BE Aerospace, Inc. Q2 2008 Earnings Call

B/E Aerospace, Inc. (BEAV)

Q2 FY08 Earnings Call

July 29, 2008, 9:00 AM ET

Executives

Greg Powell - VP, IR

Amin J. Khoury - Chairman and CEO

Michael B. Baughan - President and COO

Thomas P. McCaffrey - Sr. VP and CFO

Analysts

Robert Spingarn - Credit Suisse

Howard Rubel - Jefferies & Co.

Peter Arment - American Technology Research

TroyLahr - Stifel Nicolaus

David Strauss - UBS

Eric Hugel - Stephens Inc.

Patrick McCarthy - Friedman, Billings, Ramsey & Company

Myles Walton - Oppenheimer

Presentation

Operator

Good morning. My name is John Daniel, and I will be your conference facilitator today. At this time, I would like to welcome everyone to the B/E Aerospace Second Quarter 2008 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. And after the speakers' remarks there will be a question-and-answer period. [Operator Instructions]. As a reminder, ladies and gentlemen, the conference is being recorded this day, July, 29th 2008. Thank you.

I would now like to introduce B/E's Vice President of Investor Relations, Greg Powell. Mr. Powell, you may begin your conference.

Greg Powell - Vice President, Investor Relations

Thank you, John. Good morning and thank you for joining us this morning. Today, we are here to discuss our financial results for the second quarter ended June, 30th 2008. By now you should have received a copy of the news release, we issued earlier this morning. If you haven't received it, you'll find a copy on our website.

We will begin with remarks from Amin Khoury, Founder, Chairman, and Chief Executive Officer of B/E Aerospace, and then we will take your questions. For today's call, we've prepared a few slides to help you follow our discussion. You can find our presentation on the B/E Aerospace website at beaerospace.com.

Please go to our Investor Relations page and follow the Webcasts link. In addition, copies of the slides we posted on our website for you to review after the call. Joining us for the question-and-answer session are Mike Baughan, President and Chief Operating Officer, and Tom McCaffrey, Senior Vice President and Chief Financial Officer.

As always, in our prepared remarks and our responses to your questions, we will rely on the Safe Harbor exemptions under the various securities acts, and our Safe Harbor statements and the company's filings with the SEC. We will address questions following our prepared remarks. At that time, the operator will provide instructions. As in the past, please limit your questions to no more than two at a time. So that we can get all of you... get to all of you as possible this morning.

And now I will turn the call over Amin Khoury.

Amin J. Khoury - Chairman and Chief Executive Officer

Thanks Greg and good morning everyone. Of the segments of the aerospace industry which drive demand for the aerospace products continue to be strong. Specifically the demand for the consumables from the growing OE, military and aftermarket were very robust.

In addition, new wide-body deliveries, new business jet deliveries and aftermarket retrofit upgrade and the refurbishment programs, for the first and business class cabins of the major international airlines, are all strong.

The strong demand, coupled with solid operational execution, resulted in yet another record quarter for B/E Aerospace.

Our operating earnings continued to grow at a faster rate than our revenues. And during the second quarter, revenues increased 31% while our operating earnings were up 42% as a result of a 120 basis point expansion in operating margins to 16.1% of sales.

Before we review the details of our Q2 financial performance, I would like to spend a few minutes reviewing the transformational acquisition of Honeywell's Consumables Solutions business and how would that position B/E Aerospace for future earnings growth. After that, I would like to review current conditions in our industry and the likely impact of capacity reduction on our business. And then we will review our financial guidance and operating result and our forward guidance.

The HCS acquisition is truly a transformational value-creating transaction. And it is expected to contribute robustly to earnings growth over the next several years. Let's take a look at slide 2, together.

Our distribution business is now our most profitable and our highest margin business. On a pro forma basis in 2007, the distribution segment would have generated approximately 42% of our revenue and 47% of our operating earnings.

In 2009, we expect the distribution business to generate approximately $1.2 billion in revenues or approximately 43% of expected total B/E 2009 revenues, again of approximately $2.8 billion. In addition, we expect this business to generate operating earnings in excess of 50% of total B/E operating earnings in 2009.

The acquisition of HCS secures our position as the leading global distribution and value- added supply chain manager of aerospace hardware and other consumables, with over 275000 SKUs and next-day service from locations in all key geographic markets worldwide. The transaction is expected to yield cost synergies of more than $85 million per year or approximately $0.55 per share on an annual basis, by 2011, thereby creating substantial shareholder value.

Our innovation team has now been in place for six weeks. Key to this effort is a seamless transition for our customers and suppliers. We expect that we will begin to realize the cost synergies from the combination of the two businesses, during 2009.

Our aerospace consumables distribution segment should yield superior financial results as we integrate the businesses, expand our product offerings and leverage the combined volume of the two businesses over our existing robust IT and automated inventory retrieval systems, and as we transition the HCS business to our stocking distribution business model.

The HCS acquisition substantially expands our customer base and doubles revenues from the military sector to over $200 million per year. Importantly, this transaction also secures a 20-year partnership with Honeywell to supply the consumables requirement of Honeywell's aerospace production facilities.

Additionally, we've acquired the exclusive direct sales and distribution right for 30 years to sell all consumables used in Honeywell's proprietary aerospace and defense product suite on a worldwide basis, directly to airlines, MROs, the military and other users. These are the consumables associated with Honeywell engines, wheels and brakes, APUs and avionics.

Clearly, this acquisition is one of the most important events in our 20-year history. And as we integrate the acquisition and combine our businesses, thereby realizing the very substantial synergy potential of the combination, we expect significant steady margin expansion on the order of 100 to 200 basis points per year, for the next three years.

At the same time, our formidable market position should allow us to substantially grow our revenues. We're confident that the business will be a major driver of superior earnings growth for B/E Aerospace for the next several years.

So as a result of the transaction, we're leading supplier to virtually all major airlines, all aerospace OEs, and MROs. We're a distributor for every fastener manufacturer in the world. We've got the largest global distribution footprint, including leading position in all of the high growth emerging markets. And our expectation here, is that the HCS operating margins are expected to approximately double from the current 12.5% of sales to approximately 25% of revenues in line with our current B/E distribution segment operating margins.

Let's turn to slide 3. I would like to briefly discuss the current market environment. Despite all the doom and gloom emanating from the press, about industry conditions, I am really pleased to report that the outlook for strong earnings growth for our company continues to look the same that continues to look healthy.

Our EPS compound annual growth rate, over the past three years was the highest of any aerospace company and our multi-year visibility allows us to set our expectations at a future EPS growth rate of about 30% per year, over the 2008 through 2010 period.

That together with our history of raising and beating quarterly guidance points towards a substantial undervaluation of our shares. Perhaps the P/E ratio of 8.5 times '09 earnings is inconsistent with our 30% EPS growth rate. Clearly industry conditions for the U.S. airline... of the U.S. airline industry as it relates to the domestic narrow-body markets, have significantly deteriorated and the price of oil is a major headwind for our airline customers.

However, for the first time ever, the airlines are cutting capacity even while there is currently insufficient capacity. And airlines are operating their aircraft at very high load. Obviously they're cutting capacity in order to implement significantly higher pricing.

Every major U.S. domestic airline has announced capacity reduction of 10% to 12% of their domestic narrow-body fleet. Our expectation is that about 800 to 900 aircraft or about 5% of the worldwide fleet will eventually be part, with a significant reduction beginning in the fourth quarter of this year.

As you can see from slide three, the announced capacity reductions by the major U.S. airlines are substantially all old fuel inefficient narrow-body aircraft. Through the five months ended May 31st, airlines had successfully pushed through in excess of 15 rate hikes and airfares CPI was up by about 11%. And this does not include significant fare hikes that took place in June and July. In fact, the lowest fares listed for travel in the next 90 days from Boston's Logan, New York's LaGuardia, from New Lake [ph] and from Washington's national are up about 30% versus the prior year.

In fact, U.S. airlines are beginning to put in place the plans to upgrade and modernize their fleet. In the long run, these actions will lead to more stable and healthier airline customers. The work of these actions meant for B/E Aerospace in the short run. To understand this, Mike Baughan, who will talk with us later this morning, had a team for our commercial aircraft group assessed the likely financial impact on B/E Aerospace as a result of the planned capacity reduction.

It is important to note that only 13% of B/E Aerospace revenues for the six months ended June 30th were from U.S. airlines. Let me repeat that, U.S. airlines accounted for 13% of B/E sales for the first six months of this year. So the capacity reductions are not likely to impact our consolidated annual revenue by more than about 1% in 2009.

I would also like to address the topic of aircraft cancellations and deferrals. As you know the bi-annual Farnborough Air Show was recently held in the UK. While the tone of the meeting was more subdued than in the past, the air show did produce 312 orders for new aircraft, approximately 38% of which were for wide-bodies which bodes very well for B/E Aerospace.

Importantly, there has not been a wave of cancellations or deferrals that had been widely speculated about in the press. Currently, Boeing and Airbus have record backlog, approximating 7500 aircraft or about 7 years of production. In fact, Boeing confirmed last week on their Q2 call that they have not experienced cancellations.

Even if some of their orders were to be cancelled or deferred, there were many buyers that would step up and take those slots. For example, pressure continues to mount on Boeing to increase production of its 777s which are sold out through the end of 2013.

Wide-body backlogs falling in Airbus are now in excess of 2500 aircraft. The outlook for new wide-body deliveries is very strong, with 1100 deliveries expected over the 2008 through 2011 period, as you know, we are well positioned in this growing segment of the market. In fact, we're currently seeing new wide-body RFQ activity at record levels. Mike will also touch on this, a little later this morning.

A few weeks ago, United Airlines presented at Merrill Lynch Equity Conference in New York City. United has stated unequivocally that they do not have any claims on order. Slide four is a slide from their presentation, in which they indicated that with one exception, they intend to significantly reduce their CapEx spending. The one exception is a major retrofit program for their international wide-body suite. They publicly stated that they will not reduce their investments in their wide-body international premium class products.

In fact, this was confirmed again last week, when United made the following statement on their Q2 press release. United's entire fleet of international wide-body aircraft are being reconfigured over the next two years with lie-flat seats, on-demand entertainment and iPod and iPhone connectivity in first and business class.

UAL is spending over $250 million with us alone, to outfit their international wide-body long haul fleet. I don't know of a stronger more on point affirmation of the strength of the wide-body premium cabin retrofit market.

Also, offsetting the weakness in the domestic narrow-body market, is the strength of the record levels of business jet deliveries. In fact, the business jet market is one area that continues to show very strong growth but it's been lost in the headlines.

The outlook for business jets remained strong as the business jet OEs are sold out and have very few slots available before 2011 and a number of large long range aircraft are sold out for several years beyond that to 2013, 14 and 15. This market is not as sensitive to oil prices and the international opportunities continue to strengthen due to the global shifting of individual and corporate wealth. So, more than 50% of new biz jet orders are coming from international customers.

In fact, our biz jet segment has a record backlog and is experiencing very robust RFQ activity.

Let's now discuss second quarter results. Thereafter we'll discuss the outlook for the company. We are pleased to be able to report our record second quarter 2008 performance. Quarter was above consensus expectation and was a record quarter for the company in terms of revenues, operating earnings, net earnings, bookings and backlog.

As I mentioned earlier, we continue to grow our operating earnings faster than revenues, as a result of continued strong margin expansion. As expected, second quarter revenue growth, earnings growth and margin expansion were driven by exceptional performance by the distribution segment, the interior segment and the business jet segment.

The seating segment delivered excellent revenue growth and a nice expansion in sequential operating earnings but lagged the outstanding performance of the three aforementioned segments, due to our previously discussed start-up and learning curve cost on new programs. We are seeing good progress on these programs and expect to see additional margin expansion in the seating segment in the second half for the year.

Let's turn to slide five and review our financial results for the second quarter of 2008. We hope you are as pleased as we are with our financial performance. A bar chart on slide five graphically illustrates our second quarter 2008 performance versus the second quarter of the prior year.

It can be seen that second quarter revenues increased by 31%, to $522 million, that's all organic growth. Operating earnings were up 42% on the 31% revenue growth. Our operating margin of 16.1%, expanded by 120 basis points as compared to the second quarter of last year, in spite of start-up and learning curve cost on new programs.

The operating margin expansion was driven by the especially strong results from our distribution, interior systems and business jet segments.

Second quarter net earnings of $54 million, were 90% higher than net earnings in the second quarter of the prior year. Second quarter 2008 earnings per diluted share of $0.59, increased by 90% or $0.28 per share as compared to the prior year period.

Now the prior year period did include debt repayment costs of approximately $0.08 per share. So excluding the prior year debt repayment costs, earnings per diluted share were up 51% versus the prior year.

Let's now turn to slide six. On slide six, we'll review our financial results for the first half of 2008. A bar chart on slide six, graphically illustrates our first half 2008 financial performance versus the first half of 2007.

It can be seen as first half revenues increased by 27%, to just under $1 billion. That is all organic growth. Operating earnings were up 40%, on the 27% revenue growth. Our operating margin of 16.2% expanded by 150 basis points, as compared to the first half of last year, in spite of start-up and learning curve costs.

The operating margin expansion was driven by the especially strong results from our distribution, interior systems and business jet segment.

Earnings before income taxes of $157 million, increased by 74%. Net earnings were $102 million. They were just under 70% higher than net earnings in the first half of the prior year, and the difference between growth rate of earnings before taxes and net income is a lower tax rate in the prior year.

Earnings per diluted share of $1.11, increased by 56% as compared with the prior year period.

Now let's turn to slide seven. Slide seven summarizes our continuing backlog growth. Second quarter was another stellar bookings quarter. Second quarter orders were a record at approximately $610 million and represents a book-to-bill ratio of approximately 1.2 to 1.

A bar chart on slide seven graphically depicts the year-over-year increase in backlog. Our record backlog of approximately $2.4 billion, increased by approximately 26%, as compared to June 2007.

It is important to note that the high quality of the backlog supports our expectations for continued margin expansion, while the size of the backlog plus shadow backlog, plus expected follow-on orders and the robustness of current RFP activity give us excellent long-term visibility.

In addition, the pie chart on slide seven indicates that the backlog continues to be very well balanced geographically. 64% of the backlog is with international customers and over 37% of the backlog is with customers in the emerging markets, particularly in Asia and in the Mid East.

Clearly the length and breadth of the current cycle is being driven by the developing nations of the world.

Let's talk about the U.S. airlines, as they seem to have received the lion share of the headlines recently. First, it's important to note that relative to the global market, U.S. airlines have not been major buyers of cabin interior equipment for new buy-aircraft. In fact, U.S. airlines comprise only 10% of Boeing's backlog and represent only 10% of our current backlog, most of which is a retrofit program.

The second quarter bookings were strong and of high quality and the geographical diversity of our customer base is expected to provide excellent future revenue stability.

Finally, as we discussed in the past, we have a large and growing shadow backlog. Shadow backlog represents expected follow-on orders from current customers for their existing fleet, orders not yet placed for new aircraft on order of the same aircraft type and for programs awarded which we haven't yet entered into our system. As we have previously mentioned, an example of the latter of the oxygen product awards for the new Bowing 787 and Airbus A350XWB aircraft. We have been awarded sole source status on both aircraft.

Another program is our recently announced Embraer win. This program alone will generate over three quarters of $1 billion of revenues for our products, none of which is in our current backlog.

Now, I'll briefly review the operating performance for each of our business segment. Let's start with the distribution segment, which is summarized in slide 8. The distribution segment continues to execute very well operationally, hitting on all cylinders, reflecting synergies on the NYF integration and the segment's highly efficient information technology and automated parts retrieval system.

Revenues of just under $124 million for the quarter, grew by 28%, reflecting the significant ongoing investments in product line expansion, the broad based increase in aftermarket demand for aerospace fasteners and continued market share gain.

Operating earnings increased 45% for the quarter. Operating margin expanded by 300 basis points as compared with the second quarter of 2007, reflecting the synergies from the New York Fasteners integration and a significantly improved and expanded mix of product.

If we can now look at slide 9, we can see that our interior systems segment also had an outstanding quarter. As we can see by the results, the interior systems segment continues to reap the benefits of the Draeger acquisition integration, operational efficiency initiatives, and operating leverage.

Revenue growth of 22% reflects both higher aftermarket demands and demand created by new wide-body aircraft deliveries.

Operating earnings grew by a whopping 49%, to $23.1 million, as the operating margin increased by 410 basis points, 22.2%, as a result of the synergies arriving from the Draeger Aerospace integration, operational efficiency initiatives and operating leverage.

Second quarter bookings and current RFP activity, is at a record level for this segment. Outlook is for continued strong revenue growth, driven by the large number of wide-body aircraft deliveries, from 2008 through 2011, all of which require significant quantities of food and beverage preparation and storage equipment, and oxygen storage distribution and delivery equipment.

Now let's turn to slide 10, where we can see that our seating segment also had a good quarter, as the segment worked through some startups and learning curve issues. Revenue growth versus the prior year was 26% and that reflects the scheduled delivery of major new retrofit program.

And operating earnings of $20 million increased 20%, as compared to the same period in the prior year. The operating margins for the second quarter of 11% improved by about 70 basis points on a sequential quarterly basis, reflecting ongoing operational improvements as well as the negative impacts of startup and learning curve costs on new programs.

Revenues during 2008 through 2010 will be driven by the large backlog, additional follow-on programs, new retrofit orders and demand created by the approximately 1,100 new wide-body aircraft, expected to be delivered in 2008 through 2011. And operating margins, over the three-year period should continue to expand significantly, due to primarily to improved product mix and learning curve efficiency.

Let's now turn to slide 11, where we can see that our business jet segment, like our distribution and interior systems segment, had an outstanding quarter. Business Jet segment continues to benefit from our prior investments in both our traditional business jet operations as well as in our super first class suite of products. And this has reflected in our outstanding second quarter results.

Revenues were up by 63%, all organic growth, reflecting excellent demand for both business jet interior equipment and super first class products. Operating earnings increased by 102%, compared to the prior year on a 250 basis point expansion in operating margins, 12.6% of sales. The significant margin expansion reflects substantially improved operational efficiency, particularly on new programs began in 2007 and operating leverage at the higher sales level.

The biz jet segment is expected to deliver continued strong earnings growth, driven by robust demand for both new business jet aircraft and super first class suites on wide-body airlines.

Slide 12 summarizes second quarter performance for our engineering services segment where we can see our return to profitability and had a nice improved $2.8 million operating earnings performance on a sequential quarterly basis. And we do expect to be able to deliver positive operating profits for this business for this year.

Please now turn to slide 13, which reflects our financial position as of June 30th and pro forma, including the HCS acquisition. As of June 30th, the company's net debt to capital ratio was 5% and net debt was $77 million, which represents total debt of $152 million less cash and cash equivalents of $75 million.

As of June 30, 2008, the company had no borrowings outstanding on $200 million revolving credit facility. Working capital, as of June 30, 2008 of $818 million, increased by $106 million or 15%, as compared with December 31, 2007, as a result of the 27% increase in revenues and the 26% increase in backlog during the first half of the current year, compared with the first half of the prior year.

Accounts receivable increased by $80 million on the higher sales levels. Our inventories increased by $97 million, reflecting the substantial increase in backlog and further expansion of the company's fastener product line, particularly in anticipation of the HCS acquisition.

The company generated free cash flow, defined as net cash flows from operating activities minus capital expenditures, of $41.3 million in the second quarter of 2008. Exclusive of the inventory investments made during the second quarter, in anticipation of the HCS acquisition, free cash flow would have been approximately $55 million. The company expects to generate approximately $150 million of free cash flow for 2008, exclusive of the impact of HCS, on free cash flow.

The company does expect to substantially increase its investments in consumables inventory, during the balance of 2008, as it begins to transition the HCS business to the company's stocking distribution business model.

In addition, the company expects to begin to incur acquisition-related integration and transition costs. So free cash flow during 2008 will be reduced by the amount of such additional investments and integration spending in the second half of the year.

On July 1, 2008, the company issued $600 million of 8.5% senior unsecured notes due 2018. On July 28th, the company entered into a new senior secured credit facility. The credit facility provides for a five year, $350 million involving credit and a six year $525 million term loan. A portion of the term loan borrowings, under the credit agreement, were used to repay approximately $151 million in our outstanding borrowings, with the balance of the proceeds from these financings, together with 6 million shares of our common stock, which were used to acquire HCS.

As of June 30, 2008, on a pro forma basis, adjusted to reflect the acquisition of HCS, the repayment of the term loan described above, total debt, net debt and the company's net debt to capital ratio, would have been $1.127 billion of total debt, a little over $1 billion of net debt and a 40% debt to cap ratio. On a pro forma basis, the entire $350 million revolver would have been undrawn.

Now, I would like to ask Mike Baughan to provide us with some insights into our current RFP activities.

Michael B. Baughan - President and Chief Operating Officer

Thanks Amin. We review our pending proposals and RFP activity on a continual basis, and all of our GMs convened weekly to discuss the more significant deals. The short summary is that our market and RFP activity remain remarkably strong. This is true across all of our major business segments. And in fact, some of our segments, such as business jet and interior systems, are seeing record levels of activity. I will give you some color in a couple of areas.

First, let's discuss our interior systems, which includes our oxygen storage distribution and delivery systems as well as food and beverage preparation and storage equipment, like ovens, refrigeration products and beverage makers. This segment generates most of its business from new wide-body aircraft delivery. And as you might expect, we are now starting to see increased bookings and RFP activity associated with the ramp up in new wide-body aircraft deliveries.

We have strong and growing shares in this segment and are doing particularly well on the 787. Additionally, since our newer products are more reliable and lighter-weight, we are now starting to generate retrofit demands, which serves to further expand our market. The result of both of these factors is a record level of RFP activity.

We also have significant shadow backlog in this segment with unbooked awards totaling over $550 million related to our previously announced 787 and A350 oxygen programs.

Business jet activity is also at record levels driven by record OEM production rates and the announced introduction of several new aircraft models in the next 3 to 4 years. We recently announced the major seating win on the new Embraer 450 and 500 aircraft which is expected to generate over $200 million of new business for us, none of which is yet in backlog.

Similarly, we have secured launch status with HondaJet and are working hard to win a number of other major business jet cabin interior positions on new aircraft being introduced at Gulfstream, Cessna, Bombardier and others. These are platform awards, so they tend to be very large programs as evidenced by the recent Embraer win.

RFP activity in the seating and super first class businesses remains robust and continues to encompass international carriers for both new and retrofit programs.

The mix of activity is starting to change somewhat, with proportionately more of the RFP activity, now reflecting new aircraft programs, driven by the growth and wide-body aircraft deliveries between now and 2011.

A good example of this, which we announced last week, is our $140 million award from a global carrier, to outfit a new wide-body fleet with premium class seating.

I'd like to point out that this award, which is not yet in backlog, reflects one new-buy fleet only. As is typically the case in our business, our seating decision for a particular new buy fleet, often extends over time, into a carrier's remaining fleet.

Therefore, we would expect significant retrofit potential from this carrier in the years ahead tied to this particular award. We have seen this dynamic play out recently in the domestic market.

Yesterday, Continental Airlines publicly announced the unveiling of its new B/E lie-flat seats for its business first cabins. What started as the next generation seating contract for new buy Boeing 787 aircraft has expanded to include the retrofit of Continental's existing 777 and long-haul 757 aircraft.

When you think of B/E Aerospace, you should consider our customer portfolio and our strong position with major global airlines such as British Airways, Air France, Emirates, Qatar, Lufthansa, JAL, Korean and others. These are the types of carriers that will be purchasing most of the wide-bodies in the coming year. And if we continue to service them properly, we can expect to participate in their future growth as they retrofit and upgrade their cabins.

Retrofit demand remained strong but varied tremendously by region. We continue to track a number of significant opportunities in Europe, Asia and the Middle East, with most of this activity representing program deliveries in 2010 and beyond. Our domestic RFPs are mostly focused on new aircraft demand, and we don't expect that to change anytime soon.

In summary, and despite the doom and gloom scenarios mentioned in the press, we are upbeat about our market opportunities. RFP activity continues to be very strong, and we see nothing at this point to suggest any change in this environment.

I will now turn it back over Amin.

Amin J. Khoury - Chairman and Chief Executive Officer

Thanks Mike. I would like to conclude our prepared remarks this morning, by noting that the outlook continues to be quite positive. We believe market forces will continue drive demand for our distribution consumables and cabin interior products for both aftermarket programs and new-buy aircraft, for many years to come.

RFQ and order activity are robust, and we expect our backlog to continue to grow. Regarding new aircraft deliveries, as we mentioned before, we expect approximately 1100 new wide-body aircraft to be delivered, over the four year 2008-2011 time period, with the market potential of approximately $2 billion to $3 billion of cabin interior products for these aircraft alone.

Today, we are raising our earnings guidance for 2008 and we are confirming our recently raised guidance for 2009 and 2010. We're raising our guidance for 2008 by $0.02 per share to approximately $2.37 per share, excluding the impact of the HCS transaction related effects.

We are confirming our full year financial guidance for 2009 and 2010 of approximately $2.85 and $3.65 per share, excluding HCS acquisition integration and transition expenses. As in the past, we will update our guidance when we release our third quarter results in October.

Slide 14 summarizes our financial guidance for 2008, 2009 and 2010 on both a pre and post HCS acquisition basis.

We can see that EPS pre the HCS acquisition, $2.37 this year, $2.80 next year and $3.50 the year after. EPS impact on HCS is $0.15 negative in 2008, $0.05 positive in 2009 and $0.15 positive in 2010. Post the HCS acquisition $2.85 and $3.65 in 2009 and 2010.

I'd like to remind you that the expected impact from the HCS acquisition is $0.05 to $0.20 per share in 2009, of which we've currently got about $0.05, in our guidance currently. And it is between well up to $0.40 a share in 2010, and we've currently got about $0.15 of that in our guidance.

And that completes our prepared remarks, and I'd like to end. With that we'll be glad to take your questions.

Question And Answer

Operator

Thank you. [Operator Instructions]. And it looks like we'll begin our segment with Robert Spingarn of Credit Suisse. Please go ahead.

Robert Spingarn - Credit Suisse

Good morning, Amin.

Amin J. Khoury - Chairman and Chief Executive Officer

Good morning.

Robert Spingarn - Credit Suisse

Mike and Tom as well. Amin, could you walk through a few of the milestones, the key milestones that we should be thinking about as you bring HCS online and perhaps you could highlight, where some of the challenges might be?

Amin J. Khoury - Chairman and Chief Executive Officer

Well, I think the thing to watch is that, as margin... we should expect to begin to see steady margin expansion, beginning in 2009. In terms of the milestones or the things that need to be done, we have duplicative facilities all over the world, in the UK, in Germany, in France, in California, in Texas, literally all over the world. And we need to consolidate operations and reduce those facilities and substantially reduce headcount as a result. Over the next couple of years, we will reduce... we expect to reduce employment in that business by about 285 people. So... and to basically consolidate, we're rolling out Texas facility, which is the 210,000 square foot facility, distribution facility and basically to move the inventory assets and operations from that facility to our facilities in Miami and to leverage the volume of the combined business over our existing, very efficient IT assets and our automated retrieval system. How that should be reflected as we report publicly is continually expanding margin as we take out costs and leverage the volume across our existing assets.

Robert Spingarn - Credit Suisse

Okay. Thank you for that. Tom, just switching over to the cash flow for a second. Can you give us a sense of the free cash flow conversion either in the quarter or f the six months so far, in the distribution versus the non-distribution businesses? We have talked about this before. Clearly, the stocking model impacts that distribution business, but it is quite different in the other business I suspect.

Thomas P. McCaffrey - Senior Vice President and Chief Financial Officer

Sure. Let me see if I can provide this for you Rob. We generated free cash flow of about $41 million in the second quarter. And exclusive of the investments that we made for... to expand our inventories in anticipation of the HCS acquisition, free cash flow would have been about $55 million. So I think that addresses the question you were looking at.

As Amin mentioned before, we do expect free cash flow of about $150 million of the year, which is unchanged from our prior guidance. But that is exclusive of the impact of this transaction. We are trying to bring in as much as inventories as we can and to... we are going to invest substantially in the consumables inventory during the balance of this year, as we start that transition. So, obviously free cash flow will be reduced by the amount of those investments and the other integration costs.

Robert Spingarn - Credit Suisse

If I caught you correctly, you talked about the exclusion of HCS in that last, in that 55, is that right?

Thomas P. McCaffrey - Senior Vice President and Chief Financial Officer

That was... we didn't own HCS, but we are buying inventories in anticipation of it. So if you could just --

Robert Spingarn - Credit Suisse

Right. Where I am going with this is, what would it look like if you excluded distribution and HCS, in other words the seating businesses, the interior systems et cetera?

Thomas P. McCaffrey - Senior Vice President and Chief Financial Officer

I don't have that data; we don't report that way, Rob.

Robert Spingarn - Credit Suisse

Okay. And what I am getting at though is it's a different conversion rate, a more traditional supplier conversion rate, am I correct?

Thomas P. McCaffrey - Senior Vice President and Chief Financial Officer

Yes.

Robert Spingarn - Credit Suisse

Okay. And then just as a final question, Mike, you talked about RFP activity being robust, a mix shift toward the OE. Would you say the overall price about the same size as last year in terms of dollar opportunity that's out there in the RFP world?

Michael B. Baughan - President and Chief Operating Officer

I would... and I'd say as mentioned, in some of the segments it's even higher, financially. There is only a little bit of a mix shift in terms of new type of the wide-body deliveries, but a retrofit is still robust in the international regions, Middle East, Asia, Europe. And I think your statement is correct Rob.

Robert Spingarn - Credit Suisse

So the market is expanding. The RFP market is expanding.

Michael B. Baughan - President and Chief Operating Officer

It's obviously as strong as we have ever seen it.

Robert Spingarn - Credit Suisse

Okay. Great, thanks very much.

Operator

Thank you. We're now joined from Jefferies, Howard Rubel.

Howard Rubel - Jefferies & Co.

Good morning. Thank you very much. Two questions, first for Tom or maybe Amin. Could you kind of help us a little bit with GAAP with respect to, on the puts and takes that we're going to see. I'm sure there is going to be some write-up costs, as you put in inventory with respect to the HCS inventory and some of these transition costs you talked about. Because the 285 in the end is not the number we're going to see for GAAP. So could you do a little bit of a walk through that please?

Amin J. Khoury - Chairman and Chief Executive Officer

Tom, you want to take it. Correct, Howard Rubel's question.

Howard Rubel - Jefferies & Co.

Thanks Amin.

Thomas P. McCaffrey - Senior Vice President and Chief Financial Officer

Howard, we haven't completed the work to do the... allocate the purchase price, yet. We are working with some outside advisors that usually, we always do with all our acquisitions to allocate the purchase price. And I don't know how much the HCS inventories would be adjusted upwards because their cost basis overall is higher than ours, because they buy short and sell long. And that's why their profitability is lower than ours. And the reason why we will be investing so substantially to expand their product offerings to stock it appropriately. But it's a long way of saying, we haven't done the work. I can't give you the answer just yet.

Howard Rubel - Jefferies & Co.

So I mean it's important for us to able to feel the GAAP numbers what we're going to see. And so at some point, you'll have to be able to reconcile sort of these costs some of which are cash and some of which are not. Some of which will create a benefit because clearly you have a tax benefit in some cases as a result of this. So that's what I am trying to...?

Amin J. Khoury - Chairman and Chief Executive Officer

Howard, we will... once we get it sorted out, we will report both. We'll report GAAP earnings and we will report the expenses associated with the integration and transition of the business. So you can see... you will be able to see what's going on, and how much we are spending.

Howard Rubel - Jefferies & Co.

I appreciate that Amin. And then just one comment on inventory or free cash flow in the quarter. It looks like it was pretty solid all quarter because sequentially interest expense was down. Is there any more that you can really add to that? I mean how did you manage to change? I mean first quarter was a huge stocking quarter and you sort of did a nice job of turning it in the second quarter. Was there anything you did special?

Amin J. Khoury - Chairman and Chief Executive Officer

No. I am sorry, go ahead Tom. Basically it's what we said was going to happen. Tom, do you want to comment on free cash flow?

Thomas P. McCaffrey - Senior Vice President and Chief Financial Officer

I just was going to say that we work on it everyday. There isn't a day when it goes by, where it's not in front of our management. And it comprises cash flow is a one-third of incentive compensation for our management team. So if they don't hit their targets they lose a third of the bonus. So it works.

Howard Rubel - Jefferies & Co.

But itwas a good... it was a good quarter from a free cash flow point of view. We were tracking to somewhere between $55 million and $60 million. We did use some of that cash, in anticipation of the closing of the HCS transaction. Free cash flow in the third and fourth quarters is expected to be substantially stronger than the second quarter and the second will be much stronger than the first obviously. But that will be reduced somewhat, by whatever... what consumables we can buy in anticipation of the transition, the integration of the two businesses.

Remember the operating margin for the HCS business that we are acquiring is 12.5%. Our operating margin is in the mid 20s. And moving from a brokerage business model to a stocking distribution model and then leveraging everything on our existing IT assets is going to get us another 12.5 points in operating margin on $600 million in revenue. So it's something we need to do. It's how we run our business and it needs to be integrated, so we're going to use some cash to do that.

Operator

Next is Peter Arment, American Tech Research.

Peter Arment - American Technology Research

Hi, good morning nice quarter. Amin or Tom, maybe you could just help me to understand the guidance a little bit on '09 and '10. You've given us quite a bit of details in terms of your range on synergies and you have only put in what seems to be a relatively low amount in nickel. And you mentioned $0.15. But you also mentioned sort of excluding the acquisition and integration transition costs, I mean can you define or help us understand how that is going to impact those... the guidance there? Or I mean is it... are you comfortable with, where those transitions costs are or how should we expect that to flow through? Any color there would be helpful.

Amin J. Khoury - Chairman and Chief Executive Officer

Well, we are now in the business for 24 hours.

Peter Arment - American Technology Research

I understand that.

Amin J. Khoury - Chairman and Chief Executive Officer

We did say that we expect to incur cash cost of around $30 million to get the acquisition integrated and to consolidate the facilities here renewable leases [ph] et cetera, and I mean all expect that to be done. And we don't have yet the timing of the expenditures. But as we mentioned in response to Howard's question, we will report both the spending and GAAP earnings as well as earnings exclusive of the spending. And we just need... we need more time now. As I said we've owned the business for one day. The team is really well organized. It's a dozen strong. It contains the best of people in both organizations, and they are working feverishly. And I think that we will have better information for you and a better look at this when we talk again in October.

Peter Arment - American Technology Research

Okay. And you're comparable to like, I guess, a kind of follow-up just from your acceptance is obviously a smaller deal. But was it within three to four months that you had a firm handle on that in terms of where those costs are?

Amin J. Khoury - Chairman and Chief Executive Officer

It waswithin a few months that we had a better handle.

Peter Arment - American Technology Research

Right. Okay, thanks.

Amin J. Khoury - Chairman and Chief Executive Officer

The New York Fasteners transaction, we tripled operating earnings after 18 months.

Peter Arment - American Technology Research

Right.

Amin J. Khoury - Chairman and Chief Executive Officer

So it takes some time, to get off to kind of a slow start, for the first 3 to 6 months. Not a heck of a lot was going on and then margins started to expand and then it really took off. I think you should expect more or less the same thing here.

Operator

We'll go to the office [ph] of Stifel Nicolaus, and Troy Lahr.

TroyLahr - Stifel Nicolaus

Thanks guys. Can you kind of talk me through the margins at interior systems. I mean is this a sustainable level at 22% going forward?

Amin J. Khoury - Chairman and Chief Executive Officer

Yes.

TroyLahr - Stifel Nicolaus

Okay and then, I mean this is just efficiencies and volumes that you are seeing now come through, is that --

Amin J. Khoury - Chairman and Chief Executive Officer

We spend a lot of money. We, of course, got the integration of the Draeger acquisition and we have got the continuous improvement initiatives which we really have been working very hard at supply chain initiatives. So we invested a lot in the business. We made it more efficient, and now as volume grows, we're really generating a lot of earnings. And so, yes the answer is yes. Our outlook for this business is continued revenue growth, and it's got record backlog, RFP activity is the most... is the highest in its history and the margins are sustainable.

Operator

We go to David Strauss of UBS.

David Strauss - UBS

Good morning, thanks. You talked a little bit about your aftermarket exposure. I think about 50% of the combined fastener distribution business now will have exposure to the aftermarket. Any sense of what portion of the aftermarket business actually goes towards, these platforms that have been part, at about the 800 and 900 airplanes, being parts [ph] on a global basis.

Amin J. Khoury - Chairman and Chief Executive Officer

As we said before, the number of airplanes entering service is going to be larger than the number of airplanes leaving service, for ones entering service are much larger aircraft requiring many more fasteners and consumables, than the ones that are leaving service. And so, we have looked at this, every which way that we can and... and our expectation is that we will have solid growth in revenues and continuing margin expansion in our distribution business.

We have looked specifically at the airplanes that are being grounded. I mean the MD-80s. In fact, we had a slide in the presentation this morning. So we have looked at the aircraft that are being grounded, which we do not see this as a major issue. We don't know how well is to say that. Earlier I think Mike said that, about 13% of our revenues came from U.S. airlines which are doing most of the grounding of airplanes that has... a 10% reductions in our domestic revenues is about 1% of our sales.

Operator

Joining from Stephens Incorporated, Eric Hugel.

Eric Hugel - Stephens Inc.

Hey, with those types of numbers with regards to your exposure to U.S., I mean with regards to the HCS deal, I mean is that sort of significantly different? Do these Honeywell consumable products, do they have any inordinate exposure to sort of U.S. older... sort of these older aircraft?

Amin J. Khoury - Chairman and Chief Executive Officer

No, there is no inordinate exposure. Honeywell's business... Honeywell's distribution business is somewhat different than ours. They have a very large OE component to their business. They've got a significant military component and a significant OE component. So they have a much larger business associated with supporting the manufacturing of assemblies, parts for new aircraft production whereas our business is more of an aftermarket oriented business on a global basis.

Eric Hugel - Stephens Inc.

Okay. With regards to your... I guess, your existing distribution segment, I guess last quarter, I remember you said you had a really good mix. And you did almost 29% operating margins, this quarter around sort of 25%, 26%. Should we think of sort of going forward, excluding HCS, when we are thinking about sort of somewhere in the middle or is 25% a better number of realistic mix going forward?

Amin J. Khoury - Chairman and Chief Executive Officer

I think 25%, 26% is pretty good for the time being. I mean our expectation is that we're going to be able to expand those margins in the future. But I think, that's the right range. We just had a wonderful mix in the first quarter, I think we told you that. And that expectation should be somewhat lower than that, in the mid to high 20's. So I think 25, 26, 27 that's a good range for expectations in margins from the business.

Operator

Our next signal is Patrick McCarthy, FBR.

Patrick McCarthy - Friedman, Billings, Ramsey & Company

Hi good morning and thanks for taking my question. Congratulations on the quarter. I just had... I was wondering if you could just comment on what you are seeing in the European marketplace. You are posting very consistent strong increases in backlog there. And just in general terms, what do you think of the health of the European airlines? And is there anything specifically occurring there that's driving in increase in the order flow? Thank you.

Amin J. Khoury - Chairman and Chief Executive Officer

Mike, do you want to take a crack at that question? Good morning Patrick by the way.

Patrick McCarthy - Friedman, Billings, Ramsey & Company

Good morning.

Michael B. Baughan - President and Chief Operating Officer

I think the same dynamic holds true in Europe as elsewhere. The airlines make a disproportionate amount of their money in the premium class cabins. And that's where the competitive bar has been raised. So I think we have talked in prior calls, about this dynamic, as BEA introduces a new product and then that is met with by Lufthansa or Air France. The bar and the competitive dynamic accelerate. So we see that continuing. We see a lot of investments in retrofit activity. Some of those airlines are big players in new wide-body deliveries. We see a continued concentration with the three major players in Europe, Lufthansa, Air France, BAL all of whom are doing well and have robust international franchises. So, we just see a lot of activities still in Europe.

Operator

And the last one final question and that comes from Myles Walton of Oppenheimer.

Myles Walton - Oppenheimer

Thanks good morning. Good quarter.

Amin J. Khoury - Chairman and Chief Executive Officer

Thank you.

Myles Walton - Oppenheimer

Amin, question for you. There has been some press reports on the Qantas accidents that may have been caused an oxygen tank failure. I know it's early in that investigation. Do you have a note, who the supplier was? Was there a B/E component or was it one of the competitors' components? I know it's still early in the investigation, but wondering if you'd scrub that?

Amin J. Khoury - Chairman and Chief Executive Officer

Well as you know, we have the passenger-oxygen system on pretty much... not pretty much in all-in production airplanes in the world. The storage system, the cylinder storage system on that aircraft is not the B/E Aerospace storage system. We believe it's a Zodiac system, Abox [ph]. There is a small possibility that it could be a Carlton Technologies system which was also qualified on that airplane. So it is not... we can say with a very high level of confidence that to the extent that an exploding oxygen cylinder caused the hole in the airplane, it was not our oxygen cylinder. We have never supplied any for that aircraft.

Myles Walton - Oppenheimer

Okay, that's really helpful. If I could squeeze in one last clarification one --.

Amin J. Khoury - Chairman and Chief Executive Officer

Sure

Myles Walton - Oppenheimer

I think in the press release, it said 275,000 SKUs with the combined entity, I am just trying to resolve that with, I think the prior number was 340. And I am just trying to see if this was kind of lessons out of the integration team?

Amin J. Khoury - Chairman and Chief Executive Officer

Yes, that's exactly where it is, as we are learning there that there are duplicate SKUs among the two companies. So while their SKUs were over 140,000, there were lot of overlapping SKUs and we back those out of the combined number.

Myles Walton - Oppenheimer

So it doesn't that in any way affect your sales expectations for the acquisition?

Amin J. Khoury - Chairman and Chief Executive Officer

No, not at all.

Myles Walton - Oppenheimer

Okay, thank you.

Greg Powell - Vice President, Investor Relations

Great. Thatwas our final question and thank you for joining us this morning. If you all have any follow up please feel free to give us a call. Thank you.

Amin J. Khoury - Chairman and Chief Executive Officer

Thanks everyone.

Operator

Ladies and gentlemen, this concludes today's B/E Aerospace conference call. Thank you for participating in the call and have a good day.

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