Moog Inc. (NYSE:MOG.A)
F2Q08 Earnings Call
April 29, 2008 11:00 am ET
Ann Marie Luhr - Investor Relations
Robert T. Brady - Chairman, President and Chief Executive Officer
John R. Scannell - Chief Financial Officer
Ron Epstein - Merrill Lynch
Cai von Rumohr – Cowen
Eric Hugel - Stephens
Welcome to the Moog second quarter full year 2008 earnings conference call. (Operator Instructions) At this time, I would like to introduce Ann Luhr of Moog Inc.
Ann Marie Luhr
Before we begin, we call your attention to the fact that we may make forward-looking statements during the course of this conference call. These forward-looking statements are not guarantees of our future performance and are subject to risks, uncertainties and other factors that could cause actual performance to differ materially from such statements. A description of these risks, uncertainties and other factors is contained in our news release of today’s date, our most recent Form 10-Q filed on February 5, 2008 and in certain of our other public filings with the SEC.
We’ve provided some financial schedules to help our listeners better follow along with the prepared comments. For those of you who do not already have the document, a copy of today’s financial presentation is available on our Investor Relations homepage and webcast page at www.moog.com.
This morning we will review the results of our second quarter and of course, we’ll update our guidance for the year. On the face of it, this quarter we appeared to be just another steady as she goes quarter, sales up 22% to $469 million and earnings $28.6 million, earnings per share $0.66, an increase of 16%.
And as we go through the segments, you’ll notice that there were some unusual puts and takes in the quarter. lots of good news, some not so good news. A quick summary goes like this. Aircraft had higher sales, but the sales increase was mostly the F-35 development program, a cost plus program was very low margins. So the higher aircraft sales generated about the same operating profit as the similar quarter last year.
Space and defense had the benefit of the recent QuickSet acquisition. QuickSet sales were outstanding, and provided enough profit to overcome a reserve that we set up in the satellite business.
Our industrial segment and our components group both had very strong margins on higher sales. Then on the other hand our new medical devices segment had a disappointing quarter both in sales and in profits.
If you look at our consolidated P&L gross profits up $21 million, in spite of an increase in cost of sales percentage, R&D at $26 million up less than 2% from a year ago. SG&A down as a percentage of sales, interest expense up to $9 million, reflecting our additional borrowings to support working capital, CapEx, and our recent acquisitions. The result, a net earnings increase was 17%.
Now I’ll go over to segments, aircraft, aircraft Q2, total aircraft sales up 11% to $162 million, increased all on the military side and primarily on the F-35 development program. F-35 sales in this quarter were $26.6 million, almost double last year’s $13.8. Every quarter I remind you that on the F-35 development program, we’re the lead contractor and work done by our partners, Parker Hannifin, Hamilton Sundstrand, and Curtiss-Wright, becomes cost to us, which we then pass on to Lockheed.
However, in this quarter $17 million of the $26.6 in sales with work done in our company, an increase of over $9 million from a year ago. Over the last couple of quarters, there has been a sizable increase in the staff devoted to this program. We are finishing up qual testing on the conventional take-off aircraft, the CTOL. We are building and delivering the hardware for the short take-off aircraft, the STOVL and we’re progressing the design work for flight controls on the carrier version.
The effect of this increased revenue on a cost-plus program is much higher sales but not much benefit on the profit line. There were small increases in sales on a number of other programs including F-18, V-22 and Blackhawk and on the military side a nice 13% increase in aftermarket, with a total of $30.2 million. So in total, the military sales increased 28% in the quarter to $98 million.
Virtual aircraft sales, on the other hand, were down from the second quarter of last year, sales $63.8 million down 8%, a reduction primarily related to Boeing commercial. Last year in our second quarter, we received our initial contract for the 787, resulting in a very strong quarter with over $8 million in sales. This year, given what’s going on in the 787, our revenues were $5.1 million. In addition, OEM revenues on the Boeing production airplanes were also down a couple of million dollars, $13.3 million.
Our sales to Boeing for their production aircraft are triggered by specific orders for equipment on specific airplanes. And they vary somewhat with the Boeing build schedule in those airplanes and the Boeing inventory position on each.
Sales on our business jet product line were up 7% to nearly $13 million, increases on the Premier and revenue generated by an as yet unannounced platforms offset reduced sales on the Hawker 4000. The other bizjet news was Gulfstream’s announcement of the G650. I’m happy to announce our participation. We’re doing the flap actuation system on that airplane. And as you probably know, the aircraft’s reception in the market has been outstanding.
Historically, our commercial aircraft aftermarket revenues have been relatively low in the first quarter of our fiscal year, and then built as the year progressed. In this year’s second quarter, those revenues were $22.4 million, up from the previous quarter, but down 3% from a year ago.
In last year’s second quarter, we had more spare sales on business jets other than that, the quarters were quite comparable. Based on our experience, in the first half of ‘08, we have made some adjustments to our overall aircraft forecast for the year. Clearly inactivity on the F-35 will be sustained. We have thought that the work on the CTOL aircraft would be pretty much done by now, and that we’d be close to finished on the STOVL. As it turns out continuing support of the CTOL aircraft, continuing work on the STOVL and the carrier version will carry on through this year.
We’re now forecasting $95 million in revenue for the year, up from $75 million. We’ve increased our forecast for military aftermarket to $123 million, made some other small changes with the result that our military aircraft forecast is now $380 million, up $25 million from our last estimate. On the other hand, the reschedule of the 787 will reduce our revenues on that program by $7 million, lower sales on Boeing production aircraft reduced that forecast by $3 million, and we’re reducing our forecast on business jets by a little less than $3 million.
Given the slow pace of activity in the commercial aftermarket and the delay in the 787 initial spares provisioning, we’ve reduced forecasts for commercial aftermarket. Now total commercial aircraft forecast is now $277 million, down $20 million from our previous guidance. So in total, aircraft goes from $651 million, up to $657 with the most significant adjustment being an increase in the cost plus F-35.
Aircraft margins, given the product mix for this year and the continued investment in R&D we’ve been looking for aircraft margins in the neighborhood of 10%. This quarter margins were actually down to 8.8%, compared to the 10% we achieved last year at this time. Margins in the quarter, as I’ve said, were not helped by the strong F-35 sales. If F-35 sales were at the same level as last year, margins in the quarter would have been close to 10%.
On the last three quarters we’ve been talking about R&D spending in aircraft. Our aircraft R&D expense in the quarter just under $15 million was about the same as last quarter, even though we’re spending more on 787 than we had planned. The R&D on 787 in the quarter was $7.3 million down from $9.4 in the previous quarter.
We had hoped to get through this year with only $19 million in R&D on the 787, but the stretch out program has resulted in a higher level of continued engineering activity than otherwise might have occurred. We’re in qual test on our equipment. As a typical qual test anomaly, they have to be addressed. We do expect it as the year goes by, spending on the 787 will decline. On the other hand, we have started work on the A350 on almost $2 million in this quarter, and we expect that expense level will grow as the year continues.
Given the increased expense on the 787, we’re increasing our R&D forecast for aircraft from $55 to $61 million. However, we do have reductions in other segments that will offset this increase. And our total company R&D forecast remains at the $103 million that we forecasted last time. We expect that over the last two quarters aircraft margins will improve slightly. We’ll end the year at 9.9% on increased aircraft sales, so in terms of operating profit we’re expecting aircraft will come in very close to our most recent guidance.
We ask you to remember that in our aircraft business, we now find ourselves in the midst of a period of unprecedented opportunity. We’ve positioned ourselves on key programs, both military and commercial, F-35, 787, A350. These programs we think will ensure our long-term growth and profitability. Our heavy investment in R&D over the last few years will continue in the near-term. However, in the longer term, margins will strengthen as these new platforms go into production.
Space and defense Q2 were to have a big positive and a big negative, sales of $70 million up a remarkable 48%. The huge increase was all the result of the acquisition of QuickSet International. In the quarter, QuickSet added $17.6 million of sales in our defense controls product area that now offset a $6 million reduction rising from the completion of the LAV-25 program and a lull in sales on Future Combat Systems.
The big positive was the sales increase at QuickSet, the result of the Driver Vision Enhancer system. QuickSet is delivering this system to DRS for use on the MRAP vehicles. We had a huge delivery quarter. We delivered 5,000 units. So far this year, we’ve delivered over 6,700 of the 7,600 orders, with 840 left to ship. In addition to the DVE program, QuickSet contributed another $5.4 million in sales of surveillance systems, on what we are now calling our Homeland Security product line.
There were some other increases in space and defense. Sales of $6.7 million on constellation program more than offset a $2.3 million reduction in space shuttle. Tactical missile business up $2 million, reflecting increased shipments of Hellfire and TOW missiles. Satellite business up slightly at $14.3 million, total launch vehicles, strategic missiles and missile defense were down slightly. So the overall strength of the space and defense business, including QuickSet, was the good news.
Now here is the other side of the coin. Every once in a while we have a manufacturing problem on controls we deliver to the satellite industry, and when that happens, it’s generally expensive. In this quarter, we uncovered a problem that a thruster valve used on satellites.
Our production valve failed in test, failure analysis discovered that in this particular design there is a potential problem in the press fitting of the steel stop pin into the valve body. This design has been in production for many, many years, and we have never experienced this problem. We’ve been able, using CAT scan techniques, to evaluate the valves we have in house, and based on our findings, we’ve developed a model to estimate cost of recalling equipment that’s in the field. We’ve set up a reserve of $3.6 million in the quarter to cover this anticipated expense. So the Lord giveth and the Lord taketh away.
For the year ‘08, we have the benefit of strong orders at QuickSet, and that phenomenon has offset some downward adjustments in other defense controls. The result is an increase at our space and defense forecast by $3 million with a new total of $2.46. Space and defense margins, given the extraordinary sales level at QuickSet and the profit contribution that generated, if we had not had this recall reserve, margins in space and defense would have been an extraordinary 18.1%.
After providing for the reserve, margins in the quarter were a respectable 13%, a level that compares favorably with margins in the segment for most quarters, but not the unusually high 15% margins in the second quarter of last year which were driven by strong space shuttle sales. For all of last year, we averaged 13%. We did 11.7% in the first quarter of this year. We’re projecting more moderate margins as the year progresses. We’re now projecting 11.2% for the year.
Industrial systems Q2 our sales for the quarter $130.2 million up 17%, the majority of our industrial revenues are generated outside the US, so strong foreign currencies translate into increased sales. That effect came into play this quarter, but setting that aside, our organic sales increased by 8%, excellent organic growth in the industries in which we’re operating.
The largest dollar increase was in the motion simulator business. Sales of $17.2 million were up 31%, very strong deliveries to CAE and Flight Safety. Motion simulators is now our second largest industrial product line.
The most dramatic percentage growth in the quarter was in metal forming presses. Sales of $13.7 million were up 36% from a year ago. Most of our customers in this product category are in Europe, and that’s where most of the growth occurred. Increasing metal prices seems to stimulate the demand for presses with more accurate control, and that’s where our company comes in.
Sales in power generation increased by 17% to almost $12 million. Sales particularly strong in Asia and most particularly, in Japan, where we’re selling the controls to Mitsubishi for gas turbines, Toshiba for steam turbines, and Fuji Heavy for wind turbines.
Last quarter, our equipment used in steel mills grew by 52%. In this quarter the year-over-year growth rate moderated to 18%. Sales in the quarter was $9.4 million. The steel mill business sales have been robust in China, where we’re delivering equipment for new mills and spare equipment for mills that are currently running flat out. Business is also strong in Europe, where mill operators are upgrading their capabilities.
Sales for controls of plastics machinery, our largest industrial market, increased only slightly to almost $20 million. As we went through our review of our industrial systems business for this quarter, there was no mention of recession. In the market areas that are important for us, flight-training simulators, metal forming presses, power gen, age control for steel mills, plastics machinery, we have not yet seen any signs of weakness. So far these markets are vibrant, incoming orders have been strong.
We’re forecasting a second half for ‘08 that will be $10 million higher than the first half and $10 million higher than our previous guidance. So we’re now projecting industrial sales for ‘08 in a range centered around $516 million. Industrial margins 14% up nicely from 13.3% a year ago. Last quarter we were projecting 13.7% for the year. We’re well ahead of that for the first six months. And we now expect that the product mix in the back half of the year will support a repeat of the first half, so we’re currently projecting 14.3% for the year.
The components group Q2, last quarter, I described our components group as a juggernaut that continues to steam ahead, and it hasn’t slowed down. Sales are $84.2 million, up 21% from a year ago. Of the $14.8 increase $3.3 million was generated by recent acquisitions Thermal Control Products, Techtron and Prizm. Nevertheless organic growth still an impressive 17%, sales up in every market area.
Sales of aircraft products, $26.6 million up 13%, and the increase primarily in the Guardian program at Northrop. The program was not in production a year ago and it’s most recent quarter sales were $3.8 million. The power unit you may know is the system designed to protect military and commercial aircraft from shoulder fired missiles.
Sales in the Blackhawk Helicopter continued strong at $2 million, so well over $1 million worth of avionics equipment to Rockwood-Collins. The Arrowhead target acquisition system for Lockheed increased by over a third to $1.2 million.
Sales of component products used in space and defense at $16.8 were up 29% for the quarter. The Commanders Independent Viewer on the Bradley continue to be the largest program. Sales in the quarter are $3.8 million up 35% from a year ago. Sales of turret slip rings used on both the Bradley and the Abrams continued strong in the quarter, aftermarket sales plus market increases by a third to $2 million.
In ‘07, our sales in the marine markets grew by 32%. We weren’t inclined to simply extrapolate this growth rate when we put together the ‘08 plan, so we projected flat sales. The sales in this quarter of $11.4 million were up 73%. On a year-to-date basis we’re up 58%, so clearly the growth continues stimulated by the continually increasing price of oil.
Sales in the medical market $14.9 million up only 4% from a year ago, the increase is driven by higher slip ring sales to customers for CT scanners primarily Philips Medical and Hitachi.
Industrial and component sales are $14.5 million up 22%. The increase in this area was primarily revenues from the TCP and Techtron acquisitions. Incoming orders remain strong. We do know however, that two of our slip ring customers with closed circuit TV business over-ordered in the first two quarters as they began new projects and future sales maybe somewhat lower. As I’ve said in the past, forecasting the components group is more art than science, but relatively few large long running orders, so we began each year with a relatively conservative forecast and adjust as we go along.
Our guidance 90 days ago was that we finished the year at $326. We’re now inching that forecast up to $330 million driven primarily by the continued growth in the marine market. Aircraft and space business are also up slightly over-moderating our forecast in medical and industrial.
Components margins in the quarter are 17.3%, up nicely from last year’s 14.2%. Currently running ahead of our margin prediction for the year, margins in this business are very much affected by the product mix that we’re projecting, hopefully conservatively a moderation of the last two quarters and the year-end average of 16.8%.
Medical devices Q2, the performance of our fledgling medical devices segment in the first quarter of ‘08. The first quarter was very close to our plan and left us optimistic for about the rest of the year. Sales in that quarter were just over $27 million, operating profit just over 13%. We were objecting subsequent quarters averaging $24.8 million in sales and $3.5 million in operating profit or about 14%.
The results in the second quarter did not come close to that forecast. Sales were a disappointing $22.7 million. Operating profit was $350,000 or just 1.5%. Here is what happened. Pump sales at $8.2 million were $1.8 million off plan on sales of the more profitable intravenous pumps were $3.6 million off plan.
A number of reasons, B. Braun, our sales agency had very strong hospital sales in quarter one, which didn’t repeat. We theorized that some hospital administrators had held on to their pump budget and released it at the end of their calendar year, which is the end of our quarter one.
In addition, we had some key part shortages, which held out shipments of pumps to Europe, also sales of a disposable pain pumps suffered in the quarter since we’re in the process of changing distributor organizations. Sales of admin sets at $7.8 million were $0.5 million off plan, but once again, the shortfall was at administration sets for IV pumps, which are more profitable.
During the quarter we introduced a new offshore supplier and got hung up with B. Braun approval of this new source. So although the overall sales risk was only $2.1 million, the dramatic product mix shift resulted in $2.3 million shortfall in gross profit. And that accounts for most of the problem.
The other part is in higher SG&A. It turns out that the ZEVEX organization has a sales commission plan such that if certain sales goals are met, it triggers higher payouts. Very high ZEVEX product sales in our first half actually hit the trigger and the result was an unusual payment.
In addition, we had some unanticipated legal fees and we’re investing more in R&D than we planned. The result was increased expense of about $800,000 and a very modest operating profit. So where does that leave us for the year? We had targeted for the year sales of $102 million, operating profit of 14% or $14.2 million.
Based on our analysis, the first half we now believe that a reasonable sales forecast for each of the next two quarters is about $24 million. We think that because it appears that sales of IV pumps will recover in the second half. Sales of IV administration sets have already resumed with the approval of the new supplier. So it seems reasonable to believe that the normal run rate in this business will not be $22.7 as in the second quarter, but more like $24 million.
In addition, the commission payments will moderate so we believe operating profit of $2 million a quarter or about 8% should be achievable. The result will be year-end sales of $97.9 million, operating profit of $8 million or about 8.2%. I’m sure that many of you remember that we began our initiative in the medical market hoping to develop a product line with a potential for double-digit sales growth and 20% operating margin. Given our acquisition pattern, we’re achieving the sales growth, thus far we haven’t achieved the 20% margins, but we still believe that potential really does exist.
We think that this year ‘08 will be a year of rearranging and in some cases re-staffing our organization, a year of investing in the improvement of some of our production planning and quality assurance systems and the year of learning to work with the channels of distribution in what is a new market for us. While we continue to believe that our initial assessment was correct. We have very strong products and there is the potential in this business for high growth and strong margin performance.
So a summary of ‘08 guidance let me summarize where we think we are for the fiscal year. The bottom line is that although we’re revising our segment sales forecast mostly upward, and margin forecast some up/some down, the bottom line comes out the same. We’re now projecting sales in a range settled around $1.846 billion. A net earnings midpoint of $117.3 million for $2.71 a share, which I hasten to point out, is a 16% increase from last year.
Looking at the segments, we’ve increased aircraft sales to $6.57, changed our marketing projections from 10% to 9.9%. Space and defense increased sales forecast to $2.46, changed margins from 12% to 11.2%. And industrial, we’re increasing sales projections to a range of around $5.16, an increasing margin from 13.7% to 14.3%. And in components we’re increasing sales from $330 million and margins to 16.8%. In medical devices, sales now forecast at $97.9 million, margins of 8.2%. We’re anticipating $0.69 earnings per share in the third quarter at $0.72 in the fourth, slight change in those two quarters from our recent guidance.
I will now turn you over to John Scannell. John is going to talk about cash flow and our balance sheet.
John R. Scannell
I would like to follow the same format as last quarter. First, I’d discuss cash flow in the quarter, and provide an update for the year. Then I’ll speak to our recent financing activities. I will talk about our tax rate and finish with some other items from the balance sheet.
Q2 cash flow, our free cash flow in this quarter was breakeven, an improvement of $29 million over the first quarter. Net debt decreased by $4 million in the quarter. The reduction was the result of the translation effect on our overseas cash deposits. Cash flow from operations was positive at $21 million, $25 million higher than in Q1. The improvement was the result of slower growth and working capital.
Capital expenditures were down from $25 million in Q1 to $21 million in Q2, but depreciation and amortization in the quarter was $15 million. Interest payments totaled $13 million, but our cash tax payments were $12 million.
We’re maintaining our forecast for free cash flow for the year at positive $5 million. We anticipate that our cash flow from operations will come in at $95 million, and our capital expenditures will be about $90 million. As we said last quarter, this forecast assumes we will receive $20 million from Boeing for work performed on the 787. Our discussions with Boeing on this subject continue and we are encouraged by the recent news that Spirit AeroSystems has received a cash payment from Boeing.
Financing, we closed an expansion to our senior revolving credit facility in March. This increased our capacity from $600 million to $750 million, and reset the term to five years. The additional funds will support our continued growth, both organic and through acquisitions. Given the tough credit market conditions, we were very pleased that each of the banks in our credit facility supported our expansion and we were able to complete this transaction with an oversubscribed offering.
Taxes, our effective tax rate in the quarter was 32.7%. For the year, we’re forecasting an average tax rate of 31.6%. The reduction for the second half will come from some tax benefits associated with foreign taxes and R&D tax credits.
Other items, our non-cash stock compensation expense in the quarter was $700,000. Contract loss reserves increased by $4 million over the prior quarter, driven by our satellite valve recall. Finally at the end of March, our net debts to total capitalization stood at 48.1%.
Now we’ll go to questions.
(Operator Instructions) Your first question comes from Ron Epstein - Merrill Lynch.
Ron Epstein - Merrill Lynch
So when we think about medical going forward, and we were hoping that things would have been stabilized at this point, can you give us any more color on how we should think about it, how we should model it, that kind of thing?
Yes, well, I think your model for this year ought to be what we just described because that’s what we think is most likely to happen, $24 million a quarter in the next couple of quarters and then a couple of million in operating profit. We think that next year will be stronger in operating profit. When we began this initiative, as I said, we believed that this would be a market that would provide faster than the average sales growth and nice profitability.
Now I think what we’ve learned is that in the acquisitions we’ve made, we have acquired some very strong products. We are, however, getting acquainted with the channels of distribution in the clinic market for intravenous pumps and the pain management pumps, which was the McKinley product line, and in the enteral pumps.
And we have some things to learn; it’s a new market for us, and as I mentioned in the prepared remarks, in this particular quarter, we had some unusual expenses, which we don’t think will recur. I’m still optimistic that this is going to turn out to be a strong product line for us. And I think we just have to be patient.
We bought ZEVEX halfway through last year. We’re in the process of combining these, the ZEVEX and what was the ZEVEX and the Curlin organization into a coordinated unit with one engineering organization, one sales management outfit, and one operations organization. And we’re making real progress.
I can tell you I spent last week in Europe and visited a couple prospective customers, companies that are not yet customers for the products that we are talking about and they have a very high regard for the products that we have. So, when I say these are strong products, it’s not just my opinion. It’s the opinion of people who actually have been in the market.
Ron Epstein - Merrill Lynch
With the award on the multi-year on the V-22 to Textron and Boeing, how big an opportunity is that for Moog as we walk out over the next year or so?
The V-22 has been a strong program for us. We’re optimistic that the production rate will increase. Over the next couple of years, we’re forecasting 36 aircraft a year and that’s a good business for us. We think it’s an indicator of strong support for the program.
Ron Epstein - Merrill Lynch
In the second half of the year here, the R&D spend, do you expect it to just be flat in the second half or where do we expect it to go?
Year-to-date, we’re just over $50 million and we’re expecting to end the year at about $103. We’re actually expecting it to be up somewhat over the balance of the year. The aircraft portion which everybody seems to be focusing on, we expect will be about the same in the back half, a slow decline in the 787 and an offsetting increase in A350 and a couple of other programs. There’ll be an increase in R&D spending in some of our other segments, so as I said, we expect to wind up the year at just under $103, which was the same guidance we provided last quarter.
Ron Epstein - Merrill Lynch
In the industrial businesses, Bob, have you seen any signs of a slowdown, given what’s going on economically, particularly in the US? Has it filtered out to any of your industrial businesses?
Yes. Our industrial segment, I think you will remember, over three quarters of our sales are generated outside the US. Customers are in the businesses of building power generation facilities all over the world, steel mills in China and in Europe. Flight-training simulators are an important business for us. The plastic business, plastics controls, all of our customers are exporters.
And in the market areas that we’re in and as you can imagine, we listened very carefully and we went through the review all of those businesses to prepare for this quarter’s report, there was not one mention of the term “recession”.
Also, in the industrial portion of our components business, as yet, we haven’t seen any signs. So it’s not to say that there isn’t a recession, but we don’t have products that are related to home construction. We don’t have any investments in CDOs and sub-prime mortgages so we’re not having those kinds of problems, so we’ll see.
It’s not to say that ultimately a slowdown in sales of autos might ultimately have some effect on metal forming presses, but we haven’t seen any signs of it yet. On the contrary, our order book is quite strong.
Your next question comes from Cai von Rumohr - Cowen.
Cai von Rumohr - Cowen
You had mentioned in talking about medical, if I recall, that you changed distributors. Who is your new distributor? What was that change?
Well, I did mention that, Cai, and that was related to our disposable pump product line. We’re not changing from; B. Braun is still handling the Curlin electric ambulatory pumps. But we did have an important distributor in the pain pump business, as you may remember is the McKinley product line. And the focus of that distributor was on the orthopedic business, and for a variety of reasons, that outfit has withdrawn from that business.
And we’re now in the awkward position of changing, we’re actually interviewing, if I can use that term, evaluating alternative distribution. And the result of that was a very weak sales quarter in the disposable pump business.
Cai von Rumohr - Cowen
And then you mentioned being $800,000 above expenses included legal and R&D. Why was the legal over? Did the R&D, how much was it over, about? And is that going to be higher for the year?
The R&D wasn’t the biggest part of it. The R&D over-budget was about $100,000. The legal expenses were between $100,000 and $200,000, and for a couple of activities that will not continue. I don’t know if they’re worth getting into, but we had some legal issues that had to be resolved. Let me leave it there.
Most of the increase was in commission in sales. The ZEVEX organization had some arrangements with some distributors that when they really hit the jackpot, if sales achieved some particular levels, which no one ever anticipated to hit. You may remember we had very strong ZEVEX product sales in the first quarter, largely an order from Abbott.
And that taken together with strong sales in the second quarter, actually, we’ve kept those triggers and wound up with some distributors that had a real payday. So that was the biggest part of that increase. And that will continue. We hadn’t anticipated it. It wasn’t budgeted, but it did happen and that won’t continue.
Cai von Rumohr - Cowen
If we look at the second half, it looks like you’ve brought your expectations down and I assume your mix should improve. What should we think about, you’ve missed enough here that you really want to be cautious, that you’re planning to spend a little bit more to really get it sorted out. How should we think about how you’re approaching that in medical, and the potential variability around the number? Is that number a not to be below number or a conservative guess, or the midpoint of a range? How should we think about it?
I think for the balance of this year, these look like achievable numbers. I don’t know that I’d be willing to say it’s not just be below, but I think it’s likely that we’ll make those numbers, the $24 million in sales, the operating profit. Maybe do a little bit better. A part of this picture that we don’t describe in the recitation that we just went through, we’re looking at the sales numbers, earnings numbers in the current quarter.
The thing that we don’t describe is that there is in the market a lot of interest in the products that we have. And I’m optimistic. I’m not suggesting that the interest in these products is going to have a big impact on sales in the next three to six months. But I continue to be impressed that prospective major customers have a lot of respect for the quality, the capability of these products.
And we’re hopeful that as a result, this business will build nicely in ‘09 and the years beyond. And I think with a little more volume in, particularly in the intravenous pumps, the financials will swing around.
Cai von Rumohr - Cowen
On the Spirit call, in addition to mentioning the revised payment schedule, they mentioned that they are looking at lower gross margins on the 787 because of the disruptions of a delayed schedule. What’s the impact on you, how much is beyond the expected to be for the year on the 787?
As I mentioned, we have been talking about getting through this year with an R&D spend on the 787 of about $19 million. We’ve revised that estimate up to over $29 million, $29.7. On the other hand, we have some offsets in the aircraft business, so as I mentioned in my text, we’re taking aircraft R&D from $55 to $61 million, but we’re under-spending our original budget in some of our other segments and so the total R&D spend for the year, we expect will still come in at about $103 million. So the 787 is going to be more expensive in terms of R&D than we anticipated.
In terms of the ongoing production profitability, that’s still a work in progress. We’re still negotiating changes with Boeing. I’m still comfortable that the production pricing is going to be just fine. So long-term I think we will have invested more in R&D to get the program launched. On the other hand, we’re able to afford doing what we’re doing and we’re still generating 16% increases in EPS quarter-after-quarter, so I think the whole picture fits together okay. There is still the issue of the cash impact on our company.
As John mentioned, we’re happy to know that Boeing has decided to pay somebody some cash and we’ll continue our discussion about what the cash payment ought to be. There isn’t any question, let me put it this way, it won’t surprise you I don’t think if I tell you that the change that they’ve made in their recently announced reschedule would have been really helpful for companies like ours if they had come to that schedule a year or a year and a half ago.
We’ve been investing in CapEx and developing capacity for ‘09 and 2010 that it now appears we didn’t need to, but I’m sure we’re not alone in that sentiment.
Cai von Rumohr - Cowen
Given all these disruptions that Boeing has imposed on you from, let’s be fair, their own bad planning, what are your opportunities to get request for equitable adjustment actually addressed?
We’ll see, we continue with those discussions. As I’m sure you can appreciate, the folks that were trying to have those discussions with have been very busy, and so our ability to conduct that dialogue is intermittent and foreshortened, but we think they’ll be reasonable. We think that, I’m hopeful that now that they have a sensible schedule that the folks will be able to devote more attention to the circumstances of suppliers like ourselves.
Your next question comes from Eric Hugel - Stephens.
Eric Hugel - Stephens
Can you give us an update as to where things stand right now with your relationship to B. Braun? I know it’s been on-again/off-again?
I would say overall, it’s positive or potentially positive. There have been some hitches, we’re still getting adjusted, I think, to their forecasting process. I mentioned that in this quarter that we encountered a delay in our ability to deliver admin sets because of an approval process of a new offshore source. One might have hoped for a more supportive posture on their part, but I think overall the relationship can be a positive one.
It just so happens that I visited B. Braun headquarters last week and had a very positive and productive conversation with the man who is ultimately responsible for sales of our products. He is one of the people that is quite enthusiastic about the capability of the product that we have. So, I think long-term it can be a positive and supportive relationship. In terms of the product line financials, we need a little more volume and we’re working on that.
Eric Hugel - Stephens
With regards to the medical business in general, Bob and the senior management team, do you find yourselves spending in order? There just seems to be every quarter these things come out of left field. do you find yourself spending an inordinate amount of time dealing with these issues relative to the size of the business?
Well, I don’t regard it as inordinate and it may seem that way. we’re talking about a company that’s going to do over $1.8 billion in sales and we have segment reporting because of the SEC requirements for segment reporting on a segment that’s going to do $100 million out of $1.8 billion.
So in a way or in a fashion, it’s the segment reporting that pumps this particular product out of proportion in terms of the apparent attention. It is a new business for us and so we’re all in the senior management group interested in getting better educated, better acquainted in this market. But this is something we’ve been through in the past.
I hasten to point out that our company, when I joined the company, was primarily a space and defense company that delivered servo-valves and servo-actuators and little else. We had to learn the industrial market. We learned the international market. We learned the commercial airplane business.
Our company was not a participant in the commercial airplane business until almost 1980. I don’t think it’s unusual or inappropriate for the senior management to pay attention to new opportunities for the company, and we’ll learn our way around this business.
We talk about it because it’s different and interesting and there is a lot of interest in it. But you shouldn’t walk away with the impression that the management of our company spends all our time on the medical business, quite the contrary.
Eric Hugel - Stephens
No, it just seems to me that from a technology standpoint where you excel, everything looks great. It’s really the distribution business end of it where you are just relying on other people, where you have the issues.
Yes. I wouldn’t quarrel with that characterization that we need to learn effective distribution in this market. And I think we can.
Eric Hugel - Stephens
Is there a case that to be made for just bringing the distribution in-house or just doing it internally with the sales force? Or is that just more cost than it’s worth?
That’s the question. I think that case can be made depending on the volume potential of the product. But I don’t think there is an obvious answer. And I think in part, it will depend on the interest in this product line on the part of organizations like B. Braun. And if that company, that is a very sizable and very capable company. And if their interest in our products continues to grow, it could be a great relationship.
I think we need to be patient and shouldn’t overreact to the particular results quarter-to-quarter in this business. We’ve got to give ourselves some time to get the business organized and get acquainted with the market. And I think the results of this year going from $14 million in operating profit to $8 million is hardly going to slow our train down.
Eric Hugel - Stephens
The components business, looking at the medical sales up 4%. If I remember correctly your main customer is Respironics? They were acquired, or are in the process of being acquired by Philips?
They are acquired by Philips.
Eric Hugel - Stephens
Has there been any change in the relationship or anything that’s going on there?
No. The thing that’s going on there is a very sizeable automation project to automate the production of, I was going to say motors. It’s now a motor-blower assembly that we’re building, so Respironics has actually made an investment in automated equipment, which is installed in our factory, which reduces the cost of the product and also the price of the product.
And as a result, sales in total are not growing at the rate that they have been in recent years, recent quarters. But as far as the relationship is concerned, we’re still dealing with the same people and as yet we don’t see any impact of the acquisition of Philips.
Eric Hugel - Stephens
Can you update us on the Philipino peso headwind?
John R. Scannell
In the last quarter we reported that the Philippine peso had strengthened by about 20% over the previous 18 months, and we had about $30 million in peso denominated costs that has filtered through to about $4, $5 million additional cost in this fiscal year. The peso, actually the spot rate at the moment, the peso has come down, had strengthened or weakened relative to the dollar over the last quarter or so.
So in Q1 the average rate was about 43, in Q2 the average rate was 41, but we’re now back up at about 42 to the dollar. So the situation seems to have stabilized. The peso, we would say, is trending weaker against the dollar, but we are also in the process of reviewing our hedging strategies and do plan to insulate ourselves more proactively as we move forward.
Eric Hugel - Stephens
And lastly, can you give us an update as to how many 787 production ship sets that you’ve already shipped? What’s in the pipeline?
Well, we’ve shipped about six ship sets. These are primarily for the flight test aircraft, so we’re just getting close to the delivery of production aircraft. We certainly have delivered as much hardware as Boeing is able to use at the moment.
Eric Hugel - Stephens
It’s now like you’re in a situation where you shipped the heck of a lot more and they’re going to tell you to stop until they catch up. You’re still in line with their actual production rates.
Yes, actually we have slowed down our production and our production deliveries in anticipation of something like their current reschedule. We explained some weeks back that we were taking that action and put some of the procurement folks in an awkward spot. Off the record, we got a wink and a nod that what we’re planning to do looks like it was about right and that’s the way it came out.
We have no further questions in queue.
Thank you very much for coming and listening, and we’ll see you next time.
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