Third Quarter Conference Call, Fiscal Year 2013
July 26, 2013
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 July 26, 2013, our most recent Form 8K filed on July 26, 2013, 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 third quarter of fiscal ‘13 and update our guidance for the full year. We will also provide our first look at fiscal ’14.
This quarter has quite a few headlines.
First, our operations came in on plan at 90 cents per share – in line with our last forecast. This is exclusive of a couple of asset write-downs which I will describe later. In the quarter, our Aircraft and Components businesses were strong and we have not yet seen an appreciable impact from sequestration.
Second, our Industrial business is improving. The benefits of our restructuring efforts are starting to filter through.
Third, our Medical business had its strongest operating quarter in 5 years. We benefited from some strong sales in our enteral pump line, combined with the continued focus on cost control.
Fourth, our Space and Defense group had a very tough quarter. One of our recent acquisitions has turned up a significant technical challenge on a particular program – and we ended up taking a $5 million program charge to fix the problem.
Fifth, we had 2 write offs of note in the quarter. In our Medical segment, we took a $7 million pre-tax write down on the divestiture of the Buffalo Ethox operations and in our Industrial segment we took a $2 million write down on a technology investment that we made a couple of years ago.
Sixth, we announced a strategic review of the remainder of our Medical segment in collaboration with the Royal Bank of Canada. We think this process will take 6 – 12 months.
Finally, we are providing a first look at fiscal ’14 this morning. We think sales will be up marginally next year, but margins and earnings will be up nicely. We are projecting EPS in a range of $3.90 - $4.10 per share on sales of $2.7 billion.
Now let me provide you with some numbers, starting with the third quarter results.
Sales in the quarter of $671 million were up 10% from last year. We saw higher sales in every segment except Industrial. Acquisitions contributed the majority of the $60 million sales increase. Excluding the effect of the write-downs I mentioned earlier, adjusted net earnings of $41 million were up 7% from last year and adjusted earnings per share of 90 cents were 6% higher.
Taking a look at the P&L, our gross margin is down slightly, primarily as a result of the program charge taken in the Space and Defense segment in the quarter. R&D remains elevated as the A350 program continues to move to certification, but other G&A expenses came in lower as a percentage of sales. We incurred $5 million in restructuring expense in the quarter, mostly in our Industrial segment. Our effective tax rate was up slightly from last year. The overall result, after restructuring and the write-offs I mentioned earlier, was net earnings of $34 million and earnings per share of 75 cents. The Medical write-down was equivalent to 11 cents per share and the Industrial write-down was another 4 cents per share. Adding these back, gives us an adjusted earnings per share of 90 cents, in line with our April forecast.
Last quarter we forecast that the year would finish out with earnings per share in the range of $3.40 to $3.50 on sales of $2.6 billion. Sales for the year should be pretty much on plan, and the underlying operating performance of the businesses should end the year at the low end of this range. We also need to include the 15 cents per share of write downs in the third quarter in our projection for the full year. Taken all together, EPS for the year will be $3.25.
For next year, we are projecting a 3% increase in sales and a significant improvement in profitability, with earnings per share up 23% from fiscal ’13. This year, our Industrial business has struggled with a significant slowdown in demand and our Space business has suffered from some technical challenges at a couple of our recent acquisitions. We have spent the year repositioning our businesses and we will see the benefits in our margins in fiscal ’14. Sales next year should be up in Aircraft, Space and Defense and Components. We are assuming flat sales in Industrial, while sales in our Medical segment will be down slightly as a result of our recent sale of the Ethox Buffalo operations. Organic sales in Medical will actually be up in fiscal ’14.
Operating margins for the company in fiscal ’14 will be up to 12.4%, from 10.6% in fiscal ’13. We are projecting earnings per share in a range between $3.90 and $4.10.
Now to the segments. I would remind our listeners that we have provided a 2-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.
Q3 continued the pattern of strong organic growth and healthy margins. Total aircraft sales were up 13% in the quarter. Over the last several quarters, the commercial side of the house has been the engine of growth but in this quarter about half of the dollar increase in sales came from the military side. The F-35 drove most of this growth. In the third quarter we received a long-awaited order for LRIP 6 resulting in an unusual pop in sales. Next quarter will be a more normal revenue run rate for the F-35. We also had higher sales on the KC-46 tanker, the Korean T-50 and in the military aftermarket this quarter.
On the commercial side, sales to Boeing were up nicely as the legacy book strengthens and the 787 ramp continues. Sales to Airbus were also up on higher production rates. The commercial aftermarket was down from last year, the result of slowing initial provisioning for the 787.
Aircraft Fiscal 13
We are adjusting our full year fiscal ’13 sales forecast upwards for the strength we saw in the third quarter, while keeping the fourth quarter sales in line with our April forecast. The result is that the full year sales will be $20 million higher than our forecast of 90 days ago – $10 million in military and $10 million in commercial. We believe the strength we saw in the third quarter will not repeat in the fourth. Compared to the third quarter, sales in the fourth quarter will be lower in the military market and about the same in the commercial market.
Aircraft Fiscal 14
We are projecting a modest 2% increase in total Aircraft sales in fiscal ’14. Military sales will be down 5% on much reduced F-35 development work, lower V-22 production rates and a softer aftermarket. Our military projection includes our best guess on the effect of sequestration. On a positive note, we should continue to see strong growth in the commercial market as the 787 continues to ramp and the A350 production starts up.
Margins in the quarter were 11.4%, slightly lower than our first 2 quarters. We incurred a restructuring expense of just over $1 million in the quarter. Aircraft R&D in the quarter was up over last year but down from last quarter. The spend rate on the A350 program slowed this quarter somewhat. We believe the R&D spend has turned a corner on that program and, assuming the airplane development continues on plan, we should see a continued reduction in A350 R&D through fiscal ’14. On the other hand, our recent Embraer win on the new E-Jets program will start to ramp up through ’14. Aircraft R&D in fiscal ’14 will be about 50 bps lower as a % of sales than in fiscal ’13.
Margins for the full year fiscal ’13 should be in line with our last forecast at 12.2% after restructuring. For fiscal ’14 we are projecting margins of 13.0%. In fiscal ’14 we’ll have a less favorable product mix as the sales shift from military applications to commercial OEM sales. However, R&D will start to moderate, albeit slightly, and our continuing Lean activities should result in a nice uptick in margins over fiscal ’13.
Space and Defense Q3
Sales in the quarter were up 15% from last year to $100 million. Similar to last quarter, sales from our recent acquisitions, In-Space Propulsion and Broad Reach Engineering, drove all the growth. Factoring out the impact of these acquisitions, organic sales were down slightly from last year. In the space market, we have seen the commercial satellite and launch markets soften over the last few quarters and that trend continued this quarter. Defense was up this quarter as we benefited from some spares orders for the LAV-25 program. Security sales were flat with last year.
Space and Defense Fiscal ’13
We are moderating our sales forecast for the year by $17 million to $404 million to reflect our experience in the third quarter. We are reducing our Space and Defense forecast in response to the continued softening of the commercial satellite market. We are also moderating our security forecast slightly to the run rate of the last 2 quarters. We are keeping our defense forecast unchanged.
Space and Defense Fiscal ’14
For fiscal ’14 we are projecting a 7% increase in sales to $433 million. Space should be up about 8% as we include a full year’s sales from our Broad Reach Engineering acquisition. We are forecasting the defense business up 8% next year with growth on the THAAD program and some foreign military vehicle programs. Security should be up 3% with the additional sales coming from some recent new product introductions.
Space and Defense Margins
Margins in the quarter were a disappointing 6.7%. This quarter we learned that one of our recent space acquisitions had significantly underestimated the technical complexity of a job they took on before we acquired them. A thorough review of the program resulted in a $5 million program charge to cover the costs to complete the present contract. The problem that we’ve encountered is a very subtle manufacturing issue in a very complex satellite subsystem. At the time of the acquisition we could not have anticipated this problem. But, we are where we are and we believe we have identified all the problems at hand. We have dispatched the necessary resources from across our Space and Defense segment to address the underlying systems issues and ensure we stay on track in the future.
Given the poor performance in the third quarter, we are moderating our margin forecast for the year to 8.9% pre-restructuring. As a result of the challenges we are seeing in this segment, we are planning a restructuring charge in the fourth quarter of $1 million to better align our cost structure with the business conditions. Post-restructuring, margins in fiscal ’13 will be 8.5%. Margins in fiscal ’14 should recover to 10.0%.
Historically, space has been a great contributor for our company. However, our space business tends to be cyclical, a combination of market dynamics and the mix of development and production programs we are involved in at any particular time. Looking past the short term cycles, it is a great business for us, with high barriers to entry and limited competition for specialized components. We believe our recent moves to expand our scope of supply and broaden our geographical footprint, put us in an excellent position to continue our growth trajectory in this market and deliver double digit profitability over the long term.
Industrial Systems Q3
Sales in the quarter of $147 million were down 7% from last year but in line with the run rate of the first half. We believe sales have stabilized at a run rate of about $145 million per quarter. Compared to the same quarter last year, energy sales were off $10 million, driven by the continued slowdown in our wind energy business. Our non-wind energy sales were actually up a couple of million dollars from last year. Industrial automation sales were down from a year ago, but up marginally from last quarter. Finally, our simulation and test business was up nicely from a year ago. The macro picture remains unchanged – a very challenging wind market, a stabilizing industrial automation market and a strong simulation and test market.
Industrial Systems fiscal ’13
Our wind sales had another disappointing quarter and, as a result, we are reducing our forecast for the full year in that market by $5 million to $72 million. Despite the challenges in wind, it is our second largest single industrial market, after simulation, and an important opportunity for future growth. On a positive note, we just received an order for 300 pitch systems for Brazil over the next 3 years using our new AC technology system. This is a milestone for our wind business as it is the first significant production order for our new pitch control solution. We are keeping our industrial automation and test and simulation forecasts unchanged from 90 days ago. The result is a total forecast for fiscal ’13 of $585 million.
Industrial Systems Fiscal ’14
Going into fiscal ’14, we are assuming flat sales in each of our key markets. We believe we have found the bottom in the wind sales – time will tell. We think industrial automation is stable but with Europe in the doldrums and China slowing, there are few signs of a recovery in sight. Test and simulation was strong in fiscal ’13, and with the continued increase in new airplane deliveries, as well as healthy investment in auto test facilities, the combination of these markets should remain strong in fiscal ’14.
Industrial Systems Margins
Margins this quarter require a little extra explanation. Let me provide 2 margin numbers to help explain what is happening. First, let me discuss the underlying operating performance of the business – excluding both restructuring charges and the effect of an asset write down in the quarter. This operating margin was 9.8% in the third quarter. This compares with 6.6% in the second quarter and 6.1% in the first quarter. Sales for the first 3 quarters were about flat, so our underlying operations are starting to recover nicely as our cost reduction actions take hold.
Second, we had $3 million of restructuring expense in the quarter, and we booked a $2 million asset write down which brought our all-in margins down to 6.3%.
Let me offer some more color on the write down. A couple of years ago we took a small stake in a technology start up with a $5 million equity investment. The company had several interesting industrial technologies which we wanted to incorporate into our products. Our technical cooperation with this startup worked well over the last couple of years, but unfortunately, the majority owners have decided to sell their interest at a price which reduces the value of our investment to $3 million. As a result, we took a $2 million valuation adjustment in the quarter.
Given the events in the third quarter, we are moderating our margin forecast for the year to 7.0%, down from 7.2% 90 days ago. For fiscal ’14, we are projecting a significant improvement in margins to 12.2% on sales of $585 million.
Sales in the quarter were up 25% over last year with strength in both the A&D and industrial markets. In the A&D markets, we saw some additional spares activity and some stronger foreign military sales. In the industrial markets, sales in our energy sector were up almost 70%, a combination of continued strengthening in this market and the sales from our TriTech acquisition. Medical sales were up on stronger demand for motors for sleep apnea machines from Respironics and our general industrial sales were up as a result of our Aspen acquisition. Overall a very nice quarter in our Components Group with growth in every major market.
Components Fiscal ’13
We are tweaking our sales forecast a little this quarter as we include the results of Q3. We think our military aircraft business will be a little stronger that our forecast in April, but our industrial automation business will be a little softer. The net impact is a downward sales revision of $4 million. This results in full year sales of $421 million, a 12% increase over last year.
Components Fiscal ’14
We are projecting a sales increase of 9% in fiscal ’14 to $460 million. Component sales into the aerospace and defense markets will be down slightly from fiscal ’13, but sales in energy and industrial automation should be up nicely as we enjoy the benefit of a full year of the Aspen acquisition and increased sales at TriTech.
Margins in the quarter of 16.3% were strong. The margin shift in this business quarter to quarter is primarily a function of the sales mix. Given the strong third quarter, we are increasing our margin forecast for the year to 16.5%, from 16%. Full year fiscal ’13 margins will be particularly strong given the mix of business and the benefit of an earn-out reversal in our first quarter on our Protokraft acquisition. This reversal contributed $2 million in operating profit and boosted the margins for the full year by 50 bps. For fiscal ’14, we are projecting margins of 15.0% on a slightly less favorable mix of sales.
There was a lot of news in our Medical segment this quarter. We had strong sales and double digit operating profitability. We sold our Ethox Buffalo operations on the last day of the quarter and we announced a strategic review of the full segment. Let me start this section with a discussion of the strategic initiatives and then go to the numbers.
We sold Ethox Buffalo this quarter for just over $5 million. This operation contributed sales of $12 million annually and broke even. We took a write down of $7 million pre-tax largely associated with intangible assets. We acquired the Buffalo operation in our purchase of Ethox International in 2009. At the time, the facility was primarily a contract manufacturer producing products designed by its customers. However, the folks there were also developing some proprietary products which we thought were promising. Unfortunately, those products did not pan out and Ethox Buffalo remained a contract manufacturing facility. Our broad technology base does not provide us any advantage in this market and therefore we decided to divest the operation to a buyer with more expertise in that area.
In parallel with the sale of Ethox Buffalo, we have engaged Royal Bank of Canada to help us with our strategic review of the rest of our Medical Devices Group, including the possibility of a sale. You may remember that we first got into the Medical Devices business with the acquisition of the Curlin company in 2006. In total we acquired five companies between 2006 and 2009, all focused on pump technology. At the time we entered this business, we believed that a technology company like Moog could design a better and more reliable pump than the competition. We believed our capabilities in fluid control, reliability engineering and digital control systems would give us an edge in this market. Our strategy was based on introducing new products on a regular basis and winning market share with our superior performance. It was a strategy based on innovation – something we are really good at.
In the first few years our strategy worked well. Our business grew and we were nicely profitable. Then, the regulatory environment changed. The Food and Drug Administration, which regulates medical devices, put an intense focus on pumps and changed the game for introducing new products to the market. A new pump that used to take 3-6 months to get regulatory approval was now requiring several years to get through the FDA. As a result of this shift in the FDA’s behavior the effectiveness of our innovation strategy has been greatly reduced. Therefore, we’ve decided to explore the possibility that another company, employing a different strategy, could be more successful. This process is likely to take 6-12 months. We are relatively early in that timeline, so I don’t expect there will be any more news for a quarter or two.
Now back to the quarter.
Sales in the quarter of $38 million were the highest in 2 years. Pump sales were up slightly and we had a nice pick up in sets and “other” sales. “Other” sales include both aftermarket services as well as a range of medical components. This quarter we had higher aftermarket sales as well as unusually strong sales on a particular OEM product.
Medical Fiscal ’13
We are revising our full year forecast down by $2 million. The divestiture of the Ethox Buffalo operation will result in $3 million lower sales versus our forecast from 90 days ago, but we think the remainder of the business will be about $1 million stronger. The result will be full year sales of $139 million.
Medical Fiscal ’14
Full year sales in fiscal ’14 are projected to be $137 million, down $2 million from fiscal ’13. Organic sales will be up about $7 million compensating for $9 million of reduced sales as a result of the Ethox Buffalo transaction. The organic growth will be in pumps as our sales efforts continue to gain traction. Set sales will be lower due to a shift in our contract with a large customer who is moving from a component sale to a royalty structure. This shift results in better margins but lower set sales.
Excluding the $7 million pre-tax write down on the Ethox Buffalo transaction, margins in the quarter were 10.4% - the best showing in many years. Strong sales, a favorable mix and continued cost containment all contributed to the strong performance. Including the write down, we had an operating loss of $3 million in the quarter.
Fiscal ’13 full year margins are forecast to be 6.4% excluding the write down, up from our forecast of 5.0% 90 days ago. Full year margins including the write down will be 1.5%.
For fiscal ’14, we are projecting full year margins of 7.1%.
After all the various adjustments, our fiscal ’13 sales forecast is now $8 million lower than our forecast from 90 days ago. Total sales in fiscal ’13 should be $2.58 billion, up 5% from last year. The sales growth is a story of strong commercial aircraft combined with sales from acquisitions, compensating for lower Industrial Systems sales. Our operating margin for the year will be 10.6% and earnings per share $3.25. Our EPS of $3.25 includes 15 cents per share in restructuring and 15c per share in asset write-downs. Exclusive of these charges, the underlying operations should deliver $3.55 per share.
In fiscal ’14 we are projecting a small sales increase but a significant improvement in earnings. Sales in fiscal ’14 will be $2.67 billion or 3% higher than this year. Aircraft sales will be higher on ramping commercial demand. Components and Space and Defense sales will also be higher on full year acquisition sales. Industrial and Medical will be about flat with fiscal ’13. We are projecting earnings per share in a range of $3.90 to $4.10 per share. At the mid-point of the range, net earnings will be $185 million, net margins will improve to a record 6.9% and earnings per share will be up 23% from fiscal ’13.
So, what do we see as the risks and opportunities associated with our forecast for fiscal ’14? On the risk side, I would say that sequestration remains the major concern. Our forecast for next year includes our best guess as to how sequestration will play out for us, but given the uncertainty around how the DOD will achieve the mandated savings, there remains the same uncertainty in our defense projections. On the opportunities side, our industrial businesses could see some pick-up in demand and our space businesses could perform better than planned. As always, we try to provide a forecast which balances these pluses and minuses.
Now let me pass you to Don who will provide some color on our cash flow and balance sheet.
Thank you, John. Good morning, everyone.
Free cash flow in our third quarter was strong at $52 million. Our net debt declined to $623 million.
Through the first nine months of fiscal ’13, our free cash flow was $97 million compared to YTD net earnings of $105 million. Balance sheet account movements over the last three months were relatively quiet as receivables, inventories and accounts payable netted to show a minor decline. Offsetting those positive movements was a decline in customer advances to $109 million resulting in a $14 million use of cash. Our loss reserve balances increased by $1 million to $45 million.
Capital expenditures were $18 million in the quarter compared to $27 million of depreciation and amortization. For the first nine months, CapEx was $63 million while D&A was $80 million. We’re now forecasting our CapEx to come in around $95 million for all of fiscal ’13, down $10 million from our forecast last quarter and compared with projected depreciation and amortization for all of fiscal ’13 of $108 million.
In our first nine months of fiscal ’13, our global DB plan expense was $38 million and cash contributions were $30 million. We’re estimating that our full-year 2013 global DB pension plan expense will be $50 million while our contributions will be $43 million.
All in all, we’re expecting another strong free cash flow quarter in Q4 that will result in free cash flow for all of fiscal ’13 of $140 million, up slightly from last quarter’s forecast. This will result in a cash conversion ratio above 90% in FY13.
Our initial free cash flow forecast for next year, fiscal ’14, is $165 million, or a cash conversion ratio of about 90%. We’re forecasting $105 million of capital expenditures and depreciation and amortization of $113 million. Our global DB Plan expense for fiscal ’14 will be $41 million while our contributions will be $51 million.
Turning to our finances, we had total debt outstanding at the end of the quarter of $785 million, and our cash balances were $162 million. Our total book equity was $1.4 billion. Our quarter-end net debt as a percentage of total capitalization was 30.8%, about the same as last year’s. Our leverage ratio (Net Debt divided by EBITDA) was 1.74x. The quarter-end unused available capacity on our $900 million revolving credit facility, which terms out in 2018, was $378 million.
Interest expense will be $27 million in fiscal ’13 and decline to $24 million in 2014 as we called in our 6¼% debentures back in January of this year.
Our effective tax rate in the third quarter was 28.1%, up slightly from last year’s 27.2%. For the first nine months, the effective tax rate was 28.5% compared with 29.1% last year. For all of fiscal ’13, we are forecasting our effective tax rate to be 29.8%. Looking ahead to fiscal ’14, we’re forecasting an effective tax rate of 31.7%, up from this year’s rate, largely due to fewer favorable tax adjustments including the 2013 benefit of the retroactive reinstatement of the R&D tax credit.
As John stated, we try to present a balanced outlook as we provide guidance. The biggest uncertainty for us at the present time as we head into fiscal ’14 is sequestration and we’ve tried to capture the effects of what that might mean, showing a decline in our military aircraft business of 5% despite the belief that we’re on some very good programs. We’ve almost got fiscal ’13 in the record books and we’re happy to begin focusing on 2014.
Thanks for listening. We’ll now turn to the call back over to our moderator and take any questions you may have.
(The Q and A is not available.)