

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

So just looking at your guidance and the revisions, you've now got revenues and margins, I guess, down to a single point, and yet, there's still $0.10 kind of swing for just this fourth quarter, so can you just kind of talk about what might move you from either $4.40 or $4.50 in that range or are you much more comfortable, I guess, at one part of that?

Patrick E. Allen

I would say this, I mean, we've selected a single point estimate for margins and for sales but there is variability around that. So I would tell you that those are the 2 things that are most likely to swing our earnings per share to the lower end or the top end of that range would be where we fall relative to those single data points.

Clayton M. Jones

If we tightened it, it'd make your job too easy.

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

Of course. And then just separately, Patrick, can you just -- where did you end the quarter in terms of the preproduction engineering within the inventory?

Patrick E. Allen

Hold on just one second, I'm not -- Steve's looking that up. We were forecasting about a $130 million growth year-over-year and I would say, we're still on track for that growth. What the total balance is, is coming here shortly. We ended up in about $534 million of preproduction engineering for the quarter.

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

Okay. And just -- I mean, does that growth stay at that same pace into next year or does it moderate for next year?

Patrick E. Allen

When we provide guidance, we'll let you know but I would suspect there's still going to be a fair amount of spending on preproduction engineering next year as we continue on programs like the A350 and the CSeries.

Operator

Our next question comes from Rod Epstein of Bank of America Merrill Lynch.

Ronald J. Epstein - BofA Merrill Lynch, Research Division

Just a quick question for you, Clay. You mentioned the possibility of sequestration in your prepared remarks, how do you prepare the company to deal with that uncertainty, given all the uncertainty around does it happen, doesn't happen. I mean, as a leader, how do you think about that?

Clayton M. Jones

Well, we talk about it a lot. The way we're going to deal with it, Ron, is we're going to prepare scenarios as best as we can, as to what the impact would be if there was sequestration, knowing we're almost certainly going to be wrong. But there is some reasonable expectation we can put around and across the board, instantaneous reduction in spending and how that might flow to us, so we're going to take the best swag we can at it. The other difficulty is there's only so much you can do to prepare, in fact, a lot of that you don't want to do to prepare because, again, I think we're all discounting the fact that it's going to happen but there is some possibility that it will. So given that, you don't want to do anything stupid beforehand, anticipating it's going to happen and then it doesn't, and then you put yourself in a spot given the probability. But that said, I think it will mostly be reactive and preparing ourselves to react as quickly as possible should that become the law of the land or state law of the land I should say, and then we'll react as quickly as we can accordingly. The unfortunate part is the biggest disruption is going to be on people and what the potential impact could be to employment. And all I can do is be honest with our people that, that's a possibility that we hope won't come to fruition but if it does, we're going to have to move quickly, and get the people who have to take those actions ready to do so and then support and work with the people that might be impacted as best we can. It's a horrible thing to consider but we may have to do it so we'll man up and do it.

Operator

Our next question comes from Howard Rubel of Jefferies.

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

Just 2 things. One first on Hawker, how do you manage what you have to deal with there, Clay? It looks like you probably took reserves for about half of your exposure? And then I have a follow-up.

Patrick E. Allen

As it relates to reserves, we took about -- roughly about a $5 million reserve against Hawker. And last quarter, we disclosed a rate of about a $30 million receivables, so the exposure is far greater than twice $5 million.

Clayton M. Jones

And with that said, Howard, we are full well expecting that whatever they do, whether they sell the company or come out of bankruptcy and continue to operate, that the balance of that receivable will be in assumed contracts because they certainly will not be able to produce airplanes unless they continue to accept our equipment. And so as they work their way through either the sell or the bankruptcy process, we think that the ultimate conclusion will be that they'll assume those contracts. Now we're also saying that as they work their way through that process, it's unlikely they'll make that determination before the end of our fiscal year, and that's why we've lowered a good portion of our cash flow guidance because those receivables are going to be very difficult to get in this fiscal year. So I think there's some of those things we have to work out but we have a reasonably good expectation that they'll assume the contract, except for those we wrote off.

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

Right, I understand. I mean, the reality is if they don't, then there's a different negotiation that goes forward.

Clayton M. Jones

Yes, right.

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

And then the second thing is could you talk a little bit about where you are in the military radio market? I mean, especially in the army world, it's kind of been tilted upside down and you're still in the hunt for a number of things?

Clayton M. Jones

Yes. I mean, first thing, we're really pleased with the growth we experienced this quarter as we got the pig through the pipeline there and a lot of the programs that were dragging us down went through, and it's where our traditional strengths are, data links, some of the networking comm business. We're very hopeful that the Defense Acquisition Board, which is expected to meet later this week will approve the Low Rate Initial Production of the JTRS HMS program. And if it does, then that will provide at least one of the surviving, in fact, I would say, that and this [ph] the only 2 surviving JTRS components will be moving forward. And so that is specifically addressed at the army market and the applications that will have, which we believe could be a nice growth engine for us if that DAB LRIP is approved and we move forward there. So that's probably in military communications, one of the big growth drivers we have, in addition to the data links and some of the international software-defined radios that we're already working on.

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

So that's one of -- I mean, it sort of sounds like that's a bright spot, Clay, and maybe it's a little bit better than you might have thought? I mean, it does offset some of the other issues, is that fair?

Clayton M. Jones

Well, yes. In the Government business, we're looking for any bright spots we can. And if you look at our business in total and you look at the 4 portfolios, without question, Avionics and Communication represent the majority of the core and what we believe are going to be nice, stable, required elements of someone's defense structure, both home and abroad in the future. And those will be the strengths of our company that we build around that I believe in the long term, will serve us and the share owners very well, yes.

Operator

Our last question comes from Michael Ciarmoli of Keybanc Capital Market.

Michael F. Ciarmoli - KeyBanc Capital Markets Inc., Research Division

Clay, maybe just a point of clarification. On the aftermarket, on commercial transport side, did you say you're expecting that to trend up into the high single-digits in the fourth quarter? And if so, I mean, typically, I think of maybe the summer flying season as a lot of utilization, maybe some slow aftermarket, what's giving you the confidence and visibility there?

Clayton M. Jones

I did say that we expect the Air Transport segment or the aftermarket to trend up in the fourth quarter. And I think that's a function of the line of sight we see into a lot of the discretionary aftermarket. The thing that really hit us hard this quarter, I'll reiterate, is that discretionary piece that is remarkably lumpy and if I said it once, I said it a thousand times, don't judge us on one quarter, making a trend in that retrofit market, because it comes and goes as programs start and stop, as airlines decide to buy or not buy, and it's just not a linear activity. We have regionally good visibility because we actually talk to these customers about what they're going to buy or not buy, and that's what gives us some confidence we're going to see a relatively more normalized growth in the air transport aftermarket. Now I did say, just for perfect clarity, that we're probably going to see continued weakness in the biz jet aftermarket, as a result of those systemic global economic trends there. So that's likely not to be quite as robust, that's probably going to be maybe low single-digits. But you combine the 2 and we should return to a reasonably good aftermarket growth in the fourth quarter.

Operator

This concludes the question-and-answer session. I'd now like to turn the call back over to Steve Buesing for any closing remarks.

Steve Buesing

We plan to file our Form 10-Q later today, so please see that document for additional notes and disclosures. I want to thank everybody for joining us and participating on today's conference call.

Operator

Thank you. This concludes Rockwell Collins Third Quarter 2012 Financial Results Conference Call. You may now disconnect your line.

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