First Quarter Conference Call, Fiscal Year 2018
(INTRODUCTION FOR CONFERENCE CALL)
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 26, 2018 our most recent Form 8K filed on January 26, 2018 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 webcast page at www.moog.com.
Good morning. Thanks for joining us. This morning we’ll report on the first quarter of fiscal ‘18 and affirm our operational guidance for the full year. Overall it was a good quarter and a healthy start to our new fiscal year.
Let me start with the headlines.
First, we celebrated another first flight this quarter when the V-280 Valor took off for the first time on December 18th. This helicopter is one of the 2 candidates for the army’s future vertical lift program, the replacement for the Blackhawk, and we’re delighted to be teamed with Textron on this incredible vehicle. We also received the development supplier of the year award from Embraer for our work on the E-2 flight controls program – honoring the hard work, dedication and skill of our engineering team.
Second, our underlying operations performed well this quarter. Excluding the effects of tax reform, our underlying business delivered 93c per share, above the high end of our guidance from 90 days ago. Free cash flow in the quarter of $23 million was in line with our expectations.
Third, we took some charges this quarter in connection with the new tax legislation in the U.S. Tax reform will be a longer-term benefit for Moog but was a drag on earnings this quarter.
Finally, macroeconomic forecasts for each of our major markets of commercial aerospace, defense and industrial continue to be bullish. Commercial delivery rates continue at record levels and OEM backlogs remain strong. Defense spending is poised to accelerate in the US in response to years of budget tightening and increased global security threats. In addition, GDP growth is healthy in most of our major industrial markets. Sustained periods of GDP growth eventually translate into accelerating capital investment which, in turn, trickles down to increased demand for our products. This bullish outlook for our major markets gives us confidence in our forecast for this year and optimism about our longer-term outlook.
Now let me move to the details starting with the first quarter results.
Q1 Fiscal ‘18
Sales in the quarter of $628 million were 6% higher than last year. About a quarter of the increase was due to stronger foreign currencies relative to the dollar. Sales were up in each of our three operating segments. Taking a look at the P&L, our gross margin was unchanged from last year but our R&D expense was down on lower spending in the Aircraft Group. SG&A was up as a percentage of sales as a result of the timing of various expenses and planned higher selling expense in select growth markets. There is a lot of movement in the tax rate this quarter which Don will explain in more detail later. Including the impact of tax reform net income was $1 million and earnings per share were 4 cents. Excluding the impact of tax reform, net income was $34 million and earnings per share were 93 cents, up 11% from last year.
Fiscal ’18 Outlook
We’re keeping our sales guidance for fiscal ’18 unchanged from 90 days ago. We anticipate full year sales of $2.62 billion. Excluding the impact of tax reform we’re also keeping our projected EPS unchanged at $4.10 plus or minus 20c. Adjusting for the tax impact, the new range for EPS is $3.43, plus or minus 20c.
Now to the segments. You will remember that, at the end of last fiscal year, we split our Components group into its 2 major markets and integrated them with the Space and Defense and Industrial Segments. As a result, our reporting going forward covers 3 segments. I’d also 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.
Sales in the quarter of $279 million were 4% higher than last year. On the commercial side, sales to Boeing were about flat with last year while sales to Airbus were up nicely on the continued ramp up of the A-350 program. Sales in the commercial aftermarket were up in the quarter on strong initial provisioning for the A-350.
On the military side, sales were down 3% on a slow start to the F-35 program as well as a soft aftermarket. The relatively low military aftermarket was driven by lower B-2 activity as that program winds down, and some technical challenges on the V-22, which are now behind us. We anticipate the V-22 aftermarket will recover as we move through the year.
Aircraft Fiscal ‘18
Given the experience of the first quarter, we’re tweaking the sales mix slightly. The F-35 sales will accelerate as we move through the year and start work on LRIP 11, but given the slow start in Q1 we’re moderating the full year forecast by $10 million. On the commercial side, we’re updating our production rates for both Boeing and Airbus resulting in $5 million higher sales to Boeing and $5 million lower sales to Airbus. Finally, given the strong start to the year for the commercial aftermarket, we’re increasing that forecast by $10 million for the full year. The net result is full year sales of $1.18 billion, unchanged from 90 days ago.
Margins in the quarter of 11.0% were up nicely from last year. Our gross margin was up on a more favorable sales mix and we had 170 basis points lower R&D than last year. The first quarter R&D of $18 million is below our projected run rate of $20 million per quarter this year. The lower spend was the result of material receipts for development programs pushing into Q2. We still anticipate full year R&D spend will be $80 million, as projected last quarter.
For the full year, we’re anticipating margins of 10.6%, unchanged from last quarter.
Our aircraft markets remain strong. As production rates continue to ramp on both the commercial and military sides, we remain focused on execution and margin expansion. We’re working to strengthen our supply chain and exploit lean techniques to reduce the cost of our OEM book. In parallel, our commercial R&D is coming down as we slowly wind up development programs and transfer our engineers to funded military programs. Our aftermarket is showing signs of improving with a lot of runway to go as fleets grow and our targeted initiatives to win share bear fruit.
Space and Defense
Space and Defense Q1
Sales in the quarter of $133 million were 9% higher than last year. Sales into the defense market were 11% higher on continued strength in our ground vehicles programs, both in the U.S. and Europe, as well as higher sales on the Guardian program. Sales into the Space market were up 5% on robust sales of avionics products for satellite applications.
Space and Defense Fiscal ‘18
We’re leaving our forecast for the year unchanged. We anticipate full year sales of $547 million, up 3% from last year. This sales total is a combination of approximately $200 million in the Space market and $350 million in the defense market.
Space and Defense Margins
Margins in the quarter of 12.2% are a healthy start to the year. In the first quarter last year, margins in this business included a $9 million write off associated with the divestiture of our European space facilities. Exclusive of this impact, margins this quarter are actually down about 250 basis points from a very strong performance last year. The exceptional performance last year was the result of a very unusual and favorable sales mix in quarter. For the full year, we’re keeping our margin forecast unchanged at 11.5%.
Over the last year two years, we’ve refocused our space business to concentrate on the U.S. market and we’re now seeing benefits in our win ratio for avionics on new military platforms. A major long-term focus for us in this segment is to win a significant position on the GBSD program, the modernization of the ground-based nuclear deterrent capability. We’re encouraged by the recent commentary coming out of Washington and the Department of Defense which suggests accelerating funding to this initiative and to defense programs in general. Overall, our defense business is showing encouraging signs. One example of note is, that after several years of investment, this quarter we won a first order for our remote integrated weapons platform – a product which we believe has significant potential for the future.
Industrial Systems Q1
It was a good start to the year for our industrial businesses with sales of $216 million, up 9% from last year. One third of the growth is due to stronger foreign currencies relative to the U.S. dollar. We organize our industrial sales into 4 major markets. In the Energy market, sales were up nicely on higher shipments of products for on-shore drilling applications, while sales to our wind customers were flat with last year. Sales were also up in our industrial automation market across a broad range of our traditional customers. Simulation and test sales were up double digits as we shipped several systems for auto test applications and enjoyed strong sales of simulation systems for entertainment purposes. Finally, sales into the medical market were up on higher component sales into a variety of end market applications. Sales of pumps and sets were about flat with last year.
Industrial Systems Fiscal ‘18
We’re leaving our full year sales forecast unchanged from 90 days ago at $894 million, a 6% increase from fiscal 17.
Industrial Systems Margins
Industrial margins in the quarter of 8.9% are a slow start to the year but in line with our expectations. In this quarter we had a couple of one-time charges which will not repeat in future quarters. Our margin forecast for the full year is unchanged at 11.2%.
Most of our traditional industrial markets around the globe are strengthening. Wind remains a challenge, but even our exploration business, which is tied to the price of oil, is marginally up from the low point in fiscal ’17. Our broad approach to the industrial markets is to work closely with our customers to solve their problems and create value in their applications. We’re investing to grow both our traditional hydraulics business as well as our electric drives business with new technologies and products. We believe advanced automation has a bright future in applications ranging from service robots to autonomous systems. Moog has a deep expertise in motion technology and our experience across markets from the far reaches of outer space to the depths of the ocean position us ideally to create advanced technical solutions that the average supplier of motion products is unable to match.
Q1 was a good start to the new fiscal year. Earnings per share were above the high end of our guidance and cash flow was in line with our expectations. Our aircraft business is strong and margins are on the rise. Space & Defense is also doing well after a couple of years of portfolio clean up. Our industrial businesses are off to a slow start but our book to bill is firmly above one and our backlog continues to build. The macroeconomic outlook for our major markets is bullish and we’re pleased to affirm our guidance from 90 days ago. Tax reform is a real positive for the long-term but a drag this quarter and for the year. All in all, a quiet quarter on the operational front but a quarter of good news on the macroeconomic front and great news on the tax front.
I like to finish my remarks each quarter by offering some thoughts on the upside opportunities and downside risks associated with our forecast. On the positive side, the aircraft business is doing well and we could see upside in both the commercial and military aftermarket. On the negative side, our wind business continues to be a challenge. Our new products are meeting their technical and cost goals but increased price pressures in the broader market for wind turbines continue to put stress on our business model. As always we try to provide the market with a forecast which balances these pluses and minuses. Exclusive of tax reform, adjusted full year earnings remain unchanged at $4.10, plus or minus 20c. For the second quarter, we anticipate earnings per share of $1.10, plus or minus 10 cents.
Now let me pass you to Don who will provide more details on the tax reform impact and some color on our cash flow and balance sheet.
Thanks, John. Good morning.
It’s certainly a complicated quarter with the impact of the enactment of the Tax Cuts and Jobs Act on December 22nd. I’ll do my best to reconcile reported EPS and Free Cash Flow to our adjusted results that are exclusive of tax-related effects from the tax Act. Despite the nearer-term earnings and cash impacts, the tax Act is beneficial to us over the longer-term.
At a macro level, adjusted EPS and Free Cash Flow were better than our expectations coming into the quarter. Adjusted EPS was $.93, above the high-end of our guidance range from three months ago. With only one quarter now behind us, we’re affirming the midpoint of our 2018 full year adjusted EPS guidance of $4.10. Free Cash Flow in Q1 was $23 million, slightly better than the slow start we were expecting, and we’re affirming our forecast for adjusted Free Cash Flow for all of 2018 at $135 million representing an adjusted conversion ratio of about 90%. The business is performing well.
Starting with EPS, the $.89 per share difference between our Q1 reported GAAP EPS of $.04 and our adjusted EPS of $.93 is comprised of five tax-related elements:
- First, the transition tax on our offshore cash and earnings results in a charge to our Q1 earnings of ($.85) per share. We have in excess of $350 million of offshore cash. This transition tax results from applying the Tax Act’s statutory rates of 15.5% and 8.0% on cash and non-cash assets, respectively, offset by allowable foreign tax credits.
- Second, our plan is to repatriate to the U.S. as much of our existing offshore cash as possible and our future earnings. This results in a Q1 charge for estimated withholding taxes of ($.41) per share.
- Third, we have a rather minor charge to our Q1 earnings for the revaluation of our deferred taxes of ($.03) per share. This reflects deferred tax assets and liabilities that were measured at the old tax rates and must now be revalued.
- Fourth, the reduction of the corporate tax rate to 21% from 35% per the tax Act reduces our effective tax rate for 2018 and results in a Q1 tax benefit of $.07 per share. For all 2018, our estimated adjusted effective tax rate, reflecting the lower statutory corporate tax rate, is 26.2% compared to last quarter’s forecast of 31.0%. The 26.2% reflects three quarters of the reduced statutory tax rate because our fiscal year ends in September. This lower 2018 tax rate, in isolation, increases our projected EPS for 2018 to $4.40 from our current adjusted guidance of $4.10.
- Fifth and last, we have the opportunity to manage contributions to our U.S. defined benefit pension plan in a tax efficient manner. We’re planning to accelerate contributions into the DB Plan that we were otherwise planning to make in 2019 and 2020 and receive an incremental tax benefit of $.33 per share. All of that benefit gets recorded in Q1 of 2018.
In the first quarter of 2018, our effective tax rate computes to just under 100%. Removing the effects of the new tax legislation, the adjusted effective tax rate in Q1 was 29.6%. This compares with last year’s first quarter where we had a very low tax rate of 17.6% because of divestitures. Stripping out the effect of the divestitures, the “clean” effective tax rate in Q1 of 2017 was 28.7%. Accordingly, the adjusted tax rate for this Q1 vs. a year ago is pretty consistent. For all of 2018, we’re now forecasting an adjusted effective tax rate of 26.2% inclusive of the ongoing benefits of the lower corporate statutory rate. And a very preliminary look at 2019 suggests that our effective tax rate will be in the 25.0% realm as we benefit from a full twelve months of the lower U.S. corporate tax rate.
In summary, the important takeaway is that after removing the tax-related effects of the new legislation, our adjusted EPS in Q1 was $.93 and we’re still forecasting adjusted EPS for all of 2018 of $4.10. More concisely, our operations remain on track, as John described.
Let me now turn to free cash flow which will also be affected by the tax Act. Free cash flow in our first quarter was $23 million compared to our projection for all of 2018 of $135 million. We expected a slow start to the year. However, cash flow actually came in a bit stronger than we expected due to the timing of some cash advances. For the year, we expect our adjusted free cash flow to still come in at $135 million, unchanged from our forecast from three months ago. This represents an adjusted cash conversion ratio of about 90%. Our free cash flow from operations is on track. However, as we report our future results, we’ll end up reporting free cash flow of $85 million for the year. What’s causing the $50 million difference between adjusted and unadjusted free cash flow? As I referenced earlier, we’re accelerating $85 million of cash contributions into our U.S. DB Pension Plan in 2018 (from 2019 and 2020) for which there is an offsetting cash tax savings. This accelerated pension funding strategy generates an economic savings of $12 million as we’ll receive the benefit of a tax deduction on our 2017 tax return at 35% instead of at the new lower rates.
I’m hoping that our description of the effects of the new tax legislation on EPS and free cash flow is helpful. As John noted early on, we have provided supplemental financial data on our website that may be useful in understanding this busy quarter. Allow me to move on so that we can get to your Q&A.
Net debt decreased $22 million compared to free cash flow of $23 million.
Net Working Capital (excluding cash and debt) as a percentage of sales increased to 26.7% at the end of Q1 compared with 25.4% a year ago. This increase is largely due to the timing of product shipments, mostly in our industrial group, and we’re expecting to show a year-over-year decrease in this metric as we report out at the end of this year.
Capital expenditures in the quarter were $21 million and depreciation and amortization totaled $22 million. For all of 2018, our CapEx forecast remains unchanged at $95 million. D&A in 2018 will be about $90 million.
Cash contributions to our global pension plans totaled $19 million in the quarter compared to last year’s first quarter of $17 million. For all of 2018, we’re now planning to make contributions totaling $181 million, up $85 million from our previous forecast. By accelerating these contributions into 2018 our U.S. DB Pension Plan will be close to fully funded by the end of 2018. As a result, we don’t expect to be making any significant cash contributions to this Plan over the subsequent few years. Our recent historical norm has been about $60 million of annual contributions into the U.S. DB Plan. Global retirement plan expense in the first quarter of 2018 was $15 million, similar to last year. Our global expense for retirement plans is projected to be $58 million for 2018, down from last year’s $64 million.
Our leverage ratio (Net Debt divided by EBITDA) decreased to 1.85x at the end of Q1 compared with 2.1x a year ago. Net debt as a percentage of total capitalization was 31.7%, down from 40.8% a year ago. At quarter-end, we had $516 million of available, unused borrowing capacity on our $1.1 billion revolver that terms out in 2021.
I’d like to wrap up by commenting on two more topics…. Global cash management and Capital deployment.
At the end of the quarter, we had just under $400 million of cash on our balance sheet. Most of this cash is offshore. As a result of the tax legislation, we’re planning to bring back to the U.S. as much offshore cash as possible and as soon as practicable. We are targeting to repatriate approximately $250 million by the end of 2018. And we’ll manage the rest of it timely and appropriately. Our current plan is to pay down our outstanding revolver. This will increase the unused, available capacity under our revolver but has no impact on our leverage as our net debt position is unchanged.
Lastly, Capital deployment. We’ve shared previously our target leverage is between 2.0x and 2.5x (Net debt divided by EBITDA). We’re currently below our target range and are forecasting solid cash flow from operations, excluding this year’s revised pension funding strategy. Over the last five years, we’ve had very little to report with respect to acquisitions. However, we continue to see a lot of pipeline activity. We believe that we can provide attractive returns for our shareholders by growing the business strategically. We remain disciplined and are focused on both organic and acquisitive growth. Organically, we’re increasingly optimistic that the headwinds we’ve discussed over the past number of years are shifting to tailwinds. And we’re looking forward to the time when we can report on strategic acquisitions that will complement our overall growth strategy. Growing the Company, both organically and through acquisitions, will provide optimal returns over the long-term.
With that, I’d like to turn you back to John to answer any questions you may have.