MOG.A (MOG.A) Q3 2015 Earnings Report, Transcript and Summary

Good day, and welcome to the Moog’s Third Quarter FY ‘15 Earnings Conference Call. Today's conference is being recorded. [Operator Instructions] At this time I would like to turn the conference over to Investor Relations Manager, Ms. Ann Luhr. Please go ahead.

Good morning. 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 31, 2015, our most recent Form 8-K filed on July 31, 2015 and in certain of our other public filings with the SEC. We've provided some financial schedules to help our listener’s 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. John?

Thanks Ann. Good morning. Thanks for joining us. This morning we will report on the third quarter of fiscal ‘15 and update our guidance for the full year. We’ll also provide our look at fiscal ‘16. Let’s start with the headlines. First, earnings per share of $0.94 in the quarter, was slightly ahead of what we were projecting 90 days ago. Included in this total is a $0.11 of restructuring charges. It was also another good quarter for cash flow. Second, we continue to see sales and margin headwinds in many of our businesses. We’re responding with additional restructuring activities and ongoing reviews of our products and business portfolio. Third, we decided to look for strategic alternatives for our European space operations. These three operations had total sales of about $15 million in fiscal ‘15. Fourth, we’re reengaging in our sales process for our medical pumps business this coming quarter. Fifth, we continued our buyback activity in the quarter and we’re on track to complete our current 9 million share authorization around the end of the fiscal year. And finally we’re providing a first look at fiscal ‘16 today, for next year we’re projecting 1% sales growth and earnings per share of $4 up 14% over our fiscal ‘15 forecast. Now, let me provide you with some numbers, starting with the third quarter results. Sales in the third quarter of $635 million, was 7% lower than last year. Two thirds of the decline was due to the effects of the stronger US dollar. Setting the currency FX aside, sales were down in our Aircraft and Space and Defense segments flash in Industrial and Components and up in our Medical Devices business. Taking a look at the P&L, our gross margin is in line with last year. R&D is up on higher aircraft spends on the E2 program for - development program. While SG&A expenses are lower as we continue to manage our costs. Interest costs were up due to last November sale of high yield debts and increased borrowing as a result of our share buyback activity. We incurred almost $7 million of restructuring expense in the quarter. Our effective tax rates was 28.4% and the overall results was net earnings of $36 million and earnings per share of $0.94. Fiscal ‘15 outlook, with three quarters behind us, we’re defining our sales growth forecast for the year very slightly. There are some puts and takes in each of the groups, but nothing of significance. Full year sales should be 2.53 billion. We’re updating our earnings per share forecast to reflect higher restructuring charges than forecasted 90 days ago as well as the impact of our ongoing share buyback program. Ninety days ago we provided a full year forecast of $3.55 per share. We’re on track to complete our authorized share buyback around the end of the fiscal year, adding $0.05 to that total to putting us to $3.60. Our forecast of $3.55 90 days ago assumes 5 million of restructuring in Q3 and Q4. We’re now increasing that restructuring total to $11 million or about an additional $0.10 per share. The net result of full year earnings forecast of $3.50 per share. Fiscal ‘16 outlook, for next year we’re projecting sales of $2.57 billion up 1% from this year. We anticipate commercial OEM sales will continue to grow as the A350 RAMS [ph]. Sales in Space and Defense, Industrial and Medical will be in line with fiscal ‘15, while sales in our Components segments will be slightly lower as a result of continuing low oil prices. Operating margins in fiscal ‘16 are forecasted to be 10.7% up from our forecast of 10% this year. We’re projecting earnings per share of $4 up 14%. We’re not including the effect of any further share repurchase plans in this total. Cash flow next year is projected to be 150 million or just over 100% of net income. Now to the segments, I’d remind our listeners that we provided a two page supplemental data package posted on our website, which provides all the detailed numbers for your models. We suggest you follow this entire level of the text. Starting with our Aircraft segments, Aircraft Q3, sales in the quarter up 270 million were 8% lower than last year. The familiar pattern of lower Defense sales continued this quarter, but unusually Commercial sales were also lower this quarter. On the military side, sales were lower in both the OEM and the aftermarket areas. Sales in the F-35 development program declines to below 1 million, while sales on various foreign platforms were also down from a year ago. On the commercial side, sales were lower in every submarket except Airbus. Sales to Boeing were down from a record quarter last year as a result of the timing of orders and deliveries. Sales to Airbus were up on the continued ramp in the A350 program and sales into the Commercial aftermarket were lower on general market softness as well as lower 787 initial provisioning. Aircraft fiscal ‘15, with three quarter behind us we’re defining our sales mix for the year to include slightly higher military sales and slightly lower Commercial sales. More specifically, we believe the F-35 and the V-22 production sales would be higher, while A350 production sales will be lower on a slower ramp than anticipated. The total remains essentially unchanged at 1.09 billion. Aircraft fiscal ‘16, we’re projecting fiscal ‘16 sales of 1.13 billion, an increase of 43 million over this year. The increase is all on the A350 program, which will be up $47 million from ‘15 to ‘16. Other Commercial OEM sales should more or less in line despite slightly lower business jet sales. We’re forecasting the commercial aftermarkets to be down to 5% in fiscal ‘16 as 787 initial provisioning continues to moderate. On the Military OEM side, higher F-35 sales will make up for lower V-22 and Black Hawk sales. The Military aftermarkets will be down 3% as our refurbishment program on the C-5 winds down. Aircraft margins, margins in the quarter of 10.5% were up from 10.3% last year despite the adverse mix. We also had 2 million higher R&D cost this quarter driven by our Amber Air [ph] program. We continue to make progress on our Commercial book of business with declines in unit cost this quarter on both the 787 and A350 programs as planned. Despite the margin improvement this quarter from 12 months ago, we’re behind our plan for the year and therefore are moderating our full year margin forecast to 9.5%. For fiscal ‘16 we’re forecasting an adverse shift in the sales mix with lower aftermarkets in both the Military and Commercial markets. R&D next year should be in line with fiscal ‘15 as spending on A350 and E2 programs continues at an elevated level. In total we anticipate that the continued improvement in the Commercial book of business will compensate for the negative mix shifts to yield full year margins of 9.5% in line with fiscal ‘15. Twelve months ago, we reached that expectations for the trajectory of our Aircraft margins over the following few years. At that time I described the following challenges. Margin price on our domestic military book of business and lower sales on a variety of foreign military platforms and ongoing cost challenges as we ramp up production on our new commercial programs combined with continuing high R&D spend for a few more years. I said that we would continue to see margin headwinds for a couple of years and that when got up to fiscal ‘17, we should start to see margins expand again as our commercial book of business matures and R&D spending comes closer to 5% of sales. Twelve months later, today the story has not changed. Although the magnitude of the headwinds has proven to be bigger than we had projected. We anticipate that fiscal ‘16 will be a low point for aircraft margins and that in fiscal ‘17 we’ll turn the corner on a path to higher margins over the following years to get to the mid-teens by the end of the decade. Before I leave our Aircraft segments, let me put our margin headwinds into a longer term perspective. Over the last decade we’ve become the leading supplier flight control systems globally. We’ve moved from a Tier 2 component supplier into a Tier 1 system supplier. This has been a patience and deliberate strategy, a multi program strategy, not a single airplane project. It’s a 20 year strategy and perhaps inevitably it’s not without its challenges along the way. Since the early 2000s we’ve invested heavily in R&D which has compressed our margins. The 787 and A350 programs have taken longer and cost more than originally planned. We’ve learned a lot from these programs and our more recent development programs are performing very close to plan. We’re now in the relatively early stages of the production phase of our strategy. Similar to the development phase, it is turning out to be more expensive than we had anticipated. We’re introducing new products and new technologies to production and learning about building a global supply chain, while we - I’m pleased with the ramp rates. The margin headwinds associated with our heavy R&D space are now starting to shift to the early production phase. As with our development programs, we’re learning along the way and we’re seeing favorable results at the production starts up on our newer programs are performing much better than the earlier programs. We’re clearly disappointed that our margins have not started to improve as quickly as we had predicted a few years ago. However, our strategy remains solid and the long-term payoff would be worked away [ph]. The path to higher margins remains the same. On the Commercial side, R&D will abase as we look out to fiscal ‘17 and beyond, production cost will come down and the aftermarket will grow. On the Military side, the F-35 program will continue to grow and as the hardware matures and the aftermarket develops the margins will expand. We should also see some of our foreign programs pick up again and we’re positioning ourselves for the future with our contents on the tanker program and our teaming arrangements on the next generation helicopter and long range strike programs. Day-to-date the team remains focused on delivering on our customer commitments and working all of the cost developments to meet our long-term financial growth. Turning now to Space and Defense, sales in the third quarter of 95 million were down 7% from last year. Following the pattern of last quarter the weakness was all on the Space side of the business. The wind down of various satellite programs continued this quarter and combined with lower activity at NASA on the soft capture program resulted in a 21% overall sales reduction in the Space markets. This type of sales fluctuation in the Space market is familiar to us and it’s a natural cycle of programs shifting from developments into production and then back to the next development phase overtime. In contrast in the Defense market sales were up 13%, as strong sales on vehicle programs and into the neighbor [ph] markets more than compensated for lower security sales. Space and Defense fiscal ‘15, we’re reducing our full year forecast by 5 million to $384 million. The reduction is all in the Space markets as we anticipate continued weakness in both our satellite and NASA businesses. Space and Defense fiscal ‘16, we’re projecting fiscal ‘16 sales flash with fiscal ‘15, although we anticipate a continued shift in the mix from Space to Defense. We’re forecasting a further 7% decline in our Space sales next year on top of the anticipated 11% decline this year. On the defense side we’re projecting an 8% increase in sales in fiscal ‘16 on top of the anticipated 8% increase in fiscal ‘15. The underlying drivers in each markets are the same in both ‘15 and ‘16. On the Space side, two effects are driving the decline in sales. First the natural program cycle of shifting between production and development and second the results of our internal review of the product portfolio to focus on our most profitable products. On the Defense side, we also have two major effects over the ‘15, ‘16 period. First missile sales have continued to improve and second military vehicle sales have recovered from their loads of a few years back with nice gains in both domestic and foreign markets. Space and Defense margins, margins in the quarter were 6.5%. However, this margin includes $6 million of restructuring charges taken in the quarter. Exclusive of this restructuring charge, margins in the quarter were a healthy 12.9%. For the full year, we’re now projecting margins of 8.1%. Excluding the restructuring charge, this full year margin projection is up 70 basis points from our projection 90 days ago, as the underlined business continues to perform well. For fiscal ‘16 we’re forecasting margins of 11.5%. As I mentioned in my opening remarks, over the last few months we’ve done a deep dive review of our Space business. Back in fiscal ‘11, our sales into the Space market were $136 million and were based on matured products and technologies. Over a 12 months period from December ‘11 to December ‘12, we completed three small acquisitions which brought our sales in fiscal ‘13 up from 136 million to 220 million. Our strategy was to expand footprint in Components and to broaden our market opportunities by acquiring sites in Europe. During fiscal ‘13 and ‘14, we struggled to integrate these acquisitions and learned that small independent Space businesses often do not have sufficient capabilities and controls in place to meet their program commitments. Over this time we made the necessary investments to complete the commitments to customers which we had acquired, while we’re evaluating the portfolio to focus on the most profitable products going forward. Coming out of our recent review we’ve decided to focus our future investments on opportunities in the US markets and in particular the [indiscernible] program. As a result we’re reviewing the strategic alternatives for our European space sites. These European operations will have combined sales of about $15 million in fiscal ‘15. We anticipate it could take up to 12 months to complete this process and we’ll keep you informed as events unfold. Turning now to our Industrial Systems business. Sales in the third quarter of 131 million were 12% lower than last year. Excluding the impact of the stronger dollar wheel sales were essentially flash with last year. Again setting the Forex effect to one side, we saw our sales decline in our nonrenewable energy markets compensated by slightly higher sales in our industrial automation and stimulation businesses. Industrial Systems fiscal ‘15, we’re adjusting our full year forecast down 6 million to 524 million. We’re tweaking the forecast in each category, sales in energy and stimulation markets would be slightly lower, with sales in our general industrial automation markets slightly higher. Industrial Systems fiscal ‘16, we’re projecting flat sales for fiscal ‘16 at 525 million. Over the last several quarters, sales in these segments have been very consistent at about $130 million. The macroeconomic outlook for fiscal ‘16 does not suggest any improvement in the general industrial arena and while we have several internal initiatives underway to drive sales growth, we’re not comfortable at this stage forecasting how successful they may be. Industrial Systems margins, margins in the quarter were 10% consistent with prior quarters and with last year. The absence of organic growth combined with our ongoing investments in the Wind Energy business are making margin expansion difficult. However, we believe we’ll see improvements in fiscal ‘16 to 10.7% as a result of our continuing focus on managing our cost. Before I leave the Industrial segment, let me offer some comments on a couple of the few growth opportunities we’re pursuing. The first is in wind energy and the second is in the aftermarkets. As our listeners are aware, we’ve had a rollercoaster ride with our wind business over the last five years. Similar to our Space business, we recently completed a thorough review of our wind business and considered the various options and alternatives to maximize shareholder value including the potential sale of the units. Our analysis of the future opportunity made it clear that the best option to maximize shareholder value was to continue to invest to grow the business. The wind market is projected to grow between 5% and 10% over the next five years and the profitability of the market participants is improving after several years of losses. The competition in our space of pitch control systems had suffered over the last few years as have we and we may be the only company prepared to make the investment in new products. We have a product road map laid out and have already feel that the question [ph] of iteration what we call our AC system. We’re well underway with our second product iteration, which will further enhance functionality and improve profitability. We anticipate having first units of the second iteration in the fields during 2016 and we believe we have an addressable market overtime of several hundred million dollars. It will be late ‘17 or perhaps even into 2018, before we know for definite if our strategy has been a real success, for we believe the upside opportunity justifies the investment we’re making today and stay in the course. The other area of opportunity is in the aftermarkets. Over the years we placed hundreds of thousands of hydraulic and electric components in the field. Over that time we’ve enjoyed some aftermarket in this business, but we’ve never built an aftermarket organization focused on capitalizing on this installed base opportunity. We’ve done this very successfully in our Aircraft segment and are now bringing that same learning to our industrial markets. The organization change has been relatively recent and it’s too early yet to gauge the potential gains, but we believe there’s a lot of opportunity that we’ve not exploited in the past. Turning now to our Components segments, sales in the third quarter of 107 million were down 3% from last year. The weakness was all in our non-aerospace and defense market. Sales into the energy sector were way down as weak oil prices impact the pace of offshore explorations. We also saw lower sales into our medical markets as demand from a major customer from [indiscernible] equipment fell. On a positive note, sales in our general industrial markets were up on strengths from our Aspen acquisition. In the aerospace and Defense markets, sales were up 4%. We continue to see a trend affirming missile and vehicle sales as well as some improving demand for Slip Ring assemblies used on military aircraft. Components fiscal ‘15, this quarter sales came in ahead of expectations though we’re adjusting our full year forecast up by 5 million to 415 million. We believe military aircraft sales will be higher and despite the continued low price of oil, we think our full year sales into the energy market will be slightly higher than our conservative estimate from 90 days ago. Components fiscal ‘16, we’re projecting a modest sales decline of 2% in fiscal ‘16 to 405 million. However, we anticipate some significant swings in the mix. Within our space and defense markets we see some nice gains on foreign vehicle programs as well as continuing strength in our missile programs. On the downside, we anticipate our sales into the energy sector will be off by over 20% as the full year impact of lower oil prices helped us [ph] through the lower demand for our components. Components margins, margins in the quarter were 12.7% similar to last quarter. Our components segment is going through a period where the mix of business is less favorable than in the past and the top-line is coming under pressure. We’re taking action to respond to the situation, but we’re likely to see relatively soft margins for this segment until the top-line recovers and oil rebounds. For all of fiscal ‘15, we’re forecasting full year margins of 13.5% and next year we’ll see the impact of a full year of lower oil prices and therefore are forecasting full year fiscal ‘16 margins of 12.6%. Turning now to our medical devices segment, Q3, this was another very good quarter for our medical devices segment. Sales were up 10% with continuing strength in both pumps and sets. We continue to see growth opportunities in our IV pumps as competitors remove some older products from the market. Our set business was also strong across both our IV and enteral product lines. Growth in sets comes as we place more pumps in the markets from the installed based growth. Medical fiscal ‘15, given the strong sales in the third quarter, we’re inching our full year sales forecast up by $1 million to 122 million. Medical fiscal ‘16, full year sales in fiscal ‘16 are projected to be flash with fiscal ‘15 at 122 million. However, you may remember in fiscal ‘15, we had approximately $3 million of sales from our life sciences operations, which we sold in March this year. Adjusting for these lost sales we’re projecting a 3% organic growth raise in fiscal ‘16. Medical margins, this segment continues to outperform our expectations with excellent margins in the quarter of 15.4%. Given the strong performance, we’re adjusting our full year margin forecast up to 12.8%. For fiscal ‘16, we’re forecasting further margin improvements to 13.6%. Before leaving our medical segment let me remind you where we are in our strategic review process. In July 2013 we began this process. At the time our medical segment was facing significant challenges. Our planned sale of the segment fell through in March 2014 and over the last 15 months we focused on refining our strategy and improving profitability. Today we have a very healthy business with highest margins in the company. However, we continue to believe that medical pumps are not a long-term fit for Moog and therefore we’re restarting the review process in the coming quarter and testing the market’s appetite for our asset. In contrast to however, to the process we started in 2013, we now have a business which is growing and nicely profitable. Therefore we’ll be seeking up price that reflects this new reality and will not hesitate to keep this business for longer if we cannot realize full value for our shareholders in the sales. So let me provide some summary comments. Out of all the various tweaks, our fiscal ‘15 sales forecast is now $8 million lower than our forecast from 90 days ago. Total sales for fiscal ‘15 should be 2.53 billion. Our updated operating margin is 10% and earnings per share $3.50. This EPS number includes the total of a $11 million in restructuring charges Q3 and Q4 and also assumes we complete the present buyback program around the end of September. In fiscal ‘16, we’re a 1% increase in sales and a 14% increase in earnings per share. The most significant change from fiscal ‘15 will be higher sales in our commercial aircraft business as A350 production ramps up. We’re projecting earnings per share of $4. Net earnings will be 148 million and our free cash flow conversion should be just over 100%. Fiscal ‘15 is turning out to be much tougher going than we anticipated 12 months ago. On our third quarter call in July of 2014, I offered some thoughts on the risks and opportunities associated with our forecast for fiscal ‘15. On the risk side, we thought that slowing defense spending combined with cost challenges in the early stages of our new commercial aircraft programs could cause us to miss our numbers. On the other hand we thought there might be some upside in our industrial and space forecast. It’s turning out that our risks have materialized while our upside opportunities have not. In fact, both our industrial and space forecasts for fiscal ‘15 are now well below what we thought 12 months ago. In addition we had not anticipated the robotic shift in exchange rates or the sharp drop in the oil prices. So all in all fiscal ‘15 is turning out to be a year of headwinds across the board. Our medical devices group has been the real bright spot in the portfolio. Looking to fiscal ‘16, we don’t anticipate a significant change in the macroeconomic environments. Therefore we’re proactively adjusting our cost structure now to size our business, to meet goals for next year. Historically, our company has enjoyed the benefits of diversification across many different end markets. Typically these end markets were [indiscernible] where we had tailwinds we pushed for earnings growth and where we had headwinds we reduced our costs and prepared for the next upswing. Today we find ourselves in the unusual situation where we face headwinds in almost all of our markets. We’re addressing this situation proactively and as we see the challenges mount in a particular business, we’re taking all necessary steps to restructure the business for success. Two years ago we had a struggling medical devices business. We took a step back, we focused the business and today it is performing much better. Over the last few years, our space business is also facing significant challenges. Over the last 12 months we’ve refocused the business and taken some significant steps to reduce the cost space. As a result we’re forecasting improving margins for fiscal ‘16 even in the face of declining space sales. Our aircraft business is now facing bigger challenges than we’d predicted. As with our other businesses we’re taking all of the necessary steps to ensure we get back on a margin expansion trajectory as soon as possible. The folks across the company remain focused on the long-term health of the business. We continue to pursue our in journey and maintain our investments in new innovation that will drive the next wave of growth. We’re generating strong cash flow and following a capital allocation strategy which maximizes shareholder value. We’re forecasting $4 per share in fiscal ‘16 on flat sales and another year of good cash flow to be a 14% increase in EPS and a record year for the company. Now, let me pass you to Don who’ll provide some color on the cash flow and balance sheet.

Thanks very much, John and good morning everyone. Free cash flow in the third quarter was $56 million bringing in the year-to-date total to 149 million. This represents a cash conversion ratio, which is free cash flow divided by earnings of 153% for the third quarter and 144% for the nine months ended June 2015. While our free cash flow is strong, our net debt increased by $29 million over the last 90 days as we used $91 million to continue to our share repurchase program. With respect to free cash flow, we’re seeing some benefits of focusing on our balance sheet. Since 2013 we’re averaging 200 basis points of lower trading working capital annually growing from 34.4% of sales in ‘13 to 30.6% presently. Our forecasted free cash flow for ‘15 is unchanged at $190 million or cash conversion of 138% and in ‘16, our initial forecast for free cash flow is $150 million or a conversion ratio of 102%. Through the end of June, we repurchased under our existing board authorization approximately 7.9 million shares at an average per share price of just under $70 resulting in a total return of capital to shareholders of $549 million since January 2014. Our plan is to complete the authorized buyback program by repurchasing the remaining 1.1 million shares by around the end of our fiscal year. Capital expenditures in the quarter were $20 million in depreciation and amortization totaled $25 million. For the nine months ended June, CapEx was 58 million while D&A was 78 million. We’re reducing our 2015 forecast for CapEx to $80 million, which compares with projected depreciation and amortization of $105 million. For 2016, we’re forecasting CapEx of $90 million and D&A of 107 million. Cash contributions to our global defined benefit pension plan totaled $27 million in the quarter. Our forecast for all of 2015 is unchanged at $62 million, for 2016 we’re planning to contribute $71 million. Our effective tax rate in the third quarter was 28.4% compared with last year’s 25.6%. The low rate in last year’s third quarter resulted from the tax detectable loss associated with the sale of the FX medical operations in the prior June 2013. We’ve lowered our projected effective tax rate for all of 2015 to 27.7%, resulting from a favorable shift in taxable income. For 2016, we’re forecasting an effective tax rate of 28.5%. Our financial ratios at the end of the quarter reflect the effects of our stock repurchase program. Net debt as a percentage of total cap was 42% compared with 27% a year ago and our leverage ratio, net debt divided by EBITDA is currently 3.45 times compared to 1.6 times 12 months ago. At the end of our third quarter we had $350 million of available unused buying [ph] capacity and a $1.1 million revolving credit facility. 2015 has turned out to be a more difficult year than we had forecasted a year ago. We got with numerous unexpected challenges by critically reviewing our portfolio of products, restructuring appropriate and focusing on generating strong cash flow. We’ve seen some sound success with cash flow affording us the opportunity to return value to our shareholders and inform of our share repurchase program. Lastly, M&A is still an integral part of our growth strategy. We’ve not done an acquisition since the second quarter of 2013, but we’ve been busy assessing opportunities and we’ve seen recent increase in the outflow. We intend to remain disciplined in our capital allocation decisions focusing on what will provide an optimal return for our shareholders. And with that I’d like turn you back to our moderator to facilitate any questions that you may have for us. Diana?

Thank you. [Operator Instructions] And we’ll go first today to Robert Spingarn with Credit Suisse.

Good morning.

Good morning, Robert.

Good morning, John, and I have just a couple of guidance questions and then an aftermarket question, so John, for ‘16, it sounds like your authorization completes this year. Any buyback contemplated in the guidance?

No, not in the guidance we would say, in the text I said that the guidance for next year does not assume any further buyback activity. We anticipate that we would complete the present 9 million authorizations around the end of this fiscal year and let me give a broad answer to that. Our focus is on trying to make sure we are doing the right capital allocation strategy to create value. And there’s a couple of pieces that go with that. We have obviously over the last couple of years return value to shareholders in the platform of a buyback. But there is also - we continue to believe that long term M&A as an important element of our growth and we just haven’t seen anything interesting. But as Don said, it seems like there may be a little bit of pickup activity there. So we would be making the decision on the basis of the right opportunity for our shareholders. But there is obviously M&A versus buyback opportunity. The other thing is that we have certain limitations in terms of our covenants and what we’ve said to folks who have the questions in terms of the capital allocation strategy and a leverage ratio is that typically around the two and a half times is the limits that we feel comfortable with our covenants go to three and a half times, but that the two and a half gives us enough flexibility to response and perhaps interesting acquisition opportunities or to make sure that it’s indicated a rainy day, you just are not too close to the limit. So that’s our strategy and that two and a half will kind of close to that right now. So that may be an automatic covenant in terms of next year in terms of what we would like to have to do. But in addition to that, our Board’s authorization runs out at the end of the September, we haven’t had that further conversations with our Board. So I don’t want to get ahead of that Board maybe.

Okay. Fair enough. On the margins in the guidance, the 70 basis point increase, I know there is some restructuring in this year, how do we think about the underlying margin delta? Is there anything one-time in next year’s number? What’s the organic margin change if you will?

Well, we anticipate next year that maybe some - at this stage it’s early and of course it all depends on how some of the businesses come in. We anticipate there may be some small amount of restructuring in next year’s number. Now having said that, 12 months ago I couldn’t have anticipated the amount of restructuring that we did this year, so we will respond appropriately if the business happens. But the underlying margin position is not changing significantly this year to next year, particularly if you back out the restructuring charges this year, plus the accounting correction that we did in the second quarter, you get the underlying margins that are not significantly different. Now between the groups of course, the margins do shift. We are seeing aircraft margins about flash. We are seeing a pickup in space and defense margins, industrial margins a little bit of a pickup. Our components margins are going to be down next year and that really is the impact of the lower oil prices. We saw margins this year compressed by that and we think next year with the full year of that, we are going to see some further compression. And our medical margins are forecasting to be up a little bit. So there is organic margin shifts between the businesses, but overall, as I say, if you back out some of discretions [ph] this year, the total margins for the company are fairly similar to what they are this year.

Okay and then just last one I guess it’s for Don about the free cash flow decline into next year, the lower conversion just what’s behind that?

I think we’ll start now with a conservative estimate. We have said that we want to see some respectable strong cash flow in excess of 100% conversion, so we are starting out with around 100%. I’m optimistic that it could turn out to be better than that. But we don’t want to get ahead of ourselves.

Okay, thanks, I will jump back in.

And we’ll go next to [indiscernible] with Cowen.

Good morning.

Yes, yes, good morning, John. So I’m kind of intrigued in your comment about fiscal ‘17. So R&D, what’s your target for this year? It’s still 130 and then I assume the target would be about 130 for fiscal ‘16, of which about 80 is in the aircraft, is that the way they think about it?

Yeah, so actually we bumped up the total for the year by a couple of million dollars and it’s in the aircraft and so we go from about a 130 to 132 and that $2 million increase is really what we saw this quarter, we saw the [indiscernible] business, R&D a little bit higher. Next year it’s pretty much dash with this year. Aircraft is around that 81, 82 mark and it’s really a continuation. There will be a little bit of shift. So we think airbus will be the A350 about the same. We think the e-jets will come down a little bit, but we would see some more activity on the 919 and there is a couple of other things like the 525 and B280 that will see a little bit of pickup on. So we still have heavy spends on what I call the new commercial programs, 350 and by [indiscernible] C919 fairly significantly.

Okay, now you said R&D, so basically your numbers imply R&D to sales in the aircraft group of about 7% next year and you talked of going down to 5% in 2017 that would imply that R&D would be down 20 million sequentially. Is that what you are really thinking?

No, that’s not what I said Kai. I’m actually trying to find text, what I said is we will head down towards 5% over a period of time. What I said is as R&D spending comes closer to the 5%, but this is expand margins, so the commercial book of business which shows and R&D comes down, but I said starting in fiscal ‘17 we would - that we’ve seen a comedown as a percentage of sales over the last couple of years. So it’s not - this is not a commitment but it’s going to get the 5% in fiscal ‘17. That’s probably a couple of years beyond that. So I wouldn’t like to leave that kind of hanging in the air, I do think it will continue down next year until ‘17, but at this stage we are not giving specific guidance for ‘17 on either the spend or the sales percentage. If I’ve to say come to say that it will come down as a percentage of sales again in ‘17.

Got it. And so your commercial aftermarket forecast calls for a second year of decline this year it’s down about what 12 million to 1.18 next year another 6 million, is that conservative and given that we should see some build in provisioning on the A350 and 787 was down this year, what are your assumptions in that assumption?

Yeah, over the last, I would say, three or four years Kai, kind of ‘13, ‘14, ‘15, ‘16, if you back out initial provisioning, you pretty much get to about a $100 million run rate underneath us more or less it’s kind of been fairly 30 flat. As we’ve talked over the periods that has to do with the mix of airplanes that we’re on the fact that it’s not scheduled maintenance et cetera. So in this fiscal year in 2015 we’ve actually seen a softening underneath that and if I put the 87 provisioning, it’s 20 million that’s down from 30 million a year ago. Now there is a little bit of pickup of about 5 million of the A350. But if I combine A350 and 787IP, I’m getting to about 26 million and next year that drops off we think to about 17 million, so the 87 we are dropping down to half of that and a little bit of pickup on the A350. So really it’s an impact that’s almost a $11 million drop on the IP reflecting that in the overall total which we are not bringing down quite that much, so that’s what’s happening. We are thinking that IP will drop out. In the past we’ve been pleasantly surprised by the amount of IP that we’ve sold but we are doing the best we can in terms of trying to put a conservative estimate on us. I would love it if it would be better, but at the end of texts I described last year I thought there was upside in some things and it turned out that that wasn’t the case, so perhaps that was an upside there on the IP. It’s very hard to predict as I said on the 87, we were way off in terms of what we thought. We are trying to take that experience into the 350, but it’s still an IP story next year in terms of why it’s down.

Great and the last one, So, John, in the second quarter you took the negative EAC on commercial programs because of problems and transitioning to suppliers or supplier churn if you will, could you update us on that situation and tell us what you are doing to make sure that that kind of gets back on track and you can really hit the lower cost that you’ve been hoping for?

Well, let me give you this update. We didn’t take any adjustments in the third quarter, so that’s a positive. I would say in terms of what we are doing, we are doing everything humanly possible Kai. I mean there is a team of folks work on this on a day to day basis, have been working it for the last couple of years. So it’s not as if there is a magic bullet that we can pull on to say, now let’s focus on doing this. We have added some additional talents at the top of the supply chain organization. We are looking at all of our classes and systems. We continue to look at all of the vendors. We look at the strategy we are employing and we continue to focus on incrementally quarter after quarter coming down the cost curves. And as I said, this quarter we have seen that cost reduction, we continue to see in this quarter and there were no negative variances in this quarter on those major programs the 87 and the 350 in particular. So there continues to be a lot of work in that area. There continues to be a lot of focus in this. It’s going to be a growing day to day, month to month and quarter to quarter and it’s probably going to take us another couple of years to really get a - what I call, mature supply chain in place. But the newer programs as we look at the early stages, now we are not in production yet on the E2, but as we are forecasting out and we are seeing what’s happening there, we’ve learned a lot and we think we will be much closer to the curves that we are laying out and they are much accelerated curves from our experience now on 87 and 350 is better than 87, but we see the future as continuing to be better. But it will remain a challenge and as I said, on the last couple of quarters, each quarter we’ve discovered that there is a little bit more of a challenge that we had predicted. But we hope that we are starting to see the low end, the bottom of that in terms of margin compression and that as we look out at the ‘17 and ‘18, we’ll start to see that come back.

Thank you very much.

Thank you.

And we’ll take our next question from Steve Cahall with RBC.

Good morning, Steve.

Yeah, thank you. Good morning. Maybe first one on the aircraft margin, maybe both for the balance of this year, but more importantly in FY ‘16, with the flat margin I imagine you have mix moving against you in terms of less aftermarket and more A350. So I’m guessing the improvement comes in kind of the commercial portfolio and around learning curve. So, A, is that right? And, B, can you walk us through kind of what you need to achieve next year in order to hold that margin flat in the face of those headwinds?

Your analysis is exactly right. If you look at the total aircraft sales next year, they are up almost $50 million and essentially it’s $50 million of additional A350 production and as you might imagine, we are in the very early stages of that steep ramp, a lot of learning curve, so that’s not going to be a significant margin contributor next year. It will be - if anything it will be obviously a margin headwind in terms of the total margin. So that’s the challenge. On top of that, then you got the commercial aircraft aftermarkets going down, which is usually a real positive and you got the military aftermarkets up a little bit. And we are seeing on the military OEM side, we are seeing F-35 replacing some of the more - in terms of sales, some of the more mature programs F-18 and V-22, Black Hawk. Again as you might imagine earlier on, even on the military side, typically you don’t have quite the same margin performance as you do when you get into mature production. So there is natural headwinds from mix shifts and the military OE side, military aftermarket, commercial aftermarket and then the headwind associated with their sales growth on early production. And the - what we are doing the strategy in terms of making the margin is making sure that we achieve the cost reduction plans that we have for those early production phases of 87 in particular the 350 where we see the growth next year. So that is really the both the opportunity and the challenge next year and as I mentioned to Kai there is a team of folks that are laser focus on making sure that we do that. But we can’t predict whether or not an individual supplier will have challenges whether there is a technical issue, this year quarter or two ago we talked about an ordering issue. That was a complete surprise, a vendor related issue that we couldn’t have anticipated that caused a hiccup and that typically happens in these types of programs. Something comes up as a surprise. But we are trying to make sure that we got enough opportunity to cover that and make sure that we continued on those curves. Does that help, Steve?

Yeah, are you - would you be willing to quantify what that cost reduction impact is, so essentially if the sales project forward just as you’ve got in the guidance and you didn’t do any cost reduction, how big of a margin headwind is that?

No, we wouldn’t. We don’t break out our margins by commercial or by program and if we head down that path, we start to do that and that’s competitively sensitive data that we don’t think is appreciate to share at that level.

Okay, fair enough. And then maybe on the restructuring efforts, the $4.4 million, we have less, will we see the preponderance of that again in the Space and Defense Controls segment? And is some of that also going into the business that you are looking to divest?

Well, in the quarter, in Q3, we took about $6.6 million. Most of that was in the Space and Defense business and then with a little bit in our Components business. When we project restructuring, we’re lots to get into discussions as to where it will be, because it’s kind of reserve that we haven’t yet worked through all of the details and we definitely haven’t had an opportunity internally to communicate what that might mean in the various businesses and therefore it’s inappropriate even in our guidance and the supplementary. We kind of carve it out. We say we haven’t yet allocated it back to the segments. However, I would say given the size of the restructuring we’ve already taken in this Space and Defense business side, I think we feel that we’ve got most of that behind us in that business and it’s not really focused necessarily on the European operations if we are looking to find alternatives for.

Okay and then maybe just a final one on tax, if I’m doing my numbers right, it looks like the tax rate implied in the fourth quarter kind of inches up back towards 30%, which would be above where it’s been aggregated in the last six or so quarters and lower than what you’ve guided to next year. So is that correct? Or are you getting into a structurally lower tax environment going forward?

Yeah. Steve its Don. Your math is correct. When we do expect just because of the mature things and the way things are coming together that the tax rate in the fourth quarter solely by itself would be a little bit over 30%.

Right, thank you.

Thanks.

And we’ll take our next question from Michael Ciarmoli with KeyBanc Capital Markets.

Good morning, Michael.

Hey, good morning, guys. Good morning. Thanks for taking my question. Just on aircraft margins as we move into ‘17, certainly you are not the only supplier out there who talks about ramp or just improvement in ‘17, but how much visibility do you have? You talked about a couple of programs, Long-Range Bomber, I think some other helicopter programs. What else is out there that might come into the fold in 2017 that might either create some more R&D if you are successful in winning business on the program? I mean I’m just wondering how you are contemplating the margins in the out period when you are not sure. Or if you can give us a sense of what you think there is a high probability that you win? Is that contemplated into the margin improvement?

Yeah, so in the - in our outlook, when we do a multi-year outlook on the business, we do typically reserve a certain amount of funding in our R&D line in aircraft in particular for unknown or unnamed or unborn programs. Some of those you can anticipate. So for instance, the Long-Range Strike is obviously a big opportunity that a lot of companies are pursuing. We think we’re reasonably well-positioned on that. That’s something that we hope to know about within the next few months is to flat position we - we actually are on both teams. So depending on which team wins, we’ll have a better understanding of what concept we may have on that and we have a value reserve for next year, but that’s the sales number because that’s the [indiscernible] development, so it would be in the sales line, probably no margin type of business, but nonetheless it doesn’t go through the R&D line. So on the military side, typically it’s more - it goes more into the sales. It absorbs engineers that come out of some of the commercial programs. We are putting in a little bit of investments on some other military programs to position ourselves V-280, the replacement helicopter program. We think that’s important. So we are doing some work there. And then on the commercial side, typically we might reserve a bucket of money for our major programs coming up and assuming that there may be some other opportunities. However, it’s hard to see I think we’ve already mentioned that we don’t have any significant content on the 777X and there is no major stocks that we can anticipate. It seems as if the planes, particularly Boeing and Airbus are getting into an evolutionary type of development on their airplanes on the 37 and the 320, perhaps that will generate an opportunity for a surface here or a surface there, but it’s probably likely to be a much smaller amount of R&D. The Chinese are talking about a wide body jet, the 929, it’s very early stages. We typically found that we can - there is some opportunity to recover some of the R&D if you work with the Chinese, who the heck knows how that might play out. And then there is talk, I guess, of a 57 replacement. Again I think it’s way too early. We don’t have any specifics on that. So typically we’ll reserve some bucket of money to make sure that we’ve built a tremendous capability. We obviously don’t want to lose that capability. Part of that capability will go to hopefully building military programs, Long-Range Strike in particular. And then some of it will reserve to make sure that we’ve got capacity to response to ongoing commercial opportunities, but it’s an estimated - it’s a source [indiscernible] because it never quite plays out exactly as you think. However, our commitment overall is to getting that R&D spend more in line with what I call a long-term run rate is definitely there. We’ve made a huge investment over the last decade and we don’t anticipate that we would need to continue at that pace in the future.

Got it! That’s helpful. And then just on the - you’ve obviously got the business jet revenues forecasted down next year. How comfortable are you maybe with some of the risks there specifically with Bombardier or just kind of line of side [ph] into that market maybe creating more pressure?

Yeah, that’s a good question, Michael. I mean typically what we do is we try to forecast on the basis of what our customers are seeing. Obviously, Bombardier is going through some challenges. Our focus with Bombardier is on the Challenger 300. That seems like it’s a fairly solid program, has been for the last couple of years. We are projecting that that will be fairly solid next year at the production program and hopefully that will continue to be kind of the stable in their diet [ph]. Apart from that, Gulfstream is a big part of our business, but we are not anticipating growth on Gulfstream next year and into the couple of other bits and bobs in the bus jet. So overall this year we’re anticipating that it’s going to be about $50 million. Next year we are anticipating it’s going to be up three or $4 million. So it’s not in the scheme of the $1.2 billion business, 1.1, 1.2, it’s not a huge number and the shift from one year to the next is pretty small. So our exposure to business jet is relatively contained.

Got it and then just a last one if I could, maybe a bigger, broader, strategic question, as you guys conduct your restructuring, it seemingly comes and goes on a quarterly basis and it seems to be more reactionary. It’s driven by end market. I mean do you guys have some broad or more holistic operating improvement plan that is just looking to permanently right-size the operation in addition to, I know you are putting the RP system in, but it just seems like the consistency, I guess, of the restructuring just seems to be more end market driven rather than just more of a lean, constant improvement. I mean is there any more detail you can give us on what you guys are doing to kind of structurally just improve the business in the absence of end market dynamics?

Yeah, you are right. And that our restructuring or a lot of the restructuring that we are doing is in reaction to end market impact. But I would suggest that that’s probably the case with almost any business. So we’re just done restructuring in our business in Halifax, because the price of oil collapsed over the last 12 months. Up until then, we were expanding there and adding people. So restructuring is almost always the result of lower sales because for whatever reason our customers aren’t buying our product. Underlying structural long-term improvement is based on improvement systems and processes and we are on a lean journey. We’ve been on it for a couple of years. It’s proving to be a cultural shift, which is taking quite a while. But we are seeing improvement from that. We are seeing and we have a lot of activity around us. And that is causing, I would say, a gradual underlying improvement in the business and we do look at how many facilities, the structure, the underlying footprints of our business on a repeated basis. So there are underlying things that are going on, Mike. But it’s a little bit like at the moment the perturbations around market shifts are so much larger than that underlying what I call steady day after day Kaizen [ph] type of improvement that you don’t see this. I would say that the cash flow, we’ve had very strong cash flow for the last few years. We anticipate even though next year we are seeing $150 million. If you average our cash flow conversion rates over the last three years, kind of a rolling average, we’re well north of a 100%. So that is the result of a lot of these activities resulting in lower working capital and we continue to focus on improving that cash position. And there is continuing activity at the ground level to improve our operations. We have only three major initiatives that we continue to push across the company. It’s the whole area of talent, which is all about the people, right people in the right jobs doing a great job. It’s leans which is all around operational focus, on time delivery, great quality, constantly reducing cost and then it’s innovation, because we are a company where engineering capability, new products, new technologies with a lot of long-term growth. And those three themes even in the face of all of the kind of the short-term restructuring shifts in the market, they continue to be the underlying theme across the company. We continue to push them at every opportunity and there is a continuous movement to keep improving in those areas. But as I say, unfortunately when you see these big waves washing over the company on a quick response, quick action that we are taking, which I would say is being very proactive that tends to mask the underlying improvement that you might otherwise see.

Got it. That’s really helpful. Thanks, guys.

Thank you.

[Operator Instructions] We’ll go to a follow-up from Robert Spingarn with Credit Suisse.

John, I just wanted to dig into aftermarket a little bit and ask about some of the things, the trends you are seeing that have caused the forecast to go a little bit array, you’ve talked about provisioning being off, so I’m curious both on the provisioning side and on the normal aftermarket, what are you seeing lately and what are your expectations within the aftermarket guidance for next year?

So, Robert, the forecast go array and I’m not sure that the forecast did go array. I think the forecast it’s kind of in line with what we were saying, if you look at the forecast we made 90 days ago versus today, we have popped it up by a couple of million dollars. But right in front of me I don’t have what we start at the year.

I might have misunderstood your comment on 787 provisioning coming into the year.

Yeah.

Maybe I missed.

What we’ve been is we’ve been, I would say, over the last couple of years, we’ve been positively surprised by the 787 initial provisioning, but we’re probably being a little bit negatively surprised by some of the other underlying aftermarkets activity. So if I look at this particular quarter and I compare with what we said 90 days ago, we’ve increased the 787 provisioning, but we’ve taken down some of the other. We’ve got some engine components and some other stock and we’ve taken that down. So within the number there’s a mixed shift, but the underlying overall aftermarket has not changed much. But now, okay, can you go back and ask me the second part of your question again, because I’m not sure I remember.

Well, what I was getting at is you’re actually heading there, so maybe array is the wrong word, but what I’m trying to figure out is why the provisioning numbers are higher? What the airlines are doing differently than expected there? And then why the other aftermarket is weaker? Is it a surplus parts availability situation or is it just more disciplined buying by the airlines that we really haven’t seen until recently? What do you think is going on?

Yeah, so let me do the second part first. I think it’s all of those affects that you mentioned, but our aftermarket business, so there is the macro impact, which airplane programs are you on, how many hours do they play those airplanes and where are they in their lifecycles. And as some of these programs get closer to the end of life, there’s more of them that are in the desert, there’s more of them that get parted out and you start dealing with completion there, which is hard to get your arms around as to whether or not, how much of it you’re getting and how much you’re not. So I think the book of business we have 57, some of the bigger platforms, 57, 67, 47, those are some of the bigger platforms for us. So obviously you can imagine those flight hours on those airplanes are probably starting to come down. Our stuff is not scheduled maintenance, but you start - it’s difficult to say for every flight hours this amount of production. And I think there is clearly a trend that the airlines are being more prudent in terms of how much money they want to spend in the aftermarket and looking best value opportunities. But our stuff is not PMA. I mean it’s not - anybody, if they want a new component or a piece part, they are going to end up buying it from us one way or another. The only competition there is smaller shops who might decide to rework a part or somebody that’s parting out airplanes that are in the deserts. So does that effect? And I would say it’s very difficult for us to get our arms around and we can really - we can read the macro trends, we can see the flight hours and the airplanes were on, but it’s been tricky to anticipate exactly how that would play out. Then on the provisioning side -

No, no. Well, just before you go to provisioning, just a high level question, really just interested in your opinion. I think some of us have been surprised by the shortfall in aftermarket across the sector given where fuel prices are and it seems what’s happening is given the inflow of new aircraft and the discipline on capacity, airlines maybe reluctantly parking over other aircraft. And I’m just curious to see if you’ve seen anything that would essentially endorse that view?

I think that’s probably right. I would value my opinion on that - that said probably some of the other folks that you could get opinion from. So I wouldn’t take my opinion to any bank on that one, but I - we’ve seen the effects of that. So what’s causal [ph] versus what’s actually coincidental and what’s actually driving it, I would hesitate to say exactly what that is.

Okay and then just on the provisioning.

[indiscernible] that it’s not our underlying aftermarkets - we’ve anticipated that it’s not going to really grow. I think we’ve anticipated that for the last several years and we anticipated for the future that the underlying existing programs would probably continue to be under a little bit of pressure and of course the upside of the new programs. So I don’t think that’s fundamentally changed from what we were anticipating over the last several years even in the light [ph] of kind of increased, light hours and utilizations.

Right.

So then the IP - so I think what’s - let me talk about the 87 because right now the 350IP is still relatively small. Essentially this year was the first year we had any of it, it’s about $4 million or $5 million. The 87, the model on 87 is different from what we had traditionally done in our aftermarket. So if you go back traditionally with our type of stuff an airline, bus, an airplane, several airplanes and they decided on how much initial provisioning they wanted to hold in their warehouse in order to able to respond to any particular issues. What’s happening with the 87 is that you have a shift from that kind of traditional model to where airlines are signing up for either the full airplane up maintenance with a third party, one of the big guys Lufthansa Technik is an example and we have a contract with Lufthansa Technik or they’re signing up directly with the OEM in this case ourselves for a maintenance contract around their fleece, so the larger ones some of them are interested in that. And because our stuff on the 87 and the 350, we now we get to - where we have a sufficiently large package that we’re one of the bigger players in term of the list of potential cost drivers in the aftermarket, we now get invited to that party where we never got invited before. Of course the Engine [ph] guys have been doing that for many years and [indiscernible] has been doing that. So we’re now offering both to the - direct to the airlines and to large third party MROs options around what I call service by our type contract and with that comes various pooling operations where you provide aftermarket inter pools and I think what’s happened is that some of the third parties have decided to stock their pools in anticipation of large fleet growth in advance of what we’re historically seeing. So the aftermarket model is shifting a little bit in the 87 versus the historical and therefore some of what we’ve seen - it was just we had no experience base go on. We think with the A350, we got - obviously we felt some of that experience around the 87, so hopefully we’re closer. It’s been a positive surprise each year. Each year we said, well based on all of our analysis there can’t be that much initial provisioning still required and we’ve kind of valid it [ph] back but we’ve been surprised. Now, in the end the total amount of initial provisioning is probably not going to be dramatically different from what we anticipate it requires for a particular fleet. So it’s not with the [ph] fundamental shift in the amount of initial provisioning that’s going to be out there we believe. So it’s more a question of if you get it earlier than anticipated.

Very, very interesting dynamics, I appreciate your elaborating and then one last one if I may. John, you may have covered it, but I don’t think I heard it. The upcoming trainer program, what your thinking is there and the opportunity for the company?

This is on the US trainer program?

Yeah, this is TX yeah.

Yeah, I mean we’ll be engaged in pursuing it. At this stage I think it’s too early for us to say what if anything we may or may not get on this. So I’m afraid I couldn’t provide with a lot of color on that.

Okay, thank you.

Thank you.

And we have no further questions at this time. Gentlemen, I’ll turn the call back over to you for any additional or closing remarks.

Diana, thank you very much indeed. Thank you all for dialing in and for listening. And we look forward to updating you again in 90 days’ time. Thank you.

Thank you and that does conclude today's conference. Thank you for your participation.