Second Quarter Conference Call, Fiscal Year 2014

April 25, 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 April 25, 2014, our most recent Form 8K filed on April 25, 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

Introduction - John Scannell

Good morning. Thanks for joining us. This morning we’ll report on the second quarter of fiscal ‘14 and update our guidance for the full year. This is a good news quarter with results coming in a little ahead of what we had forecast. On this call, we’ll also provide a progress update on our strategic review of our medical devices segment. I’ll start with the headlines for the quarter, update our thinking for the year, and then dive into the numbers.

Headlines

Sales in the quarter were up 1% and our operations did well, delivering earnings per share of 82 cents, slightly above the top end of the range we had forecast 90 days ago. Given the challenging conditions in several of our markets, we consider any sales growth a real positive. In general, the macro picture remains unchanged. The commercial aircraft market is very strong, our industrial markets are essentially flat and our defense markets continue to be soft, with some bright spots outside the US. In total, our defense sales across all our segments are down 6% from the same quarter last year, with our other markets making up this shortfall.

We also had another quarter of good cash flow. During the quarter we commenced our share buyback program which Don will describe in more detail later. Based on the results in the second quarter, we are edging our sales forecast up very slightly for the year, while keeping our earnings forecast unchanged at $3.65 per share. This earnings forecast is exclusive of the impact of the share buyback which could add an additional 5 cents per share to the total.

Now let me provide an update on the strategic review of our Medical Devices Segment. You’ll remember that we entered the medical devices segment back in 2006. We chose pumps as our area of focus. We believed that our company could be successful in this market through continuous product innovation - the “better mousetrap strategy”, as we like to call it. Between 2006 and 2009 we completed five acquisitions of small medical device companies and proceeded to integrate them into a single segment. Sometime around 2010 the regulatory environment changed and the FDA started to put increased scrutiny on all medical pumps. As a result, the length of time to get a new product approved by the FDA went from months to years. With the increased time, the cost of new product development also went up significantly. In the face of this new regulatory environment, our strategy of continuous innovation became very difficult.

Last July we announced that we were partnering with RBC to conduct a strategic review of the segment, including the potential of a sale. Over the last 9 months, we have gone through an intensive process to seek a suitable buyer for the complete segment. Unfortunately, late in the quarter, an anticipated sale of the business to a prospective buyer under an exclusive arrangement fell through. This was a disappointing setback, but does not change our overall strategy for this segment. The medical pumps business is not core for Moog and we believe this business would be more successful in the long run under alternative ownership. Our strategy up to now has been to find a single buyer for the complete segment. However, the business consists of several product lines, and we have learned that different buyers have different interest levels in the various product lines. As we move forward, we will continue our process of seeking a suitable buyer for the full segment, but will also broaden our approach to consider options for each of the product lines, if appropriate. We’ll provide the market with updates as newsworthy events occur.

Now let me move to the details starting with the second quarter results.

Q2 Fiscal ‘14

Sales in the quarter of $650 million were up 1% from last year. Sales were up in our Aircraft, Industrial and Components segments, but were lower in our Space and Defense and Medical Devices segments. Taking a look at the P&L, our gross margin is down slightly from last year on a less favorable mix of sales in our Aircraft business. R&D is also down slightly but administration expenses are higher as a result of our SAP start up activities. In the quarter, our SAP investment depressed margins by about 100 basis points. Q2 was the peak spend rate for the project in this fiscal year and we are anticipating that the expenses in the third and fourth quarters will be about half the expenses in the second quarter. Interest expense was $4 million lower than last year due to the retirement of our 7.25% high yield bonds which we completed in our first quarter. Taken all together, net earnings of $38 million and earnings per share of 82 cents were both about 3% higher than last year. 

Fiscal '14 Outlook

We are increasing our sales forecast for the year slightly to $2.64 billion. We are also adjusting the mix based on the second quarter results. Relative to our forecast from 90 days ago, sales in our Industrial and Aircraft segments will be up marginally, while sales in our Medical Devices segment will be lower. These sales tweaks will not affect our earnings per share forecast, which remains unchanged at $3.65 per share.  

Now to the segments. I would remind our listeners that we have provided a two-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.

Aircraft Controls

Aircraft Q2

Sales in the quarter were up 6% from last year to $275 million. The sales story remains unchanged - strong organic growth on the commercial side compensating for slowing defense sales. Commercial sales were up 17% in the quarter, with strength in both the OEM and aftermarket segments. Sales to Boeing and Airbus continued to grow, driven by the 787 ramp and the startup of production on the A350. The commercial aftermarket also had another good quarter, helped by strong initial provisioning on the 787.

In the military market sales were down 3% from last year. F-35 production was up nicely in the quarter but the development contract continues to abate, down about $2 million from last year. Helicopter sales were down as activity slowed on the V-22, Black Hawk and several other smaller programs. The KC46 tanker program remains a bright spot but lower foreign military sales this quarter resulted in a net reduction in the other military OEM category of 4%. The military aftermarket was down in the quarter, but up from our first quarter. Last year we had some unusually strong foreign military aftermarket sales in Q2 which did not repeat this quarter. On a positive note, we are starting to see the first signs of F-35 aftermarket as the fleet hours start to accumulate.

 

Aircraft Fiscal 14

We are increasing our sales forecast for the year by $10 million. The increase is all in the commercial aftermarket. 787 initial provisioning is running well ahead of our forecast, although the rest of our commercial aftermarket is a little softer than forecast. The net result is a $10 million increase to the year’s commercial aftermarket total. There is no change to our military forecast.

Aircraft Margins

Margins in the quarter were relatively soft at 9.4%. An unfavorable mix, combined with higher operating expenses, resulted in relatively soft margins. R&D is up relative to last year driven by the Embraer program. Administration expenses are also up as a result of our SAP initiative. Despite the relatively soft second quarter, we are maintaining our margin forecast for the full year at 12.1%.

Space and Defense

Space and Defense Q2

Sales in the quarter were down 10% to $95 million. The weakness was all on the Space side of the business. We had lower sales on both satellites and launch vehicles as various production jobs wound down and the follow on jobs have not yet ramped up. On a positive note, we have had very strong bookings in our Space segment over the last couple of quarters and our backlog supports a much stronger second half of the year. Defense sales in the quarter were about even with last year. Sales on US military vehicles were lower but sales on foreign vehicle programs were higher. Taken together, vehicle sales in total were down about 10% in the quarter. Balancing this out were higher security sales which were up about 10% in the quarter.

Space and Defense Fiscal 14

We are keeping our sales forecast for the year unchanged at $420 million. This forecast assumes a stronger second half in both our space and defense markets. In Space, we should see higher sales on a variety of satellite programs, and on the Soft Capture and Space Launch Systems for NASA. On the defense side, we are anticipating a sales uptick in the second half in missiles, naval systems and various military vehicle programs.

Space and Defense Margins

Margins in the quarter were 9.4%. This compares to margins of 7.3% a year ago. We are seeing the benefit of the restructuring we completed in the fourth quarter as well as better performance in some of our recent space acquisitions. We are forecasting second half margins of 9.5%, to yield full year margins of 9.1%.

Industrial Systems

Industrial Systems Q2

Sales in the quarter of $151 million were 5% higher than last year. We are starting to see pockets of good news in some of our industrial markets, although not enough evidence just yet to turn bullish on the overall segment.

Sales into the energy market were up nicely in the quarter with wind energy sales up 17% from a year ago. The strength in wind came from some recent contract wins in Brazil for our new AC system, as well as slightly higher sales in Asia. The wind business has been a real challenge for us over the last few years, but we think we may be turning a corner for the better. Industrial automation sales were also up nicely in the quarter with increases across all our major market categories. In particular, we had a strong quarter for our Formula 1 business in Q2. This is a seasonal business, which got a boost this year as the F1 governing body changed some of the regulations which resulted in additional Moog content on each carThis F1 business will not repeat in the next few quarters. Finally, our simulation and test business was down in the quarter as several of our large simulation customers continue to adjust their inventory levels.

Industrial Systems Fiscal 14

We are inching our sales forecast for the year up by $15 million to $590 million. This forecast assumes a second half about even with the first half.

Industrial Systems Margins

Margins in the quarter were 9.9% up from 5.4% a year ago. Overall margins are benefiting from the restructuring actions we took last year. For the full year fiscal ‘14, we’re forecasting margins of 11.0%, up from fiscal ’13 operating margins of 7.1%.

Components Group

Components Q2

Sales in the quarter of $101 million were up 2% over last year. Our Aspen industrial motors acquisition, which we completed in Q2 2013, contributed an incremental $8 million in sales over the same quarter a year ago. Excluding acquisitions, organic sales were down 5% in the quarter.

 

Sales in the aerospace and defense markets were lower as a result of reduced sales on a range of aircraft and vehicle programs. The THAAD missile program was a bright spot in the portfolio, but across the rest of the programs we are seeing push outs and continued declines in production rates. Sales into the energy and medical markets were about flat with last year while sales for industrial applications were up strongly as a result of the acquired sales from Aspen Motion Technologies. Overall, the markets across our Components segment remain challenging as a result of the declining military budgets and the slow industrial recovery.  

Components Fiscal 14

We are keeping our sales forecast for the year unchanged from 90 days ago at $438 million. This forecast assumes a pickup in the second half of the year, based on higher foreign military sales, completion of some large projects in our energy sector and an improvement in the industrial markets.

Components Margins

Margins in the second quarter were unusually soft at 13.4%. Excluding the costs associated with our SAP project, margins in the quarter would have been 14.4%. Declining organic sales and an unfavorable shift in the mix away from military sales is having a negative impact on our margins. We are continually adjusting our cost structure in response to these challenges. For the year, we are maintaining our margin forecast at 14.7%.

Medical Devices

Medical Q2

Q2 was a very mixed quarter in our medical segment, with weak sales but respectable operating margins. Sales in the quarter of $27 million were $8 million lower than last year. $3 million of the difference is due to the disposal of the Buffalo Ethox facility which we completed in June 2013. Excluding the effect of the divestiture, there are two reasons for the decline in organic sales. First, similar to what we are seeing in some of our industrial markets, one of our medical device distribution partners is going through an inventory adjustment process. Second, the management team in this segment has been very busy with the strategic review process over the last few quarters, and this distraction from the day to day business has taken a temporary toll on the sales performance.

Medical Fiscal 14

Given the soft sales in the second quarter, combined with the outlook that the inventory adjustment underway at our distribution partner will take another quarter to work through, we are moderating our sales forecast for the full year by $10 million down to $127 million. The reduction is split evenly between pumps and sets.

Medical Margins

Margins in the quarter of 5% were 130 basis points higher than the same period last year, despite the significantly lower sales. Given the lower sales forecast for the year, we are moderating our full year margin forecast to 6.9%, down from 7.1% 90 days ago.  

As I said in my opening remarks, we have determined that this segment is not core to our business long term. As we move forward, we will continue our process of seeking a suitable buyer for the full segment, but will also broaden our approach to consider options for each of the product lines, if appropriate.

Summary Guidance

Our second quarter was a fairly quiet quarter. Earnings came in a little ahead of what we had forecast and we experienced a temporary setback in the strategic review process of our Medical Devices segment. Coming out of the quarter, we are increasing our full year sales forecast slightly and keeping our earnings forecast unchanged from 90 days ago. The defense markets remain challenging and we continue to look for signs of sustained improvement in our industrial markets. Commercial aircraft remains the bright spot.  

Just to remind you, our full year sales forecast is $2.64 billion, up about 1% over fiscal ’13. Earnings per share should be $3.65. We are anticipating a stronger second half with earnings per share in the third quarter of about $1.00, plus or minus a nickel, and earnings per share in the fourth quarter of about $1.13. Our earnings forecast of $3.65 per share is exclusive of the effect of our share buyback program which could add an additional 5 cents per share to the total.  

Now let me pass you to Don who will provide some color on our cash flow and balance sheet.

Cash Flow and Balance Sheet - Don Fishback

Thanks, John. Good morning.

Free cash flow in the quarter was $32 million compared with the reduction in our net debt over the last 90 days of $9 million. The difference relates to cash used to repurchase Company shares during the quarter under the buyback program we announced three months ago. On a year-to-date basis, free cash flow was $81 million reflecting a 116% cash conversion ratio (free cash flow divided by net earnings).

Our free cash flow outlook for the year remains unchanged since our last forecast at $165 million, reflecting a cash conversion ratio of just about 100%.

Our share repurchase program began late in the quarter due to the timing of events associated with our efforts to sell the Medical Devices segment that John briefly described. During March, we repurchased approximately 357,000 shares under our 4 million share buyback authorization. The impact on our weighted average shares outstanding in the quarter was negligible. We expect to complete our buyback program by the end of the calendar year.

Looking at the balance sheet, cash-free/debt-free working capital was relatively flat compared with last quarter-end on sales that were up modestly. Accounts Receivable were up $16 million due to the timing of collections on late quarter-end invoicing which we expect will improve next quarter. This was offset by increases in a number of miscellaneous accruals. Inventories were flat. Customer advances were down $9 million over the last 90 days to $137 million and loss reserves declined by $4 million to $35 million.

Capital expenditures were $15 million and depreciation and amortization totaled $28 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 $14 million in our second quarter, in line with our projected contributions for all of fiscal 2014 of $55 million.

Our effective tax rate in the second quarter was 29.6%, up from last year’s 26.9% due to higher R&D tax credits a year ago. Our forecasted effective tax rate for all of FY14 is 31.5%, unchanged from our last forecast 90 days ago.

Our financial ratios at the end of the quarter are solid. Net debt as a percentage of total capitalization was 24.3%, down from 32.8% in last year’s second quarter. Our leverage ratio (Net Debt divided by EBITDA) is 1.47x. At quarter-end we had $295 million of unused borrowing capacity on our $900 million revolver that terms-out in 2018.

In summary, as John described, we’re projecting FY14 EPS of $3.65 before consideration for the effects of our share buyback program. We’re optimistic we’ll end up reporting record sales, net earnings and earnings per share by the time this fiscal year is complete.

With that, I’d like to turn you back to John for any questions that you may have.

(Note: The Q and A id not available.)