Second Quarter Conference Call, Fiscal Year 2015

May 1, 2015

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 May 1, 2015, our most recent Form 8K filed on May 1, 2015 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.

Press Release and Financial Statements

Introduction - John Scannell

Good morning. Thanks for joining us. This morning we’ll report on the second quarter of fiscal ‘15 and update our guidance for the full year. As usual, I’ll start with the headlines before diving into the numbers.

Headlines

First, earnings per share of $.80 cents in the quarter include a couple of one-time charges. Excluding these charges, EPS of $.96 cents in the quarter is up 17% over last year on slightly lower sales. The EPS growth is a combination of slightly higher operating profit, a more favorable tax rate and a lower share count.  

Second, we had an accounting correction in the quarter. We recorded an $8 million non-cash charge to earnings or $.13 cents per share. This correction related to an error which accumulated over the last 3 years, but was not material to the results of any prior periods. I’ll provide a little more color when I get to the Space and Defense segment in a few minutes.

Third, during the quarter we completed the sale of 2 small operations in our Medical Devices segment. These were part of the Ethox acquisition which we completed in 2009. The operations had combined sales of just over $7 million in fiscal ‘14 and were about break even. We received approximately $3 million in cash for these assets and took a non-cash charge of $1.2 million, or $.03 cents per share. The sale of these operations continues the restructuring of our Medical Devices segment.

Fourth, it was a mixed margin quarter with strong performance in both Space and Defense and Medical Devices but lower margins in Aircraft.

Fifth, it was another good quarter for free cash flow. We continued to return this free cash to our shareholders through our share buyback program.

Finally, we continue to see weaknesses in several segments as we look out over the next 2 quarters. Consequently, we’re adjusting our full year sales forecast down by $28 million. In response, we’re planning some restructuring over the balance of the year. From an EPS perspective, the combination of the Q2 write downs, the future restructuring charge and the impact of the softer business outlook results in full year earnings per share of $3.55.

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

Q2 Fiscal ‘15

Sales in the quarter of $637 million were down marginally from last year. Adjusting for the effect of the stronger U.S. dollar, sales were up slightly over 2014. Sales were up nicely in our Medical and Components segments. Sales in Aircraft were unchanged while Space and Defense sales were down marginally. Sales in our Industrial segment were sharply lower, mostly the effect of foreign currency translation.

Taking a look at the P&L, our gross margin is down about 300 basis points. About one third of this reduction is due to the accounting correction we made in the quarter. The remainder is the result of lower margins in our Aircraft segment. R&D is down due to lower aircraft activity on our new commercial programs. Our SG&A expenses are also down as a result of past restructuring and our on-going focus on expense reduction. Our effective tax rate was unusually low at 22%, a combination of some one-time benefits and the changing mix of earnings projected for the year. The overall result was net earnings of $32 million and earnings per share of $.80 cents. 

Fiscal '15 Outlook

Fiscal '15 Outlook

We’re moderating our sales forecast for the year by $28 million. $4 million of this reduction relates to medical operations we sold in the quarter. The remainder is due to a weaker sales outlook in our Space and Defense and Components segments. The result is full year sales of $2.54 billion. We’re also moderating our full-year earnings outlook. We’re reducing our full year EPS from $3.85 last quarter to $3.55. The reduction is made up of the following items:

1)    $.13 cents for the accounting correction in Q2.

2)    $.03 cents for the disposal of the medical operations, also in Q2.

3)    An $.08 cent restructuring reserve for anticipated costs in the second half.

4)    And, $.06 cents due to all other impacts including operational headwinds, offset by a more favorable tax rate and the benefit of a lower share count.

As in previous quarters, this outlook does not include the positive impact of further share repurchases over the coming 2 quarters. Should we continue our buyback program on a pace to conclude our 9 million share authorization by the end of this fiscal year, then earnings per share would be $3.60.  

Now to the segments. I would remind our listeners that we’ve provided a two-pagesupplemental 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 of $274 million were flat with last year. The mix shift continued its familiar pattern with stronger commercial sales and weaker military sales. Total commercial sales were up 5% in the quarter, driven by healthy increases on the OEM book. Sales to Boeing, Airbus and on business jets were all up nicely over last year. The commercial aftermarket was down in the quarter as the pace of initial provisioning on the 787 slowed.

 

In the military market, sales were down 5% from last year. F-35 production continued to grow and we had a pick up on our major helicopter programs. Some of our other military OEM programs were lower, however, and in particular the KC-46 Tanker development work is winding down from last year. The military aftermarket was also down in the quarter as a result of slightly lower sales across a wide range of programs.
                                 

Aircraft Fiscal ‘15

We’re leaving our full year forecast unchanged at $1.09 billion. We’re also leaving the mix unchanged, with 52% commercial and 48% military.

                                                                                

Aircraft Margins

Margins in the quarter of 8.1% were disappointing. The challenge is all in the gross margin line, as R&D was relatively low this quarter. There are 3 effects driving the lower gross margin this quarter. First, the mix was particularly adverse with lower aftermarket content on both the commercial and military sides of the house. Second, we had a quality issue with a vendor supplied part which slowed production and resulted in higher costs. This issue is now behind us. And third, we continue to experience adverse cost variances on our new commercial programs.

Margins in the second half will improve due to a more favorable mix of sales, particularly on some foreign military programs. However, given the cost challenges we’ve seen in the first half on the commercial OEM book, we’re moderating our full year margin forecast to 10%.

Space and Defense

Space and Defense Q2

Sales in the quarter of $93 million were down 2% from last year. The weakness was all on the Space side of the business. We had lower activity on various satellite programs as existing contracts wound down, compensated partially by additional work on NASA programs. In the defense market, we had higher sales on our missile, vehicle and naval programs, but lower sales in our security markets.

 

Space and Defense Fiscal ‘15

We’re reducing our full year forecast by $14 million. The change is all in the outlook for our security business. This is a business which has struggled with profitability over the last few years. As a result of a deep dive into the business this quarter, we’re refocusing the portfolio to ensure the operations are profitable going forward. The result is that we anticipate $14 million of lower sales as we stop some of our less profitable activities. Separately, we’re adjusting the mix in the remainder of the Space and Defense business to better align with the experience of the first half. We’re reducing our Space forecast by $10 million and increasing our Defense forecast, exclusive of security, by the same amount.

 

Space and Defense Margins

Margins in the quarter were 5.3%. This margin includes the effect of the accounting correction this quarter. During the quarter, we identified that some working capital balances, including inventories, receivables and payables had not been appropriately accounted for in one of our business units over a period of 3 years. The accumulated accounting correction this quarter totaled $8 million. This was a non-cash charge to earnings as we corrected the relevant working capital accounts. Exclusive of this charge, margins in the quarter were a healthy 13.7%. From an operational perspective, the restructuring activities of the past years are bearing fruit and we’re getting the program challenges on some of our smaller acquisitions behind us.

For the year, we’re adjusting our margin forecast to include the impact of the accounting correction in Q2. This will result in full year margins of 9.1%. 

Industrial Systems

Industrial Systems Q2

Sales in the quarter of $129 million were 15% lower than last year. The decline was primarily driven by the stronger U.S. dollar. In addition, we’re seeing a general weakness across many of our global industrial markets. We had lower activity in each of our major market categories – energy, industrial automation and simulation & test. In each of these markets, the change in exchange rates was the dominant factor, but we also experienced a small real sales decline in each market. On a positive note, wind energy sales into Brazil continue to grow driven by the adoption of our new AC platform.

 

Industrial Systems Fiscal ‘15

You will remember that in our first quarter call, we reduced our full year forecast by $70 million down to $530 million. This quarter we’re leaving our full-year sales forecast unchanged. We believe this forecast already captures the combined effects of currency shifts and the softening macro-economic picture.

 

Industrial Systems Margins

Margins in the quarter were 9.8%. We continue to adjust our cost structure to align with the lower sales outlook. We anticipate that second half margins will improve to an average of 11.5% to yield full year margins of 10.7%.

Components Group

Components Q2

Sales in the quarter of $109 million were 7% higher than last year. Within our A&D markets we saw some nice increases on missile programs and various military vehicle applications, a similar trend to our Space and Defense segment. In the non-A&D markets we had an increase in our energy market as we finished up a couple of large projects and completed shipments as anticipated. We also had increased sales in our general industrial markets where our acquisition of Aspen Motion Technologies in 2013 continues to perform well.

 

Components Fiscal ‘15

We’re moderating our forecast for the year by $10 million to $410 million. We’re reducing our A&D outlook by $3 million as several programs which we had anticipated booking in Q2 have moved to the right. We’re reducing our non A&D forecast by $7 million, a combination of further anticipated weakness in the energy market and slower growth in our general industrial business.

 

Components Margins

Margins in the quarter were 12.8%. These relatively soft margins are a result of higher costs on a new military development program and negative impacts from the stronger US dollar. Through the first 6 months of the year, margins are 13.7%. Looking out to the balance of the year, we anticipate margin headwinds as sales into the energy market slow down. In response, we will continue to adjust our cost structure and believe we can more or less maintain the margin performance of the first half. We’re now forecasting full year margins of 13.6%.  

Medical Devices

This was another good quarter for our Medical Devices segment. Sales were up 16%, with strong gains in both pumps and sets. We’re seeing a pickup in demand for our IV pumps as other players remove some older products from the market. In our sets business, our enteral volumes have returned to more normal levels after a year of inventory destocking by a major customer in 2014.

 

Medical Fiscal ‘15

We’re adjusting our sales forecast down by $4 million. The reduction relates to the operations we sold in the quarter.

 

Medical Margins

Operating profit in the quarter of $2.7 million includes $1.2 million of loss associated with the divestiture. Exclusive of this loss, margins in the quarter were 12.1%, another very strong performance for this segment. We’re adjusting our operating profit forecast for the year down $1 million to account for the Q2 divestiture loss. The result is full year margins of 10.4%.    

Summary Guidance

Coming into the quarter, we were forecasting earnings per share of $.90 cents, excluding any additional buyback activity. During the quarter, our buyback continued, adding $.06 cents per share to the total. So our revised expectation for the quarter was $.96 cents. We did not anticipate the impact of the accounting correction of $.13 cents. And, while we were optimistic that we would complete the sale of our 2 small medical operations in the quarter, we did not include the $.03 cent impact of that transaction in our guidance. When we add these adjustments back, our quarter came in pretty much on plan. We enjoyed an unusually low tax rate in the quarter, which compensated for softer margins in several of our segments. In particular, our aircraft business continues to be impacted by margin headwinds from a shifting mix and challenges in meeting our cost reduction goals on our new commercial OEM programs. These challenges are not going to be overcome in a quarter or two. However, as we look out a few years, the OEM programs will mature, R&D will abate and the aftermarket will grow to give us mid teen margins. On a positive note, our Medical segment continues to perform well and we’re seeing some real gains in our Space and Defense segment. In addition, it was another quarter of good cash flow and we’re maintaining our cash flow forecast for the full year despite the reduction in our projected net income.

We’re now forecasting full year sales of $2.54 billion and earnings per share of $3.55. At the half way mark, we have $1.66 in the bank. The last 2 quarters will average $.95 cents, but the exact EPS will be based on when the projected restructuring charges hit the P&L. As in previous quarters, our forecast of $3.55 per share does not include any impact from further share buyback activity through the next 6 months. Should we continue our buyback program on a pace to conclude our 9 million share authorization by the end of this fiscal year, then earnings per share would be $3.60.  

Over the last year, it might seem as if our business is going through a period of one step forward and one step back. Macroeconomic forces have combined with a shifting mix to dilute the impact of the internal improvement initiatives we’re pursuing. We’ve taken steps forward with our Medical and Space and Defense segments and are seeing some nice improvements in those businesses. In our Industrial segment, our wind energy business continues to be a drag on margins but another recent deep dive into this business has convinced us that we should stay the course for the next few years. If all goes to plan, the rewards will be worth it. Our Components segment has always been a strong performer and continues to do well. Finally, our largest segment, the Aircraft segment, is going through significant growing pains as we evolve into the number one supplier of flight controls in the world. This journey is taking longer and is more expensive than we had ever anticipated, but most of the major investment is now behind us, and in the long term, we’ll all be glad we stayed the course. Day to day, we continue to focus on operational improvements and cash flow generation through our LEAN activities, while deploying capital to maximize shareholder value.

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 came in at $35 million, bringing our six-month total to $94 million against year-to-date net earnings of $67 million, or a conversion ratio of 139%. Despite the FY15 earnings challenges that John’s described, we’re reaffirming last quarter’s forecasted free cash flow of $190 million for all of 2015 which will result in a conversion ratio of 134%.

Our net debt increased by $58 million during the quarter to $769 million. The $93 million difference between our positive free cash flow and the increase in net debt outstanding is principally the result of our share buyback program.

Working capital as a percentage of sales continued its recent downward trend. Our increasing attention to LEAN is having a positive effect on the amount of capital we have invested in the balance sheet. Over the last 2 years, our trading net working capital as a percentage of sales has steadily declined by over 400 basis points.

Our 9 million share repurchase program that we initiated in January of 2014 continued during Q2. During the three months ended March 2015, we acquired an additional 1.1 million shares for $82 million at an average price of $74 per share. At the end of March, we have 2.4 million shares remaining under our outstanding Board authorization. Our present plan is to continue buying back these shares programmatically on the open market throughout the duration of 2015.

Capital expenditures were $18 million and depreciation and amortization totaled $27 million in the quarter. Our forecast for CapEx and depreciation and amortization for all of fiscal 2015 is now $90 million and $109 million, respectively.

Cash contributions to our global defined benefit pension plans totaled $18 million in our second quarter. We’re still forecasting $61 million of global DB plan cash contributions for all of fiscal 2015.

Our effective tax rate in the second quarter was 22.5%, down from last year’s 29.6%. There are a number of items that, when added together, affect this rate considerably. First and most significantly, we are benefitting from a more favorable mix of taxable earnings due to the updated forecasts that we’ve described. We’re now forecasting less U.S. taxable income taxed at higher marginal rates. Second, we recorded an incremental R&D tax credit benefit related to FY14 based on some additional work that our tax team performed during the quarter. Lastly, we had an accrual for a tax exposure at a foreign subsidiary which expired during the quarter. For all of FY15, we’re now projecting our effective tax rate to be 29.2%, down from our last forecast of 31.4%. 

Our financial ratios at the end of the quarter reflect the continuation of our strategy to return capital to our shareholders via our share buyback program. Net debt as a percentage of total capitalization was 40%, up from 24% in last year’s second quarter. Our leverage ratio (Net Debt divided by EBITDA) was 2.28x at the end of the quarter.

At the end of March, we had $1.031 billion of total debt outstanding with about half of that either priced or hedged at fixed interest rates. Also, as of the end of March, we had over $400 million of unused capacity on our $1.1 billion revolver.

Similar to many global companies, we’ve been challenged in recent years by soft organic growth. We’re using this time to focus on operational improvements. They’re hard to see as we’re fighting against the headwinds that John’s described, but they’re real nonetheless. For example, over the past 9 months our total staffing has declined by nearly 5% while sales have been flat. Additionally, we believe we’re in the early stages of embracing the principles of LEAN throughout the Company where the mindset is “everybody improving every day”, and we know we have plenty of opportunities for further improvements.

Despite our near-term challenges, we remain focused on creating shareholder value. Our strong cash flow continues to afford us the opportunity to return capital to our shareholders through our share buyback program. Acquired growth remains an important complementary strategy for value creation along with our organic growth even though we haven’t reported an acquisition in over two years. We are working on ways to increase our deal flow while increasing the likelihood of getting the right transactions across the finish line and remaining true to a disciplined approach.

In summary, John noted that our EPS for FY15 is now $3.55 including the negative effect of $.24 cents of “specials” that we hadn’t been anticipating in our last forecast. These “specials” include the accounting correction, the loss on the disposal of the medical operations, and some additional restructuring costs in response to softer business conditions. After adding back the effect of these “specials”, our FY15 EPS would be $3.79. This would reflect an 8% increase over last year’s EPS of $3.52.

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.)

Press Release and Financial Statements