Ladies and gentlemen, thank you for standing by. Welcome to the Albany International Third-Quarter 2019 Earnings Call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session; instructions will be given at that time. [Operator instructions]I would now like to turn the conference over to our host, Mr. John Hobbs, Investor Relations. Please go ahead.

Thank you, Talicia, and good morning, everyone. As a reminder for those listening on the call, please refer to our detailed press release issued last night regarding our quarterly financial results, with particular reference to the notice contained in the text of the release about our forward-looking statements and the use of certain non-GAAP financial measures and associated reconciliation to GAAP. For the purposes of this conference call, those same statements apply to our verbal remarks this morning. For a full discussion, including a reconciliation of non-GAAP measures we may use on this call to their most comparable GAAP measures, please refer to both that earnings release as well as our SEC filings, including our 10-K.Now I will turn the call over to Olivier Jarrault, our Chief Executive Officer, who'll provide some opening remarks. Olivier?

Thank you, John, and good morning. Welcome, everyone, and thank you for joining our third-quarter earnings call. Albany International delivered another very good quarter in Q3 2019, outpacing our expectations. I want to congratulate all of Albany's employees for contributing to these very strong results.We delivered solid year-over-year growth. Total company net sales increased 8%, or 9% excluding the impact of currency translation effects. We also continued to deliver strong profitability. Compared to Q3 2018, operating income grew by over 36% and adjusted EBITDA by almost 14%.Overall, we're clearly running ahead of the expectations for the full year that we shared with you on the Q2 earnings call. This outperformance is fundamentally driven by three factors. First, as I am sure you're aware, we are the exclusive supplier for the life of the program of components, fan cases, fan blades and spacers for both the LEAP-1A variant used on the Airbus A320neo family, and the LEAP-1B variant used on the Boeing 737 MAX. We mentioned on the last call that we were reducing our second half production rates for the LEAP-1B components as we await the return to service of the Boeing 737 MAX and we expressed concern about the risk of potential additional costs to production in the second half of the year.However, since then, while we have reduced our production rates, we have reduced it by less than we had anticipated. During the recent quarter, we worked with our customer to maintain a production rate of LEAP components higher than the delivery rate of those components. This action, which has been taken to ensure that we can retain our talented and experienced workforce, is expected to continue for the balance of the year.Due to the terms of our contract with our customer, the relevant accounting standards require us…

Thank you, Olivier. Good morning, everyone. I will talk first about the results for the quarter and then about the outlook for the balance of the year. For the third quarter, total company net sales were $271.1 million, an increase of 7.6% over the $251.9 million delivered in the same quarter last year.Adjusting for currency translation effects, the growth in net sales was 9%. In machine clothing, also excluding currency translation effects, and in part due to the strong Q2 in 2018, net sales declined by 2.6% caused primarily by a decline in sales of publication and pulp grades, partially offset by a modest net increase in sales across all other grades. AEC net sales grew at 28.3% primarily driven by growth in the LEAP, F-35 and Boeing 787 programs. Third-quarter gross profit for the company was $104.1 million, an increase of 12.7% over the comparable period last year.The overall gross margin increased by 170 basis points from 36.7% to 38.4% of net sales. Within the MC segment, gross margin improved from 50% to 52.4% of net sales due to reduced depreciation expense, foreign exchange impact, mix benefit and material savings, partially offset by lower net sales driving reduced fixed cost leverage.Within AEC, the gross margin improved from 14.6% to 20.8% of net sales driven by a higher favorable net change in the estimated profitability of long-term contracts, higher net sales driving increased fixed cost leverage and improved productivity. Third-quarter selling, technical, general and research expenses decreased from $49.0 million in the prior-year quarter to $48.7 million in the current quarter, and also decreased as a percentage of net sales from 19.5% to 18%.The reduction in the amount of expense was driven primarily by the revaluation of nonfunctional currency assets and liabilities, which resulted in a loss of $400,000 in…

Thanks, Stephen. In closing, I would just like to reinforce how good we feel about the business. I am proud of the accomplishments of both the MC and AEC teams, and we are thrilled to be able to increase our guidance for the year. We think we are well positioned for fiscal year '20, and I am particularly excited about the opportunities for profitable growth over the long term. Overall, I feel very good about the business and our ability to hit our expectations.With that, let's go to the line for any questions. Operator?

[Operator Instructions] I will now go to the line of Pete Skibitski. Please go ahead.

Let me start out, I guess, on LEAP-1B just so I understand the accounting. So you guys are obviously booking revenue and profits but you're not receiving cash. So we're building working capital, I guess, for some amount of time. Is that correct?

Yes, listen, you got it correctly. I mean, we -- I just would like to, however, to be clear that the inventory build that we're proceeding with, after having agreed, right, with our customer, Safran, is not something really big. I mean, we're talking about only a few weeks, I would say a few weeks, not months, a few weeks of inventory build across fan cases, fan blades, spacers, a few weeks increase versus what we had at the end of June 2019.And of course, the weeks are measured in expected 2020 demand. Now when you look at the expected ramp-up of the Boeing 737 MAX to 57, it's quite -- that a few weeks, right, increase is quite acceptable. And also, you have also to -- remember also that we started early '19 with a pretty lean inventory across all components. We also have on the A320, in regards to the LEAP-1A variant, to be ready, right, for the expected ramp-up, right, of Airbus on the A320neo as they move gradually from 63 to a higher number, right?

Yes. And Pete, just from an accounting perspective, to make sure you understand, what you will see on the balance sheet as we go through this, while we talk about building inventory, given the nature of the -- our accounting treatment where we are recognizing revenue and profit, those finished goods do not appear in the inventory line in our balance sheet. Rather, they will appear in the contract assets line on our balance sheet since they are really owned by our customer. We just have not yet invoiced those customers for those parts, but we have termination coverage should we ever need to.So those parts are appropriately treated as contract assets. You will see a slight build in the inventory line, really unrelated to this ramp-up in production. And it's really due to the overall slowdown that we previously discussed where there are certain raw materials which have a long lead time, which we ordered up to six months ago, which are currently getting delivered and which are in excess of our current needs. So you'll see some build in the inventory line but that is really just raw materials, and so that is not the finished good.And that will start to come down because, obviously, we slowed our order rates of those product and that inventory is all still good, it's well. We'll use it well within the shelf life of any raw material we get. And then you'll see a slight uptick in the receivable line. And this is really just related to the true-up on our contract.As production rates come down, our current cost is in excess of the -- our predicted sales price at the start of the year. That true-ups that we address with our customer at the end of the year get bills in accounts receivable during the year. But by far, the largest impact will be on the contract assets line, where that finished goods inventory will appear.

Okay, that's really helpful, guys, and I appreciate it. And can you share with us the rate you're actually at on the 1A, whether it's 42 months or 52 or 57?

Our customer has not authorized us to discuss that.

We are not really -- and we cannot really nor can we respeculate, right, on whether the blow will be into '20, right? I mean, our customer is Safran, not Boeing.

Yeah. Understood. And Olivier, just so I'm clear, you are getting upward demand signals on the 1A. I mean we also have a 300 unit order that just got yesterday.So that's -- is that a fair statement?

Well, you know very well about the -- our price for a very long time, right, by Airbus. I mean, their intent, right, to move up, right, the production, the production rate of the A320, of the A320neo or the overall A320 family. And I think as you heard again this morning, I mean, they really want to keep on wanting it up. So that's why we're getting ready on our side, right, to make sure that we will never be any reason, like we have never been in the past.And we'll continue to never be any reason, right, for preventing our customers, right, to ramp up.

Now, very helpful. Thanks, thanks, guys.

Thank you, Pete.

Thank you, too, Pete.

I'll now open the line of Kristine Liwag. Please go ahead.

Hi, good morning guys.

Good morning. Thank you for joining the call.

Sure. I just wanted to get a little bit more clarity about how your cost plus incentive fee contract structure for the LEAP engine works. Basically, can you discuss if what costs would not be recoverable if production rates decline? And then also, if you have lower production volumes, do your incentive fee hurdles adjust? Meaning if volumes are low but you operate well relative to that low volume, are there incentive fees that you could get on the LEAP program?

Okay, I think -- well, let me first answer you at a high level, and of course, Stephen will jump in with more color right into it. But at a very high level, it means our contract cost plus fee contract structure arrangements with Safran really mitigates, as I was saying, as you understood I hope well, I mean, mitigates any downside financial impact on our bottom line because fixed costs, right, are recoverable. Therefore, the gross profit rates, right, the gross margin on these very same products is relatively stable, right? So when our production decreases, any production change on new components would drive fluctuation and downside pressure, right, on the top line.However, right, our gross profit rate stays constant as we drive productivity. As we lower our manufacturing cost, of course, the revenue per unit drops. At the same time, the incentive fee kicks in. Therefore, the gross profit rate percentage gross margin increases.And as a result of volume demand, demand for the LEAP engine is growing over the years, I think. So we're talking about growing LEAP engines shipments, our manufacturing rate moving from 1,800 this year to about 2,500 engines in '25, volume increases. Therefore, our revenue -- total organized revenue increase. And therefore, as a result of gross profit rate increasing because of the incentive fee kicking in, our total dollar gross margin rate increases, right? That's at a very high level.And now I leave it to Stephen to give more accounting flavor to it, right?

Sure. Kristine, in terms of your concerns about are there costs which we would not recover if demand really slowed down, the short answer is there are no incremental costs. The costs which are unallowable under that contract are largely variable costs related to production, such as costs of poor quality where we do not get to recover all of those in our contract. And that is typically a percentage of revenue, irrespective of volume rather than some fixed costs which would start to overwhelm our gross profit rate on the program where volumes go down.Right now, you're correct and Olivier's correct in terms of describing how the incentive fee works, how our profit rate can step up as we get our prices down. Given where we are right now, there is not a huge amount of room for our rate to move down as our gross -- as our production rate goes down and our average cost per unit goes up because we're still relatively early in that program, as we were sitting in a position where there was far more headroom for increased gross profit rate on a go-forward basis, as we get our production rates -- as our production costs went down. So I don't think you should expect to see some significant reduction in the gross profit rate at which we're recording profitability -- profit on that program as the production rate declines.

That's really helpful and that's a lot of color. Thank you for that. And maybe switching gears to a different program. Boeing also recently announced that they're cutting the 787 production rate from 14 per month to 12 per month.Can you discuss how we should think about when that would hit your revenue outlook? I think they've said end of 2020 is when they would see this -- or end of 2022 is when they'd see this rate cut. And then also how we should think about margin impact of that lower rate for you?

Well, I would not overreact as much about these announcements. I mean, first of all, we have to wait and see the outcome of the trade negotiations, right, between U.S. and China. Basically, the slowdown -- expected slowdown, reduction in build by Boeing was driven by the Asian -- potential drop in Asian demand, right? So let's wait and see really what happens.Anyway, when you look at the grand scheme of things, I mean, the Boeing 787 demand for us, I mean, it's a very important program. But it's in the, I would say, single -- high single digits, right, of our sales, of our total revenue, right? So therefore, I don't see any major impact, and we'll address that in the second half of 2020. But I'm not -- we're not, if you will, very preoccupied with that announcement.

Great. And if I could ask one more program question. On another large program, you have exposure for the F-35. This week, Lockheed finally secured the agreement for a $34 billion order that seems to span production rate for Lots 12, 13 and 14.So that stretches for a few years, and it seems like they're on target to increasing their production rate for that aircraft in the next few years. Do you need to spend more capex to meet the expected production of the F-35? Or are you already at the capex that you need to deliver for that program?

Listen, it's a very good news, first of all, right? We're very pleased, right, to -- about this announcement from Lockheed. I mean, the F-35 is indeed one of our greatest program or growth platforms, and we always very, very happy to support, and we'll keep on supporting that program, as we have done in the past, both from on an engineering standpoint and productivity and production standpoint. We have -- we produced all those components: blades, bulkhead steel, fixed wings, skins and tooling from our Salt Lake City business. We have invested quite a lot, right, in the past few years toward that program.We have the capacity, right, and we do not -- presently, we do not foresee any significant capex increase to support, right, the growth that we expected now for a very long time, expected growth, right, of that program.

Thank you very much.

Thank you, Kristine.

Thank you.

I'll now open the line of Peter Arment. Please go ahead.

Hey, this is Asher Carey on the line for Peter. I just have a question about machine clothing. If you could talk a little bit about the machine clothing market, which has its challenges, and so there have been some softness. But the margins were about as high as they've ever been.Could you highlight some of the operational metrics you're seeing that drove that improvement? And would you be able to pull similar levers in the case that some of that softness spreads to North America? Thanks.

Yes, thank you. Great question. Listen, first of all, from a margin standpoint, I mean, we're very pleased, right, to have been able to drive 52.4% gross margin versus 50% last year. That increase in gross margin year over year was primarily -- predominantly driven by a decrease in the depreciation amortization, was basically driven by a more favorable mix, and I'll come back to that from a market standpoint, was driven by some nice procurement saving, material savings offset somewhat by, as you saw, as Stephen mentioned, about 2.6%, right, a decline in volume, driving lower recovery, right, fixed cost recovery, right? That's on the margin side.Now the very nice productivity gains also that we're continuing to driving, that the business is thriving and will continue to thrive quarter after quarter in the years to come. That being said, from a market standpoint, I don't want to challenge. I want to be very pessimistic and challenge the fundamentals of the market, right? The end market, the paper market is still a market that will be growing, as we see recently confirmed at about 1% a year, right, the overall demand of paper and paperboard, 1% a year on average, right, between '18 and '23. And of course, we can have some up and down.Continuously -- we also continue to believe that the -- our sales of publication grade PMC products, both newsprint and publication and writing, will continue to erode at about 5% to 10% a year in the next few years. And we have -- by the way, we have seen that already. We're seeing that today, September '19 year to date, right? And we also continue to really think, as this is the case also year to date, we continue to think that the increases in board…

Thank you.

Thank you, Asher.

Thank you.

[Operator instructions] I'll now open the line of Gautam Khanna. Please go ahead.

Hi, this is Jeff Molinari on for Gautam today. Good morning Olivier and Stephen. Congratulations on the strong...

Good morning. How are you?

Good and thank you. Congratulations on the strong quarter and thank you for taking my question. So you covered a lot here already, but I wanted to come back to the long-term contract revisions. There -- so in this quarter, there was a $3 million positive favorable revision.Last quarter was $5 million. Were those related at all? Or do they span multiple programs? And then I have a follow-up after that one.

So first -- to answer the first part, no, they weren't related in that there -- certainly, they're not the same issue appearing in multiple quarters. Each quarter, we measure the impact of everything we know about that at that point in time. And so there were new facts between Q2 and Q3 which led to that change in Q3. They do span multiple programs.The one where you typically don't see much change, certainly on -- particularly on the positive side is in the LEAP programs in Albany Safran because as we mentioned, the gross margin is relatively stable there, unless we trip over something where we kick into an extra layer of incentive fee. But normally, we would project that. So we thought it would be unusual to see a major positive pickup on the LEAP programs. But other than that, it's across multiple programs in our Salt Lake City and our Boerne operations.And there's no single common thread between the pickups you saw in Q2 and the pickups we saw in Q3.

However -- and thank you, Stephen, for that definition. But however, what I would like also to point out that those benefits, right, $8.8 million year to date, $3.3 million pre-tax before in the quarter, are really the result of a very strong, right, continuation of a very strong labor productivity improvements and operational efficiency gains, right?I mean, it's really what we're working on, what we have been working on relentlessly since -- for the past couple of years, deploying a very disciplined operational system across our manufacturing network, driving every day labor, labor productivity improvement and key assets, OEE improvements, equipment effectiveness improvement driven by three fundamental operational drivers: process productivity through technology initiatives, manufacturing productivity through lean manufacturing initiatives and reduction in tons -- relentless reduction of our non-quality costs, right?So I think it's very important to -- and we're very happy -- and I cannot thank more of my team to -- at each of our plants worldwide to drive and deploy this operating system, and we're very, very happy to see the results.

I appreciate the color. That's very helpful to hear. And if I may, I have another question for you. On the production rates you see for LEAP, you've been above Boeing's rate. So they've been at 42 since March. And I think you guys hit as high as 57 in advance of -- prior to the grounding. So have you guys been pretty much above them all year? Or can you give any other color about how your rate has trended throughout the year? Thank you.

Listen, I think it's a good question. And -- but we don't -- how could I explain you, we produce, right, and we ship those components against a demand coming from Safran, not from Boeing. That's point number one, right? And I can't really -- it is not public. I cannot really explain you, right? So I don't even -- we don't even know it's clarity, right, the variance between the Boeing production and the Safran production, right? So our production schedule is driven by Safran's demand once again.We had a very lean inventory across all variants of LEAP prime early in the year. And as I said earlier, we have only -- and we will have only increased by a few weeks, not a few months, right, the -- our inventory at the end of finished goods and WIP at the end of the year. We are -- we will reduce -- in some color that Stephen explained in his remarks, we will reduce in Q4 versus Q3 our production rates. So therefore, our inventory build -- leveraging, by the way, leveraging the seasonal -- the calendar, we have a lot of -- many, many holidays in France in November.We have Thanksgiving in the U.S. We have the end of the year holidays. We will be, therefore, extending a holiday shutdown in order to produce less than in Q3 naturally, still producing a bit more than the delivery rate. But we are doing that once again in accordance with Safran, and we're doing that to basically maintain employee, our very talented but experienced and dedicated team across the world in Mexico, in the U.S. and in France until we see a recovery, right, from Safran, an increase -- pretty quick recovery and return to service of the Boeing 737, right? OK?

Okay, thank you.

Thank you, Jeff.

I will now go to the line of Jonathan Franzreb. Please go ahead. Mr. Franzreb, your line is open.

I think we should go on.

Yes, is there anyone -- operator, is anyone else in the queue?

Yes, I will open the line of Pete Skibitski.

Just was wondering if you could give us the update on how the M&A pipeline is coming along? Maybe how evaluations look in this environment. That's it. Thanks.

Oh, the NMA. Well, listen, you heard certainly about what Dennis Muilenburg talk...

M&A, sorry.

I'm sorry. I'm trying -- I'm sorry. M&A, listen, we don't publicly disclose, of course, any potential strategic transaction, right. But as I've mentioned many times, we keep on exploring inorganic growth opportunities.Whether we act or not on it would depend on a variety of factors. Most importantly, how they would fit with our strategic and financial criteria. And as I've shared with many of you in the past, I mean, our strategic criteria are pretty, pretty clear. It really means looking at opportunities that would enhance our technology, that would -- with technology that would fit well our existing competencies, thinking about potential product or differentiated materials, HSMCs, process adjacencies and also definitely targets that could -- would bring very strong materials, product, process, know-how and niche -- as well as niche IP, right? So that's really what we have been sharing with you, right, in the past in order to enhance, right, and increase our profitable growth.And from -- on the financial criteria, we want to be very cautious, very, very prudent, and we would be targeting certainly strong IRR, single -- I mean, double-digit IRR. And we believe, Stephen and I and the entire team really believe in, how could I say it, in very well-defined, very well-defined synergies rather than the mother -- that I would say mother of synergies, right?So that's really what we do and what we're doing, and we are -- we have brought in, as you know, a very talented individual working for us who has basically devoted his time, devoted on exploring opportunities throughout all our end markets, especially aerospace, and we'll continue to do so.

Yes. And from a valuation perspective, Pete, look, we've seen some assets transact lately at very high prices. There is that one in particular in the -- really approaching the high teens from an EBITDA multiple perspective. Those are not prices that we are willing to chase.And so that may limit us in some opportunities. We may have to walk away because we're not going to chase prices like that. And it's -- nor are we, by the way, a bottom feeder that we're looking for just the lowest multiple of that there because as Olivier describes, we want high IP. We want high technology, which implies a fair and reasonable price. But we're not going to chase something up in the 15, 16, 17, 18 times EBITDA. That's just not the level at which we intend to transact.

Yes, I appreciate all the color. Thank you.

You're welcome.

There are no more callers in queue for Q&A.

Well again, thank you all for joining us on the call. We really appreciate your time today and your continued interest in Albany International. I would like to conclude today's call by recognizing the entire Albany team for another very strong quarter of performance. Thank you.

Ladies and gentlemen, that does conclude our conference for today. Thank you for your participation and for using AT&T Conferencing Service. You may now disconnect.