Today, we will share our update on a quarter notable for record sales, strong underlying operating performance improvement masked by a space vehicle charge and cash demands above expectation. We are also increasing our full-year EPS guidance while also reflecting this stronger demand on cash.
It is almost 2 months since our Investor Day conference in NYC. Our team was delighted to have the opportunity to make public our business plans.
For the first time, we were explicit on our goals for the business, namely,
- Revenue CAGR of 5%-7% to FY26 from our FY22 baseline
- Average Annual Adjusted Operating Margin Expansion of 100bps to FY26
- Adjusted Earnings Per Share CAGR of 15%-20% to FY26
- Free Cash Flow returning to 75%-100% conversion by FY25/FY26
We took the time in NYC to explain how we were going to deliver on these significant improvements in performance and talked in detail about our simplification and pricing activities that deliver margin enhancement. During today’s call, I will give several specific examples of such activity within the quarter.
Two months on, I remain confident that we have a great business that is growing and becoming more profitable over the next few years.
Let me start right away with an update on our operational performance covering each of my three themes:
Starting with Customer Focus
- We delivered record sales whilst managing the on-going challenges of supply chain and labor availability. These challenges have an impact on inventory holding, product flow and overall efficiency.
- Our enhanced maintenance, repair and overhaul service was recognized by both Boeing and Airbus - achieving a top 2 ranking with Boeing.
- We continue to simplify how we are organized. We have made internal reporting structure changes within our $330M space business that empower business leaders to better meet operational needs of our customers and achieve financial performance.
Secondly, People, Community and Planet …
Our Baguio site, which is core to our Commercial Aircraft operations, was recognized by the Employers Confederation of the Philippines (ECOP) for our commitment to operational excellence, sustainability, employee relations and ethical behavior. We are thankful that our people are safe following this week’s Super Typhoon.
And finally, let me turn to Financial strength. We are relentlessly driving simplification and pricing across our business. Let me share some examples:
Within Industrial Systems, we continue to refine our portfolio with the launch of a sale process for our business in Luxembourg. For context, this is a $15M revenue operation with 70 staff manufacturing cartridge valves and manifolds.
We are refining our footprint with several moves: for example, we have changed from a direct channel to market, in South Africa, to a distributor model exiting our leased facility. In Aircraft Controls, we have announced the closure of the Cincinnati based operation of Surefly and its transfer to our Genesys Aerosystems facility. Whilst each change yields relatively small impact today, it is the accumulation of these changes over the next couple of years that delivers footprint benefit.
We are seeing 80/20 gain further traction within our businesses. We have the data analytics on profitability complete for over two thirds of our revenue base across the entire business. We have trained well over 100 leaders on the 80/20 approach. We are growing capability as pilot sites mature the process and expand scope from profitability analysis to include reduction of cash conversion cycle. Ultimately, 80/20 is accelerating decisions that increase our profitability. For example, we have identified several product lines that we feel are at end of life and we are either working with customers to close out production, or finalizing agreements with other companies who will continue to support the product.
Now let me turn your attention to pricing. We are driving pricing activities across all the markets that we serve. We have a systematic approach – pursuing high-impact opportunities early and using 80/20 to focus further margin enhancement. Our philosophy is to ensure that pricing reflects the value that we deliver. Aircraft Controls has made very significant margin improvements through pricing that are now reflected in our full-year forecast. In addition, Industrial Systems has delivered substantial operating margin enhancement in this quarter, with pricing being the most important contributor. Across all businesses, pricing is driving margin enhancement.
Now let me turn to the macroeconomy.
The Department of Defense Budget for FY24 is still working its way through House and Senate. The requested increase of 3.2% is looking to protect new platforms. Significantly, this includes maintaining the Future Vertical Lift funding stream, moving Next-Generation Air Dominance Aircraft and Collaborative Combat Aircraft to Programs of Record in 2024, and increasing to $30B the funding of the Space Force.
Unfortunately, the war in Ukraine has now stretched beyond 500 days. Politically, the obstacles to Sweden’s accession to NATO have been overcome and ratification by Turkish and Hungarian parliaments is anticipated. The significant demands of arming Ukraine is driving missile replenishment orders and increased equipment MRO activity . According to Lockheed Martin , the fleet of F35 fighters operating in Europe is expected to increase over 4-fold by 2030.
US-China tensions continue with the trade dispute over semiconductors now extending to cloud computing and precious minerals. It appears that important diplomatic efforts continue with Anthony Blinken, Janet Yellen, Henry Kissinger and John Kerry all visiting China in recent weeks. Whilst the slowdown in Chinese economic activity is a minor concern, escalating trade embargoes would be a greater concern and potentially more disruptive. Our philosophy remains to be “in China for China”.
The recovery of commercial aircraft continues. Consequently, we are seeing real strength in aftermarket and, consistent with investor day, Boeing and Airbus continuing to project doubling of rates in widebody production by FY26.
Industrial automation remains a watch item. The June Purchasing Manager Index for manufacturing shows contraction in US and for 12 straight months in the Eurozone. Our order intake for industrial automation is down about 4% in the last 6 months relative to the prior 6 months. However, we have a healthy backlog to carry us into fiscal year 2024.
Now, turning to what was notable in the quarter
We returned to the Paris Airshow after a 4-year absence. It was a remarkable show in which sentiment was extremely positive. Both commercial aerospace and defense markets are anticipating continued strong growth. In fact, record breaking gross orders for 1000 aircraft were placed with OEMs in the month of June! There was quite a notable presence of eVTOLs at the show and we are pleased to supply hardware so on two of these aircraft so far.
In May, the C919 entered revenue service with China Eastern. This is a significant step for Comac. We are planning a handful of shipments in CY23 and gradual increase through CY24.
As noted at Investor Day, the Engineering and Manufacturing Development phase of V-280 started in June. We are making good progress in ramping our engineering team.
It was notable that Collins Aerospace was sold by RTX to Safran. Given no new commercial platform development over the next decade, the sale does not in our opinion change the competitive landscape for flight control systems.
Now turning attention to our financial performance. “Our second consecutive quarter of record sales was a great achievement for our entire staff. We are starting to see benefits of simplification and pricing feeding through in our operational performance.”
- We delivered sales of $850M, up over 10% on prior year with every segment posting double digit organic growth. We are seeing the recovery of commercial aircraft, Reconfigurable Integrated Weapons Platform at full-rate, and high levels of activity in Space Components, Industrial Automation and Simulation.
- Our bookings remain strong overall, with twelve-month backlog at $2.3B up 2% over prior year. We do see some softening within Industrial Automation as noted earlier.
- Our adjusted operating margin was down 30bps on prior year. Excluding space vehicle charges, our margin performance would have been up 120bps. This margin enhancement is due to pricing and business growth.
- Our cash flow was clearly pressured in this quarter with a $19M use of cash arising from growth in physical inventory.
Before I hand over to Jennifer, I’d like to expand on my view of the two key issues impacting performance in this quarter and for the full-year, namely Space Vehicle charges and cash flow.
Firstly, we incurred a $14M charge on our space vehicle fixed price contracts. You may ask, since we were 90% complete on our last call, how a further charge could arise. The charge is driven by two factors, namely additional software development effort required to resolve all remaining open issues necessary to achieve flight-ready software; and additional integration and test effort required to rework issues arising at integration of the last couple of flight units. These are complex systems in which the final stages of integration can flush out unanticipated challenges.
Despite incurring year-to-date charges of $25M in space vehicles, I remain very confident in that business. These charges represent additional investment in gaining a much deeper understanding of satellite bus system integration and building our capability to execute. Our achievements to date include the development of two spacecraft bus platforms, namely Meteorite and Meteor, which weigh 120kg and 650kg respectively. These buses share many common components, in particular the avionics unit and the software base. We have now fully built and tested six payload-ready Meteorite class satellites, and we have shipped all flight hardware required under two contracts as of last week. We will deliver final software release within the next 2 weeks.
From my perspective
- we have a great offering with two satellite bus platforms that can carry a variety of customer payloads,
- we are operating in a rapidly expanding market and see plenty of new opportunities ahead.
- Our execution risk is reduced due to our improved capability and the commonality of hardware and software across the Meteorite and Meteor platforms.
Now turning my attention to our cash situation. We adjusted our free cash flow guidance from zero to minus $60M for FY23. Let me describe what has changed. First, our sales have come in much stronger than anticipated. We also believed 90-days ago that there would be less growth of physical inventory during the second half of the year. We now recognize that it will take longer for our actions to slow the growth of inventory, as we work to strike the right balance between slowing material inflow and meeting growing customer requirements. Our efforts have begun to reduce the underlying rate of increase in physical inventory and we expect this improvement to continue. Given our leverage, the demand on cash is manageable with free cash flow turning strongly positive in Q4 reversing a 3-quarter use of cash.
We are actively managing the situation. First, we are working to reduce material inflow whilst dealing with material constraints and ensuring a healthy supply chain. We are also unlocking production challenges to improve throughput and material flow, whilst dealing with material availability and labor constraints. We reflected during Investor Day that cash flow would take until FY25/FY26 before it would normalize. We are confident that this is getting the necessary attention and oversight through the organization. We have executed and will continue to drive many tactical changes that are slowing inventory. We are now focused on longer term actions that drive improvement by FY25/26.
On these two key issues, I believe that we are making progress. We have significantly reduced risk on our space vehicles contracts. We have made initial progress on physical inventory and will drive progressive improvement over coming quarters.
Overall, I remain very optimistic for our business. We have strong growth which I see as a sign that we are creating value for our customers. In addition, we have made excellent progress on our journey to improve margins through simplification and pricing.
Now, I’ll hand over to Jennifer to review our financials in more detail…
I’ll begin with a review of our third quarter financial performance. I’ll then provide an update on our guidance for all of FY 23.
It was another exceptional quarter from a sales perspective. For the second quarter in a row, we hit a record level of sales for the company. Our adjusted operating margin was 10.2%, including $14 million of charges on space vehicles programs. Our underlying operational performance was strong this quarter. We achieved $1.37 of adjusted earnings per share, which was negatively impacted by $0.33 from the space vehicle charges and was positively impacted by $0.13 from tax adjustments associated with higher R&D tax credits. This suggests performance near the high end of our guidance when carving out these two factors.
Sales in the third quarter were $850 million. Total company sales increased 10% over the same quarter a year ago. Excluding the impact of divestitures, sales were up 11%.
The largest increase in segment sales was in Aircraft Controls. Sales of $355 million increased 12% over the same quarter a year ago. Commercial OE sales in the quarter were especially strong, driven by the continued market recovery in widebody platforms as well as growth on business jets. Commercial aftermarket sales were at a record high, with strong sales on the A350 program, which has been steadily ramping over the past several quarters.
Military aircraft sales declined in the third quarter compared to the same quarter a year ago. The military sales decrease reflects lower funded development activity, including the delayed start on the FLRAA program. In addition, military aftermarket sales were down slightly from the same quarter a year ago.
Sales in Space and Defense Controls of $242 million increased 8% over the third quarter last year. Adjusting for the divestiture of a security business last year, sales increased 11%. The ramp up in production on the reconfigurable turret program, which hit full-rate production levels in the first quarter this year, drove sales this quarter. The sales growth was also driven by increased activity on avionics and components for satellites.
Industrial Systems sales increased 9% to $253 million. Excluding the divestiture of our sonar business last year, sales were up 11%. Within Industrial Systems, our industrial automation sales growth was driven by demand for capital equipment. This business has recovered nicely since the pandemic, though we’re now seeing orders slow down in line with global capital spend. Our growing construction business is also contributing to the industrial automation sales growth. Simulation and test sales were also strong, driven by high demand on flight simulation systems. Sales in energy, adjusting for the divestiture last year, were up nicely compared to a year ago. These sales increases were partially offset by lower sales in medical, which was impacted by supply chain issues.
We’ll now shift to operating margins.
Adjusted operating margin of 10.2% in the third quarter decreased 30 basis points from the third quarter last year. The space vehicle charges pressured our total operating margin by 150 basis points. These pressures were mostly offset by strong operational performance on our underlying business and a marginal return on the sales increase.
Adjustments to operating profit this quarter and the same quarter a year ago were $2 million and $1 million, respectively. These adjustments reflect restructuring and other charges.
I’ll now describe the key drivers of our adjusted operating margins for each of our segments. Operating margin in Aircraft Controls was 10.9% in the third quarter, compared to 11.0% in the same quarter a year ago. Operating margin in Space and Defense Controls was 7.8%, down 360 basis points from 11.4% a year ago. As Pat described, we incurred significant charges on space vehicle programs again this quarter, over 500 basis points worth, masking the benefit associated with higher sales and improvements in the core business. Operating margin in Industrial Systems was 11.5%, up nicely over the 8.7% of last year’s third quarter. Benefits associated with our pricing initiatives accounted for three quarters of this improvement. In addition, last year’s margin was pressured by supply chain disruptions and the pandemic impacting our operations in China.
Interest expense is another area that’s impacting our financial results. In the third quarter, interest expense was $17 million, up $8 million over the third quarter last year. The increase in interest expense relates to higher interest rates and, to a lesser extent, higher levels of debt.
Our adjusted effective tax rate in the third quarter was 16.0%, about the same as in the third quarter last year. We’re benefitting from higher levels of R&D tax credits and have captured these benefits in our return to provision third quarter adjustments in both years.
Putting it all together, adjusted earnings per share came in at $1.37, within the range we provided a quarter ago. EPS is down 15% from the same quarter a year ago due to higher interest and corporate expenses, partially offset by increased operating profit.
Let’s shift over to cash flow. In the third quarter, we had negative free cash flow of $19 million. Net earnings were solid and capital expenditures were on plan; however, net working capital, in particular physical inventories, grew substantially.
Growth in physical inventories, both unbilled receivables for long-term contracts and inventories as shown on the balance sheet, resulted from continuing to receive in materials at a faster rate than shipping product to customers. We’ve maintained material flow to ensure we’re positioned well for customer deliveries; however, a combination of staffing shortages, supply chain challenges and production inefficiencies have limited our ability to convert inventories to cash. In addition, this quarter, we took ownership of some inventory from a vendor to prevent a supply chain disruption.
Capital expenditures were $35 million. That’s pretty much in line with our average spending last year, and just over the average quarterly spend this year excluding the facility we purchased last quarter. We’re investing in facilities to accommodate our growth, focus our factories and enhance our capabilities through automation.
Our leverage ratio, calculated on a net debt basis, as of the end of the third quarter was 2.7x, within our target range of 2.25x to 2.75x.
Our capital deployment priorities, both long-term and near-term, are unchanged. Our current priority continues to be investing for organic growth.
We’ll now shift over to guidance for the full year.
Compared to a quarter ago, we’re increasing sales, adjusted operating profit and adjusted earnings per share, and modifying operating margin down slightly. Based on continuing pressures on cash, we are decreasing our free cash flow guidance for the year.
Let’s take a more detailed look at our guidance.
We’re projecting sales of $3.3 billion in FY 23, which is up $60 million over our previous guidance. That’s a 7% sales increase compared to FY 22, and 9% when we adjust for divestitures over the past year and the impact of foreign currency movements. We expect high single-digit organic sales growth in each of our segments.
Aircraft Controls sales are projected to increase 8% to $1.4 billion. The increase is all on the commercial side of the business. Commercial OE will be up across the board, with growth on Airbus and Boeing platforms, business jets and the Genesys business we acquired a couple years ago. We’ll also see growth in an already-strong commercial aftermarket business. To account for strong sales this quarter, we’re increasing our commercial OE forecast by $35 million and our aftermarket sales forecast by $20 million. We expect a decline in military aircraft sales, driven by lower funded development and aftermarket sales. We’re decreasing our military aircraft sales guidance by $30 million to reflect the results we’re seeing, especially related to funded development activities.
Space and Defense Controls sales are projected to increase 7% to $930 million. Adjusting for the divestiture of a security business late last fiscal year, sales will be up 9%. When looking at our numbers within this segment, you may recall that we shifted a product line from defense into space at the beginning of our first quarter. We’ve now adjusted last year’s numbers for that shift in our supplemental materials. Space sales will increase for satellite components and space vehicles, and defense sales will increase on production ramps for the reconfigurable turret and tactical missile programs. Our sales forecast is up $10 million over our previous forecast, reflecting the strong sales levels we’re achieving in both space and defense.
Industrial Systems sales are projected to increase 6% to $965 million. Adjusting for the sale of the sonar business and foreign currency movements, the increase is 10%. Most of the growth will come from industrial automation and simulation and test, both of which were particularly strong this quarter. Our sales forecast is up $25 million from our previous forecast on record sales this quarter.
Let’s shift over to operating margins.
We’ve updated our segment operating profit and margin guidance to reflect retroactive pricing benefits we’ll get in the fourth quarter on aircraft programs, the higher level of sales we’re now projecting and the charges we incurred this quarter on space vehicle programs.
We’re now projecting an adjusted operating margin of 10.9% in FY 23, which is up from 10.2% in FY 22. Industrial Systems will increase 190 basis points to 11.4%, largely due to progress on pricing initiatives. Aircraft Controls will increase 70 basis points to 10.8%, also reflecting the benefit we’ll see from pricing initiatives. Factory utilization will improve as sales in the commercial OE business increase; however, this benefit will be largely offset by an unfavorable mix, with the relative increase in commercial OE. Operating margin in Space and Defense Controls will decrease 40 basis points to 10.5%, reflecting $25 million of charges incurred on space vehicle programs this year, offset by incremental return on higher sales.
Higher interest expense will depress adjusted earnings per share by $0.62 relative to FY 22. For FY 23, we’re now projecting adjusted earnings per share of $5.75, plus or minus $0.10, which is up 3% over FY 22. Adjusting for interest, EPS would be $6.37, an increase of 15%, reflecting strong operational performance. Next quarter, we’re forecasting earnings per share to be $1.71, plus or minus $0.10.
Finally, turning to cash.
We’re projecting free cash flow for FY 23 to be negative $60 million, down from zero that we were projecting 90 days ago. The change largely reflects our third quarter growth in physical inventories. As we move into the fourth quarter, we expect working capital to be a source of cash, the first time in several quarters. Receivables will be the largest generator of cash within working capital. Accruals for compensation will normalize from a timing perspective in the fourth quarter, also contributing to free cash flow generation. Those sources of cash will be partially offset by continued growth in physical inventories, though we’re beginning to see the growth in physical inventories trend downward. Outside of working capital, we’re projecting a strong earnings quarter and we’re maintaining our forecast of $165 million in capital expenditures for the year.
Overall, we had a solid third quarter and our outlook for the fourth quarter looks strong. We’re positioned well from a liquidity and leverage standpoint, enabling us to invest for future growth in our business.
And now I’ll turn it over to Pat.
Thank you, Jennifer.
As you have heard, we closed out a solid quarter delivering record sales and we are on path to deliver a fiscal year with 9% organic sales growth and 70 basis-point margin improvement.
We are now happy to take your questions.