Third Quarter Conference Call, Fiscal Year 2014
July 25, 2014
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 25, 2014, our most recent Form 8K filed on April 25, 2014 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 ‘14 and update our guidance for the full year. We’ll also provide our first look at fiscal ’15. Let’s start with the headlines.
First, Q3 was a good quarter. Sales were up modestly on growth in the commercial aircraft business. Operating margins were 11% and earnings per share of $1.08 were up 44% from last year. We also had a very strong quarter of free cash flow at $72 million.
Second, fiscal ’14 is on track to meet our earnings guidance. We’re affirming our EPS guidance of $3.65 per share excluding the effect of our share buyback program. The buyback program is running well and we’re more than half way through at the end of June. The effect of the buyback will be to add 7 cents per share to this year’s earnings. However, we anticipate the need in the fourth quarter to incur some restructuring charges to set ourselves up to meet our fiscal ’15 outlook. We estimate that this restructuring will be about 7 cents per share – cancelling out the contribution from the share buyback. The details of the restructuring are still under review so, for the moment, we have put a place holder for the restructuring reserve in our corporate costs. Turning now to free cash flow, we’re increasing our forecast for the year to reflect the strong performance we have seen in the first 9 months of the year.
Third, for fiscal ’15 we’re projecting a 1% increase in sales, a 50 bps increase in operating margins to 11.7% and a 16% increase in earnings per share to $4.25. We’re also projecting a cash conversion ratio of over 100%.
While fiscal ’15 will be another year of improving performance, the pace of operating margin expansion is slower than we’ve been anticipating. Excluding our Aircraft segment, we’re forecasting 90 basis points of margin expansion next year in the other four segments, so that’s very positive. However, we’re forecasting flat margins in our Aircraft segment. This is disappointing, but is the result of the long term approach we’re taking to our investment strategy in the commercial aircraft business. Our major programs are costing us more in the short term than we had anticipated. Long term, however, they will pay off handsomely. Let me provide a little background and some perspective on the future.
Over the last decade Moog has gone from being a second tier supplier of hydraulic components to the leading supplier of flight control systems on commercial airplanes. We have won major positions on all the significant new platforms, including the 787, A350, C919, Gulfstream business jets and most recently the Embraer E-2 program. We have consolidated the industry through our acquisition of the GE, formerly Smiths, high lift company in the UK. We have delivered on all our program commitments and have established an excellent reputation in the market. Establishing this industry leading position has required an enormous investment of resources, as well as the dedication and commitment of thousands of staff around the globe. It has been an incredible accomplishment over a 10-year period.
Today, we have an enviable position in the market, while at the same time we have an immature book of business when compared to other companies in the industry. Approximately half our OEM book of business today is on brand new programs and our aftermarket is only 20% of our sales. In addition, our R&D expense continues high as we invest in new opportunities while completing out the commitments we have already made. In our segment of the commercial aircraft market, the business is characterized by large up front investments followed by 20+ years of production and another 20+ years of aftermarket. Margins suffer in the investment years, recover slightly in the early years of production and then improve dramatically as we move through the production life cycle and the aftermarket grows with the fleet size.
Going back a couple of years to fiscal ’12, military aircraft made up 60% of our total aircraft sales. In fiscal 15, that ratio will drop below 50%, as military sales slow and commercial sales grow. This commercial growth is coming from new platforms. In addition, our R&D run rate today is $20 million to $30 million ahead of what we anticipated back in 2012. This increased spending is due to our decision to invest in the new Embraer program, as well as higher costs to complete our existing projects. The combination of slowing military sales, early production commercial work and higher R&D is putting margins under more pressure than we had expected. We’re seeing this effect come through in the second half of fiscal ’14 and, based on our latest estimates, will continue to see this pressure for a couple of years to come. As we look out to fiscal ’17 and beyond, we will see margins expand again as our commercial book of business matures and our R&D spending comes down to about 5% of sales.
Our financial goals remain unchanged. We’re looking to increase our operating margins into the mid-teens, deliver 100%+ free cash flow conversion each year, grow organically faster than our markets and allocate capital prudently to maximize long-term shareholder value. Our revised outlook for aircraft margins does not change our strategy. Rather, it means it will take us a couple of years longer to reach our margin goals than we had planned.
Now let me provide you with some numbers, starting with the third quarter results.
Sales in the quarter of $684 million were up 2% from last year. Organic growth in the commercial aircraft market of 25% and some nice increases in our Space business offset a $10 million decline in sales in the Medical Devices segment. Sales in Industrial Systems and Components were more or less flat.
Taking a look at the P&L, our gross margin is unchanged from last year. R&D is down slightly while G&A costs are up slightly as a result of our SAP start up activities. In Q3 fiscal ’13 we had several unusual items including restructuring costs and the loss on the sale of our Ethox Buffalo operations. This quarter we had no unusual items. Interest expense in the quarter was down almost $4 million and we benefited from some favorable tax specials giving us an unusually low rate of 25.6%.
Fiscal ’14 Outlook
We’re increasing our full year sales forecast by $9 million. On the positive side, commercial aircraft sales continue to exceed our expectations, while on the negative side, our Medical Device sales are coming in well short of plan. We’re moderating our forecast for operating margins by 30 basis points to 11.2% on lower aircraft margins. We’re forecasting earnings per share of $3.65, including both the effect of our share buyback and some restructuring costs we anticipate in the fourth quarter. Cash flow is strong and we’re increasing our forecast for the year by $20 million to $185 million.
Fiscal ’15 Outlook
For next year, we’re projecting sales of $2.69 billion, up 1% from fiscal ’14. We anticipate commercial aircraft will continue to grow and that we will see some recovery in our industrial markets. Defense sales will be off slightly from fiscal ’14. Operating margins in fiscal ’15 are forecasted to be 11.7%, up from 11.2% this year. We’re projecting earnings per share of $4.25. Cash flow next year is projected at $190 million or 105% of net income.
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.
Sales in the quarter were up 8% from last year to $294 million. The familiar pattern continues – strong organic growth on the commercial side compensating for slowing defense sales. Commercial sales were up 25% in the quarter with strength in both the OEM and aftermarket segments. Sales to Boeing and Airbus maintained their upward trajectory, led by the continued 787 ramp and the startup of production on the A350. The commercial aftermarket also had a strong quarter, driven by continued strong initial provisioning on the 787.
In the military market, sales were down 5% from last year. Sales on OEM platforms were down 11% with lower sales on both the V-22 and F-35 platforms. In our third quarter last year we received a long-awaited order for the F-35 LRIP 6 resulting in an unusual pop in sales. This quarter the F-35 sales were running at a more normal level. The military aftermarket was up in the quarter, ironically, the result of higher sales on both the V-22 and F-35 platforms.
Aircraft Fiscal 14
Given the strong sales in the third quarter, we’re increasing our full year fiscal ’14 sales forecast by $38 million to just over $1.1 billion. Military sales will be $13 million higher and commercial sales will be $25 million higher. On the military side, the increase is on the F-35 production contract and across a range of aftermarket programs. On the commercial side, the increase is in both the OEM and aftermarket categories, driven by the 787 program.
Aircraft Fiscal 15
We’re projecting a minimal sales change between fiscal ’14 and fiscal ’15, although the mix will continue to shift from military to commercial. Military OEM sales will be $17 million lower, the reduction split evenly between domestic and foreign military sales. The military aftermarket will be about $5 million lower. Commercial OEM sales will be $35 million higher as the A350 production ramps up. On the other hand, the commercial aftermarket is forecast to be down $17 million next year on a significant slowdown in the 787 initial provisioning – off almost $20 million from our forecasted fiscal ’14 total. In fiscal ’14 we enjoyed abnormally strong initial provisioning as various customers put large amounts of hardware on the shelf in anticipation of their future fleet sizes.
Margins in the quarter were 10.3%. This was below our forecast. Given the results of the third quarter, we’re moderating our margin forecast for the year to 11.1%, down 100 bps from our forecast 90 days ago. One third of this margin reduction is due to higher R&D costs and the other two thirds are due to higher early production costs on our commercial programs.
Given the margin challenges in fiscal ’14, we have taken a hard look at fiscal ’15 and beyond. In fiscal ’15 we’re forecasting full year margins of 11.1%, in line with fiscal ’14. On the military side, we’re seeing margin pressure on some domestic programs and lower sales on a variety of foreign military platforms. On the commercial side, the initial production ramp up on the A350 program, combined with $20 million lower 787 IP sales are further margin headwinds. Balancing these out, we will see some relief on the R&D expenditures as the A350 development slows down. As I said in my opening comments, when we look beyond fiscal ’15, we believe we will continue to see margin headwinds for another year or so before R&D starts to ease off and the new commercial production programs mature.
Space & Defense Q3
Sales in the quarter were up 2% from last year to $103 million. Strong growth in the space market compensated for lower sales in the defense market. Within our space market, we had higher sales of components on both satellites and launch vehicles. We benefited from several large production orders for fluid components for satellites, and our work on the NASA Soft Capture System was up nicely from last year. In the defense market the lower sales were in the military vehicle applications. Last year we enjoyed a very strong quarter of spares sales for the LAV-25 vehicle and this quarter those sales did not repeat.
Space & Defense Fiscal 14
We’re moderating our sales forecast for the year by $10 million down to $410 million. The change is all in the defense market where the military vehicle business continues to be softer than we were forecasting. The softness is in both the domestic and foreign military markets. We’re keeping our space forecast unchanged from 90 days ago.
Space & Defense Fiscal 15
For fiscal 15 we’re projecting a 2% increase in segment sales to $418 million. We’re forecasting a stronger defense business as the military vehicle market recovers from the low in 2014. In the U.S., our military vehicle sales have dropped from $50 million in 2012 to less than $15 million in fiscal ’14. We anticipate a modest recovery in the U.S. vehicle sales in fiscal ’15 as well as stronger foreign military vehicle sales. We should also see slightly higher sales in both naval and security applications. Space sales in fiscal ’15 will be slightly lower than 2014, a combination of lower satellite component sales, compensated partially by higher launch vehicle sales.
Space & Defense Margins
Margins in the quarter were 8.5%, up from 6.7% a year ago. Margins continue to improve as we move through fiscal ’14 and we get some of the challenges with new acquisitions from fiscal ’13 behind us. We’re maintaining our fiscal ’14 full year margin forecast at 9.1%. For fiscal ’15, we’re forecasting further margin improvement to 10.3%.
Industrial Systems Q3
Sales in the quarter of $148 million were flat with last year, but the mix was quite different. We had higher wind energy sales as our new applications in Brazil for our AC system continued to ramp up. Overall, the wind business has stabilized this year at between $18 and $19 million of sales each quarter. The non-wind energy business was off in the quarter as we shipped fewer products for steam and gas turbines. In industrial automation, we had another good quarter, with sales up 9% from last year. We continue to see modest improvement in almost every sub-market within this category. Finally, our simulation and test sales continued to be relatively weak compared to last year as our major simulation customers complete out their inventory adjustment process. We anticipate these sales will start to improve in the coming quarters.
Industrial Systems Fiscal 14
We’re keeping our forecast for the full year unchanged at $590 million. We’re changing the mix slightly however, increasing our Industrial Automation sales by $5 million while reducing our simulation sales by the same amount.
Industrial Systems Fiscal 15
Looking to fiscal ’15 we’re anticipating 3% sales growth to $608 million. Wind energy sales should be up on sales growth in South America. Industrial automation sales will be about flat with this year. Finally, we’re anticipating a recovery in our sales to the simulation market as our customers return to a more normal buying pattern after their period of inventory adjustment in fiscal ’14.
Industrial Systems Margins
Margins in the quarter were up nicely to 11.4%. We continue to see the benefits of the restructuring actions we took in fiscal ’13 as well as an improving mix in the business. We’re anticipating further margin improvement in the fourth quarter to yield full year margins of 10.5%. We believe we will see further margin improvement in fiscal ’15 to 12% on slightly higher sales.
Sales in the quarter were down 2% from last year. In the A&D arena we continue to see weakness in both the Aircraft and Space & Defense markets relative to last year. In general, the reductions were across a wide range of platforms reflecting the general slowdown in military spending. On a more positive note, over the first 3 quarters of fiscal ’14, our A&D sales have stabilized at a run rate of $45 million per quarter. In the non-A&D markets, sales into the energy sector were 12% higher than last year driven by continued strength in offshore exploration applications. In this energy sector, our Tritech acquisition, which we completed in August 2012, had a very nice quarter and is performing ahead of original expectations. Sales into the medical and general industrial markets were within a million dollars of last year.
Components Fiscal 14
We’re moderating our sales forecast a little this quarter as we include the results of Q3. We think both our A&D and non-A&D markets will be weaker than our April forecast. The net impact is a downward sales revision of $9 million. This results in full year sales of $429 million, a 3% increase over last year.
Components Fiscal 15
We’re projecting a modest sales increase of 3% in fiscal ’15 to $440 million. Component sales into the A&D markets will be up slightly from fiscal ’14 based on slightly higher sales in the space market and an improved foreign military vehicle business. Sales into industrial applications should also be slightly higher as the U.S. economy continues to improve.
Margins in the quarter were 15.3%, up nicely from Q2. The margin shift in this business quarter to quarter is primarily a function of the sales mix. Given the stronger third quarter, we’re increasing our margin forecast for the full year to 15%. For fiscal ’15, we’re projecting margins of 14.8%.
Sales in the quarter of $29 million were down $9 million from last year. About $3 million of the difference is due to the sale of the Buffalo Ethox operations at the end of the third quarter last year. The other $6 million is due to lower sales into the Enteral feeding market. In Q2 fiscal ’13 we entered into a new distribution agreement with a large distributor of enteral products in the U.S. The agreement results in lower average selling prices for Moog but also lower selling and overhead costs. Since the agreement has come into place, we have experienced some sales volatility quarter to quarter as our partner works to size their inventory correctly. Looking past this volatility, there is the opportunity for significant volume increases as we look to the future.
Medical Fiscal 14
Given the weak sales in Q3, we’re revising our full year forecast down by $10 million to $117 million. The reduction is across all our sub-segments. The intensive divestiture exercise we went through during the first 6 months of this year resulted in significant management distraction and has taken its toll on the sales outlook for the year.
Medical Fiscal 15
Full year sales in fiscal ’15 are projected to be $120 million, up slightly from fiscal ’14. We should see improving pump and set sales balanced by slightly lower component sales in our “other” category.
Margins in the quarter were 8.2%. Given the low level of sales in the quarter this margin performance is particularly encouraging. We continue to manage our costs prudently and focus our attention on positioning the business for sale. Given the strong third quarter, we’re increasing our full year margin forecast from 6.9% to 8.3%. For fiscal ’15, we’re projecting full year margins of 8.8%.
Before leaving our Medical segment, let me reiterate what I said last quarter about our strategic direction. We have determined that the medical pump business is not core long term. As we move forward, we’re continuing our process of seeking a suitable buyer for the full segment, but also broadening our process to consider options for each of the product lines, as appropriate. We will provide the market with updates as events unfold.
After all the various tweaks, our fiscal ’14 sales forecast is now $9 million higher than our forecast from 90 days ago. Total sales for fiscal ’14 should be $2.65 billion, up 2% from last year. The change in the forecast is the combination of higher Aircraft sales, balanced by lower Space & Defense, Components and Medical sales. Our operating margin for the year will be 11.2% and earnings per share $3.65. Our share buyback program will contribute an additional 7 cents per share to this total, but will be cancelled out by 7 cents per share in restructuring costs which we anticipate in the fourth quarter.
In fiscal ’15, we’re projecting a small sales increase and a double digit increase in earnings per share. Sales in fiscal ’15 will be $2.69 billion or 1% higher than this year. Aircraft sales are projected to be flat with fiscal ’14 but with a continuing shift in the mix from military to commercial. Sales in each of the other four segments will be up between 2 and 3%. We’re projecting earnings per share of $4.25. Net earnings will be $181 million, net margins will improve to 6.7% and earnings per share will be up 16% from fiscal ’14.
So, what do we see as the risks and opportunities associated with our forecast for fiscal ’15? A look at the events of fiscal ’14 is perhaps the best guide. On the risk side, slowing defense spending combined with cost challenges in the early stages of new commercial aircraft programs remain the major concerns. On the opportunities side, we’re assuming very modest growth in our industrial businesses and that our space business will be soft next year – both of these assumptions could prove to be conservative. 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.
Thanks, John. Good morning.
As John noted, free cash flow in our third quarter was $72 million. This compares with an increase in our net debt over the last 90 days of $53 million. The difference relates to $121 million of cash used to repurchase Company stock during the quarter. On a year-to-date basis, free cash flow was $152 million reflecting a 129% cash conversion ratio (free cash flow divided by net earnings).
Free cash flow has been strong this year. A number of areas, when added together, are contributing to this progress. We’re having some success with more favorable contract terms including milestone payments, improved inventory turns, and lower spending on capital expenditures. As a result, we’ve seen our working capital (excluding cash and debt) as a percentage of trailing-twelve-month sales decline about 150 bps in the last 12 months. Because of our performance to date, we’re increasing our free cash flow outlook for the full year 2014 to $185 million compared to our last forecast of $165 million, reflecting a cash conversion ratio of 110%. For 2015, our initial forecast for free cash flow is $190 million, or a cash conversion ratio of about 105%.
Our 4 million share repurchase program that we announced in January of this year continued in earnest during the third quarter. Year to date, through the end of June, we’ve repurchased approximately 2.1 million shares, representing about 4.5% of our average weighted shares outstanding, at an average per-share price of about $67. Our plan is to complete this buyback program by the end of the calendar year.
Capital expenditures in the quarter were $22 million and depreciation and amortization totaled $27 million. For the nine months ended June, CapEx was $58 million while D&A was $82 million. We’re reducing our 2014 forecast for CapEx to $90 million, which compares with projected D&A of $109 million. For 2015, we’re forecasting CapEx of $100 million and D&A of $112 million.
Cash contributions to our defined benefit pension plans totaled $18 million in
the quarter. We’ve increased our projected contributions for all of 2014 by $15 million to $70 million. We’re now planning to contribute $14 million to our German DB plan, putting some of our excess overseas cash to work. For 2015, we’re planning to increase the pace of contributions into our U.S. defined benefit plan as a result of the persistence of low discount rates. As a result, our contributions to our global DB plans will be approximately $80 million in 2015. Despite the increased contributions to our DB plans over the last few years, we’ve been able to show strong, improving free cash flow results. Global pension expense for our DB plans in 2015 is projected to be $46 million compared with $36 million in 2014. This $10 million increase is equivalent to a $.15 per share drag on 2015 EPS compared to 2014.
Our effective tax rate in the third quarter was a very favorable 25.6%, compared with last year’s 28.1%. The low rate in the quarter resulted from a tax-deductible loss associated with the sale of the Ethox Medical operations in June 2013. As a result, we’ve lowered our projected effective tax rate for all of 2014 to 29.6%. For 2015, we’re forecasting an effective tax rate of 31.0%.
Our financial ratios at the end of the quarter are solid, even after considering the effects of the stock repurchase program. Net debt as a percentage of total capitalization was 26.9%, down from 30.8% in last year’s third quarter. Our leverage ratio (Net Debt divided by EBITDA) is 1.60x.
During our third quarter, we announced that we amended and extended our revolving credit facility. We increased the total bank commitment by $200 million to $1.1 billion with our existing 13 banks, and we’ve refreshed the 5 year term to mature in May 2019. We also have an accordion option for an additional $200 million. All other terms of the credit agreement are materially the same. At quarter-end, we had $416 million of unused borrowing capacity on this revolver.
In summary, as John described, we’re projecting 2014 EPS of $3.65 including the effects of our share buyback program, and we’re forecasting 2015 EPS to increase 16% to $4.25 on 1% sales growth.
With that, I’d like to turn you back to John for any questions that you may have.
(Note: The Q and A is not available.)