Moog Inc. (MOG.A) CEO John Scannell on Q2 2021 Results - Earnings Call Transcript

Moog Inc. (NYSE:MOG.A) Q2 2021 Results Conference Call April 30, 2021 10:00 AM ET

Company Participants

Ann Luhr - Head of IR

John Scannell - Chairman & CEO

Jennifer Walter - VP & CFO

Conference Call Participants

Cai von Rumohr - Cowen

Ken Herbert - Canaccord

Mike Ciarmoli - Truist Securities

Operator

Good day, and welcome to the Moog Second Quarter Fiscal Year 2021 Earnings Conference Call. Today's conference is being recorded.

At this time, I would like to turn the conference over to Ann Luhr. Please go ahead.

Ann Luhr

Good morning. Before we begin, we call your attention to the fact that we may make forward-looking statements during the course of this conference call. These forward-looking statements are not guarantees of our future performance and are subject to risks, uncertainties and other factors that could cause actual performance to differ materially from such statements.

A description of these risks, uncertainties and other factors is contained in our news of April 30, 2021, our most recent Form 8-K filed on April 30, 2021, and in certain of our other public filings with the SEC. We've provided some financial schedules to help our listeners better follow along with the prepared comments. For those of you who do not already have a document, a copy of today's financial presentation is available on our Investor Relations webcast page at www.moog.com.

John?

John Scannell

Thanks, Ann. Good morning. Thanks for joining us. This morning, we'll report on the second quarter of fiscal '21. Over the last 90 days, we've become more confident that global operating conditions have stabilized to the point where we feel comfortable providing guidance for the second half of the fiscal year.

Overall, it was a very good quarter, and we're optimistic that the remainder of our fiscal year will continue this strong performance. As followed my usual format today, starting with the headlines under the three headings of macroeconomic, microeconomic and Moog's specific items. First, on the macro front, we've seen a lot of change in the last 90 days.

In the U.S., the new administration is firmly in place in Washington, and federal spending is set to increase dramatically over the next few years as COVID relief, infrastructure investments and green initiatives are aggressively pursued. Eventually, U.S. taxpayers will have to pay for this spending, and it now seems inevitable that corporate tax rates are set to increase.

The only question is by how much and when? For the coming year, the defense budget seems to have averted any major impact. But given that defense is a major portion of the federal budget, we assume that longer-term, defense spending will be impacted. On the other hand, global tensions continue to simmer with China starting to assert itself as equal of the U.S., Russia threatening the Ukraine and both Iran and North Korea pursuing their nuclear agendas.

Trade and national security have become intertwined as the U.S. seeks to reestablish a base in critical capabilities, including chip manufacturer and supply chains for the key components of tomorrow's clean tech economy. On the COVID front, we're seeing optimism in the U.S. as vaccinations reach over half of the adult population and the talk turns to reopening the economy in full. This contrasts to the ongoing challenges in Europe and South America, where vaccination rates are much lower and the emerging crisis in Asia, particularly India as new variants fuel the next wave of infections.

Overall, the global economy is showing signs of renewed strength, driving supply chain shortages in critical components, particularly electronics. Second, on the microeconomic front, our major markets are continuing to perform well. Spending on defense and space applications continues to be robust, and we're starting to see a slow recovery in some of our industrial markets.

Commercial air traffic is on an upswing driven by domestic demand. Boeing is ramping up deliveries of the 737 MAX and resumed deliveries of the 787 in the quarter, production rates at Airbus have stabilized, and the aftermarket is much improved from six months ago. Overall, a much more encouraging picture than 12 months ago as we headed into the pandemic. Third, it was another good quarter for our business. Total sales were down only 4% relative to a year ago, despite a near 40% decline in our commercial book of business.

As we discuss our performance relative to the same quarter a year ago, it's important to keep in mind that our second quarter last year was the last pre-COVID quarter we enjoyed. GAAP earnings per share this quarter were $1.51 and up marginally from the same quarter a year ago, but included $0.18 of benefit from a curtailment gain on a foreign pension plan. Absent this gain, adjusted earnings per share of $1.33 were the strongest quarter we've had since COVID hit, and clearly show the underlying strength of our diverse portfolio of businesses.

COVID continues to impact our business globally but our infections have come down over the last quarter, and our operations have continued to perform. We've not yet started to bring our folks back into the office, but we're optimistic that this will start to happen in select geographies as we enter our fourth quarter. Cash flow in the quarter was soft after a blowout first quarter. Despite the soft second quarter, year-to-date, we're still running a healthy conversion ratio of over 90%.

Looking at our key markets, Space and Defense continued strong; Industrial is showing early signs of recovery; Commercial is stable; and Medical is solid, but coming off a surge in COVID-related demand over the last year. Our supply chains continue to function well, although the emerging component shortages in the industrial markets are a watch item for the coming quarters.

Finally, on February 18, our space team celebrated the successful landing of the Perseverance Rover on the surface of Mars. The Moog team provided valves, which meted the flow of fuel to the descent rocket motors. We use the phrase, When Performance Really Matters, to illustrate the critical nature of the applications which use our products.

Ensuring a safe landing on the surface of Mars after a seven-month, 350 million-mile journey is the perfect example of When Performance Really Matters. My congratulations to all our team members who contributed to this technological wonder. Now let me move to the details, starting with the first quarter results. Sales in the quarter of $736 million were 4% lower than last year. Similar to the story for the last four quarters, sales were up in Defense, Space and Medical, down slightly in Industrial and significantly lower in Commercial.

Taking a look at the P&L, gross margin was in line, while R&D was up slightly, partly driven by the Genesys acquisition. SG&A was down on a dollar basis, but up marginally as a percentage of sales. Interest expense was in line. We had a onetime $6 million gain in the other line associated with the pension curtailment in a foreign plan, which Jennifer will explain in more detail.

The effective tax rate this quarter was 21.6%, resulting in net income of $49 million, down 2% from last year and earnings per share of $1.51, up 2% from last year on a lower share count. Fiscal '21 outlook. We continue to assume that COVID will be a major factor through the end of this fiscal year and are planning accordingly. We believe the second half will be very similar to the first, both in terms of sales by market and underlying earnings.

I'll provide more detail in the roundup for each segment. Taken all together, we're expecting full year sales of $2.84 billion and full year earnings per share of $5, plus or minus $0.20. Now to the segments, I'd remind our listeners that we've provided a three-page supplemental data package posted on our webcast site, which provides all the detailed numbers for your models. We suggest you follow this in parallel with the text.

Beginning with Aircraft. Sales in the second quarter of $304 million were 11% lower than last year. The pattern of the past year continued with strong military sales compensating for lower commercial sales. Comparing with the same quarter last year, military OEM sales were up 1/3 on increased funded development work and higher F-35 sales.

We also booked $8 million in sales from our Genesys acquisition, which completed at the end of December. In contrast to the OEM, the military aftermarket was down 20% from a very strong Q2 last year. The softness was a combination of some delayed shipments at the end of the quarter combined with a more general slowdown across a broad range of programs. It's too early to tell if this is a trend or just the natural fluctuation in the business on a quarterly basis.

On the commercial side, OEM sales were down almost 40% from a year ago, with continued weakness across the complete portfolio. Sales on our two largest programs, 787 and the A350 were both down over 40%, while sales on business jets were down almost 50%. Commercial aftermarket was down 34%. On a sequential basis, Q2 showed some encouraging signs over the first quarter. Military sales remained strong, albeit down slightly from the first quarter on lower aftermarket sales.

Commercial OEM sales showed nice improvement across almost the entire portfolio as production rates stabilized and Boeing deliveries of 787s resumed. The commercial aftermarket was also up as domestic flight operations continue to improve. Aircraft margins. Margins in the quarter were 7.2%.

In reviewing the margin performance this quarter, three comparisons helped tell the story. First, as expected, margins were down from Q2 fiscal '20 on the lower commercial sales. Second, also as expected, margins were down sequentially from our first quarter. 90 days ago, we explained that we had an unusually favorable mix in the first quarter, and we're anticipating lower margins in subsequent quarters.

Third and most important, margins were up significantly from the adjusted run rate of 3.5% in the second half of fiscal '20. This improvement in the underlying business is a result of the continued strength in the military book, the firming demand in the commercial book and the actions we took last year to resize the business.

Aircraft fiscal '21, We're projecting the second half of our fiscal year will be very similar to the first. Sales into the military market will remain strong with OEM sales in the second half marginally lower than the first half, but aftermarket sales marginally higher. On the commercial side, the production rates on the major programs have now settled and will probably remain stable well into next year.

In the aftermarket, global flights operations continue to pick up. But we believe we've already seen this benefit flow through in our first half as sales increased almost 20% from the run rate of the previous six months. Taken all together, we're forecasting a second half in commercial in line with the first half. The net result is full year sales of $1.18 billion, including $40 million from the Genesys acquisition we closed in December.

This total is down just 2% from fiscal '20 sales. Second half margins will be approximately 8%, bringing full year margins to 8.2%. Turning now to Space and Defense. Sales in the second quarter of $206 million were 7% higher than last year.

Space business continues to drive the growth with sales up 19% from a year ago. We have continued strength in our NASA work as well as growth in our integrated space vehicles product line. Over the last decade, we've strengthened our component offerings and worked to combine these components into integrated space vehicles. Our Orbital Maneuvering Vehicle, or OMV, was the first product of this effort. And over the last couple of years, we've continued to broaden that offering to include small satellite buses.

The boom with low-cost satellites and the availability of cost-effective launch capability is now fueling our growth in this business. Sales into the defense market were in line with last year with some shifts in the mix. Sales of components on military vehicles were up as were sales into naval applications. These increases were offset by lower sales of fin steering systems for tactical missiles and into security applications.

Margins in the quarter were 12.9%. This margin performance is particularly strong given the high proportion of funded development work in this business combined with the challenges of COVID. Space and Defense fiscal '21. We're projecting full year sales of $795 million.

We believe both the space and defense businesses will remain strong and will each have sales in the second half pretty much in line with the first half. Full year margins will be 12.3%. Coming now to our Industrial Systems business. Sales in the second quarter of $226 million were marginally lower than last year.

Adjusting for foreign exchange movements, real sales were down over 5%. Sales were lower in our energy and simulation test markets. Compared to last year, energy sales were adversely impacted by delays in various exploration projects. On a more positive note, the run rate for energy sales has been fairly stable over the last few quarters. And we're seeing signs of modest growth going forward.

Sales of motion bases for full flight simulators were down over 50% from the same quarter a year ago as the demand for additional simulator capacity has plummeted. Sales of product into industrial automation were in line with last year after adjusting for ForEx. On a positive note, sales into industrial automation are up sequentially from the last three quarters, indicating that this market is starting to strengthen.

Sales into the medical market were up 7% from a year ago and in line with our first quarter. Margins in the quarter were 10.5%. Margins in this business are starting to improve as we see the first signs of recovery particularly in the industrial automation market. Industrial Systems fiscal '21. For the full year, we're projecting sales of $865 million. Similar to our other two groups, this assumes a second half total in line with the first half.

We will, however, have some slight changes in the mix. Comparing the next six months to the last six months, we think sales into the energy and industrial automation markets will strengthen marginally. Sales into simulation and test will be flat, and sales into medical markets will be down slightly. The slowdown in our medical markets is caused by the reduced need for COVID-related equipment, which drove a spike in our pump demand over the last 12 months. We're projecting full year margins of 10%, in line with the first half.

These margins are down slightly from the second quarter as a result of additional organic investments we're planning to make in emerging opportunities in the industrial off-road electric vehicle market. Summary guidance. We're pleased with our performance in the first half of the year and are looking forward to repeating that performance in the second half. Our businesses continue to operate effectively despite the ongoing imposition of COVID restrictions.

Over 60% of our business is in the U.S. and with vaccines now widely available, we're hopeful that our fourth quarter could be the start to the transition back to a more normal work environment. Our operations in Europe and in some Asian countries are probably 1/4 or more behind the schedule. But we're optimistic that our fiscal '22 will be the start of the post-pandemic era. Market diversity and financial prudence have guided us through the pandemic and will continue to be the core of our business going forward.

Our capital allocation strategy is unchanged. We look to invest in growth and return excess capital to shareholders through our dividend and buyback programs. As we emerge from the pandemic, we're seeing increasing opportunities to invest in organic growth, the combination of capital expenditures and R&D. We also continue to be active in the M&A markets, but with that's almost free and excess capital looking for a home, prices remain at levels we find unattractive. We will continue to search, but will remain both patient and prudent.

As we look to the second half of the year, we're reinstating guidance after a 12-month hiatus. We believe the second half will pretty much mirror the first, resulting in first full year sales of $2.84 billion and full year earnings per share of $5 plus or minus $0.20. For the third quarter, we anticipate earnings per share of $1.16, plus or minus $0.15.

Now let me pass it to Jennifer, who'll provide more color on our cash flow and balance sheet.

Jennifer Walter

Thank you, John. Good morning, everyone. Free cash flow in the second quarter was $6 million compared to $12 million in the same period a year ago. This follows a very strong first quarter and brings our year-to-date free cash flow conversion to just over 90%. The moderation in our cash flow this quarter resulted from slower collections on receivables, shipments late in the quarter and increased investments in capital expenditures.

The second quarter marks a turning point in our inventory, which were a source of cash for the first time since 2018. The substantial amount of effort, focus of our teams across the Company and most notably in our aircraft operations resulted in this achievement. Efficiencies associated with Operations 2.0 are beginning to be realized as we also continue to focus on optimizing incoming receipt.

The $6 million of free cash flow in Q2 compares with an increase in our net debt of $9 million. During the second quarter, we paid our quarterly dividend and repurchased just under 100,000 shares of our stock for $7 million. Year-to-date, we acquired about 250,000 shares for $17 million. Net working capital, excluding cash and debt, as a percentage of sales at the end of Q2 was 30.5% compared to 29.2% a quarter ago.

Receivables grew during the quarter as key customers in our commercial aircraft business both came in at quarter end. Receivables also increased due to the timing of industrial shipments, which were unusually strong late in the quarter. An increase in customer advances partially offset the growth in receivables. Capital expenditures in the second quarter were $38 million, up sharply from $20 million in the first quarter.

We started to catch up on capital investments that we had delayed during the more uncertain times of pandemic. We are also investing in our operations to achieve greater efficiencies in our facilities to support our business. At quarter end, our net debt was $878 million, including $91 million of cash.

The major components of our debt were $500 million of senior notes, $396 million of borrowings on our U.S. revolving credit facilities, and $69 million outstanding on our securitization facility. We have $670 million of unused borrowing capacity on our U.S. revolving credit facility. Our ability to draw on the unused balance is limited by our leverage covenant, which is a maximum of 4.0x on a net debt basis.

Based on our leverage, we could have incurred an additional $427 million of net debt as of the end of our second quarter. We are confident that our existing facilities provide us with the flexibility to invest in our future. Cash contributions to our global retirement plan totaled $14 million in the quarter compared to $12 million in the second quarter of 2020. Global retirement plan expense in the second quarter was $13 million, down from $20 million in the second quarter of 2020.

The decrease in expense is attributable to a $6 million curtailment gain associated with terminating our defined benefit pension plan in the Netherlands. We replaced this plan with a defined contribution plan, and this change benefited both the Company and the planned participants. The gain is recorded in the non-service pension line.

This financial impact resulted from participants transitioning from active status in the plan to deferred participant status and the related projected benefit obligation decreased due to these participants becoming inactive. The curtailment gain increased our earnings per share by $0.18. Our effective tax rate was 21.6% in the second quarter compared to 19.2% in the same period a year ago. We had benefit in each of these periods.

In the second quarter of 2021, there was no tax expense associated with the curtailment gain on the termination of the Netherlands defined benefit pension plan, thereby lowering the effective tax rate. Last year's second quarter rate reflects the reduction in tax rate related to taxes accrued on accumulated earnings in one of our foreign jurisdictions as well as reduced withholding taxes previously accrued in another foreign jurisdiction. We expect free cash flow generation in 2021 to be in line with our long-term target of 100% conversion.

Excluding the noncash gain from the pension curtailment, we were at that level in the first half of this year. In the back half of the year, we expect cash flow generation from working capital. Inventories will contribute to cash inflows while we work down customer advances.

Capital expenditures will continue to be elevated as we invest in some facilities to support future growth and consolidate other facilities as we refine our footprint. We expect 2021 capital expenditures to be $140 million and depreciation and amortization to be $91 million. We are well positioned to invest in our organic growth and are finding this to be an attractive opportunity in deploying our capital. We continue to explore opportunities to make strategic acquisitions and return capital to shareholder. 12 months ago, we were facing great uncertainties in our business.

We came into the early days of the pandemic having recently refinanced our debt, positioning us nicely coming into the challenging business environment. We responded by conserving our cash and preserving our liquidity as well as managing expenses and certain investments.

Our approach has paid off and shows in our leverage ratio. Our leverage ratio was 2.7x on a net debt basis as of the end of the second quarter compared to 2.6x a year ago. This slightly higher ratio reflects the pressures on EBITDA from the impacts of the pandemic over the last 12 months and our acquisition of Genesys, offset by very strong cash flow generation during this period. Our current leverage ratio continues to be within our target zone of 2.25x to 2.75x.

With that, we'll turn it back to John for any questions you may have. John?

John Scannell

Thanks, Jennifer. And Nick, we would like to open the line for questions, please.

Question-and-Answer Session

Operator

Thank you. [Operator Instructions] And our first question comes from Cai von Rumohr with Cowen. Please go ahead.

Cai von Rumohr

Good quarter, John. Nice work. So commercial, you mentioned the commercial aircraft numbers, while they were down, they looked certainly better than we'd indicate -- we'd guessed. What was making it up? I mean was it the normal Airbus and Boeing deliveries ex 87 and 350 or was it other? Because they looked a little stronger than I would have guessed.

John Scannell

So a couple of things, Cai. One of the things about our commercial business is that it's so hard to factor in the impact of inventory coming in. It's -- of course, it's long-term contract accounting. So it's not based on shipments. And that's sales are driven a lot by incoming inventory, of course, orders from our customers.

A couple of things happened, though. If you look at the Airbus sales that we had a couple of quarters ago, they were doing enormous destocking. And while the headline number was that Airbus went from 10, 350s to 5, 350s, we were shipping almost no product for a quarter or 2. And so that's now stabilized.

So some -- and I think to some extent, that's happened at Boeing as well. So there's been some of that destocking has kind of washed through, and we now feel that we're at a pretty stable production rate. But as a result, we've seen sequentially, our commercial OEM business pick up over the last few quarters because of that.

Then we have the fact that orders have been pushed out. But nonetheless, we still have open orders. And as we get inventory in, which we've been working really hard to slow, but that inventory gets pegged to orders and so you actually take sales on that as you go through the system. So there's a lot of moving pieces over the last several quarters that make it difficult to extract some kind of a conclusion from our actual sales number in one quarter versus the past. What I would say is that we believe now that inventory destocking at the primes has washed through.

We believe that our incoming inventory is now much better matched to the demand going forward. And we believe that the rates are relatively stable. And that's why we think our second half will kind of line up pretty much with what we saw in the first half.

Cai von Rumohr

That's very helpful. And then you have these very strong military aircraft sales, and you mentioned the development work. Is that development work on one program or several programs?

John Scannell

No, that's a broad range of programs, Cai. And It's one of the things I emphasize that I think is important that we have a concern. I think everybody in the defense business has that, if you move out a few years, Defense spending is highly likely to be pressured just given the amount of government spending that's going on. But on the other hand, the only -- I think the only indicator of the future is how much development work, how much are we working on the future programs. And that's very strong.

It's now running well north of $100 million this year. And if we go back four, five years, it was a $20 million business.

So we have won a lot of positions on new programs. Most of them we can't talk about. I don't know how many of them will turn into big production programs in the future, but it is a positive sign. So that is very strong. And it's up from what we thought entering the year by $10 million, $15 million, $20 million, just given the strength of some of the programs that we've won and the opportunities we're seeing.

Cai von Rumohr

And then the last one for me is space. You continue to deliver these very, very strong numbers. Your full year guide kind of implies you're going to slow down in the second half, which I think is what you were kind of saying last year? And you didn't. Could you give us some color in terms of what is driving this very, very good growth? And what's the potential that maybe the second half is a little better than you're projecting?

John Scannell

So the growth has been driven by a couple of things, Cai. We've kind of mentioned them over the last year or 2. One is NASA. There's just a lot more work in that on the SLS system. So we've really benefited from that.

The hypersonics, as we mentioned, we code hypersonics into two areas. The fin steering is in our defense side; and the launch stuff, we put on the space side. So that's been a -- obviously, there's been a lot of work in that.

And then the third piece is what we're calling integrated space vehicles. And this is where we've been working over the years to kind of pull our components together and offer more of a small satellite bus. And we're seeing some nice opportunities in that and some growth in that side of the business. Could the second half be better than the first? Perhaps. But I would also caution that you can't keep growing at 19%, 20%, 20% per quarter on an ongoing basis forever.

And so what is starting to happen is we're just seeing that level up. I mean it's a tremendous business. It's double what it was just a few years ago. But that heavy growth is just not going to be something that we're going to continue to see indefinitely. So I was wrong last year.

Maybe I'll be right this year. Is there upside? Yes, but I'd be cautious about getting ahead of us so.

Operator

And our next question comes from Ken Herbert with Canaccord. Please go ahead.

Ken Herbert

John, I just wanted to follow up on your comments on the military aircraft market. When I look at the second half implied numbers, it looks like you're seeing some nice growth, high single digits in the business, but you're looking for better high-teens growth on the OEM side with aftermarket down on the military side. And I know you made some comments earlier about it's a little early to draw aftermarket military trends. But I wondered if you could flush that out a little bit. I know you've got some tough comps there, but how should we think about the military aircraft business in the second half? And what are some of the key puts and takes in that business?

John Scannell

Yes. So what we're pitching is that we think the second half will be similar to the first on the total. If you look at the run rate of the first half and you just double that, it's pretty much what we're seeing. But we believe that the OE side will be down a little bit and the aftermarket side will be up. So let me do this, Ken.

If I go back to '19, our OE side was about just $415 million. Last year, our OE was $470 million. And this year, we're forecasting the OE at $580 million. So just to put it into context, it is up significantly from what we saw a year ago. It's up over 20% from what we saw last fiscal year.

We had incredibly strong first and second quarters. I mean our F-35 business has been particularly strong. And as I mentioned earlier, you got to keep in mind that some of that has to do with how inventory comes in, and it's not just all shipments.

So we think that's been very strong. We think it will continue strong. We've seen the -- on the development, as I mentioned, to Cai, improved significantly over the last year. But in terms of just taking a step back rather than just saying, let me look at the second quarter and annualize that, look at fiscal '20, $470 million; fiscal '21, $580 million on the OE side, and that's a significant pickup. And again, major drivers are F-35 under development.

And keep in mind, we also have $40 million of Genesys in there. So that contributes, too. If I do the same for the aftermarket side, if I go back to '19, again, and first, we'll have pre-COVID here, $207 million. Last year, we did $250 million in the military aftermarket. So that was really a blow-out year.

And this year, we're now forecasting $230 million. So it's still up nicely from '19, off a little bit from '20, but it's still a really strong year, and that's up from the run rate in the first half. So we think the first half was depressed a little bit, particularly in the second quarter, we had some shipments that didn't go out and then there was a little bit of softness in the business. We're not -- we're anticipating it to get better as we go through the second half. So we'd see a pickup in the second half.

So the story for the second half, you put it together, it's kind of flat for the total. But the OE side will be up a bit coming up with a very strong first half, but still much better than last year. And the military aftermarket will be up from the first half, but down again from a very strong last year. So little bit of a mix shift there. But overall, I think it's still a very strong performance.

You just have to take a little bit of a step back and look at a longer time period.

Ken Herbert

No, that's very helpful. As we think for the military aircraft business sequentially from the first half to the second half in '21, shouldn't the better aftermarket sales and the growth sequentially relative to some of the OE sales down perhaps drive better margins? Shouldn't you see some more mix benefit than perhaps the guidance implies in the second half of the year?

John Scannell

So the -- if we do the margins in the aircraft business, we had very strong first quarter margins, which we had mentioned last quarter, that's not going to be sustainable for the long term. They were in the mid-9s. We just did our margins at 7.2% in the second quarter, which I would say would be more in line with the business, and we're forecasting 8.2% for the year.

So we're forecasting the second half margins will be about 8%. So they'll be up from a run -- from the second quarter of 7.2%. But down from, as I said, a very unusual first quarter. So actually, yes, the margins are up on a slightly improved mix, as you point out, the military aftermarket will be more of a contributor.

So they'll be up from 7.2% to about 8% in the second half, Ken. And the other comparison I think is really helpful is if you look at the second half of last fiscal year, this was the six months of COVID that we suffered, and you adjust for some of the significant restructuring we did, underlying margins were about 3.5%. And so we still have a book of business, our Commercial is way down.

Military force is really strong, but those underlying margins have gone from 3.5% over the last six months of last year to what we're saying is going to be north of 8% for this year. And I think that's a significant improvement in the business. So yes, margins will be up a little bit from the second quarter, but down from the first on a kind of an unusual mix.

Ken Herbert

That's great. And if I could -- just one final question for Jennifer. The free cash flow continues to be very strong, and I think you're talking about 100% conversion for the full year. As you look into the second half of the year, I know you've gone through some of the pieces of working capital, but where could we see upside again on the free cash flow? Is there more in working capital you can do on inventory in particular than what you've called out?

Jennifer Walter

So this is, as I mentioned in the prepared remarks, the inventory is the first time that we've had a positive inflow of cash related to inventory. So we are projecting for the next couple of quarters to also have contributions from our inventory being a source of cash. We don't want to get ahead of ourselves to say how quickly that can ramp up, but we're certainly feeling good that we've been able to turn that corner as well. So when I look at some of the other pieces in there, we've had really strong customer advances the last couple of quarters. And certainly, we're going to be needing to work that down over the next couple of quarters.

So we're going to see some pressure on there. And feeling like we're in a pretty balanced position as we're looking at that, especially considering the investments that we're pursuing related to our capital expenditures that's going to offset some of the generation from the working capital.

Operator

[Operator Instructions] We'll take our next question from Mike Ciarmoli with Truist Securities. Please go ahead.

Mike Ciarmoli

Nice results. Maybe -- I don't know who wants to take this, I guess, John, just how should we think about the margin sort of expansion journey? And I guess I'll start in aircraft. You're certainly doing very well now, and you just talked about a second half run rate of 8%. You're still dealing with lower volumes. You've got the benefits of Operation 2.

0. And I'm assuming you've still got higher-margin provisioning volumes that are still going to be way down.

How do we -- I'm not going to ask you for guidance next year, but it seems like exiting at 8% should be definitely a new floor, and it would seem like as the volumes come back, you get some more of the efficiency benefits with Operation 2.0 and even provisioning volumes. It should seem like you've got a good trajectory here for margin expansion. Any kind of thoughts on how we should think about this going forward?

John Scannell

Yes. I think your thesis makes sense, Mike. But I think to see it, so we could -- we've seen some nice improvement, as I've said, from the second half run rate to the first half of this year and all the year. And what's come through is, of course, the benefit of the restructurings that we've done and the continuing focus on efficiency improvements and stuff.

We should still continue to see some marginal gains from that, I think as we go out over the next couple of years. But the real gain is when you start to get those volumes back up, both on the commercial aftermarket and on the OE side. I mean, and that's really -- looking out at the moment, it's not clear that Boeing and Airbus are going to be ramping up their 87 and 350s rates anytime soon. And while the aftermarket -- the aftermarket should continue to come back, so that would be good, if they started flying particularly the international routes. But that's -- that also looks like that could still be a ways away.

So yes, if we could see the commercial book continue to improve, we continue to see that margin expansion. Military stuff is very strong. If that continues, we've continued to enjoy that. And our operational activities continue to show some benefit. But I think the real catalyst from here on, our commercial book is still 40% down on what it was a year ago.

If we could see that come back, we'd start to enjoy much better margin performance.

Mike Ciarmoli

Got it. Got it. And then just, Jennifer, you were just talking about inventory being a tailwind to cash. And John, you just said you don't know when those widebody rates are going to come back. But How are you thinking about your inventory levels? We've already been hearing from some management teams thinking about potential tightness in the supply chain if there is a potential big ramp back up to those production rates.

I mean as you evaluate your suppliers and think about inventory levels, do you feel comfortable with the ability to ramp back up and that you'll have access to your raw material?

Jennifer Walter

Yes. That's a good question. It's certainly an area that has gotten more attention in the news. We've been paying more attention to it because of the discussion with what's happening in automotive and those types of areas right now. So we are closely monitoring that so that we will mitigate the risk associated with any supply chain disruption.

But we feel like we're in reasonable shape in making sure that we're managing the inventories to appropriate levels while also trying to manage that risk.

John Scannell

Yes. I can't imagine, Mike, that we're going to go back to building 10 787s a month -- overnight. I mean I'd be delighted if we had that problem to struggle with, but it feels to me like the acceleration of the ramp-up -- my concern always in the aircraft business is not the ramp-up, it's always the ramp down because the ramp down happens overnight, and we just saw that in the last 12 months.

Typically, the ramp-ups are pretty well planned and can be scheduled out. So we manage -- I think we would be happy to have that problem, and we've got plenty of inventory at the moment. So we're feeling -- I think we're feeling pretty good about any ramp-up.

Mike Ciarmoli

Got it. Just on that ramp down, you mentioned, are you guys still dealing with or struggling with a lot of excess capacity costs? Have you been able to reallocate to other military programs? Or how much of a drag is sort of excess unallocated overhead to the aircraft margins right now?

John Scannell

So we did the significant resizing. We actually ended up doing it a couple of times, Mike, much as we didn't want to through the end of last calendar year. That's all behind us in terms of the staffing levels. We took some significant write-downs as well on some equipment and facilities, if you remember, at the end of our third and fourth quarter in particular last year.

However, you still end up carrying if you think of just the organization, you need -- the fact that you're buying instead of buying 10 or something, you're buying five or something, you still have the same number of suppliers, same number of inspections, et cetera. And so there is excess overhead relative to the size of the business. In other words, as you scale up, you'll get more efficiencies out of that.

I wouldn't put a figure on it right now, as I say, we try to cut to the level that we think is sustainable. But there's no doubt if rates start to go up, it's -- we would start to see nice incremental margins from there. But it is -- there is a bit of pressure on that in terms of having less than fully utilized facilities and probably carrying more on the overhead side based on a larger organization, which was what we needed before.

Operator

[Operator Instructions] And it appears that we have no additional questions at this time.

A - John Scannell

Nick, thank you very much indeed for your help. Thank you all for listening in. We hope everybody remains safe. I hope like us, everybody is starting to think about how do we start to get back to a more normal lifestyle.

And we look forward to coming back to you in 90 days' time. Thank you.

Operator

And this concludes today's call. Thank you all for your participation. You may now disconnect.