Third Quarter Conference Call, Fiscal Year 2016

July 29, 2016

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 29, 2016 our most recent Form 8K filed on July 29, 2016 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 '16 and update our guidance for the full year.  As usual, I’ll start with the headlines before diving into the business.

Headlines

  • First, it was an exciting quarter from a technical perspective with 2 major milestones for Moog hardware. On May 23rd, the new E2 jet from Embraer completed a 3 hour and 20 minute flight, ahead of schedule, with the complete fly-by-wire flight control system from Moog performing perfectly.  And on July 4th, the JUNO space probe entered orbit around Jupiter after a 5-year space flight. There is a multitude of Moog hardware on this NASA vehicle including valves, engines and various avionic components. We congratulate the teams at Embraer and NASA on these great successes and the Moog teams which helped make them happen.
  • Second, it was a good quarter financially, with earnings per share of $1.00, coming in above the high end of our guidance.
  • Third, it was another strong quarter of free cash flow.
  • Fourth, we purchased over 300,000 shares of our stock in the quarter for $17 million.
  • Finally, we’re maintaining our full-year earnings per share forecast at $3.35, and narrowing the range to plus or minus 10 cents.

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

Q3 Fiscal '16

Sales in the quarter of $613 million were down 3% from last year. The lower sales were primarily the result of softness in our Components Group. Unlike previous quarters, changes in foreign exchange rates from last year had a minimal impact on the top line this quarter.

Taking a look at the P&L, our gross margin is in line with last year.  R&D was up a couple of million dollars but SG&A was down by a comparable amount.  Last year, we incurred $7 million of restructuring expense in the third quarter which did not recur this year. Our effective tax rate was 30.9%. The overall result was net earnings of $36 million and earnings per share of $1.00, up 6% from last year. 

Fiscal '16 Outlook

We’re fine tuning our sales forecast this quarter to reflect our experience three quarters of the way through the year. We now believe full year sales will be $2.42 billion, $45 million below our projection from 90 days ago. Most of this sales reduction is a refinement of our growth projection for our commercial aircraft business based on 9 months of sales and 3 months left to go. We’re also planning for 12 cents of additional restructuring charges in our fourth quarter as we continue to adjust our businesses to market conditions. Coming off a strong third quarter, we’re maintaining our full year earnings per share forecast despite the lower sales and additional restructuring headwind. We are forecasting $3.35 per share, while narrowing the range to plus or minus a dime. This suggests a fourth quarter EPS of 79 cents – down from Q2 and Q3, so let me explain the drop. Last quarter we said the third and fourth quarters would be in the range of 85 cents to 95 cents. The third quarter was strong and came in ahead of guidance at $1.00. We believe the operations in the fourth quarter will be in line with our previous guidance and adjusting for the additional restructuring, results in a fourth quarter of 79 cents, at the midpoint of our range. 

Now to the segments. I would remind our listeners that we’ve 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. 

Aircraft

Aircraft Q3

Sales in the quarter of $274 million were up marginally from last year. It was a familiar story with commercial sales up 8% while military sales were down 5%. On the commercial side, sales to Boeing were up across the product portfolio, while sales to Airbus surged on a more than doubling of our production on the A350 program. Business jet OEM sales were off on softer demand while the commercial aftermarket was also down on lower 787 initial provisioning and weaker business jet activity. 

In the military market, F-35 production work increased but we had lower sales on the V-22 and Black Hawk programs. On a positive note, we had higher sales on some foreign airplane programs which boosted margins in the quarter.  The military aftermarket was down 4% in the quarter. There were various puts and takes in the military aftermarket, with two noteworthy changes from a year ago - a continued wind down of our work on the C-5 program, compensated by a gain in the F-35 aftermarket. 

Aircraft Fiscal '16

We’re moderating our full year sales forecast by $40 million to $1.09 billion. We’re reducing our military forecast by $10 million, primarily the result of lower F-35 and V-22 sales. We’re reducing our commercial forecast by $30 million driven by
lower 787, A350 and business jet sales. There is no fundamental change in our commercial OEM outlook – this adjustment is merely a refinement of our forecast based on 9 months experience. 

Aircraft Margins

Margins in the quarter of 11.1% were stronger than we have seen in the recent past. A particularly favorable mix of business, with relatively strong foreign military sales, drove this performance. R&D in the third quarter was down significantly from the second quarter but still slightly ahead of what we had planned. We believe this run rate will continue in the fourth quarter so we’re increasing our full year estimate for R&D by $5 million. Despite this higher R&D investment, we’re maintaining our full-year margin forecast at 8.5%, unchanged from 90 days ago. 

Our R&D investment in new programs over the last decade has been a topic we have discussed on many occasions. We have typically focused more on the numbers and less on the technical marvels our engineering teams have produced as a result of these investments. I would like to highlight 2 such marvels this quarter. First, as I mentioned in my headlines, this quarter our team celebrated the flawless performance of our fully integrated flight control system on the first flight of the Embraer E2 jet.  Second, the F-35 STOVL stole the show at the Farnborough Airshow with an amazing demonstration of flying agility. Starting back in the early 2000’s, Moog engineers developed both the flight controls for this airplane as well as the control unit for switching from horizontal flight to vertical hovering mode.  Both of these R&D investments will pay dividends for decades to come. 

Space and Defense

Space and Defense Q3

Sales in the quarter of $91 million were down 5% from last year. The weakness was predominantly on the space side of the business with lower sales across a range of avionics and component markets. In the past, we’ve described how our sales cycle in the space business is a result of the shift in programs between development and production. We also explained that we were experiencing a slowdown in sales this year as existing contracts closed out and we awaited follow on production orders.  The effect of this cycle has been that sales slowed each quarter from Q1 FY15 to Q1 FY16, but have sequentially increased in Q2 and Q3 this year and we believe will continue that pattern in Q4.

Space and Defense Fiscal '16

We’re moderating our full-year forecast by $15 million, split 40/60 between space and defense. The drop relative to our forecast from 90 days ago is across multiple product lines and is largely due to delays in anticipated bookings.   

Space and Defense Margins

Margins in the quarter of 15.1% continued the pattern of strong performance this year. These margins are up from 6.5% last year. Third quarter margins last year included $6 million of restructuring charges and absent these costs, margins in Q3 last year were 12.9%. Given the very strong performance over the first 9 months of this year, we’re increasing our full-year margin forecast to 14.0%. 

Industrial Systems

Industrial Systems Q3

Sales in the quarter of $130 million were flat with last year. The quarter was broadly similar to Q3 Fiscal '15, with wind energy a little higher on some additional sales to our European and Chinese customers, but industrial automation and simulation and test a little lower.  All in all, our industrial markets are fairly stable.

Industrial Systems Fiscal '16

The third quarter came in a little stronger than we had forecasted and as a result we’re increasing our full year sales forecast by $10 million to $505 million. The increase is split evenly between our wind business and our test business. 

Industrial Systems Margins

Margins in the quarter of 8.9% were in line with our forecast but a little softer than last year and softer than our first 2 quarters this year. Increased R&D on our next generation wind products was the primary driver for this lower margin. This quarter we made significant progress in qualifying some new technology and as a result incurred some higher external services expenses than our normal run rate. Overall, our development remains on track and our first prototypes are working at customers. We remain optimistic that Wind will be a great business for us in a few years. 

With solid performance through the first 3 quarters, we’re increasing our full-year margin forecast to 9.8%.    

Components

Components Q3

Our Components Group continues to recover from the sales nadir in Q1, although the quarterly comparisons with last year continue to remain unfavorable. Sales in the quarter of $92 million were down 18% from last year. The picture is similar to what we described in both Q1 and Q2, with reductions across every market we serve. So far this year, Q1 was the low point for sales, Q2 recovered nicely and Q3 was pretty much flat with Q2. The story remains the same as in the last 2 quarters.  Lower sales across a range of A&D programs, including spares into the aftermarket, combined with general softness at our industrial customers and the continued depression in our energy markets. On a positive note, we’ve continued to restructure the business over the last 3 quarters and despite the disappointing top line, we’re seeing margin improvement as we move through the year. 

Components Fiscal '16

We’re keeping our full year forecast unchanged from last quarter at $365 million.  This forecast assumes an uptick in sales in the fourth quarter, primarily in our A&D markets. This sales uptick is supported by backlog schedule for the fourth quarter on several aircraft, missile and defense vehicle programs. 

Components Margins

Margins in the quarter of 11.7% were down from last year on the lower sales, but up sequentially from the second quarter. For the full year we’re maintaining our margin forecast at 10%.

Medical

Medical Q3

Sales in the quarter of $26 million were in line with last year. Higher sales into the enteral market compensated for lower sales into the IV market. Comparing sales year to date with last year shows a positive trend. Last year we divested our life sciences businesses half way through the year, and adjusting for that sale, our Medical Devices Segment has delivered organic growth of 8% so far this year. We’ve seen this growth in both the Enteral and IV product lines. This performance validates the strategy we developed 2 years ago of focusing purely on the pump business. 

Medical Fiscal '16

We’re maintaining our full year forecast at $102 million. This corresponds to 7% organic growth over Fiscal '15.  

Medical Margins

Margins in the quarter of 8.4% were down from last year and from our results
in the first and second quarters. The difference is primarily due to additional investments we’re making in next generation pump products. We have a pipeline of new products in development and this quarter we incurred relatively high expenses for outside services in support of these new developments. This additional R&D equates to over 400bps of margin headwind this quarter compared to last year. For the full year, we’re maintaining our margin forecast at 11.4%. 

Before I leave our Medical segment I want to report on the results of our strategic review process. After detailed study, we’ve decided to keep this business as it fits our strategic objectives for both growth in new markets and long-term margin potential. Let me provide some more color on this decision. Our listeners may remember that we started this process back in early 2013 – a time when this business had incurred several years of poor results.  For the following 12 months we conducted an intensive campaign to sell the business. In March 2014 we thought we had agreed a sale, but at the last minute the deal fell through. At that point we decided to restructure the business and, when the business was in better shape, reconsider our strategic options once again. We cleaned up the portfolio by selling the life sciences business and transferring the handpiece and sensor product lines to our Components Group. That allowed the management team to focus exclusively on pumps. We also refocused our development strategy on our ambulatory pumps and developed a product roadmap to strengthen our position in those markets. We increased our investment in R&D while reducing our other expenses to yield significantly improved margins. The result of all this work can be seen in our Fiscal '16 performance - a business with healthy margins and enviable organic growth.

Our original premise when we got into the medical devices business a decade ago was that a company like ours, focused on a product niche, could develop a very attractive business, with strong margins and good organic growth. The medical market was growing and the device manufacturers were nicely profitable. A decade later, after many challenges, we believe we are now firmly on our way to achieving that goal. Over the last 2 years, the management team has done an outstanding job of delivering short term profitability while investing for long-term growth. We have paid our tuition to learn this business, and we have demonstrated that we can make money. It is a business with a strong future and we look forward to reporting its continued growth and success to our shareholders in the years to come.

Summary Guidance

Overall Q3 was a good quarter. Sales were a little soft, but we came in above the high end of our EPS guidance and we had another quarter of strong free cash flow. With 9 months in the bank, we’re adjusting our full-year sales forecast down by $45 million and adding about $6 million of additional restructuring charges which we anticipate taking in the fourth quarter. Despite these combined headwinds, we’re maintaining our full year earnings per share forecast at $3.35, while narrowing the range to plus or minus a dime. This total assumes a fourth quarter in the range of 74c to 84c. As usual, this forecast does not assume any impact from further share buyback activity. As we announced in our conference call last quarter, we’ll provide our first look at Fiscal '17 when we report on the results of our fourth quarter. 

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 our third quarter was $67 million bringing our YTD free cash flow to $118 million, or a cash conversion ratio of 127%.  Net debt decreased $41 million.  The $26 million difference between our free cash flow and the change in our net debt is mostly related to share repurchases. For the full year 2016, we’re moving our previous free cash flow forecast up slightly to $135 million, or a 112% conversion ratio. Due to the strong third quarter and the timing of certain receipts, we’re expecting a relatively softer fourth quarter for free cash flow.

Working capital as a percentage of sales continues to improve. Coming off of the strong third quarter, net working capital ended up at just under 29% of sales, an improvement of over 450 basis points since the end of Fiscal '13. We continue to better manage our balance sheet, including paying more attention to cash-related contract T’s and C’s at the beginning of the business cycle all the way to the end of the cycle where we’re collecting that cash. We have many LEAN projects that are having a positive impact on our cash including increased attention to inventories.  Improved quality, lead times and timely deliveries are the ultimate result and we’re seeing those benefits across all of our businesses. We’re still in the early phases of our LEAN journey, but we believe our focus on “everyone improving everyday” is having a real positive impact.

During the third quarter, we repurchased 324,000 shares under our share buyback program for $17 million. We have 3.4 million shares remaining under the outstanding Board authorization. We’ll continue to report our repurchasing activity at the end of each quarter.

Capital expenditures in the quarter were $15 million and depreciation and amortization totaled $25 million. CapEx spend for the first nine months of 2016 was $43 million compared with D&A of $75 million.  For all of 2016, we’re reducing our CapEx forecast to $70 million. Our fourth quarter will be at a higher run rate as compared to the first three quarters, largely due to the purchase of one of our offshore facilities that is currently being leased. D&A in 2016 will be about $100 million.

Cash contributions to our global retirement plans totaled $42 million in the quarter compared to last year’s $32 million. For the nine months to date, we’ve contributed cash totaling $88 million. For all of 2016, we’re planning to make contributions into our global retirement plans totaling $95 million, unchanged from our forecast three months ago.  Global retirement plan expense in the quarter was $17 million, up just slightly from a year ago. In 2016, our expense for retirement plans is projected to be $66 million compared with $61 million in 2015, up largely because of the effects of updated mortality assumptions. 

Our effective tax rate in the third quarter was 30.9% compared with last year’s 28.4%, up due to the higher taxable earnings in the U.S. For all of 2016, we’re forecasting an effective tax rate of 28.0%, up 40 basis points from our forecast 90 days ago. Our tax rate for all of last year (2015) was about the same at 28.3%.

Our leverage ratio decreased to 2.33X at the end of the quarter compared with 2.45X a year ago. Net debt as a percentage of total capitalization was 41% vs. 42% last year. 

During the quarter, our Treasury team successfully extended the term of our $1.1 billion revolving credit facility by two years. We were nicely oversubscribed reflecting the strong and valued relationships that we have with our bank group comprised of 13 banks. At quarter-end, we had $368 million of available, unused borrowing capacity on our $1.1 billion revolver that now terms out in 2021.

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

John.