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Executives

Dan Swenson - VP of IR

Clayton M. Jones - Chairman, President and CEO

Patrick E. Allen - Sr. VP and CFO

Analysts

Lee Rawlings - Morgan Stanley

Ronald Epstein - Merrill Lynch

Joseph Nadol - JPMorgan

Myles Walton - Oppenheimer & Co

Robert Spingarn - Credit Suisse

George Shapiro - Citigroup

David Strauss - UBS

Cai Von Rumohr - Cowen & Company

Carter Copeland - Lehman Brothers

Howard Rubel - Jefferies & Co.

Rockwell Collins, Inc. (COL) Q3 FY08 Earnings Call July 11, 2008 9:30 AM ET

Operator

Good morning and welcome to the Rockwell Collins Third Quarter Fiscal Year 2008 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, Dan Swenson. Please go ahead, sir.

Dan Swenson - Vice President of Investor Relations

Thank you, Teresa and good morning everyone. 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 are presenting today on our website at www.rockwellcollins.com under the Investor Relations tab. Please note today's presentation and webcast will include certain projections and statements that are forward-looking as defined in the Private Securities Litigation Reform Act of 1995.

Actual results may differ materially from those projected as a result of certain risk and uncertainties, including but not limited to those detailed on slide two 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 the date hereof and the company assumes no obligation to update any forward-looking statement.

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

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

Thanks Dan, and good morning everybody. Before I get into my introductory comments about the quarter, a couple of things I'd like to cover. First, I want to formally welcome Dan Swenson to our IR team. He could be a great asset and many of you who have had a chance to meet or talk to him and those who haven't, I know you'll look forward to that in the future, so Dan welcome aboard. Second, thing is I want to extend my sincere appreciation to everybody on this call who set... indications of your concern and best wishes during the recent very tragic floods that affected Cedar Rapids in the Iowa area where as you know our headquarters is.

Rockwell Collins was very fortunate to have none of our facilities affected by that, and I can tell you now as many of you already know, there's absolutely no impact to our financial results now or into the future as a result of this flood. However, we had a few employees whose homes were lost, many of our friends and neighbors were affected by this, and so on behalf of us, and them I want to tell you how much we appreciate your best wishes.

Well there is a lot to talk about today, and so let me set the stage by summarizing our very strong third quarter financial performance. We continue to demonstrate the strength of our balanced portfolio of business by delivering third quarter earnings per share of 24% growth and total segment operating profit growth of 17%, and this is on a top-line revenue growth of 7%, clear testimony to our ability to consistently expand margins and grow our profits well in excess of revenues. Patrick is going to cover the details of our financial results later in the call, so, for the balance of my introductory comments I'd like to share with you some of my observations about the current market environment.

I know all of us are reading the same headlines, record oil prices, escalating operating cost at our airline customers, reduction in capacity in the airline fleets, and predicted impacts on the backlog of Boeing and Airbus. Everywhere you look, it seems there is another article or report proclaiming the end of our industry as we note. Meanwhile, we and another companies doing business in commercial aerospace have been caught in a downdraft that these headlines are creating, and as a result we're seeing valuation level similar to the post 9/11 period.

Now all of these items are of concern to us, we pay very close attention to them. But during this time, there is also been a set of bylines that seem to have gone unnoticed. First, record bookings at business jet manufacturers driven in part by the other side of the economic coin of oil, the wealth that it's creating in the Middle East, Russia and other oil producing economies.

Second, continuing new orders and solid delivery demands in the aggregate at Boeing and Airbus. And third, a steady commitment to the protection of our nation, and its allies in the base that fifth budget put in place to assure that protection. These items seem they have been pushed to the side by the doom and gloom reporting on a portion of one market segment.

So, during this time of uncertainly and ambiguity, we thought it would be useful to share with you our view of the market factors affecting our business, and how we're positioned deal with them. And I'll start with that piece of the market that everyone is concerned with air transport business.

As all of you know, many airlines have come out with capacity reduction announcements, but our analysis of the actions being taken suggested a disconnect in how the equity market is reacting. Our analysis based on public announcements to-date and discussions with the airlines leaves us to believe that the impact of oil at current prices will cause about a 5% global capacity reduction. That's 10% in North America, 3% in Western Europe and about 1% in Asia-Pacific.

This 5% reduction corresponds to about 800 to 900 parked airplanes. These actions will certainly create some headwind especially related to the aftermarket. But let's not lose side of the fact that even with these capacity reductions expectation still call for passenger miles to be up on the order of 1% to 3% next year.

On the air transport OEM side, we have an environment in which the OEMs have over 7,200 aircraft orders in backlog or about seven years of production. These OEMs continue to forecast market growth, excluding the 787 program of about 8% through 2010 and including modest 787 delivery assumptions that growth could be 10% or better through 2010.

Now a lot of you, however, I've heard or you have written about the possibility of order cancellations and deferrals. I agree that the likelihood we will see some of these cancellation deferrals is high. But what is open to variance in opinion, is their magnitude. So how great could the magnitude be? To put that in perspective, it's estimated after 9/11, Boeing had cancellations and deferrals of about 12% of its backlog. And that was during a period when consumer demand for air travel literally dried up due to safety concerns. And the industry operating economics allowed those airlines to operate their older best fuel efficient fleets.

If we saw a similar magnitude drop today, that backlog would go from about 7,200 aircraft to about 6,300 aircraft or from seven years of production down to six years. But we're dealing with an environment that still has good consumer demand for aircraft and economics that are making new aircraft even more attractive due to their relative fuel efficiency.

If we move over to the business aviation market, we've been out talking to business jet operators, FBOs and others in the industry. The feedback we're getting is different depending on who you are, at the large corporations and with very high networth individuals they are using their aircraft regardless of the incremental fuel cost of the trip.

However, the mid-sized corporate level like ourselves, we're hearing that travel department is coming under budget pressures due to fuel cost and they are reacting by either deferring maintenance items or flying less.

So we are seeing reductions in spending as flight departments try to rebase line their budget. But let me give you an educated guess about what's going to happen next. I can tell you because my jet of flight officer [ph] has already told Patrick, that he is going to need more money in his budget next year. And chances are I and CEOs like me are going to give it to him, because we intend to keep using these valuable assets to do business.

Also, it's not difficult to anticipate a trend, where more businesses and individuals who can afford it actually look to business jet travel, in order to avoid the impacts that result from the capacity reductions we just talked about the airlines.

So, while in the short-term, you'll see an adjustment period due to higher operating cost, we think at the long-term you still have dynamics that are favorable to the industry. And we're seeing the best evidence of these long-term dynamics coming from business and regional jet OEMs, where demand continues to be strong.

In fact, international demand is so strong that for many models buyers are continuing to pay a premium for early delivery slots. We saw a recent indications of this international demand as the E-BASE business jet ratio in May of this year which had record order announcements of more than $5 billion most of it coming from outside North America.

Now, turning to the other half of our business that everyone seems to have forgotten about. We see relatively stable conditions in the defense market for government systems. We expect the base defense budget will grow about in line with inflation over the next several years. But with areas of greater than inflationary growth related to network communications, open systems architecture application, and advanced munitions guidance, all areas where our business has core strength and where we participate on a wide variety of programs.

So how is Rockwell Collins positioned to deal with the market dynamics that face us now and into the future. Over the past decade, we focused on balance between our segments, and diversification across our businesses and it's at times like today that this approach will serve us very well.

Let me illustrate this point by putting some context around the commercial aftermarket. Our commercial aftermarket revenue makes up about 23% of our total sales for this year and the air transport portion is only about 15% total sale.

As I mentioned earlier, anticipated capacity reductions are likely to be the most significant head-wins we and other companies face over the next year or so. Within that capacity reduction, much of it is from aircraft like the MD-80s, DC-9s, and older 737s where we have frankly very minimal revenues, and low market share in the maintenance and repair of that equipment. That just compared to our greater content on light body aircraft which we see is being used on a more profitable routes and so somewhat less likely to be part.

And we also anticipate opportunities for some growth on items like RNP or Required Navigation Performance, which will allow airplanes so equipped to fly more direct, and fuel efficient flight patterns which as you can imagine is an area of heightened interest by the airlines. One other piece of context here, post 9/11, our maintenance and repair sales were down only 2% from 2001 to 2002. So in this environment for us to see about flat year-over-year MRO sales would be consistent with that experience.

Now regarding air transport OEM sales, although we know there will be cancellations and deferrals, there is more than enough demand to support projected rollout rates and we're expecting more orders at the Farnborough Air Show next year... next week. In fact, we've seen in some cases low cost carriers who have begun to defer orders and some legacy airlines who have actually stepped-in to take those delivery slots, the best example, recently is American Airlines, actually accelerating their equipments [ph] of 737 Next Generation.

This mix shift is actually a very positive trend for us. Now going into 2009, we're also continuing to benefit from incremental share gain in Avionics. If you back to 2006, we've won eight of the last nine business jet cockpit competitions. And have positions on aircraft being introduced in each of the next four years including Cessna's XLS PLUS and CJ4, the Bombardier Global Express XRS 5000 and Learjet 85, and we've been successful with customers where we didn't have any prior position such as Embraer with the MSJ/MLJ aircraft. Our cabin system business will also add to the OEM growth with new aircrafts scheduled to enter delivery including the

Dassault Falcon 2000, 900 and 7X and Hawker Beechcraft Horizon 4000 just to name a few.

Within government systems we're looking at our business that has opportunities on several fronts. With the army, we have key positions on growth platforms such as our integrated computer system and our display systems for FCS along with our CAAS [ph] open systems based avionics packages on the rotary wing market.

We're also moving into higher levels of system and subsystem integration on programs like the E6 on which we're the prime contractor for the upgrade on the backend mission system. And finally, with our acquisition of Athena Technologies recently we expect more content on UAVs where we see a growth opportunity of about 15% over the next several years.

Finally, let me wrap up with a comment about margins. Consistently through our history, we have been able to show margin expansion in times of even modest growth, and the ability to quickly react and manage cost in times when it's needed. If you look to FY 2002 following 9/11, our margins declined only 1 percentage point on a 12% overall sales decline. And the following year we were able to grow margins 60 basis points on only a 2% sales growth.

Now given the growth we're expecting in 2009, we expect to see continued margin expansion. So, all things considered, I see strong industry fundamentals driving commercial OEM revenue growth and that more than offsets any softness we see in the aftermarket.

In addition, to that we have a well position government system business with a broad portfolio of programs and opportunities. If you take those top-line drivers along with the incremental margins, we've consistently been able to deliver it should give you confidence in the ability of our balance and diversified company to continue to outperform the market and our industry.

With that, let me turn the call over to Patrick to walk through the specifics for the quarter. Pat?

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

Thanks Clay and good morning to everyone as well. Let's get started by first reviewing our results for the total company moving on slides three and four. In total we grew sales at a rate of 7% increasing by $81 million to $1.194 billion. Our net income increased by $28 million or 19% and our earnings per share increased by $0.21 to $1.07 per share a growth rate of 24%.

Let me highlight a couple of items here relating to our net income and EPS results. First, you'll see the EPS growth rate for the quarter was 5 percentage points higher than the growth rate we reported for net income. Principally driven by the significant impact of our on going share repurchase program. Also our effective income tax rate for the third quarter was 29.8% compared with 30.1% for last year's third quarter. This quarter's rate benefited from the settlement of several open tax years, which I discussed on last quarter's call, plus the impact of higher than anticipated deduction related to domestic manufacturing activity. These benefits more than offset the expiration of the federal research and development tax credit and higher pre-tax earnings.

Moving on to slides five through eight, we have the strong results, posted for the third quarter by our commercial systems and government systems businesses. Commercial systems revenues increased 8% driven by share gains and continued strong demand for new business regional and air transport aircraft. OEM revenues increased a double-digit rate in all three market areas.

In air transport, revenues grew 24% as higher narrow body deliveries and increased capture rates on airline selectable equipment. We're only partially offset by an expected decline in our line in-flight and entertainment sales.

This growth was complimented by 17% growth in business and regional OEM revenues resulting from an increase in customer funded development and from higher avionics and cabin system sales. Partially offsetting this very strong OEM growth was a decline of 4% in our aftermarket revenues.

In our core aftermarket, that is excluding mandate revenues in light body IFE systems, our revenues were down 2% year-over-year. This decline was caused by that previously discussed and anticipated $10 million decline in 787 simulator hardware, which more than offset moderate growth of about 2% in maintenance, spares and retrofits. Tough comparables gets mandate sales in the third quarter of last fiscal year were the main contributor to the remainder of the overall 4% decline.

Moving to page six, and taking a look at commercial system's margins. Even though the sales mix from about 50-50 OEM aftermarket split last year, to about of 55-45 split in this year's third quarter, operating margins improved about a 190 basis points to 23.7%. The improvement came as a result of strong incremental margins on OEM sales, lower employee incentive compensation costs and keeping SG&A expenses flat, on a higher revenue basis. Once again making the point that our shared service business model provides structural operating leverage.

Turning to slide seven, another very solid quarter was turned in by our government systems business as well. Revenues increased 7% for the overall segment. Growth in airborne solutions was up 6% on strong international sales, such as the C-130 integrated electronics systems upgrade programs entitled in the Singapore. And from development programs including the E-6 mission system upgrade.

Growth in surface solutions was up 9% due to higher sales of ground based GPS receiver application modules, or GB-GRAM systems and new system sales to international customers such as the Precision Targeting System to the U.K. Ministry of Defense.

Turning to page eight, earnings growth by our government systems business was 18% driven by higher revenues and a segment operating margin that expanded by 210 basis points to 21.6% this quarter. This margin growth was due to productivity improvements and a reduction in employee incentive compensation costs.

Moving along to slide nine, we'll take a quick look at our total company performance for the first nine months of the fiscal year. Total sales came in at about $3.5 billion, up $303 million or about 10% from last year's first nine month results.

Net income and earnings per share were up 16% and 20% respectively both well in excess of our 10% rate of growth in sales. And once again, an EPS growth rate that is noticeably higher than our net income growth rate due to our share repurchase program.

Looking at our cash flow for the first nine months, cash provided by operating activities caught up to last year's pace from the end of the second quarter and now stands at $310 million. The main drivers here were $67 million higher net income, $74 million lower year-to-date pension plan contributions, and favorable collections against receivables. These were partially offset by less of a build-up in upfront advance payments for our customers, higher employee incentive compensation payments in this year's first quarter, and higher inventory levels to support our growth across both commercial and government systems.

On to chart 10, where we take a look at our capital structure, given our belief in the fundamentals of our business, we once again utilized the capacity and flexibility of our balance sheet along with our free cash flow generation to continue the pace of our share purchase program. During the quarter, we borrowed an additional $68 million increasing our total outstanding short-term debt balance to $429 million and raising our debt to total capital ratio to 29%, a leverage ratio that still leaves us with plenty of balance sheet flexibility.

Turning to slide 11, where we summarize the current progress and program to-date status of our ongoing share repurchase program. This quarter we repurchased 1.4 million shares at a total cost of $81 million or about $58 a share. This further reduced our outstanding share count to 159.7 million shares at the end of the third quarter as compared to 165.8 million at the end of fiscal year 2007.

Program to-date, we've now repurchased nearly 49 million shares at a total cost of $2.3 billion and as of June 30th, we had a authorization remaining to repurchase up to $245 million in additional shares, roughly another 4 million shares of capacity at the average price we paid on the last quarter. In addition to enhancing shareholder value through share repurchases, we paid a $0.24 per share dividend to shareowners in early June, a 50% increase in our quarterly dividend.

Now our final slide, slide 12 which contains the updated picture of our financial guidance for the full fiscal year. We lowered our projective effective tax rate range for FY 2008 from 31.5% to 32.5% to 30.5% to 31% due primarily to higher than anticipated benefits from the domestic manufacturing deduction that I mentioned earlier.

As a result of the rising tax rate range and our enhanced visibility and confidence regarding the balance of the year, we are raising, and narrowing our projected EPS range from $3.95 to $4.05 to $4.05 to $4.10. Also, while our overall cash flow target of $675 million to $725 million remains unchanged, the components of it have. While the negotiations with Boeing for payment of outstanding receivables related to 787 program are moving forward and we are hopeful for a resolution soon. We now view the collection of these receivables as less likely in FY08.

As a result, we have adjusted our cash flow forecast to exclude both, the collection of approximately $70 million of accounts receivable from Boeing, and the pension contribution of up to $75 million. All other elements of our financial guidance remain unchanged.

That concludes my comments on the financial results, and updated full year financial guidance.

So with that I'll turn the call back over to Dan.

Dan Swenson - Vice President of Investor Relations

Thank you, Patrick. In order to give everyone the opportunity to ask questions, we ask that you limit your questions to two per caller. If you have further questions, simply reinsert yourself into the queue and we'll answer those questions if times permits. Operator, we're now ready to open the lines.

Question And Answer

Operator

Thank you. The question-and-answer session will be conducted electronically. [Operator Instructions]. And we'll go first to Lee Rawlings with Morgan Stanley.

Lee Rawlings - Morgan Stanley

Hi, good morning guys, nice quarter.

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

Thank you.

Lee Rawlings - Morgan Stanley

Just wondering could you just give us a bit more color on the commercial aftermarket sales especially what you are seeing in the different regions around the world?

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

Sure, commercial aftermarket is worse in United States, best in Asia-Pacific, and its okay in Europe, very good in the Middle East, and it kind of falls where you would expect it to be with the economic activity around the world.

Lee Rawlings - Morgan Stanley

Okay. And then, I was looking at your commercial OE, its soft year-over-year, but it looks to be down quarter-over-quarter, just wondering with rates going up, just what are the moving pieces here?

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

I think... correct me if I'm wrong Dan but the biggest difference is some of our IFE systems revenues that tends to come in pretty along be just to certify [ph] who is taking delivery of the aircraft and I think sequentially that's down quarter-over-quarter is that -- ?

Dan Swenson - Vice President of Investor Relations

That's correct.

Lee Rawlings - Morgan Stanley

Great, thank you gentlemen.

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

And I might add remember we predicted this IFE drop-off for the course of the year, we'll continue to see that in the fourth quarter for those of you who are modeling that.

Operator

And we'll go next to Ron Epstein with Merrill Lynch.

Ronald Epstein - Merrill Lynch

Hi, good morning guys.

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

Hi, Ron.

Ronald Epstein - Merrill Lynch

Clay can you just give us maybe a little more color on... I find your initial comments intriguing, interesting on how you guys came up with the capacity that you come out in different regions in the world, what kind of things you are assuming, certainly it's an exercise a lot of folks are trying to go through now?

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

Yes, I think so Ron and I think to summarize [ph] all of the place we thought we'd jump into the deep-end of the pool with them. We did that in a variety of ways but the most I think instructive way as we actually asked our entire sales force that distribute outside of United States and inside the U.S to go and actually talk to the airlines.

So two primary methodologies number one, well I should say three. Number one, we actually inventoried all the announcements to this point, there is a number of airlines that have been very vocal mostly in United States about making very public announcements those with the headlines we've all been seeing and we just categorize those.

Number two, we went out and had our sales force talk to the airlines and ask what their fleet planning exercises were, as you know we have sales force distributed around the world they are very good. These are the people out winning all that, be at the market share we've been talking about for the last several years. And it's in every ones interest to understand better how we're going to be able to support those customers. So they are telling us.

And the number three we put... I would say our own Kentucky Vintage [ph] based on as I tried to promote in my opening comments the most devastating downturn in my 28 year history in this industry which is post 9/11 and what could and did happen there and try to correlate that parametrically into this. And that's how we came up to where we were. We as I mentioned to make this clear.

We assumed at least for the near term oil prices stay about where they are now. And that goes out for some period of time and then we would project into 2009 actually a normalization where whatever that is but that means a drop of oil prices to some level below this.

Now I would be quick to tell you, if oil prices go higher, and some of you model that, then you can probably take that 5% and increase it by few percentage points as it exacerbates the issue in the relatively near term. And so our view is that from all around of what we know today and everybody is going to go wherever they want to go in terms of what you think is going to happen six months, or twelve months, or eighteen months from now.

And frankly, that's a war nobody can win, and you're going to guess whatever you guess in your model. Our view is if you look at the normal cycle of world commodities, and if you look at the normal cycle of aviation, there is still no better way to transport goods, services and people than fly it on airplanes. And so, if there is a slight decline in that in the near term, we believe one or two things are going to happen, either it'll stabilize out after the cycle runs in a year or so, or we'll all adjust to the new norm.

And once we understand what the norm is and people will get back to run their lives just like they will for gasoline prices, and the adjustments that we make nobody in United States is going to quit drive their car. But what they are going to do is they're going to buy more fuel efficient cars. Well guess what the airlines are doing.

So I think that there's a more normal and rational approach to this and expectations that we're going to see turning 30% - 40% come out of fleets and contrive downturn in new order deliveries. We just do not see that. You can speculate it, we do not see that.

Ronald Epstein - Merrill Lynch

Sure, great, super. Thank you Clay.

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

You bet.

Operator

And we'll go next to Joe Nadol with J. P. Morgan.

Joseph Nadol - JPMorgan

Thanks, good morning.

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

Good morning, Joe.

Joseph Nadol - JPMorgan

Clay, before my questions, I want to be doubled out if you can just point out that you may've only seen a 12% cancellation rate but production dropped for Boeing 60% last cycle. So it's not necessarily just to what happens to the backlog but it's necessarily just what happens to the backlog but it's the timing of deliveries the people of course care about?

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

Sure and I understand that Joe and you go look at our financial results if you want to model what that downturn and delivery rates did to us too. And I think that sales and margin performance still apply to what we believe this business could sustain. So as I said, we all can guess where the sales and orders are going to go, what I'm telling you is I can't imagine scenario worse the 9/11, and we've got through it pretty well, certainly better than what I think the market would guess we would.

Joseph Nadol - JPMorgan

Okay. So, first question on the aftermarket one more time. Clay, I think you said last quarter something like 5% to 10% was your expectations for second half of the year aftermarket growth excluding the IFE sort of run-off and that you were lower than that this quarter. Is that because of time in Q3, and Q4, or it that because things have slowed a little bit over the past three months?

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

I think it's a little bit of both Joe. I mean if we look at our core aftermarket revenues, they grew about 2% excluding the simulator sales and excluding the mandate revenues. So, what we're going to see in the fourth quarter is... I will say continued modest growth in our core business, but we're going to... we're going to face head-wins particularly on the IFE retrofit systems upgrades, it's going to be to the tune of about $25 million of head-win in our aftermarket revenues in the fourth quarter.

Joseph Nadol - JPMorgan

Do you expect that 2% to be higher in the fourth quarter or lower?

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

I would say probably a little bit higher.

Joseph Nadol - JPMorgan

Okay. Second question is just in the government side Patrick. What was the impact of the contract the net favorable adjustments?

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

About $5 million and there was probably about seven in last year's third quarter. So, they kind of net off I guess doing quarter-to-quarter comparable.

Joseph Nadol - JPMorgan

Right. Okay. I appreciate it. Thank you.

Operator

We'll take our next question from Myles Walton with Oppenheimer.

Myles Walton - Oppenheimer & Co

Thanks. Good morning.

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

Good morning, Myles.

Myles Walton - Oppenheimer & Co

Clay, could you comment on any changes in maybe buyer preference you're seeing on the buyer furnished equipment from airlines. Certain equipment that you are selling is optional and potentially either adding cost or wait for some performance benefit or customer convenience and I guess have we gotten to the point where the non-discretionary is on the OE side is starting to get impacted here?

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

Well the answer to your first question is, as I mentioned in my opening remarks, we are seeing some distinct preference and high interest in RNP type products that we're selling as the FA expands their number of approaches using required navigation performance. We're seeing a lot of airlines move into the... equip inch necessary to do that. And that's probably the hottest selling item we have right now. And I would expect that to continue if oil prices remain high, but the payback on that is very justifiable.

Related to your second question, I think the biggest drop-off in the non-discretionary area that we're experience is actually in the business aviation market, and that's and things like our rental exchange, because of a relative drop in flight hours with though as I'll say medium and smaller carriers that are adjusting their budgets to the fuel prices they're having to pay. And so if people are managing to the budgets, to do that they are either deferring, some of it would be discretionary items, we can't break it out that well. Deferring some, maybe efficiency upgrades or planned maintenance or they're just flying their aircraft for less time, which of course correlates to some of the basic core MRO and so we're seeing some of that.

Myles Walton - Oppenheimer & Co

Okay. And then in the first quarter call I think back in January obviously six months ago is a world away, but you commented then about the... kind of your targeted organic growth of 8% for long-term targets that Collins has maintained for a while now and your visibility for that still or your high confidence is not still for the next few years, six months later I mean what is the appropriate thinking for what our target should be?

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

Well you know as we have pointed out and we stand by, when we say long-term we are looking at periods of three to five years and that's we do that range of time because that's kind of how we plan and it's also through cycles. I am still very confident in the ability of this company to grow with that organic rate over the long-term. But just like we saw in 2002 and 2003 there are economic conditions that make that more challenging and we could be coming into one of those next year.

Now I think it's relative to that 8%. It's going to... we're going to have to push lot harder to get to that level but I still am very confident that over the long-term we have the basic market positions, the diversification, we've got the long-term investments only one but being planned that will allow us to deliver that over that period of time.

Myles Walton - Oppenheimer & Co

Okay. Thank you.

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

You bet.

Operator

Our next question comes from Robert Spingarn with Credit Suisse.

Robert Spingarn - Credit Suisse

Good morning.

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

Hi, Rob.

Robert Spingarn - Credit Suisse

Clay, just sort of following up on the growth question. You alluded to fiscal 09 in the press release this morning talked a little bit to that and talked about continued growth next year. But you have had a track record of very robust growth. Can you give us some context for what kind of growth you're looking for next year?

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

I will in September, Rob.

Robert Spingarn - Credit Suisse

And we're pretty close in to this point because my interpretation of what you said is it will be up but not necessarily by much. So I wanted to give you or ask you for the opportunity to elaborate on that?

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

Well, I have to get into, what it was that... was is I think, how much is much? Let me say this, what we've said to this point because I think there is concern about it is I definitely believe there will be growth and there will be growth adequate for us to continue to expand our margins and to grow our earnings faster than our revenue growth. As I said we're right in the middle of our planning process right now and as we always do in early September, we'll come out with the specifics of our financial guidance for next year.

Robert Spingarn - Credit Suisse

Okay. Well thank you for that. On the aftermarket side last quarter in April, I think you talked a little bit about seeing maybe some aftermarket relief in the third quarter, in this quarter and then maybe some more headwind in Q4 I think Patrick just alluded to this. I was expecting more of a flat year-over-year number in aftermarket this quarter it was down 4% you've talked about some of the reasons, so what is different than you might have forecasted three months ago, if any thing?

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

I would say first thing I think that trend we talked about is still valid, we have a little bit more IFE headwind in the aftermarket in the fourth quarter than we had this quarter. And that's still what we relatively predicted, as Pat has already pointed out the 787 simulators were sort of known as was the mandates.

I would say that the relative change and our look forward in that is primarily in the business jet area and in the MRO volume that we were seeing as a result of them clamping down a little bit on the number of flight hours flown.

So if I go to back three, four, five, six months ago, we probably didn't have as good visibility in to that, so I'd say that there is a percent or so of additional weakness in the aftermarket just as thereby each predicting as a result of these adjustments to oil prices that were the differential.

Robert Spingarn - Credit Suisse

Have you seen any advanced affect from the fourth quarter capacity cuts coming out of the airlines?

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

No.

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

Not much.

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

Not really because as we all know, they're still maintaining a great deal of that capacity through the summer, and so we've not seen any emancipation that yet, we know its coming. We're planning forward, it was included in sort of our context that I gave you earlier. Even though I didn't give you as much as you want them, but now I think most of that will come in the fall.

Robert Spingarn - Credit Suisse

Okay, thanks. And then just last on cash deployment. Your authorization is getting close to being done. Your leverage is a little higher than it's been historically but still very strong balance sheet. How do you think about the future stock repurchases?

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

First of all, we're only just a little more than halfway through our current authorization we still have about $245 million left under authorization, and I would say that it's about our leverage a very comfortable with the leverage we have right now. We're anticipating a very good cash flow quarter, in our fourth quarter and I would expect us to continue to deploy cash for share repurchases.

Robert Spingarn - Credit Suisse

Thanks.

Operator

We'll go next to George Shapiro with Citi.

George Shapiro - Citigroup

Yes, good morning. Patrick I think you quantify the contract adjustment but you also mentioned there were lower compensation cost, first is that due to the lower stock price or what's affecting that and if you could ballpark how much of a benefit that was in both the commercial and the government businesses?

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

Yes George. It really has nothing to do with the stock price, it's really our payout relative to our targets that we said at the beginning of the year. And if you remember last year's third quarter included some pretty hefty what I'll call cumulative catch-up adjustments to our incentive compensation pay, and that didn't occur in this year's third quarter. As to how much it is, it's about a 100 basis points of benefit in both commercial systems and government systems.

George Shapiro - Citigroup

And if you looked out to the fourth quarter does that number change much or that's still going to be that kind of ballpark of a benefit?

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

I think that I'm not sure first of all because I'm not sure where our payout is going to end up, but I would say the benefit will still be there, but it will be lower.

George Shapiro - Citigroup

Okay. Thanks, and Clay if I just follow-up I mean you still sound obviously quite bullish on the prospects despite everything out there. What would it take for you to see... for you to get more pessimistic out there?

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

First I'll rephrase your comment George, I feel bullish including everything out there, and not despite everything out there, because I read the same papers you do. And, I'd look at market conditions. If oil goes from $140 to $175, and $180, that would give me more pause and I think it will affect that 15% more of this really than we see right now. So that's an indicator we look at very close, but again I remain confident that if they do that the OE rate will stay pretty high, and... so I think the big determinant right now is the continued pace of the price of oil, and we hope that... that's a game nobody can win trying to predict where the price of oil is going to go, so let's just wait and see. We'll see who's right.

George Shapiro - Citigroup

Okay, thanks.

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

You bet.

Operator

We'll go next to David Strauss with UBS.

David Strauss - UBS

Thanks. Good morning.

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

Good morning, Dave.

David Strauss - UBS

So you read awful lot of numbers with regard to the aftermarket. Just sound clear at this point were you predicting for next year for Rockwell Collins is roughly a flat aftermarket?

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

I think that's in the neighborhood.

David Strauss - UBS

Okay. And rather than focus on 2009 you have this $6.50 to $7 EPS target out there for 2012 given everything that you're seeing, is that still applicable you think at this point?

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

Absolutely.

David Strauss - UBS

Okay, great. That's all I have. Thanks.

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

Thanks.

Operator

Our next question comes from Cai Von Rumohr with Cowen & Company.

Cai Von Rumohr - Cowen & Company

Yes, Clay you eluded to the fact that you did a great job after 9/11. As you look going into next year, you've won some shares, so I guess you don't have as much control over R&D. What kind of levers can you pull if demand all of a sudden gets worse, if oil goes to a $180 to $200, demand comes off faster. What kind of flexibility do you have to sustain profitability in that event?

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

Here we had all the same things we did after 9/11. If you recall, till May 1st we had no adjustments to R&D spending at that time. I think our R&D is going to sail back in 2002, 2003 around 20%, 19% now. Our MO if you will, as we don't start eating our [indiscernible], but what we have going for us it's been tested, in strength of our share services business model, so we have... we know where our fixed cost is, and the ability to scale at fix cost here the share service business model has been proven that we can do it.

The rest of it is production and production scales basically with people, and with parts, and material that comes in there, because of our relatively short cycle time we can turn that material down. And we can turn those people down if we have to do that. We hope not to, but we know how to do that. And though we have other levers that I think they were the same ones available to us if it gets Draconian relative to wage increases and things of that nature that we've shown the ability to do it. It's essentially... most exactly what we did post 9/11 and we did it extremely quickly.

Cai Von Rumohr - Cowen & Company

Okay and a follow-up. You bought stock at over $70. Your stock is now below $50. As you generate cash what are the change if any in priority given that some of your airline customers maybe larger credit risks do you feel you need a stronger balance sheet, more cash on hand or just in general for any given circumstance, you're going to be more interested in repurchasing shares?

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

I would say that there are priorities for our cash point haven't changed fundamentally. So our main focus is growth both internally through acquisitions and what we have, as we have in the past we're going to continue to repurchase shares. I just for... I'll say the weakness of our customers, just to kind of give you a sense we have right now have about $20 million of account receivable outstanding to domestic U.S airlines, which are the ones that I would view as being highest the risk.

And what we saw at 9/11 is what I would expect to see is spending surge drive up the airline, that number comes down and so our exposure is pretty manageable with respect to bankruptcies. So I am not too concerned with respect to the financial impact of airlines going bankrupt on our company.

Cai Von Rumohr - Cowen & Company

Excellent. Thank you very much.

Operator

We'll go to Carter Copeland, Lehman Brothers.

Carter Copeland - Lehman Brothers

Hi, good morning guys.

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

Hi, Carter.

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

Good morning.

Carter Copeland - Lehman Brothers

Clay, thank you for all of the color this has been pretty helpful. I just wondered if you could dig in a little bit, you've obviously changed a bit of your expectations, I mean a lot has happened in last three months but where has the bigger revision come, you've talked about both business jets and the utilization of those aircrafts especially on the low end and then obviously we're talking about capacity cuts in air transports. Where has the bigger revision occurred in your thinking in those two market as how you're looking forward to 09 and beyond?

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

I think if I look at the market today versus what I would have said maybe nine months ago. All of the revision has come in the aftermarket and it has come primarily in the discretionary part of the aftermarket where the slight revision maybe in the non-discretionary part.

Carter Copeland - Lehman Brothers

And has that affected business jets or commercial differently or the same or is there one more than the other?

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

Depends on what you're looking at, my view is its affected business more this year, because of the relative numbers of flight hours been flown across the board. We think that will recover next year and we're thinking next year we'll probably see more impact in the... especially MRO side of the airlines as those capacity reductions begin to come down.

Carter Copeland - Lehman Brothers

Great.That's helpful. And one for Patrick, you talked about the pension contribution, are you eliminating that out of this year's guidance, does that move to next year or how are you thinking about that?

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

I'd hesitate to say whether we're planning a pension contribution for next year because we have to see the impact of interest rates on our liability impact of asset performance on our funded status. So, there a lot of... still a lot of moving part so I would say that there's a good chance we'll have a pension contribution next year but I don't know how much at this point.

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

I mean we can also say that directionally as we look at interest rate, it's more likely to be a tailwind than a headwind.

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

That's true.

Carter Copeland - Lehman Brothers

Thanks a lot guys.

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

You bet.

Operator

We'll take our next question from Howard Rubel with Jefferies.

Howard Rubel - Jefferies & Co.

Thank you very much. For a change Clay no 787 question, so I thought I'd ask for a moment could you talk a little about the progress and also explain Patrick, why the negotiations have taken a little bit longer than you have expected to conclude a deal with Boeing this year?

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

Well first thing the progress is that it's been reported, we get power on actually ahead of their schedule, when they did this. I think again Boeing continues to be relatively transparent about issues even little problem they had in the... on aircraft 4. As far as the systems stuff Howard that we see it's going very well. It always had been going very well.

Where I think this is the first aircraft they developed in a long time where the systems are not the pacing element, it's the structure. But everything I see, suggest that Boeing is getting its handles around the problems. They are making good progress, especially on all that travel work that kind of cascaded to aircraft 1.

And so on as I said I think a few weeks ago, I am reasonably confident they can stay on the schedule and make that build first flight and delivery that they have got now, but I think we're at point for all others, we believe that when we see it, because this has been a more difficult process than we saw. But I see nothing new from my prospective that has been already been reported that would give me any different feelings than you have. Relative to --

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

Relative to the negotiations --

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

Yes.

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

And the pace of the negotiations. The only thing I could say is yes, we have identified this is risk throughout the year and there are times there are more optimistic times and less optimistic and only thing I would say it's a fairly complex negotiations because we're dealing with engineering change orders that they are negotiated and then kind of what's due and when is it due with respect to our hardware shipments. And Boeing is obviously pretty busy negotiating with a number of suppliers right now and so the time window for negotiation is starting to get pretty narrow for us to agree bill and collect in this fiscal year, which is why we've taken it out of guidance.

Howard Rubel - Jefferies & Co.

No I think that's... I think that's fair and I also recognize that you've not been a pacing item at all with respect to this and that you've lived up to your side of the issues, so I mean --

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

Yes, our view is this Howard we feel no need to have to force the issue with Boeing and be heavy handed. Our view is we work very cooperatively with them through this whole thing we're going to continue to do that. And I think that's in our or could we put it, it's long-term best interest on the settlement.

Howard Rubel - Jefferies & Co.

Clay, second issue and I am buying to your plus one or a plus three growth rate. I mean I might argue it could be down a point or two in terms of global traffic next year. But it's all on the margin. What you'll... I mean are you going to have discussions with the OEs in terms of their production rate, because they're saying obviously the same thing you are, either in terms of shuffling of the order book or I'd say move forward in some cases or other issues so that, you can avoid part of the over-production, if rates are held where they are, even trimmed modestly. I mean how you sort of, because you do have the ability to say, guys your eyes are bigger than your stomach?

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

We typically don't do that. We follow their lead, because we can Howard. Our production capacity here is extremely flexible. It doesn't require us to scale our operations, higher or lower like it does some of the more heavy guys. And so, we don't take that approach with Boeing.

I don't try to be smarter than they are because I'm not in terms of the visibility, and their production rate. So my view is tell me where you're going to go, and I'll be there. Now, I've stayed very close to the conditions that I think that Boeing is looking at, and I'm bullish on the conditions because I've seen this happen in the past, one of the things we didn't talk about, but I guarantee you, if they start accelerating deferrals, or cancellation, the leasing companies are just sitting on the edge of the sideline hoping that will happen, because they'll jump in there and suck up that capacity if they have in the past, probably at a more advantageous rate, and so that's a balancing effect in the whole system there.

My view of it is this, it's not on the margin as to whether they'll cut rates, it is actually the issue is whether or not they'll increase rate of their narrow bodies. Now, we've given them all the information they need to do that. We're supporting them fully on that, but I'll say that's up to their decision. So, if I'm arguing on which direction the OEMs are going, if not will they decrease rates. Its how much if they will... whether they will decrease rates, but rather will they increase rates.

Howard Rubel - Jefferies & Co.

All right and so what you've been saying is that you feel pretty comfortable with the way you've positioned your manufacturing business so that either through productivity or other factors and so that you'll be able to maintain your level of profitability?

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

Absolutely. Again we have a global enterprise with a factory that can take almost any product at any time and as an electronic product, we have a significant advantage in terms of capacity in our factory that literally we can turn off within days.

Howard Rubel - Jefferies & Co.

Thanks very much Clay.

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

Sure.

Operator

And we have a follow-up question from George Shapiro with Citi.

George Shapiro - Citigroup

Yes, Patrick just a couple of little things. If you didn't have the tax benefit this quarter, the rate would have been about 33% is that a good assumption for what the rate would be next year or are you going to have some other potential benefits assuming the R&D credit of course doesn't get extended?

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

Without the R&D credit, I would say we're probably in the range of 33% to 34%.

George Shapiro - Citigroup

Okay. And one of other Clay, you broke out earlier that you had in your aftermarket you broke out how much was large commercial versus the business market. Can you breakout how much the aftermarket... what the aftermarket did year-over-year in both those sectors?

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

I don't have that in my command I think Dan can probably get it for you George.

Dan Swenson - Vice President of Investor Relations

Yes, if you look at the aftermarket and George you're looking at the aftermarket on the business jet and regionals versus the air transport systems?

George Shapiro - Citigroup

Yes, I think it's the... I assume the breakout that Clay you gave initially the 23% of which air transport was 15%; I assume that 15% was the large and the balance stand was aftermarket and was business jet and regional.

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

That's correct.

George Shapiro - Citigroup

Okay. Yes so if you could just broke it out in those categories that you provided the numbers for?

Dan Swenson - Vice President of Investor Relations

Well if you look at the HS [ph] aftermarket was about 15% of sales this year and then you could and far from that, the VRS [ph] aftermarket was about 7% of sales from this year and in dollar terms --

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

Well you said in last year --

Dan Swenson - Vice President of Investor Relations

For last year if you look at the comparison year-over-year --

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

As a percent.

Dan Swenson - Vice President of Investor Relations

As a percent --

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

We'll get that data for you George, and I'll have Dan give you a call.

George Shapiro - Citigroup

Okay. Thanks very much.

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

You bet.

George Shapiro - Citigroup

Thanks guys.

Dan Swenson - Vice President of Investor Relations

And operator I think if there are any other calls we have probably time for one more call before we wrap up here.

Operator

And Mr. Swenson it appears there are no further questions at this time. So I would like to turn the call back over to you for closing remarks.

Dan Swenson - Vice President of Investor Relations

Thank you everyone for joining us today. We will be filing our Form 10-Q later this month. And I want to thank you for your participation.

Operator

That does conclude today's conference. Thank you for your participation. You may now disconnect.

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Source: Rockwell Collins, Inc. F3Q08 (Qtr. End 06/30/08) Earnings Call Transcript
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