Second 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 April 27, 2018 our most recent Form 8K filed on April 27, 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 home page and webcast page at www.moog.com
Good morning. Thanks for joining us. This morning we’ll report on the second quarter of fiscal ‘18 and affirm our operational guidance for the full year. Our operations continued to perform well and at the half way mark we’re nicely on track to meet our original targets for the full year. However, it’s another complicated story this quarter with 2 specials, wind and Tax Reform. This quarter we concluded that we have to change course in the wind pitch control business and are taking a charge associated with that decision. In addition, there are some further refinements of the impact from tax reform which are flowing through our numbers this quarter. Our reported GAAP EPS of 39c/share is therefore made up of 3 elements: $1.16/share from operations, -72c/share for wind and -5c/share for Tax Reform. We’ll do our best to explain all these moving parts as we move through the text.
Before going to the headlines, I’d like to recalibrate our listeners on our guidance for fiscal ’18. Back in October, before any changes to the U.S. tax regime, we guided to $4.10/share. Ignoring the one-time impacts of tax reform, and adjusting for the reduction in the U.S. tax rate from 35% to 21%, our original $4.10/share becomes $4.40/share. This is the revised benchmark for our operations in fiscal ’18 and we’ll use it throughout our text.
Now to the headlines.
One, our underlying operations had another good quarter. Adjusting for wind and Tax Reform, our core EPS was $1.16/share, ahead of our guidance of $1.10/share from 90 days ago. On an adjusted basis, 6 months into the year we’re just about 50% of the way to our full-year forecast. Free cash flow in the quarter was more or less in line with our expectations, and included a $50 million additional payment into our US DB pension plan.
Two, we announced a quarterly dividend of $.25/share starting in June. This is the next step in our strategy of ensuring prudent management of our shareholders capital and reflects our confidence in the future of our business.
Three, we completed the acquisition of VUES on 29 March for a total consideration of $63 million. This company makes a range of large electric motors and generators that complement our existing industrial product lines. They’re based in the Czech Republic and we anticipate sales of about $40 million over the coming 12 months.
Four, after several years of investment, we’ve concluded that we no longer see a viable business model for Moog in the wind pitch control business. As a result, we incurred a charge of $31 million in the quarter, or 72c/share. Of this $31 million hit to earnings, approximately $10 million is cash. I’ll provide more detail about this decision when I talk about our industrial businesses later.
Five, we took $5c/share of additional charges this quarter in connection with the new tax legislation in the US.
Six, we have a very good news story on our U.S. DB pension plan this quarter. Over the last few years, a combination of regular contributions, prudent investment and higher interest rates means that today we find ourselves almost fully funded. Next quarter we’ll contribute $65 million and then we shouldn’t have to make any further cash contributions to this plan for the foreseeable future.
Finally, our underlying businesses continue to perform well and the macroeconomic outlook remains positive. We’re therefore comfortable affirming our full year operational guidance, exclusive of the wind and one-time Tax Reform impacts, at $4.40/share plus or minus 20 cents.
Now let me move to the details starting with the second quarter results.
Q2 Fiscal ‘18
Sales in the quarter of $689 million were 9% higher than last year. About a quarter of the increase was due to stronger foreign currencies relative to the U.S. dollar. Adjusting for both forex and the impact of acquisitions and divestitures, underlying organic growth was 6%. Sales were up in each of our three operating segments. Our wind restructuring charge of $31 million is split into $7 million of inventory write down above the gross profit line and $24 million of other charges below the gross profit line. Excluding these wind charges, our gross margin was down slightly from last year on a less favorable mix while R&D expense was down on lower spending in the Aircraft Group. SG&A expense was up on additional selling activity as well as forex effects, acquisition-related expenses and some higher medical claims. Similar to last quarter, there was considerable movement in the tax rate this quarter. Including the impact of wind and tax reform net income was $14 million and earnings per share were 39 cents.
Fiscal ’18 Outlook
Based on the stronger than expected first half sales, we’re increasing our full-year sales forecast by $70 million this quarter. We now anticipate full year sales of $2.69 billion. Excluding the impacts of the wind restructuring and tax reform, we’re keeping our projected EPS unchanged at $4.40 plus or minus 20c. Including these impacts our full year GAAP EPS will be $2.67, plus or minus 20c.
Now to the segments. I’d remind our listeners that we’ve provided a 3-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 $311 million were 8% higher than last year. On the military side, sales were up nicely on the F-35 and across our portfolio of other OEM programs, including higher funded development work on classified programs. Military aftermarket sales were slightly lower as work on standing up F-35 depots slowed.
On the commercial side, sales to both Boeing and Airbus were lower than last year. The 787 is at full rate, but the legacy book of Boeing business continues to slow, driven by lower 777 shipments. Sales on the A350 were slightly lower this quarter as some shipments pushed to the right, and sales on legacy Airbus programs were also down. The commercial aftermarket had a super quarter with sales up over $11 million from a year ago. Higher spares for both the 787 and A350 as well as gains from aggressive actions to recapture past business drove the increase.
Aircraft fiscal ‘18
Given the experience of the first half, we’re increasing our military sales forecast by $20 million. About half of this increase comes from funded development jobs and the other half from strength across various legacy platforms. On the commercial side, we’re reducing our forecast for sales to Airbus on the A350 by $10 million while increasing our forecast for the commercial aftermarket by the same amount. The net result is full year sales of $1.2 billion.
Margins in the quarter were 10.8% and for the first half were 10.9%. Our gross margin was slightly lower on a less favorable sales mix, while R&D was down by $4 million relative to a year ago. Through the first half, our R&D spend in Aircraft is $35 million against a full-year projection of $80 million. R&D spending will accelerate in the second half but we believe the full year will now come in at $75 million. This is down $11 million from fiscal ’17 as programs ramp down and engineering resources are transferred to funded military jobs. Given the projected lower R&D spend, we’re increasing our full year margin forecast to 10.7%.
Space and Defense
Space and Defense Q2
Sales in the quarter of $144 million were 3% higher than last year. Sales into the Space market were very strong this quarter, up 19% from a year ago. Allowing for the loss of sales from space operations we divested late in fiscal ‘17, organic sales into the Space market were actually up 29% relative to last year. Our underlying business is very healthy, although this quarter also had the benefit of some favorable sales timing, which will not repeat. We saw strength in both our Space Avionics business and in our launch products. Avionics sales are being driven by classified work while the launch business is benefiting from higher activity on NASA programs.
Sales into the defense market were down 5% from last year. Fiscal ’17 was a very strong year for military vehicle sales in both the U.S. and Europe and this year we’re seeing that business return to a more normal level. On a positive note, our security business was up 25% in the quarter on aftermarket activity for the DVE program.
Space and Defense fiscal ‘18
We’re increasing our full year sales forecast by $10 million to account for the strength we’re seeing on the Space side of the house. We now anticipate full year sales of $557million, up 5% from last year, a combination of 11% higher space sales and 2% higher defense sales.
Space and Defense Margins
Margins in the quarter were 11.7% bringing half year margins to 12%. For the full year, we’re increasing our margin forecast by 20 basis points to 11.7% on the strengthening outlook for our Space business.
Industrial Systems Q2
Sales in the quarter of $234 million were up 15% from last year. About half of this increase was organic and the other half was a combination of acquired sales from our Rekofa transaction and stronger foreign currencies relative to the U.S. dollar. Rekofa is the slipring company we acquired in Europe in April 2017. Underlying organic sales were up across our 4 major markets. In the Energy market, sales were up nicely in both our exploration and generation businesses. With oil prices firming, we’re starting to see our sales into the marine market recover from their nadir in 2017. Sales were also up in Industrial Automation as our customers for high-end industrial equipment continue to experience strong demand for their products. Simulation and Test sales were up on strong shipments of test equipment while sales into our medical markets were higher on growth in our medical components products.
Industrial Systems fiscal 18
We’re increasing our sales forecast for the full year by $40 million. Half of this increase is the result of currency movements and the other half is due to the additional sales from our VUES acquisition at the end of the second quarter. Full year sales are now projected to be $934 million.
Industrial Systems Margins
Margins in the quarter were negative 2.6% due to the $31 million restructuring charge we took in our wind business. Absent this charge, margins in the quarter were 10.8%, about in line with last year. Excluding the wind charge, we’re keeping our forecast for operating profit unchanged from 90 days ago at $100 million. This results in adjusted full-year margins of 10.7%.
Industrial Restructuring: Wind
Now let me provide more color on our wind business and our decision to phase out our participation in this market over the remainder of fiscal ’18. I’ll start with a little history on how we got into this market and the strategy we’ve pursued over the last 5 years. I’ll then explain what has changed in our outlook and why we’ve decided to transition out of this business. I’ll finish with an analysis of the charge we’re taking and the future implications for our P&L.
However, before I jump in, I want to clarify that we have several different products that we sell into the wind market. We sell pitch control systems to turbine OEM’s and, in addition, various electric and hydraulic components to both the turbine OEM’s and to the wind farm operators. The pitch control business is the vast majority of our sales into the wind market and is the subject of our restructuring this quarter. Our sales of other electric and hydraulic components to wind customers are nicely profitable and will continue in the future. The remainder of my analysis below is focused on the pitch control business only.
We got into the wind pitch control business with the acquisition of a German company, LTi, back in 2008. At that time, the wind business was booming in China and sales of pitch control systems were growing rapidly. In our first few years of ownership, our sales grew to over $150 million and were very nicely profitable. About two thirds of these sales were to Chinese OEMs and the other third to European customers. Around 2010, the market in China started to shift dramatically. Government subsidies had encouraged the creation of too many turbine OEM’s and excess capacity drove prices down dramatically across the supply chain. Over a period of about 3 years, our wind sales in China dropped from $90 million to $15 million and profitability evaporated. In 2013, we did a deep dive into this business and concluded that it was still an attractive business for Moog, but that our success would be based on innovative new products which would deliver a combination of significantly lower costs and increased reliability for our customers. We embarked on a strategy which I’d call “invest to grow”. Since 2013 we have been following our roadmap for new product introductions and met all our operational milestones. However, over the last 18 months, the market adoption of our new products has not been in line with our expectations. While we met our technical and cost goals, the market price pressure has intensified and our strategy of offering increased reliability in the field is not sufficiently compelling to the turbine manufacturers. At the end of fiscal ’17, we concluded that we needed to shift our strategy from growth first to profitability first. Over the last 6 months, we’ve investigated a range of strategic alternatives for the business and this quarter we concluded that the best option is to phase out our participation in this market over the next 6 months. Over that period of time we’ll continue to meet the product needs of existing customers and develop a solution for the aftermarket to ensure our customers are serviced throughout the life of the product. We’ll also work closely with our customers to ensure they can continue to exploit our technology in their products as required. We believe this is the best solution for our customers and most cost effective strategy for our shareholders.
Over the last 5 years, we had operated with an expectation of rapid sales growth once our new products came on line. Consequently, we had maintained the infrastructure necessary to meet that growth expectation and that infrastructure now drives a relatively large restructuring charge. Our $31 million charge this quarter is made up of the following major elements:
· $13 million for intangible write offs
· $9 million for working capital and fixed asset write offs, and
· $7 million for severance.
Our investment in the wind business has been a drag on our margins over the last few years. As we look out to fiscal ’19, we’ll see about $50 million in lower wind energy sales, but we’ll see a benefit coming through in our industrial systems margins of about 100 basis points.
Q2 was another solid quarter operationally. Adjusted earnings per share were at the high end of our guidance range. Our aircraft business continues to strengthen, with company funded R&D coming down and customer funded R&D going up. OEM deliveries are strong and the commercial aftermarket is providing upside surprises. Our Space and Defense business is benefiting from strong demand in the Space market and, given the outlook for increased DOD budgets, our defense business looks well positioned for long-term growth. In our industrial markets, our book to bill remains above one and the macro-economic backdrop remains encouraging, despite the recent rhetoric about trade barriers. The conservative DB pension strategy we’ve been pursuing since the financial crisis is coming to fruition and, with our final planned cash contributions in Q3, we should see a significant improvement in free cash flow in fiscal ’19 and beyond. We’ve decided to wind down our wind pitch control business and, once fiscal ’18 is behind us, should also see benefits from that decision.
Fiscal ’18 earnings per share are projected at $2.67 plus or minus 20 cents. This includes 72 cents of negative impact for the wind restructuring and $1.01 of negative impact from the one-time impacts of Tax Reform. Adjusting for these effects, our EPS forecast remains unchanged from 90 days ago at $4.40, plus or minus 20 cents. For the third 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 our cash flow and balance sheet as well as additional color on our pension funding and tax rate.
Thanks, John. Good morning.
Free Cash Flow for Q2 was a use of funds totaling $22 million. YTD, our Free Cash Flow is a source of funds of $1 million. Included in these numbers is a Q2 incremental DB pension contribution of $50 million that we described last quarter. It’s a relatively slow first half but more or less in line with what we were expecting. Net Working Capital (ex cash and debt) was 25.5% of sales at the end of Q2 compared with last year’s 24.4%. The increase is attributed to topline sales growth and timing of invoicing and collections.
We began 2018 with a Free Cash Flow forecast of $135 million or 90% conversion. That forecast is now affected by two items:
· $50 million of incremental pension contributions, net of cash tax benefits, that we described as part of our funding strategy last quarter, and
· $10 million for the cash costs associated with our wind restructuring.
Accordingly, our revised Free Cash Flow forecast for all of 2018 is $75 million, or a conversion ratio of just under 80%. Our current projections show that our third quarter’s Free Cash Flow will be soft due to the acceleration of our U.S. Defined Benefit (DB) pension contributions before filing our tax return in June, while Q4’s Free Cash Flow will be strong partly due to us having no U.S. DB pension plan contributions as well as the timing of income tax refunds.
Net debt increased $85 million compared to Free Cash Flow usage of $22 million. The $63 million difference relates to the March 29th acquisition of VUES Brno headquartered in the Czech Republic. As John has described, VUES designs and manufactures customized electric motors, generators and solutions and had 2017 sales of approximately $37 million. The acquisition of VUES:
· expands our product portfolio with capability in medium and large rotating machines and the addition of linear motor technology
· it adds customers in similar and adjacent markets such as Auto Test, Automation & Robotics, Energy
· it increases sales channel strength in the Central European market
· and finally, it adds a lower-cost manufacturing presence in Europe.
We’ve increased our Industrial segment’s sales forecast for the last half of 2018 by $20 million for this acquisition with no change to this year’s operating profit forecast reflecting near-term purchase accounting charges. Beginning in 2019, we expect operating margins for VUES to be roughly in line with the margins for the rest of our industrial businesses. We’re excited to welcome VUES into the Moog family and integrate our respective businesses to take advantage of our complementary technologies and geographies.
Our Q2 effective tax rate was 45.6% compared with the 26.5% forecast that we provided last quarter for the balance of 2018. When we remove the wind restructuring and one-time Tax Reform effects, our Q2 effective tax rate related to our core operations was 26.7%. The wind-related accruals had a tax benefit of only 18% because of our tax situation in China. And we increased our accruals for Tax Reform in Q2 by $2 million reflecting a refinement of estimated “transition taxes”. For all of 2018, we’re now forecasting our GAAP tax rate to be 47.9% with everything included. However, our 2018 adjusted effective tax rate for core operations after removing the one-time effects of wind and tax reform will be 26.7%. 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.
Capital expenditures in the quarter were $23 million while depreciation and amortization also totaled $23 million. YTD, CapEx was $44 million while D&A was $45 million. For all of 2018, our CapEx forecast remains unchanged at $95 million. We’ve got a couple of facility expansion projects this year that are driving a slight increase in CapEx relative to recent years. D&A in 2018 will be about $90 million.
Cash contributions to our global pension plans totaled $81 million in the quarter compared to last year’s second quarter of $24 million. This includes the incremental $50 million I’ve referenced which is part of our U.S. DB funding strategy for 2018. For all of 2018, we’re planning to make global retirement plan contributions totaling $182 million, unchanged from our forecast 90 days ago. We’ve described how we’re accelerating a total of $85 million of contributions this year into our U.S. DB Pension Plan, $50 million of which was done in Q2. This results in total 2018 contributions for our U.S. DB Plan of $145 million. As far as funded status, we’re in very good shape. Our U.S. DB Plan was closed to new entrants back in 2008, but continues to accrue benefits for active participants. Just 18 months ago, at the end of fiscal 2016, we were 76% funded with a funding deficit of over $200 million. Next quarter we’ll contribute an additional $65 million to this Plan and move further down our investment strategy glide path to better align the performance of the assets and liabilities. As a result, the Plan will be fully funded by the end of this year. Accordingly, after 2018 we won’t be making any cash contributions to this Plan for the foreseeable future. In summary, and with all other things equal, we expect Free Cash Flow in 2019 to be about $100 million stronger than our forecast for 2018.
Global retirement plan expense in the quarter was $15 million, similar to last year. Our global expense for retirement plans is projected to be $59 million for 2018, down from last year’s $64 million. I’d like to take a moment to clarify that we’re currently expecting our global pension expense for 2019 to increase compared to 2018 as a result of our U.S. DB Plan funding strategy. This may sound counter-intuitive since having more cash in the Plan should result in a greater return and therefore less expense. However, we’ve also previously shared that we’ve been contemporaneously pursuing a de-risking investment strategy that results in more of our total assets being invested in lower-risk investments with lower returns. This LDI, or Liability Driven Investment, strategy will end up lowering the overall return on all Plan assets and more than offset the good news of having more assets in the Plan. This de-risking strategy is the right thing to do. And importantly, our future U.S. DB plan expense will be a non-cash cost. We’ll keep you informed as do a more thorough review of 2019 in a couple of quarters.
Our leverage ratio (Net Debt divided by EBITDA) increased to 2.10x at the end of Q2 compared with 1.91x a year ago. Net debt as a percentage of total capitalization was 34.3%, down from 37.4% a year ago. At quarter-end, we had $466 million of available, unused borrowing capacity on our $1.1 billion revolver that terms out in 2021.
Last quarter I described that we had just under $400 million of cash on our balance sheet and that most of this cash was offshore. As a result of the new tax legislation, I described our plan to bring back to the U.S. as much offshore cash as possible and as soon as practicable. I’m happy to report that our cash balance is down to $256 million at the end of Q2. This decrease results from our use of off-shore cash for the acquisition of VUES while we also repatriated $91 million of this offshore cash to the U.S. during Q2 allowing us to pay down on our revolver. Our plan for the balance of calendar 2018 is to bring back an additional $160 million which will also be used to pay down outstanding debt on our revolver. This cash repatriation has no impact on our leverage as our net debt position is unchanged.
Capital deployment. We announced on March 15th that we had initiated a quarterly dividend of $.25 per share starting on June 1st to shareholders of record on May 15th for a yield of about 1.2%. It’s been decades since Moog last paid a dividend. Many factors were considered in making this commitment including the strong position we’re in with respect to the funded status of our U.S. DB pension plan. In the end, we felt that providing this consistent return of capital to our shareholders at this time was the right thing to do. In short, we’re optimistic about our future. The annual cash cost of this strategy is about $36 million. And relative to our anticipated strong Free Cash Flow, this will be very manageable. Growth and margin expansion continue to be a priority. And this includes acquisitive growth. We are very happy to have announced the VUES deal and we continue to see a lot of pipeline activity. We remain disciplined and are focused on both organic and acquisitive growth.
In summary, despite all of the noise in our YTD numbers, our core business is performing as we had forecast at the start of the year. Our Q2 restructuring decision related to wind will make us stronger as we look out into 2019 and beyond. And although our 2018 EPS is negatively impacted by Tax Reform, these tax legislation changes will also be beneficial for us over the longer-term.
With that, I’d like to turn you back to John and open it up for any questions you may have.
Note: Q&A is not available.