First Quarter Conference Call, Fiscal Year 2014
January 24, 2014
Before we begin, we call your attention to the fact that we may make forward-looking statements during the course of this conference call. These forward-looking statements are not guarantees of our future performance and are subject to risks, uncertainties and other factors that could cause actual performance to differ materially from such statements. A description of these risks, uncertainties and other factors is contained in our news release of January 24, 2014, our most recent Form 8K filed on January 24, 2014 and in certain of our other public filings with the SEC.
We've provided some financial schedules to help our listeners better follow along with the prepared comments. For those of you who do not already have the document, a copy of today's financial presentation is available on our investor relations home page and webcast page at www.moog.com
Good morning. Thanks for joining us. This morning we’ll report on the first quarter of fiscal ‘14 and update our guidance for the full year. Our first quarter was a slow start to the year and we had a couple of unusual items which depressed our bottom line earnings number. Let me start with the headlines for the quarter, update our thinking for the year, and then dive into the numbers.
Our operations delivered 88 cents per share in the first quarter. This was close to the middle of our guidance range. Sales were a little soft and R&D was relatively high. In the quarter we redeemed our 7¼% high yield bonds and incurred an associated cost of 12 cents per share. This cost will come back to us over the next 3 quarters in the form of lower interest payments. In our industrial segment, we wrote down a technology investment in an external company which resulted in a 6 cents per share non-cash charge. Taken all together, the EPS in the quarter was $.70 per share. Free cash flow in the quarter was very strong, at $48 million.
Looking to the full year, we are moderating our forecast based on our experience in the first quarter. There are 3 major adjustments.
First, we are increasing our forecast for R&D investment in our Aircraft Group by $10 million. This increased number is based on the expanded workload to get our equipment on the A350 qualified in a hurry, as well as an accelerated development schedule on the E-jets for Embraer.
Second, over the last 90 days we have refined our cost estimate for our SAP business system implementation. When we announced this initiative 90 days ago, we had a preliminary cost estimate for fiscal 14 based on a first cut project plan. We now have a detailed breakdown of the expense in fiscal ’14 and we believe it will be about $7 million higher than our first estimate. Our original plan anticipated that more of the costs would be capitalized this year.
Finally, we are seeing some sales softness in 3 of our markets - defense, space and industrial. As a result, we are reducing our sales forecast for the full year by $45 million. We are very focused on minimizing the impact of this sales reduction on the bottom line through a series of cost reduction activities. As a result, the $45 million sales reduction will only reduce our margins by about $7 million.
Taken all together we are now forecasting earnings per share of $3.65 for fiscal ’14. We are disappointed to report a change in our earnings outlook for the year. However, we believe the additional investments in Aircraft R&D and in SAP will provide benefits for our investors in years to come. In the short term, while sales and earnings are a little softer, we continue to generate strong cash flow. We find ourselves in a slow growth, slow acquisition environment. In the present environment we believe returning excess cash to our shareholders will create the most value in the short term. Therefore, we are announcing today a 4 million share buyback program which we plan to execute over the coming 12 months, or so.
Now let me move to the details starting with the first quarter results.
Sales in the quarter of $643 million were up 4% from last year. Sales were up in our Aircraft, Space and Defense and Components segments, but were slightly lower in our Industrial Systems and Medical Devices segments. Taking a look at the P&L, our gross margin is in line with last year. R&D is up, driven by our Aircraft segment, but total operating expenses are lower as we benefit from the restructuring activities in fiscal ’13. Other expenses are up due to the call premium on our High Yield bonds and the investment write down in our Industrial business. Lower interest expense and a slightly higher effective tax rate resulted in net earnings of $32 million and earnings per share of 70 cents. Adjusting for the impact of the bond call and the investment write down, earnings per share of 88 cents were 17% higher than last year.
We are moderating our sales forecast for the year by $45 million. There is no sales change in our Aircraft or Medical segments. Space and Defense sales will be $13 million lower as our NASA business moderates and the military vehicle business slows. Industrial Systems sales will be $10 million lower as a result of reduced flight simulation sales. Components sales will be down $22 million primarily driven by reduced military vehicle activity and a softer outlook for the industrial automation market. The lower sales outlook has a 10 cents per share negative impact on earnings. Higher R&D has a 15 cents per share negative impact and our increased investment in SAP has an additional 10 cents per share negative impact. Taken all together, we are moderating our forecast for EPS from a range of $3.90 to $4.10/share down to $3.65/share. This new EPS forecast is exclusive of any benefit from our share buyback program.
Now to the segments. I would remind our listeners that we have provided a 3-page supplemental data package, posted on our website, which provides all the detailed numbers for your models. We suggest you follow this in parallel with the text.
Sales in the quarter were up 5% from last year to $265 million. This total is in line with the quarterly run rate in fiscal ’13. The familiar pattern continues – strong organic growth on the commercial side compensating for slowing defense sales. Commercial sales were up 25% in the quarter with strength in both the OEM and aftermarket segments. Sales to Boeing and Airbus continue strong driven by the 787 ramp and the initial production units on the A350. The commercial aftermarket was also strong as a result of higher 787 initial provisioning.
In the military market sales were down 8% from last year. F-35 production was up slightly in the quarter but the development contract was down almost $6 million from last year. Helicopter sales were down as the V-22 production rate moderates. Other military OEM programs showed an uptick, driven by increased activity on the KC46 tanker program. The military aftermarket was down as fewer units were returned for repair.
Aircraft Fiscal 14
We are keeping our sales forecast for the year unchanged from 90 days ago. However, we are adjusting the mix between commercial and military to reflect the experience of the first quarter. We are moderating our military aftermarket forecast by $10 million. We have speculated in the past that the military aftermarket may be where we will notice the impact of sequestration and lower defense spending. While one quarter does not make a pattern, we think it prudent to moderate our military aftermarket forecast for the year by about 5% from our previous forecast. On a positive note, we believe the strength we saw at both Boeing and Airbus in the first quarter will continue for the rest of the fiscal year. We are therefore increasing our forecast for commercial OEM by $10 million.
Margins in the quarter were 12%, slightly below last year’s 12.3%. R&D was up 170 basis points over last year. The spend on the A350 continues to run ahead of what we have planned given the amount of work required in the final phases of qualification. The Embraer E-Jets program also started to ramp up this quarter. When we adjust for the higher R&D load, we see that the operations continue to perform well, despite the adverse shift in the mix from military sales, both OEM and aftermarket, to commercial OEM sales.
We are moderating our margin forecast for the full year to 12.1%. Higher R&D is the driver. We think our Aircraft R&D spend in total will now be $10 million higher than our forecast from 90 days ago – or about 100 basis points. We believe the slowing in the A350 expenditure will not materialize as soon as we had planned, and, in parallel, we are planning to accelerate our E-Jets activity to ensure we stay ahead of the program schedule.
Space and Defense Q1
Sales in the quarter were up 15% to $100 million. Most of the growth was the result of an acquisition completed in the last 12 months. Organic growth for the segment was 5% in the quarter.
In the Space market, sales growth of 21% can be attributed to the Broad Reach Engineering acquisition. Excluding Broad Reach, space sales were flat with fiscal ’13. We saw some shifts in the mix between various programs. Of note was increased activity on the Soft Capture System for NASA – a system for docking with the International Space Station.
At the end of fiscal ’13 we consolidated the management and reporting of our security market into our defense market. Going forward we will combine these 2 markets for outside reporting. In the quarter, sales in this combined market were up 8% from last year. We had a pickup in sales on military vehicles in Europe as well as higher sales in the Security market.
Space and Defense Fiscal 14
The first quarter was a slow start to the year in Space and Defense, and, as a result, we think it prudent to moderate our full year forecast. For the full year we are lowering our forecast by $13 million to $420 million. We think space launch sales, and in particular sales to NASA, will be lower than we had forecasted and that sales on military vehicles will also be softer than plan. On a positive note, we booked several large orders in the first quarter and our revised forecast assumes stronger sales in the second half of the year.
Space and Defense Margins
Margins in the quarter were a disappointing 7.9%. We continue to struggle with some recent space acquisitions where the results continue to fall short of expectations. This quarter, we incurred another $2 million charge on various programs where the cost estimates to complete increased again. There is a lot of time and energy going into getting this right. As I said last quarter, the difficulty with space programs is that when they run into trouble, it is not possible to cut costs to improve profitability – actually the opposite occurs – we have to invest significantly more cost to get them fixed. We have struggled on space programs before and will work our way through these difficulties, as unpleasant as they may be. Given the soft margin performance in the first quarter, combined with the reduced sales outlook, we are moderating our margin forecast for the year to 9.1%.
Industrial Systems Q1
Sales in the quarter of $144 million were 3% lower than last year. Sales were down marginally in each of our 3 major markets – energy, industrial automation and Test & Simulation. The good news is that our incoming order rate is solid and that our profitability has improved significantly from the same quarter last year.
Sales in the energy market were mixed with soft wind sales in China compensated by stronger oil and gas exploration sales. In industrial automation, sales in most markets were flat with last year but lower sales into steel mills dragged the total down by 2%. In the simulation & test market, our automotive test sales into Asia were up nicely from last year, but our flight simulation sales were down as a couple of large customers adjusted their inventory levels.
Industrial Systems Fiscal 14
We are moderating our full year forecast by $10 million to align it with the run rate of the first quarter. Relative to our forecast of 90 days ago, the reduction is all in our simulation & test market. Our customers in the flight simulation business are revising their outlook slightly and adjusting their inventory levels after very strong growth in fiscal ’13.
Industrial Systems Margins
Margins in the quarter of 8.5% include the effect of a non-cash write down on a technology investment. Exclusive of this write down, operating margins in the quarter of 11.3% were up over 500 basis points from last year, despite the slightly lower sales. The restructuring activities we conducted throughout fiscal ’13 are showing through on the bottom line.
Let me provide a little more color on the investment write down. Over the last few years, we have identified a market opportunity for very large permanent magnet motors. These are motors of 3 feet or more in diameter which are capable of replacing hydraulic systems in a range of heavy-duty automation applications. The underlying driver of this shift in industrial applications is the push to improve efficiency. We know how much fuel efficiency drives the aerospace market. Well, there is a similar trend, albeit less dramatic, in the industrial markets. Ten years ago we led this shift from hydraulic to electric in the flight simulation business. Today, we see the opportunity to do the same in a wide range of industrial applications. Large motors are the key to this opportunity. Over the last few years, we have invested internally in developing large motor technology and in parallel we have made small investments in 2 technology companies who we believed had some unique capability. Six months ago, we wrote down the investment in one such company when it was sold to a third party. This quarter we are writing down the investment in the second company which has run into cash flow problems and is ceasing operations. We are disappointed with the net result of our investments, but our association with both companies has supplemented our internal development activities, which will continue apace.
For the full year fiscal ‘14, we are forecasting margins of 11.3%, up from fiscal ’13 operating margins of 8.7%, excluding specials. Our new fiscal ’14 forecast is down from our last forecast based on the slightly lower sales as well as the $4 million investment write down this quarter. This write down is equivalent to 70 basis points of margin headwind for the full year.
Sales in the quarter of $103 million were up 3% over last year. Our Aspen industrial motors acquisition, which we completed in March 2013, contributed $9 million in sales in the quarter. Excluding acquisitions, organic sales were down 6% in the quarter. Sales in the aerospace & defense markets were about flat with last year, with vehicle sales a little softer but missile sales a little stronger.
In the non A&D markets, sales into the energy sector were down as a major customer adjusted their inventory levels and we shipped fewer FPSO products. FPSO’s are Floating Production and Storage Offloading ships used in off-shore oil production. We sell very large slip rings used on these ships with average selling prices well north of $1 million. The first quarter last year was an unusually strong quarter for FPSO shipments – we shipped 70% of the total FPSO sales for the year in that quarter. The first quarter of fiscal ’14 was actually a very strong quarter for FPSO sales – just down from the boom quarter last year. In our other non-A&D markets, medical and industrial, the additional sales from the Aspen acquisition contributed over 100% of the growth, with the underlying markets showing some softness.
Components Fiscal 14
The first quarter was a slow start to the year for our Components Group. The military vehicles market continues to weaken and our industrial markets are showing little sign of improvement. We are therefore reducing our sales forecast for the year by $22 million. This new forecast still assumes a modest pickup in the second half of the year, based on slightly higher foreign military sales, completion of some large projects in our Energy sector and a small improvement in the industrial markets.
Margins in the first quarter were 15.8%, in line with the long-term average for this business. For the year, we are moderating our margin forecast from 15.0% down to 14.7% based on the higher SAP Business System project costs.
This was a very strong margin quarter for our Medical segment. Sales in the quarter of $32 million were 9% lower than last year. The difference is due to the sale of the Ethox Buffalo facility which we completed in June last year. Organic sales were about flat with last year. There was a slight shift in the mix with higher pump sales and lower set sales. Higher pump sales is a positive sign as set sales are determined in the long term by the population of pumps placed in the field.
Medical Fiscal 14
We are leaving our sales forecast unchanged from 90 days ago at $137 million, but shifting the mix slightly to reflect the results of the first quarter.
Margins in the quarter were very healthy at 11.4%. This is the first time we have hit double digit margins in this business in many years. The improvement is a result of improving mix and the continued focus on cost containment. For the year we are keeping our margin forecast unchanged at 7.1%. Given the strong showing in the first quarter, this may be conservative.
Before I leave the Medical segment, let me give you a brief update on our strategic review process. Unfortunately, at this moment, there is not a lot I can report, apart from reassuring our listeners that we are spending considerable effort on this review. Our Medical segment grew out of our acquisition campaign between 2006 and 2009. In that period, we acquired 5 small medical companies and gradually merged them together into our present segment. Given this history, we have a broad range of products and technologies which are used in diverse markets. This diversity has made our review process relatively complex and time consuming. The process continues and we would hope to provide our investors with a more specific update in the next quarter.
We are off to a slow start in fiscal ’14. In our first quarter, we have seen our defense markets weaken and the outlook in our industrial markets has not improved as we had hoped. Commercial aircraft remains a bright spot, and our medical business is doing well, but they don’t make up for the softness in the other 2 markets. Therefore, we have moderated our sales forecast for the year by $45 million. We are now forecasting total fiscal ’14 sales of $2.63 billion, up about 1% over fiscal ’13. We are also lowering our earnings forecast for the year as a result of 3 factors. First, the lower sales will have a negative impact on our EPS forecast of 10 cents per share. Second, higher R&D in our Aircraft Group will have a negative impact on EPS of 15 cents per share. Finally, higher costs on our SAP project will have a negative impact of 10 cents per share. The total cost of our SAP project this year will be about 20 cents per share or equivalent to almost 60 basis points of margin headwind in each of our segments.
Taken all together, we are now forecasting full year EPS of $3.65/share. We believe the second quarter will be similar to the first for our operations, but will have about 10 cents of additional SAP costs. The net result should be Q2 EPS between 70 and 80 cents per share. The second half should be much stronger with average EPS of $1.10 in each of the last 2 quarters.
On a positive note, we continue to generate strong cash flow. We plan to use that cash to enhance shareholder value through a 4 million share repurchase program over the next year. This equates to almost 9% of the shares outstanding. We estimate that the net benefit from this program in fiscal ’14 will be about 5 cents per share. If this estimate materializes, the year will come in at $3.70 per share.
Before passing you over to Don, let me offer some macro thoughts on the general market situation. We are a company where long term value is created through technology and product innovations, applied to markets where performance really matters. Our focus is on long term growth, while ensuring we are using our balance sheet prudently to enhance returns to our shareholders. Today we find ourselves in a slow growth, slow acquisition period. In time, that situation will change and we are investing now to position ourselves to take advantage of that shift when it comes. Short term, we are focused on overhead reductions and improving our processes through the application of Lean techniques. In parallel, we are investing in a state of the art business system to build a platform for future growth. In addition, we continue to spend on R&D to generate growth opportunities across all our markets.
Defense and Industrial face particular market challenges at present. In defense, we are pursuing additional foreign military opportunities as well as investing in new platform technologies outside our normal field of application. An example is small platform weaponization. In Industrial, we are investing in next generation systems for our major markets, including wind energy and flight simulation, we are exploring new technologies which offer improved energy efficiency based on large permanent magnet motors, and we are creating new markets for our technologies in areas like medical simulation.
Let me finish by saying that we continue to look for acquisitions which will complement our organic growth strategy. We have struggled with some of our recent acquisitions and we have taken a step back to review our due diligence process and learn from our experiences. Going forward, we believe acquisitions will continue to be a key element of our long term growth. We will evaluate them from the strategic perspective as well as the potential alternative use of capital perspective. Our decisions will be based on the best option to enhance long-term shareholder value.
Now let me pass you to Don who will provide some color on our cash flow and balance sheet.
Thanks, John. Good morning.
We had strong free cash flow of $48 million in the first fiscal quarter of 2014. This marks the fourth sequential quarter where our cash flow conversion ratio has been in excess of 100% of net earnings. Our net debt decreased by $33 million during the quarter to $519 million. The difference between free cash flow and the change in net debt outstanding is principally explained by the costs associated with the redemption of our high-yield debt. Back in December, you’ll remember we called in our $200 million of outstanding debentures that were otherwise scheduled to come due in 2018. With that transaction, we paid a call premium to retire that high-yield debt which carried an interest coupon of 7.25%. We’re now using our available revolving credit facility where we’re paying less than 2% interest. The first quarter costs associated with the call were about $8 million pretax, or $.12 per share. These Q1 costs will be offset by lower interest costs throughout the balance of the fiscal year such that the impact of this financing activity will have a negligible impact on FY14’s full year EPS results.
The most significant positive cash flow driver on the balance sheet in Q1 was the decline in accounts receivable. This was due to the timing of collections related to last quarter’s invoicing. Inventories were relatively flat from three months ago while accounts payable came down reflecting a more normal level. Customer advances were about flat quarter over quarter at $147 million and loss reserves declined by $5 million to $39 million.
Capital expenditures were $20 million and depreciation and amortization totaled $27 million in the quarter. We’re leaving our forecasts for CapEx and depreciation and amortization for all of fiscal 2014 unchanged at $105 million and $113 million, respectively.
Cash contributions to our defined benefit pension plans totaled $12 million in our first quarter, in line with our projected contributions for all of fiscal 2014 of $52 million. The funded status of our principle domestic DB plan has improved in recent years reflecting better asset performance, an increasing discount rate used to value the obligations, and a consistent level of company-funded annual contributions. At the end of our most recent fiscal year, the obligations on that domestic DB plan were 82% funded compared to only 64% twelve months prior.
Our effective tax rate in the first quarter was 31.5%, up slightly from last year’s 30.5%.
In total, our free cash flow outlook for the year remains unchanged since our last forecast at $165 million, now reflecting a projected cash conversion ratio of just under 100%.
Our financial ratios at the end of the quarter reflect a strengthening financial picture. Net debt as a percentage of total capitalization was 24.8%, down from 30.9% in last year’s first quarter. Our leverage ratio (Net Debt divided by EBITDA) is 1.47x. During calendar year 2013, we called in a total of $400 million of expensive high-yield debt ($200 million at 6.25% in January 2013 and $200 million at 7.25% in December 2013) and replaced it with lower cost revolving credit. As a result, at quarter-end we had $300 million of unused borrowing capacity on our $900 million revolver that terms-out in 2018. We also have an option to increase the size of our revolver by $200 million at current market rates associated with an accordion feature. This would increase the size of the revolver to $1.1 billion if we chose to take advantage of that option.
In summary, our financial ratios are very strong and we’re generating strong free cash flow. Although M&A is slow, we’re confident that we have ready-access to capital in the event we might need it, particularly if we were to pursue a substantive strategic acquisition opportunity. As John already mentioned, we’re focused on total shareholder return and the appropriate deployment of capital. Accordingly, we announced today that our Board of Directors has authorized the purchase of up to 4 million Class A or Class B common Moog shares, or about 9% of our total shares outstanding. At this time, we intend to acquire these shares on the open market over the next year or so, using the available capacity under our revolver. Again, we estimate that our fiscal 2014 EPS will benefit from the share buyback program by about $.05 per share above our updated fiscal 2014 EPS guidance of $3.65.
With that, I’d like to turn you back to John for any questions that you may have.
Please note that the Q&A is not available.