Executives
Brian Keogh – Investor Relations
Robert Cremin – President and Chief Executive Officer
Robert D. George – Vice President and Chief Financial Officer
Analysts
[Alan Robinson] – TimeSquare Capital Management LLC
JB Groh – D.A. Davidson & Co.
Esterline Technologies Corporation (ESL) F3Q08 Earnings Call August 28, 2008 5:00 PM ET
Operator
Welcome to the Esterline Technologies third quarter 2008 financial results conference call. (Operator Instructions) It is now my pleasure to introduce Brian Keogh.
Brian Keogh
As usual Bob Cremin, Esterline’s Chairman President and Chief Executive Officer and Bob George, Vice President and Chief Financial Officer are with me today to discuss Esterline’s fiscal 2008 third quarter performance.
A replay of the call will be available by calling this toll-free number, 1-866-245-6755. You will need the following access code, 667997. Or you can visit esterline.com. In the Investor Relations section, you will find replay information. You will also find a copy of today’s earnings release. In that release there is a paragraph regarding forward-looking statements. This paragraph covers this call as well. Essentially, it says that forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 are based on management’s current expectations and are not guarantees of future performance.
Forward-looking statements always involve risk and uncertainty and we deal those risks in our public filings with the SEC. As is our practice, we will keep our prepared remarks short so we can get to the Q&A. We are going to put a two question limit on the first round and then we will circle back for any follow-up as time allows. Now, I would like to turn the call over to Bob Cremin.
Bob Cremin
The quarter $0.68 per share result was clearly stronger than we anticipated. A month ago, when we learned that our R&D assistance talks with the Canadian government had been postponed until September, we did the prudent thing and alerted you to the short-term impact. What our forecast did not anticipate was the exceptionally strong July that our European operations would subsequently report. And Bob’s going to get into the details in a few minutes. A suffice it to say though, we are pleased with the outcome.
Organic sales growth was 17% in the quarter and when you strip out last year’s insurance proceeds third quarter ’08 earnings were up nearly 30% over the same period in ’07. I had call that a pretty solid performance. As we head into the home stretch of ’08, I am confident raising our full year guidance by another nickel to $3.50 to $3.60 per share, could I continue to like what I see.
Sales of spare parts and other after market activity remain robust and that is in both commercial aerospace and defense markets. On the OEM side, we will position our many new programs and that is due to our willingness to invest the new product development. As our R&D investments begin to trend down from their peak, we will reap the rewards from our new technologies for years to come, and there is another part of our business that we do not talk that much about and we will often refer to its simply as other. But it is 20% of what we do, and it is going to be increasingly attractive to Esterline as we go forward.
We routinely invest seed money in opportunistic other high end markets and we have made some noticeable successes with a broad base of customers and that includes medical, high speed rail, industrial power generation, gaming, and others. These markets are attractive because we can leverage the core technologies that we have early developed in aerospace and defense. We also like to margin our opportunities but just that is importantly we like the fact that they bring a different cycle to our business.
A case in point is our success in the medical industry, and this topic is particularly fresh in my mind as I just return from a day long business review at our principal medical operation in Idaho. Recently, they received an order for over 7,000 specialty keyboards from the National Health Service in England. The new designed was developed in cooperation with this guiding medical body for the UK as they target infection control.
A key issue in British hospitals, in fact a key issue in all hospitals. Think about it. Keyboards have lots of crevices to trap foreign matter. And in a hospital, many different hands touch them over the cores of a shift. Our keyboard is perfectly flat and sealed in a thin elastomer cover. There is no place for foreign matter to hide. And it is programmable which sensors that shut it down unless it is regularly wiped with disinfectant.
You know, like all good ideas the concept blossoms. There are now three sizes available, including one in the laptop size range. And we are even providing a mouse that requires the same disinfectant treatment. We branded this product Metagenic, and they will be positioned in over 150 UK hospitals and this is just the start. This is a perfect example of building in our core technologies. Metagenic not only leverages our expertise in cockpit man-machine interfaces but it manages our proficiency and advanced materials and sensors technologies as well.
I do not have time to make engineers out of you all, but we have equally attractive stories to tell you about our efforts in the gaming industry, in the veterinarian industry, in the blackberry-size input devices for secure communications. As I said many times before, we are not a company looking for a strategy. We have got a solid strategy and we are now into execution. And I think we are doing quite a few things right.
Bob, how about picking up on the numbers now.
Robert George
Well, as Bob just said Esterline’s July results were somewhat better than we anticipated. While this is certainly a nicer position to be in than the contrary one, it does merit some explanation.
As Bob noted, the primary driver of the upside surprise was the performance of our European operations. And this can be clearly seen with the sensors third quarter segment sales up nearly 28%. As you know from following the Company, this segment has our largest European content.
Jumping ahead to comments. I will elaborate on a few minutes, sensors operating profits are up 40% in the quarter compared the last year. We simply did not anticipate this strength coming from Europe during the vacation, holiday, and summer season. But not to be overlooked, another factor contributing to July’s robust performance is the continued nice mix of spare parts and after market work in many of the Esterline’s platforms.
With this as prologue, let us turn our attention to a broader view of the third quarter and nine month results. We are quite pleased with the continued strong performance of the Company compare since the last year on the quarterly and year-to-date basis are very positive. As an editorial note, last years results were influenced by the business interruption insurance recovery for one of our UK operations. For the quarter, the effect was $32.9 million operating profit and a nine month effect was $37.3 million. For comparative purposes, I will net these one-time benefits out of the applicable period results to avoid having to repeat myself every time we talk about operating profits.
As Bob has indicated, Esterline’s third quarter sales of $382 million were 17% ahead of last years $326 million all of this was organic growth. Our avionics and sensors segments showed very strong 20% and 28% growth respectively. Material segment increase was a relatively modest 4% as lower countermeasure of flare sales in both the US and the UK restrained on the upside. Year-to-date revenues of $1.1 billion are 26% ahead of last year’s $896 million. Of this growth, $72 million is acquired from the CMC transaction and the balance, 18% is organic.
We continue to focus on operations efficiencies and like the trends we are seeing. In the third quarter, gross margin this year was 31.3% compared to 30.5% last year. And for the first nine months of the year, gross margin is 32.4% comparing very favorably to last years 30.5. Segment earnings, excluding corporate expenses are increasing in lock step with the margin enhancements.
In the third quarter, segment earnings were $42.4 million compared to $36.5 million last year and year-to-date segment earnings are $137 million compared to last year’s 101, an increased of 35%. By segment, operating earnings were as follows: avionics and controls, $9.6 million in the third quarter, $42.4 for nine months; sensors and systems, $14.9 million in the third quarter, $41 for nine months; and advanced materials, $18 million in the third quarter, $53.6 million for nine months.
As we have indicated previously, the profit increases are driven by a number of factors including benefits from operational improvements, favorable sales mix in a number of areas, and importantly expansion into new markets with new products. And Bob has just elaborated on some of this a few minutes ago.
Selling, general and administrative expenses were 16.5% of sales in the third quarter this year compared to 17% of sales last year, and on the year-to-date basis, the comparables are 16.4% in ’08, 16.5% last year. As we discuss in today’s press release, research, development, and engineering expenses are moving in a trend of we have been anticipating. This quarter’s expense of $22.4 million was 5.9% of sales. Year-to-date spending is $71.3 million or 6.3% of sales.
As the major programs we have been investing heavily in begin to wind down. Including the Boeing 787 and Airbus’s A-400 M, we will benefit from a declining R&D expense as a percent of sales. And we will likely end the fiscal year with a rate around 6%. Esterline’s net interest expense is down significantly relative to prior period. Our strong cash flow enabled us to deliver following the CMC acquisition.
Net interest expense in the third quarter this year was $6.2 million compared to $10 million last year. Bottom line for the third quarter, Esterline’s net income was $20.5 million, $0.68 per share on a fully diluted basis excluding the insurance recovery. Net income last year was $15.8 million, $0.61 per share fully diluted. For nine months, earnings per share are $2.56 per share on a fully diluted basis compared to a $0.74 per share last year, again excluding the insurance recovery proceeds.
Now, wrapping up my comments the Esterline’s balance sheet in cash flow are solid. Cash flow from Operations for the first nine months was $92 million. Capital expenditures were $31 million and depreciation and amortization was $49 million. Investments in inventories are up, and that is true in both row materials and working process. Our view is this is a reflection of the strength in our backlog as we look forward. And with that, Bob back to you.
Bob Cremin
We will open up for questions now.
Question-and-Answer Session
Operator
(Operator Instructions) Your first question comes from [Alan Robinson] – TimeSquare Capital Management LLC.
[Alan Robinson] – TimeSquare Capital Management LLC
I was wondering if you could just address some confusion I had with the treatments of the R&D refund that you discussed earlier on this month during your guidance call. I was under the impression that you had anticipated that any R&D refund would occur as a credit to R&D expense. Now, it seems you did not get a credit to R&D expenses this quarter and yet still, your R&D levels were pretty low. So I guess, what I am trying to ask is if you had have had that credit. The R&D credit would we be looking at R&D levels round about the 4% level? Could you just give me some color on how we think about that?
Bob Cremin
No, we did not anticipate it in the third quarter. And we basically told people that the negotiations were going on. But we could not predict that it would be in the fourth quarter either.
Robert George
Just real quick, if you have got some confusion there might be some others as well. Let me just kind of real quickly go through the timeline of what we are looking at this year. Last year, the Canadian government changed their R&D assistance program from one call TPC to one called SADI which stands for the Strategic Aerospace Defense Initiative. At that point in time, our CMC operation was informed by Canadian government that the process would probably take about 12 to 13 months to work through. Our programs were approved and so we began the formal paper work process last year and at about this time of the year. And so we anticipated in our planning for this year that we would receive that assistance some time either in the second or third quarter.
When we did our second quarter results and talked to the Street about it at that point in time, obviously we did not get it in a second quarter. But we are still thinking it was coming in a third. When we had our press release about a month ago, at that point in time we were advised by Canada that it would most likely be in September-October. So we had our discussion a month ago, we basically took any presumption for SADI relative to our full year guidance off the table.
So our full year guidance, which is now 350 to 360 is not in any way, shape, or form dependent upon receiving the SADI assistance in this fiscal year. If we do, the number will move upward and that brings us to your specific question on our R&D percentage. You are absolutely correct, we have been talking about a number this year that has been in the 5, 6, and in the second quarter was 7% of revenues relative to R&D expense. There is no SADI credits associated with that. When the SADI payments come through, a one-time credit will go through and the numbers for the quarter will look relatively unusual.
Earlier this year, when we anticipated that we were going to receive some SADI assistance, at that point in time, we were saying that our R&D expense relative to sales would begin moving back down towards the 4.5 to 5% of sales range. That number did presume that we receive the SADI assistance. Hopeful it that the kind of is not too much detail but it helps you out.
[Alan Robinson] – TimeSquare Capital Management LLC
Okay, that make sense and then just to follow on you made, I think Bob George, you made a comment about the R&D rate at the end of this year closing out round about 6%. Is it that for FY ’08 as a whole?
Robert George
Yes, it is.
Bob Cremin
Alan, this just the last point, every time we try to predict what other parties will do, you always get stung, and I can only say that conversations are back in gear. We like the way it is shaping up, but I also am picking up run wins that they might call for an early election in Canada, in which case Parliament would be dissolved and might spill into ’09. But reiterating what Bob said, guidance does not include any consideration from SADI for ’08.
Operator
Your last question comes from JB Groh – D.A. Davidson & Co.
JB Groh – D.A. Davidson & Co.
Can you give some clarity on the tax rate for the quarter? It looked like it was a little different than it had been the last few quarters, maybe you could just give us a little update on that.
Robert George
I think the tax rate in the third quarter was pretty consistent.
JB Groh – D.A. Davidson & Co.
I thought there would be some tax rate impact related to this credit not happening. But I guess, it all occurs up at the R&D line; correct?
Robert George
That is correct.
Operator
We have no further questions at this time.
Bob Cremin
Again, thanks for your interest in Esterline as usual if you have any questions come on back at us and we look forward to speaking with you next quarter when we wrap up the year.
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