(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 July 29, 2022, our most recent Form 8K filed on July 29, 2022, 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 third quarter of fiscal ‘22 and update our guidance for the remainder of the year.
As usual, I’ll start with the financial highlights. Overall it was another good quarter for the company with adjusted earnings per share of $1.61, up 44% from last year. This quarter we benefitted from some tax specials which added about 15 cents to our EPS. Adjusting for this effect, our underlying operations delivered $1.46 per share, in line with our guidance from 90 days ago and up 30% from last year. The macro-economic headwinds of supply chain, inflation, interest rates and Covid persisted this quarter, but our teams continued to manage well and meet our commitments. Adjusted free cash flow in the quarter was soft, but not surprising, as we continue to focus on meeting our customer commitments over optimizing inventory levels. Finally, with one quarter left to go, we’re increasing our full year EPS guidance by 15 cents to $5.65, plus or minus 15 cents.
Now let me move to the headlines.
1. First, the macro-economic influences affecting our business have not changed from last quarter but they have become more acute. The war in Ukraine is still raging and there is no clear end in sight. Gas supply has become a strategic weapon in the conflict threatening an energy crisis in Europe over the coming winter. Multi-decade high inflation is driving higher interest rates, with more rate hikes expected before inflation is back to acceptable levels. Supply chain bottlenecks are plaguing almost every industry and COVID spikes continue to drag on productivity. Finally, all of these challenges look set to continue well into 2023.
2. Second, despite these challenges, our business is doing well and we’re optimistic about the future. Our diversity across end markets, long-term customer relationships, deep technical expertise, and conservative balance sheet have served us well through COVID. These same fundamentals will continue to serve us as we navigate an ever evolving geo-political and economic environment. We have multi-year tailwinds in our Defense, Space and Commercial aircraft markets. Our medical market is robust and our concerns about future industrial softness is balanced by our record backlog giving us time to react to any downturn in the business.
3. Finally, we’re pleased with the results of our third quarter. Our underlying operations are right on plan and the fourth quarter is looking solid.
Now let me move to the details starting with the third quarter results.
Q3 Fiscal ‘22
Sales in the quarter of $773 million were 9% higher than last year. Adjusting for the impact of the stronger dollar, organic sales were up over 11%. We saw organic gains in each of our operating groups. Taking a look at the P&L, our gross margin was up on the higher sales and improving mix, particularly in the Aircraft Group. R&D was down as engineers spent more time on funded development work. SG&A expenses were up on higher travel and marketing activities as we emerge from the COVID era. Interest expense was up on higher rates. The effective tax rate in the quarter was low at 15.7%, primarily the result of prior-year R&D tax credits. The result was GAAP net income of $50 million, up 40%, and GAAP earnings per share of $1.57, up 41% over the same quarter last year.
During the quarter, we incurred about 3 cents of restructuring and impairment charges giving an adjusted EPS of $1.61, after rounding. This compares with adjusted EPS last year of $1.12 – a 44% increase. The lower tax rate this quarter resulted in a 15 cent gain relative to our forecast from 90 days ago. Adjusting for this lower rate, the underlying operations delivered $1.46, in line with our forecast last quarter.
Fiscal ’22 Outlook
Our full year sales forecast is unchanged from 90 days ago at just over $3 billion, up 6% from last year. We’re also keeping our underlying operational forecast unchanged from last quarter. We’re adding the 15 cent tax benefit this quarter to our total EPS, resulting in full year adjusted EPS of $5.65, plus or minus 15 cents. This results in a fourth quarter of $1.45 in line with the operational performance in the third quarter.
Now to the segments. I’d remind our listeners that we’ve provided a supplemental data package, posted on our webcast site, which provides all the detailed numbers for your models. We suggest you follow this in parallel with the text.
Last week our team attended the Farnborough Airshow in the UK. It was the first major airshow since 2019 and most of the industry turned up, despite the record temperatures in London. The major themes from the show mirror the dynamics we’re seeing in our Aircraft business – including commercial recovery and a positive defense outlook balanced by supply chain challenges and inflation pressures.
It’s clear that commercial air travel is back. Demand is no longer an issue for the airlines, and their growth is limited by staffing shortages on both the ground and in the air. Demand and supply for narrow body airplanes is robust and Boeing is gradually getting the MAX deliveries flowing. The wide body recovery is slower, as expected, but Boeing is signaling that they are close to resuming 787 deliveries to customers. For Moog, the recovery in air traffic is playing through in our commercial aftermarket and we look forward to next year when we should start to see wide body rates increase.
The sentiment on defense is clearly positive, but the impact of world events has yet to translate into significant new contracts. For our military aircraft business, we’re not yet seeing any material impact. The next big opportunity for this business is the award of the FLRAA program which is now anticipated sometime in October. We’re teamed with Textron on the V-280 and do not have a position on the Sikorsky Defiant. Should Textron win, this program could be as big as our F-35 production next decade.
Like every other company, our supply chain teams are working hard to manage an ever changing landscape and, for the moment, we’re more focused on having sufficient inventory in stock to meet our customer commitments rather than optimizing our cash position. The battle with inflation has also intensified and we’re working with our suppliers to minimize cost increases while also working with our customers to adjust prices where possible.
Despite the volatility in the external environment, our aircraft business is performing well and we’re pleased with our progress over the last 12 months.
Sales in the quarter of $318 million were 17% higher than last year. The growth this quarter was dominated by the commercial side of the business with both OEM and aftermarket sales registering large increases over last year. Commercial OEM sales were up 25% driven by higher sales across our Boeing book of business and strength in our business jets product line. Sales to Airbus were more or less in line with last year. The commercial aftermarket almost doubled in the quarter. The underlying demand for spares and repairs contributed just over half the growth and continues to run ahead of our forecast. We also had the benefit of acquired sales from our TEAM Accessories acquisition which closed in February this year. In addition, we benefited this quarter from a one-time retrofit program which contributed about $10 million in sales.
Military OEM sales were up slightly in the quarter. Higher funded development and helicopter sales compensated for slightly lower fighter jet sales, while a strong performance at our Genesys acquisition compensated for the loss of sales from our Navigational Aids business which we divested in the first quarter of this year. Military aftermarket sales were about flat with last year, but down from the run rate of the first 2 quarters. Despite the war in Ukraine and the global commitments to increased defense spending, we are not yet seeing any uptick in our military aftermarket business.
GAAP operating margin in the quarter of 10.8% was up over 300 basis points from last year. We incurred about 20 basis points in restructuring and impairment costs, resulting in an adjusted operating margin of 11.0%. We’re seeing the recovery in commercial air travel flow through to the bottom line. The margin performance this quarter was particularly strong as a result of the outsized sales in the commercial aftermarket.
Aircraft fiscal 22
We’re keeping our full year forecast unchanged from 90 days ago but tweaking the mix of sales slightly. We’re lowering our forecast for military OEM by $15 million to $545 million and lowering our military aftermarket forecast by $10 million to $200 million. On the commercial side, we’re keeping the OEM total unchanged at $335 million and increasing the aftermarket total by $25 million to $165 million. The net result is total sales of $1.25 billion, up 7% from last year.
We’re keeping our full-year adjusted margin forecast unchanged at 10.1%. This results in a second half margin of close to 11.0%, up from a first half margin of 9.3%.
Space & Defense
It was another good quarter for our Space & Defense business. We continue to see growth across both portfolios and are optimistic that we’ll have additional growth opportunities as future defense budgets increase. Our products are well aligned with some of the key areas of focus for future defense spending, including hypersonics and Space.
In addition to higher defense budgets, changes in the way these budgets are being spent are opening up new opportunities for growth. Some funds are being redirected from the traditional, large programs-of-record to finding agile solutions that solve specific problems in the field. The Services are valuing speed of response, flexibility, smaller quantities and lower costs as they tackle ever-changing mission requirements around the globe. Our Agile Prime strategy is designed to meet these emerging requirements. This strategy is built on the success of our Reconfigurable Turret system. It will take a few years to build a broader Agile Prime business, but we’re already seeing significant interest from the market in what Moog can offer.
Space & Defense Q3
Sales in the quarter of $224 million were 9% higher than last year, a combination of 3% growth in Space and 14% growth in Defense. Similar to last quarter, strong growth on our RIwP SHORAD program drove the Defense increase. We also enjoyed some higher sales into missile applications and for various defense components, which compensated for lower sales into international vehicle programs.
On the Space side, we enjoyed growth in our propulsion and avionics product lines as well as in our integrated space vehicles business. On the downside, our work on hypersonic development programs continued its wind down. Our hypersonic activity is in a temporary lull as we wait for the government to decide which technologies and programs to move forward towards production. Given the broad range of demonstration programs we’ve participated on, we’re confident that there will be significant additional business on hypersonics in the future.
Space & Defense Margins
GAAP margin in the quarter of 11.3% included some minor restructuring charges. The adjusted margin of 11.4% was up 100 basis points from last year and in line with our forecast for the full year.
Space & Defense fiscal ‘22
There is no change to our sales forecast for the full year. Full year Space sales of $350 million assume a fourth quarter in line with the third. Similarly, full year Defense sales of $530 million also assume a fourth quarter more or less in line with the third.
For the full year, we’re also keeping our adjusted margin forecast unchanged at 11.5%. This assumes a slight pickup in margin in the fourth quarter.
The underlying macro themes in our industrial business are similar to last quarter – although even more challenging than 3 months ago. Demand has remained strong over the last quarter with a continued positive book to bill. The drive to expand factory capacity in every industry to meet supply constraints is fueling orders for our industrial automation products. Higher oil prices and the continued recovery in commercial air travel are positive for our energy and simulation businesses. However, supply chain challenges have not abated and, if anything, have become more severe in the last 90 days. In addition, we’re seeing the impact of inflation coming through in higher material and freight costs. We’re compensating with price increases but sometimes experience a lag of several months before these price increases take effect.
The war in Ukraine continues to cast a large shadow over Europe and worries about a winter energy crisis have increased the risk of a downturn over the next 12 months. The strength of the dollar has little effect on our operations since our supply chain, facilities and sales tend to be co-located. However, it has an impact on the translation of both sales and operating profits back to US dollars. Finally, COVID continues to pop up at various spots around our global footprint and drag on our efficiencies. All in all, a very positive order book but a difficult supply chain situation.
Industrial Systems Q3
Sales in the quarter of $231 million were in line with last year. However, the flat topline masks a very positive underlying story of growth. Excluding the impact of foreign exchange movements and lost sales from portfolio shaping activities, underlying organic sales were up 8%. On a rate adjusted basis, all 4 of our submarkets were up over last year. Industrial automation was up 11%, both Energy and Simulation & Test were up close to 8%, and Medical was about 3% higher. The strength in our Industrial Automation business is driven by the demand for factory automation equipment, particularly in Europe. Constraints in global supply chains is driving this investment in capital, and through our third quarter our bookings continued to be very strong. Our sales into this market are constrained by challenges in our supply chain, rather than underlying demand for our products. In the Energy market we had higher sales into both exploration and generation applications. A year ago, oil was averaging about $60/barrel, today it is over $100/barrel. If the outlook for oil prices remains high, we should see further growth in our exploration business in the future. Test & Simulation is up on increased sales of our flight simulation products. With the recovery in air travel, the increasing demand for pilot training translates into a strong outlook for this business. Finally, Medical sales were up marginally from last year driven by growth in our enteral feeding product line.
Industrial Systems Margins
GAAP margin in the quarter of 8.4% includes 30 basis points of restructuring charges. The adjusted margin of 8.7% was down from last year and below our target for the full year. Margin pressure this quarter came from a combination of inflation on our input costs and lower operational efficiency. We’re adjusting prices to our customers to compensate for inflation. Also, this quarter we had a 6-week shutdown of our facility in Shanghai which impacted our operational efficiency. This shutdown was the result of the zero-COVID policy in China.
Industrial Systems fiscal 22
We’re keeping our full year sales forecast unchanged from last quarter, despite the shifts in exchange rates. For the full year, we anticipate sales of $910 million. This assumes a fourth quarter in line with the third.
Our forecast for full year adjusted margin is also unchanged at 9.5%, with our fourth quarter recovering nicely from some of the challenges in the third to over 10%.
It was another good quarter for our business, with our operational performance in line with our forecast and a tax benefit driving outsized EPS growth. The second half of our fiscal year is playing out as we anticipated. Our sales forecast for Q4 is in line with Q3, and our EPS forecast for Q4 is unchanged from 90 days ago. Demand for our products is strong across all our major markets and we’re managing well through the challenges posed by supply chain constraints, inflation and labor availability.
As we look beyond this fiscal year, we’re seeing opportunities for further growth. The recovery in commercial air travel has already driven our aftermarket sales higher than pre-COVID levels, and, as wide body rates recover, we should see our OEM sales expand. Defense spending is in a multi-year upswing and the growth we enjoyed in our funded R&D portfolio over the last few years should gradually convert to production programs. Examples of this include the FLRAA program, various classified aircraft opportunities and hypersonic programs. Our industrial market is where we’re perhaps most cautious, as higher interest rates and concerns about energy availability in Europe increase the chances of a slowdown. However, for the moment, we have record backlogs and are focused on increasing output. As in past downturns, should we see a slowing in our business, we’ll react accordingly.
In summary, in the short term our business remains very healthy and longer term we’re bullish about our prospects to grow both sales and margins.
Finally, we’re anticipating Q4 sales in line with the third and Q4 earnings of $1.45 per share, plus or minus 15c.
Now let me pass you to Jennifer who will provide more color on our cash flow and balance sheet.
Thank you, John. Good morning, everyone.
Increasing constraints in the supply chain are impacting our cash flow generation, and we’re adjusting our free cash flow outlook for the year accordingly. We’re seeing a couple situations arise. First, the bulk of materials are coming in on time. However, certain components are being delayed, causing us to build up inventories or unbilled receivables. Second, we’re selectively purchasing certain materials in advance that we’re concerned might otherwise slow us from getting product out the door. In the current environment, we are prioritizing meeting customer commitments over reducing inventories. We expect pressures on receivables and inventories to continue into the next quarter, but also expect strong customer advances to offset these pressures. We’re moderating our full year adjusted free cash flow guidance to 20% conversion, excluding the benefit from the securitization facility.
As a reminder, we amended our securitization facility in the first quarter. This facility provides us with lower interest costs compared to those we would incur with borrowings under our revolving credit facility. Under the amended securitization facility, a receivables financing subsidiary may sell receivables to a financial institution up to $100 million. Our balance under this facility was $89 million at the end of our third quarter, $100 million at the end of the second quarter, and $90 million as the end of the first quarter. Due to the structure of this facility, the associated receivables are not recognized on our balance sheet. The new structure reduces our working capital levels. To provide a comparable look at our cash generation and financial position, I’ll first share adjusted free cash flow and net working capital metrics without the effects of the new facility. I’ll also include the metrics as calculated off our financial statements near the end of my comments for your reference.
Adjusted free cash flow in the quarter was negative $18 million. We saw pressures this quarter on working capital, most notably related to the growth in unbilled receivables. We also worked down customer advances that we received in the first quarter. We’ve had a couple tough quarters for cash, but over the past ten quarters, our adjusted free cash flow conversion on adjusted net earnings has been solid at about 100%.
The negative $18 million of adjusted free cash flow in Q3 compares with an increase in our net debt, adding in debt related to the securitization, of $40 million. We had cash outlays of $8 million for the quarterly dividend payment, $4 million for share repurchases and $3 million for divestiture activity. In addition, the strengthening of the US dollar reduced our cash balance by $5 million.
Adjusted net working capital (excluding cash and debt) as a percentage of trailing-twelve-month sales at the end of Q3 was 30.2%, up from 29.0% a quarter ago. The increase during the quarter largely resulted from the expected reduction of customer advances on military programs that we received in the first quarter. We also saw a modest growth in unbilled receivables. In particular, we experienced growth in receivables on the 787 program where our production level is higher than the rate at which Boeing is taking deliveries. We’re maintaining steady production levels to ensure a healthy supply chain and efficiencies in our facilities. Supply chain disruptions also impacted our business as material receipts drove progress on long-term contracts while delays in some specific items necessary to complete a product prevented us from shipping and invoicing. Timing of invoicing from strong sales late in the quarter also drove higher levels of billed receivables. As a percentage of sales, the growth in receivables was offset by lower inventories. On the inventory front, this quarter marks our sixth straight quarter of decreasing inventories as a percentage of sales. We are, however, starting to see pressures build in inventories as we ensure that we have sufficient inventory of critical components in a supply chain constrained environment.
Capital expenditures in the third quarter were $33 million, down slightly from the past few quarters. Our capital expenditures this year include our investment in facilities to support growth and investment in next generation manufacturing capabilities to drive efficiencies.
At quarter end, our net debt was $761 million, including $96 million of cash. The major components of our debt were $500 million of senior notes and $344 million of borrowings on our U.S. revolving credit facilities. In addition, we had $89 million associated with the securitization facility that does not show up on our balance sheet.
At quarter end, we had $736 million of unused borrowing capacity on our U.S. revolving credit facility. Our ability to draw on the unused balance is limited by our leverage covenant, which is a maximum of 4.0x on a net debt basis. Based on our leverage, we could have incurred an additional $591 million of net debt as of the end of our third quarter. We are confident that our existing facilities provide us with the flexibility to invest in our future.
Our leverage ratio, calculated on a net debt basis, was 2.4x as of the end of the third quarter of 2022 as well as at the same point a year ago. Our leverage ratio continues to be within our target range of 2.25x to 2.75x.
Cash contributions to our global retirement plans totaled $16 million in the quarter, compared to $15 million in the third quarter of 2021. Global retirement plan expense in the third quarter was $20 million, up from $19 million in the same quarter a year ago. The increases in both global retirement plan contributions and expense relate to increased participation in our defined contribution plans.
Our effective tax rate was 15.7% in the third quarter, compared to 25.7% in the same period a year ago. The relatively low tax rate this quarter reflects favorable adjustments for tax credits associated with last year’s tax return. Excluding the benefit of these adjustments, our effective tax rate in the third quarter was 23.9%. Last year’s rate included charges associated with the revaluation of deferred tax liabilities in the UK, mostly offset by adjustments to the previous year’s provision in the US. For all of FY 2022, including the benefit associated with the provision to return adjustments, we expect the effective tax rate to be 22.2%. Our base rate, without these specials, is 24.4%.
As a result of the supply chain situation we’re reducing our forecast for free cash flow from 90 days ago. We expect adjusted free cash flow generation to be $36 million in 2022, or 20% on adjusted net earnings. Customer advances are expected to be strong in the fourth quarter, and will partially offset the consumption of cash by receivables and inventories. We expect capital expenditures in 2022 to be $140 million, reflecting a fourth quarter similar to the third. Depreciation and amortization are expected to be $90 million.
I’d also like to share some of the metrics and amounts you’ll be able to calculate from our financial statements. These reflect GAAP accounting for the securitization facility. Free cash flow in the quarter was negative $29 million, and free cash flow generation for the year is projected to be $127 million, which is about 75% conversion on adjusted net earnings. Net working capital was 27.2% of sales at the end of the quarter.
Our financial situation continues to be strong despite the current pressures we, and others, are experiencing from the supply chain environment. We’ve got plenty of liquidity and are positioned nicely to fund organic growth and make investments in our operations that will make us even stronger.
With that, we’ll turn it back to John for any questions you may have.