Ducommun Inc (DCO) 2015 Q2 法說會逐字稿

Good afternoon, ladies and gentlemen, and welcome to the Second Quarter 2015 Ducommun Earnings Conference Call. My name is Chris and I will be your conference moderate for today. (OPERATOR INSTRUCTIONS.)

As a reminder, this conference is being recorded for replay purposes.

And at this time, I would now like to turn the conference over to your host for today, Mr. Chris Witty. Sir, you may proceed.

Thank you and welcome to Ducommun's Second-Quarter Conference Call. With me today is Tony Reardon, Chairman and CEO, and Joe Bellino, Vice President, CFO and Treasurer.

I would now like to provide a brief Safe Harbor statement. This conference call may include forward-looking statements that represent the Company's expectations and beliefs concerning future events that involve risks and uncertainties, and may cause the Company's actual performance to be materially different from the performance indicated or implied by such statements. All statements other than statements of historical facts included in this conference call are forward-looking statements.

Although the Company believes that the expectations reflected in such forward-looking statements are reasonable, it can give no assurance that such expectations will prove to have been correct. Important factors that could cause actual results to differ materially from the Company's expectations are disclosed in this conference call and in the Company's annual report and Form 10-K for the fiscal year ended December 31, 2014.

All subsequent written and oral forward-looking statements attributable to the Company or persons acting on its behalf are expressly qualified in their entirety by the cautionary statements. Unless otherwise required by law, the Company undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, after the date of this conference call.

Now I would like to turn the call over to Mr. Tony Reardon for a review of the operating results. Tony?

Thank you, Chris, and thank you everyone for joining us today for our fiscal second-quarter conference call.

I'll begin by providing an overview of the quarter, including some market color, after which I'll turn the call over to Joe Bellino to go over our financial results.

While facing a slowdown in our military and oil and gas markets but seeing new business growth in our commercial aerospace, we focused on improving bottom-line results and streamlining certain operations to ensure that Ducommun is right-sized for the current economic environment. The good news is that we accomplished what we set out to do this quarter -- cutting costs and expanding margins while, at the same time, evaluating our facilities for rationalization opportunities.

In addition, I'm pleased to say that our New York facility consolidation -- bringing three facilities into one newer, more advanced and more efficient manufacturing operation -- is on schedule for completion this year.

We have also now reduced headcount 10% year over year and implemented corporate-wide supply chain initiatives. As a result of these actions, and as committed to, we are on track to remove $4 million to $5 million of annualized costs from our operations this year. And it is -- and this is already showing up in our -- terms of our margin expansion.

So while revenue and income, net of one-time items, were down compared to last year, we showed vast improvement sequentially versus the first quarter of 2015. Commercial aerospace demand remains strong, and our other end markets appear to be stabilizing.

Another very element of our focus this quarter was completing our debt financing on schedule. We accomplished this goal at very attractive rates that are expected to save the company an estimated $14 million to $15 million in interest annually. It's a tremendous achievement and one that we are very proud of.

So we made progress this quarter on improving both our balance sheet and our operational performance.

Now let me put a little color on our end markets and our products and programs.

In the military and space sector, we saw some modest growth versus Q1, but we're still down year over year as expected, given the legacy programs we've discussed in the past. In fact, you've likely already heard from other government contractors -- our defense-related business is down double digits year to date, and we're starting to see some stabilization in terms of run rates across the board but still anticipate lower revenue in these markets during the second half of 2015.

Our military backlog in both aerostructures and technologies remains just north of $250 million. There was no surprise in this part of the business, but this is an area that remains a core focus in our efforts to right-size operations, so they're in line with what we call the new normal of lower defense spending. In fact, we're looking at additional streamline initiatives, including cost-cutting measures, about which I'll be able to provide more color later on this year.

I also wanted to mention a recent industry development with regard to our military and space business, specifically the recently-announced deal with Lockheed Martin to purchase Sikorsky from United Technologies. As many of you already know, Sikorsky has been and remains one of our key customers here at Ducommun. The Blackhawk is our largest military program, and we have received several prestigious supplier awards from Sikorsky over the past decade. So we now look forward to working with its new owner and believe our relationship with both Sikorsky and Lockheed will continue to strengthen in the years to come.

Now moving to our commercial aerospace operations, I'm pleased to say that, once again, we posted year-over-year revenue growth on the strength of a diverse number of high-profile platforms, such as the Boeing 737, the 777 and the 787 programs. Our commercial aerospace backlog remains solid, just under $200 million, and we expect to see this grow over the next two quarters with revenue expansion as well during the remainder of 2015.

We continue to win new content on the new 737 Max as well as various Airbus aircraft and since May have announced a number of awards in this space, including a contract from Spirit to product titanium auxiliary power unit exhaust-sparing assemblies housing the tail cone on the 737 Max. This adds to the content on the Max platform which already includes spoilers and other structural assemblies.

We also announced at the Paris Air Show a cooperative research agreement with Airbus under which we will jointly develop applications using Ducommun's Foam Matrix technology, an advanced resin transfer molding process which brings both weight and cost savings into a higher-strength assembly. We see this as the beginning of an entirely new chapter within our collaboration with Airbus.

Now, last but not least, we also recently announced a multi-million-dollar contract with Gulfstream Aerospace to support the upcoming G500 and 600 aircraft, a new family of large-cabin, long-range business jets. Ducommun will be the sole source supplier of the titanium auxiliary power unit inlet duct and the cooler duct for these platforms. It's a great win for Ducommun, and it will significantly expand our presence with Gulfstream going forward.

And these wins come on top of our previously-announced supply agreements with both United Technologies and Rolls-Royce.

So we're very pleased with our increased visibility and content within the entire commercial aerospace arena, and we currently have 30 to 40 brand new development programs in place. We continue to see plenty of business opportunities with Boeing, particularly on the 737 Max and the 787, and with Airbus on the A320neo, A330neo and the A350.

Our focus for the balance of the year will be managing these new start-up programs and other new development programs that have initial production revenue from 2016.

Turning to our non-A&D business, we saw mixed performance this quarter, as anticipated. With our energy-related end markets, we're down double digits year over year, due primarily to the negative impact of the oil market. We saw modest growth in our industrial end markets and our medical end markets -- again, both versus 2014 and sequentially -- along with strengthening backlogs. The bottom line, though, is that we expect the non-A&D areas to remain mixed but stable, likely without much meaningful improvement until 2016. As with our military and space markets, we are using this opportunity to assess our facilities for additional rationalization and take increased steps to increase our asset utilization.

With that, I would like to now turn the call over to Joe to go through our financial results. Joe?

Thank you, Tony, and good day, everyone.

We reported net income of $1.8 million, or $0.16 per diluted share, for the current quarter, compared to net income of $6.6 million, or $0.60 per diluted share, in the second quarter of 2014. I'll get into the details in a moment, but directionally it shows considerable improvement from the first quarter's results and also includes certain debt extinguishment expenses incurred related to our new credit agreement which we finalized during the quarter.

Net sales for the quarter of 2015 were approximately $175 million. That was 6% down from last year's comparable quarter. As we bridge the revenue decline, it's reflecting a continuing shift in demand for our products, including a nearly $16-million decrease in military and space sales and an approximately $2-million decline in non-aerospace and defense revenue, partially offset by an approximate $6-million increase in commercial aerospace revenue.

In the military and space sector, we have seen reduced demand for both structural solutions and technology applications, reflecting lower aggregate demand in the government defense spending sector.

Within the commercial aerospace arena, by contrast, we continue to experience growing revenues as we benefit from higher airframe build rates and increased content. We expect these mix shift trends to continue throughout the remainder of 2015 and into 2016.

Overall, the macro environment reflects softer demand as compared to historic levels.

We have previously indicated that the first half of 2015 would be a transition period as we work through this mix shift and other short-term issues. During the second quarter, we began to see benefits from actively managing this transition and from our efforts to reduce manufacturing expenses. This resulted in a 17.8% gross margin which, although down from last year's 20.2%, the 17.8% gross margin was a significant improvement from the 2015 first quarter's gross margin of 15.5%.

We continue to work to address the issues in front of us to return the company to profitability levels of which we're capable. This could include further headcount reductions, lowering of indirect labor costs and improving our manufacturing performance, as well as our execution on certain new programs. In addition, we have launched a companywide supply chain improvement process during the quarter, and we expect these supply chain improvement efforts to contribute to enhancing our profitability beginning in the fourth quarter of this year.

Operating income for the current quarter was approximately $11 million, or 6.2% of revenue, as compared to approximately $17 million, or 9% of revenue in last year's comparable quarter.

The actions taken during the quarter are improving operating margins which are now returning to levels similar to those in the second half of 2014.

In addition to the focus on gross margin improvement, we have worked to lower our SG&A expenses, which were 11.6% of revenues in the current second quarter, as we continue to right-size our overall cost structure.

The second-quarter 2015 pre-tax results include two items on separate lines in our statement of operations, the first being a $2.8-million loss on the extinguishment of debt related to our new credit agreement, which I'll discuss in a bit, and the second a $1.5-million insurance recovery listed as other income.

Our effective tax rate during the quarter was nearly 42%, compared to 32.6% for the comparable period last year. The higher rate reflects the lower levels of pre-tax income this year compared to last and the associated limitations on certain deductions. We expect the effective tax rate for the balance of 2015 to average approximately 37%, excluding any potential benefit from the federal research and development tax credits.

These federal R&D tax credits are gaining traction in Congress for approval, and this would benefit us -- it would be a benefit to us and it could be a 2-year, so it'd impact us favorably in 2015 and 2016.

EBITDA was approximately $19 million, or 10.8% of revenues, in the second quarter of 2015.

Our effective working capital execution continued in the quarter, resulting in cash flow from operations of $14 million, and for the year to date 6 months, $17.6 million versus $15.5 million during the comparable 6-month period of 2014.

Now reviewing the results by business segment. First, Ducommun AeroStructures, or DAS -- DAS posted revenues of approximately $76 million for the quarter, down nearly $3 million versus $79 million in the second quarter of 2014. In addition to the previously-mentioned sun-setting of two long-cycle defense programs, we have seen some reductions in revenue across our military helicopter platforms due to lower defense spending. This resulted in a revenue decrease in military and space structural products year over year of a total of nearly $8 million. This was partially offset by a $5-million increase in the sales of commercial aerospace structured applications, primarily on the Boeing and Airbus large commercial airframe applications.

DAS's operating income was approximately $7 million, or 9% of revenues, versus operating income of approximately $10 million, or 12.8% of revenues, for the second quarter of 2014. The negative margin comparison year over year was primarily the result of an unfavorable mix shift, higher forward loss reserves, the loss of efficiencies from slightly lower manufacturing volume, and lower overall volume, which was partially offset by lower compensation and benefit costs.

Although still below 2014 results, DAS's operating income improved significantly from the first quarter of 2015 as the benefits of our cost-cutting efforts began to take effect. We continue to aggressively address our manufacturing efficiency issues and expect sequential improvement in operating margins throughout the second half of 2015.

EBITDA was approximately $11 million, or 13.8% of revenue, as compared to nearly $14 million, or 17.3% of revenue, in the second quarter of 2014.

We expect military and space demand to remain soft throughout 2015. On the other hand, commercial aerospace orders remain solid, with most of the growth coming from existing contracts. Going forward, we expect commercial aerospace demand to continue to rise over the next several years at a 3% to 5% annual rate, which would be accompanied by expansion of margins as we right-size our cost structure.

Ducommun LaBarge Technologies' results, or DLT. Segment sales for the second quarter decreased 8.5% to approximately $99 million as compared to approximately $108 million in comparable period last year. The lower revenue reflects a nearly 13% decline in military and space electronics revenue and an almost 30% increase in oil and gas applications. This was due to a modest shift as defense electronics sales fell by $8 million, commercial aerospace electronics grew almost $1 million, and non-aerospace and defense revenues declined by nearly $2 million.

The decrease in defense technologies revenue primarily reflects reduced demand for F15 and F18 modernizations, affecting our radar rack applications, and softness in military helicopter demand. Offsetting this trend somewhat, we continue to see slightly higher demand for our missile defense electronics applications.

Through recent market development activities, we continue to enjoy increased demand for our commercial aerospace electronics applications with new customers. Going forward in the DLT segment, we expect to see stabilization in our defense electronics backlog with trends similar to those that we have reported in the last four quarters and a solid commercial aerospace backlog. In our non-A&D offerings, we have a pronounced decline in demand for our energy-related products, reflecting the adverse impact of the combination of lower oil prices and lower rig counts. Offsetting this, we are experiencing strong growth in other areas, including medical and industrial applications, resulting in higher backlogs in those segments.

DLT's operating income for the second quarter of 2015 was approximately $8 million, or 7.8% of revenue, compared to approximately $11 million, or 10% of revenue, in last year's comparable period. The decrease reflects a loss of efficiencies resulting from lower manufacturing volume and lower revenue.

We continue to reduce operating expenses and are aggressively pursuing additional cost-reduction activities while also expecting our supply chain initiatives to contribute in improving operating margins beginning in the fourth quarter of 2015.

EBITDA was approximately $12 million in the quarter, or 12.2% of revenue, compared to approximately $15 million, or 13.7% of revenue, in last year's comparable period.

Looking at corporate, general and administrative expenses, they ran at the rate of $3.7 million for the quarter, or 2.1% of revenue, and it was a decrease from $4 million, or 2.2% of revenue, in last year's comparable period, primarily due to lower compensation and benefit expenses.

Next, looking at our backlog, overall at the end of the quarter backlog tallied $524 million. This equates to a sequential decrease of $35 million versus the end of 2014, but it's mostly within the DAS business segment related to large commercial airframes. The backlog decline in our DAS commercial aerospace sector reflects a change by our large airframe manufacturing customers in placing their orders with us on a quarterly rather than on a traditional annual basis. This is more of a timing difference, accounting for about $25 million of the lower commercial aerospace bookings, and does not reflect the strong underlying long-term demand trends for large airframe products. As a result, quarterly backlogs, even if we look at it on our long-term programs, tend to be shorter in duration and lower in amounts than was previously the case. We continue to work diligently to win additional orders across both our diverse commercial aerospace end markets and defense technology platforms.

Liquidity and capital resources -- very important to us, and in the first half of 2015, as I mentioned, we generated $17.6 million of cash from operations, $2.1 million more than the comparable first half of last year. We remain diligent in effective working capital management and expect our net cash profile going forward to reflect historic seasonal patterns.

At the end of the quarter, our net-to-adjusted-EBITDA as defined was approximately 3.4 to 1.

Our financial highlight of the quarter involved entering into a new 5-year, $475-million secured credit facility which we announced on June 26. The new credit facility consists of a $200-million revolving credit line and a $275-million term loan with mandatory prepayments, both of which mature in June of 2020. With the new credit facility in place prior to quarter-end, we refinanced the existing $80-million outstanding term loan that was due in 2017. In Q3, we redeemed all $200 million of senior notes due 2018.

During the second quarter, we incurred a $2.8-million loss on the extinguishment of debt related to the unamortized deferred financing costs in connection with the prior financing that was retired.

On June 29, we initiated a call notice for the redemption to retire all the $200 million senior notes. As previously announced, this transaction closed on July 27. The notes were redeemed by paying a $9.75-million call premium, and we will record an additional $2.1-million loss on the extinguishment of this debt. The total aggregate amount related to retiring the senior notes of approximately $11.9 million will be recorded in the third quarter.

Upon completion of the refinancing on July 27, we now have $275 million outstanding on the term loan and unused balance on the revolving credit facility, resulting in approximately $198 million of liquidity under the new credit agreement. The refinancing resulted in very favorable economics for Ducommun, as the initial effective interest rate will be approximately 3.5% per annum, compared to the average prior rate of approximately 9% on our old debt. We expect interest savings annually to be approximately $14 million to $15 million as compared to our prior debt. We estimate that interest expenses will be approximately $3.5 million for the third quarter, which has a blended interest rate of old debt and new debt, and in the fourth quarter, with all new debt, we estimate interest expenses will be approximately $2.5 million. This compares favorably to the $6.7 million of expenses that we incurred in the second and first quarters of this year.

We are very pleased with the execution of this new credit agreement and subsequent refinancing, as it provides us significantly reduced expenses and greater financing flexibility to pursue strategic objectives and, in addition, create shareholder value.

At this stage, we continue toward our goal of deleveraging to targets of 2.25 to 2.5 over the next few years.

Capital expenditures were -- year to date were $8 million, and we expect to spend a total of $15 million in CapEx in 2015, similar to historic levels.

In closing, we continue to focus on managing the changing mix in our business and work to realize lower manufacturing costs throughout our operations. We also expect to see annualized cost savings of $4 million to $5 million beginning in the fourth quarter through our supply chain initiatives help drive higher operating margins and higher EBITDA margins.

In addition, we remain diligent with regard to expense management and working capital efficiencies which, along with significantly lower interest rates, should generate meaningful cash flow going forward.

I'd like to now turn it back over to Tony for his closing remarks. Tony?

Thank you, Joe.

Before turning the call over for our questions, let me just reiterate that, while we accomplished a good deal this quarter, we are by no means done with our performance improvement initiatives. As I mentioned earlier, we've already cut headcount 10% year over year, and we'll continue to look at the potential for further reductions while strengthening our operations.

We're evaluating our facilities for additional rationalization opportunities, and given the current outlook for lower defense spending and reduced demand in certain industrial end markets -- particularly the oil and gas -- we think that we have an opportunity to really take a look at asset utilization that we'll significantly improve going across the board.

We've begun the process of right-sizing our operations for the new normal and are on target to achieve our $4-million to $5-million cost savings this year, which should be evident in improved margins sequentially during the second half, even with the revenue headwinds previously discussed.

Our supply chain initiatives are also expected to reduce costs beginning in the fourth quarter, leading to improved bottom-line results heading into 2016. And our commercial aerospace business remains very robust, and we're looking at our other end markets that we believe are now stable and have stable run rates.

This continues to be a transition year for Ducommun, and as we stated at the beginning of 2015, we are evaluating the business in all stages to resize the business for our long-term growth and margin expansion. Given current demand dynamics, it is essential that we stay focused on asset utilization across our facilities and our product lines. We intend to update our investors on future calls with regards to our initiatives.

And in the meantime, we continue to make progress towards achieving improved financial results, and I'm pleased we closed our $475-million credit agreement refinancing that will significantly reduce interest expense for Ducommun going forward. This is something that we're very proud of, as Joe indicated, and it improves our financial profile and benefits our shareholders.

We are now a more nimble and faster-moving company than just a few quarters ago, and we're transforming Ducommun into an organization that is leaner and able to rapidly adapt to fluctuations in the markets. Over time, this will lead to more consistent results, increased customer satisfaction, and we believe we are going to be delivering higher returns to our shareholders.

With that, Chris, I 'll turn the call over to questions please.

Thank you. (OPERATOR INSTRUCTIONS.) Our first question comes from the line of Ken Herbert with Canaccord. You may proceed.

Hi. Tony, Joe, good afternoon.

Afternoon, Ken.

Ken?

First, congratulations on getting the refinancing done. Just wanted to ask first off on the gross margins, Joe -- nice -- really nice improvement this quarter. Did your comments imply that we continue to see sequential improvements in the gross margin through the second half of the year? And are you going to end the year close to the sort of 19, 19.5 number you've talked about or what's the cadence on the gross margin we should expect?

We believe it's going to move in that northeasterly direction -- that the first quarter was an anomaly, but they should be returning back to more historic levels. We're really working hard on the margins with all the things -- product mix and cost -- and then with fourth quarter we'll start to see some supply chain improvements kicking in. And so we do see sequential improvement in the third quarter over the second and potentially the fourth quarter over the third.

Okay. Okay. That's helpful. And then is it fair to assume that, as you start to anniversary some of the tougher comps on the defense business, that you could see growth in that business in the first quarter of '16? Or what should we expect from a timing standpoint for the defense portfolio to start to see some positive growth?

I think it will be later in the year in '16, Ken, because we have a couple of new applications that we're working on '16. I think we're seeing some stabilization. The tough call for us is in the helicopter market and how that's going to behave. So we've seen some fluctuation in that market because we have both OEM and then spares within that flow. So that's a little bit more difficult for us to project, but we believe that '16 will -- it's much more stable today than it was two months ago, but we think that towards the second quarter to third quarter of '16, we ought to see that start to stabilize and maybe pick up a little bit for us.

We updated our -- in our investors' relations our 3-year growth outlooks, and as we do it, we see a slight growth in defense technologies. Those backlogs, although there's been a mix shift within them, have been relatively flat for the last four quarters which portends what's going to be out there in 9 to 12 months from now. On the structure side, we see a 2% to 3% drop with the comments that Tony made in the helicopter business. We still don't think it's totally hit bottom.

Okay. Okay. That's helpful. And then if I could, I just wanted to make sure I understood. You have a really -- a significant drop, both within each segment within the commercial aero backlog. Was that really just timing of how your customers are placing orders or was there anything else perhaps in there?

No. It's purely timing, Ken. So we're looking for a few orders to be coming in this quarter that should bolster that backlog, and it's just a function of timing on the quarter releases, particularly for the 737 and 777 programs.

Okay. And then just finally again on the backlog, a really nice step-up in the quarter in the backlog for the medical and other markets. And I know they're smaller, but anything in particular that drove that or any particular wins you might want to comment on?

Yes. I think we had -- we had a real nice pickup in the medical market and we were able to replace a supplier for one of our key customers and support them as one of the suppliers was having a lot of trouble, so I thought that -- we've implemented a significant R&D effort for our customers in one of our -- in our circuit card assembly business, and I think that that has really helped us to get into the customers and get closer to the customers. And this pickup in the medical business has been a result of real good customer relationships and moving fast and getting them products in a hurry. So we got a nice jump in the backlog there.

Yes. That's nice. Hey -- well, thanks and nice quarter.

Thank you.

Thank you, Ken.

The next question comes from the line of Mark Jordan with Noble Financial. You may proceed.

Good afternoon, gentlemen. Question -- relative to the tax rate, you did give us guidance obviously of 37% for the second half of this year. As I remember, we started off the year looking at a potential tax rate in the low 30% range -- around 33%, I believe. With this move for the -- and guidance for the second half at 37%, if you were to look into, say, 2016, what ballpark should an expected tax rate, assuming that there's no investment tax credit initiated and what would it be if you -- if we were to get one?

It's probably a range of 32% to 34%, Mark. The R&D tax credit, which I'm getting comfortable with the things that are going on there -- last year, it favorably impacted our tax rate by 7%, and we've had those in the past experience that, so certainly that's a boon to us of $2.5 million a year, but we don't project those given the proper GAAP accounting treatment of them until that becomes law. So we look at that as an upside potential. And it's happened every year for the last 30 years or so except for one year, so we're fairly confident that it'll pass.

Okay. Tony, you talked about sequential improvement in aerostructures in the second half with regards to segment operating margin. If you were to look out into the, say, the second half of 2016 where all of your initiatives from cost-cutting to supply chain should be fully reflected in the operational characteristics plus more volume on the commercial side -- what kind of operating margin would you think would be a normal range that DAS should deliver?

Well, the operating margin -- as we look at it today, we've obviously struggled through the change in the defense side, so in looking at 2016 and the second half, it's kind of a tough call for me right here without understanding the product mix. But looking at what we're doing with the initiatives that we have in place, we expect that business to replace -- to return to its normal operating margins in the 11% -- 10% to 11%.

The operating margins overall for the company. As I mentioned, they're -- let's put a frame on it. We had operating (inaudible - technical difficulty). And as I mentioned, those -- that was about what the level of the third and fourth quarter of last year where certainly our targets are higher than the 6.2% and the 10.8%, respectively. And to the extent we could do all these things and get supply chain, we haven't quantified it exactly, but certainly our goals are to be higher than where they are today by some amount.

Okay. Thank you very much.

Thank you.

Our next question comes from the line of Edward Marshall with Sidoti & Company. You may proceed.

Good afternoon, Tony, Joe, Chris. How are you guys doing?

Good. We're good.

Hi, Ed.

So question. What was the loss reserves in the quarter -- loss reserve expense?

Well, what we -- we've put a variety of things in there, Ed. As you know, it's probably similar to what we've had in historic patterns, but it was more of a qualitative discussion, as you can see, to communicate to the investment community and to the analyst community the number of things -- the moving parts that we're dealing with, but they were not substantial relative to the whole body of work of things. And as we -- as you know, back in '12, '13 and '14, we'd quantify them more on an annual basis, and on -- after we got through a lot of programs in '12 and we got to '13, we said normally it's $3 million to $4 million a year annually. And you could use those same kinds of assumptions for the year, but by quarter to quarter, there's timing differences.

Right. So you're just booking the change in the quarter, correct? So are you saying it's less than $1 million in the quarter?

We have -- I didn't say that. It's -- they vary by quarter. And what we have is all these other things to quantify so we don't want to take it out of context, although there is more than one program. There's 3 or 4 and we change our estimates each quarter based on our manufacturing experience which could be both better or worse. But you could make --

Just so I understand the accounting, though, when -- to hit the P&L, it's the change in the expense in the particular quarter that hits the P&L on a quarterly basis. Isn't that right?

Here's the way we do it. We do our estimates to complete, and as we walk through it, Ed, we estimate what that -- most of these are in -- most -- all of these are in development programs. There's one that's in production. But the programs that are in development, we estimate to complete. So as we look at it, we actually true-up that estimate and that's what causes the reserve. So if you're going -- and it can go the other way, of course. But as you look at it, you're looking at what's it going to cost to complete this and then we'll take a reserve to cover all the costs that will overrun the program, if you will, and try to take that out to the completion of the contract so that -- or the development contract, if you will, so that we cover the cost and that we don't revisit that. So with the number of development programs you have running through here, the -- there's some opportunities in the pre-production phases that we look at. So we're -- we've beefed up our estimates to complete, and we're paying close attention to that. I would have to say we're very conservative. So there's opportunities on both side of the fence on the reserves, if you will.

Sure. Are you just -- so basically you're just saying that it's an insignificant expense in the quarter.

Yes.

Okay. So when I -- what stands out to me is the tax rate, and I'm just -- see if I can get some more clarity on it. And I think if you look at a similar tax rate for 2Q, that gets you kind of the 37% range for the full year. And I'm curious -- is there anything to do with some of the expenses that you took -- maybe the extinguishment of debt -- that's not tax-deductible or tax-deductible at a higher rate?

When we do our full-year provision, our estimate which incorporates the $11 million-plus that I spoke about -- the $11.9 million I spoke about that we'll record in the third quarter as that loss of extinguishment of debt, plus the $2.8 million from this -- those are all -- most of -- those are all deductible. And what it does is it lowers our pre-tax income, so that precludes us from taking certain deductions like the manufacturers' deductions, which is about 9%. It also may have -- cause us to carry forward some of our investment tax credits -- research and development tax credits on the federal and even on some state level. So when you get into the blended ones of those. But had we reported similar amounts that we did in the second quarter of last year, you would have seen the effective tax rate would have gone down to what we reported then.

Gotcha. So the different -- the change there in the tax rate relative to what you've said the guidance for 2016 is -- is essentially just the way you have to recognize some tax -- unrecognize some tax deductibles regarding -- related to somewhat of the extinguishment of debt, I guess.

Yes.

Okay.

And it's such a small amount, as you noted from our pre-tax number. The base was $3 million. Last year it was almost $10 million.

Gotcha.

So last year, at $10 million the effective tax rate was 32.6%.

And just to be clear, the $1.3 million net -- and if that's extinguishment of debt less the insurance recoveries, which was a gain. So roughly $0.07 after tax? Is that about right?

Well, I would use -- for modeling purposes, you can use an effective incremental tax rate of 37% over 11.3 million shares.

I'm talking about specifically for the quarter for 2Q though.

Yes. No, that's how you can do it.

Okay. Using --

Even though the effective tax rate was almost 42%, the incremental tax rate after a certain level is really 37%.

Gotcha. Good clarity. The debt -- did you say that there was going to be $275 million on the balance sheet as of July and so, as we look into September -- the September quarter -- assuming you don't pay anything down, it'll be roughly $275 million plus any working capital adjustments on the debt line?

Yes. If you look at the balance sheet at the end of June, it was $265 million and then we had some cash and all that stuff so we borrowed $275 million. We used some of that to true that up. But we actually do, on that term portion of the $275 million -- the first year we have to pay 5% of the principal, which is about $13.75 million. We'll pay a quarter of that in the September quarter, Ed. So we're at $171 million and change -- $271 million and change is what our balance will be at the end of the third quarter, assuming we don't prepay any additional debt.

Gotcha. And so you've got -- that leads into the next question, I guess. There's going to be, I guess, $14 million to $15 million less tax of incremental cash flows coming into the business, and I'm just curious. You've been paying debt down pretty steady pace and this is a term loan, so I'm kind of curious to get your sense as to what pace do you think you'll continue and, more importantly, is that still the motivation with excess cash flows?

Okay. So that's a good question, Ed. So what we're going to do is we're going to -- right now, we're coming out of this quarter, Ed, at leverage of about 3.4. And what we'd like to do is get that down to the 2.75 -- 2.5 to 2.75 range. So we'll look at the debt and then, starting next year, we'll start to look at potentials for acquisitions as we want to bolster the target line. I think that we want to use this year and probably into the first quarter to really make sure that we've got our cost-reduction programs well-managed and well under control and then some of these new development programs on pace. So as we look at the cash and try to drive the cash through, I would say that the remainder of this year -- we have cash on the balance sheet right now and we're not into the revolver, so we'll use that to trim the debt.

So are you saying that you're going to pay debt down faster than -- and chunkier than the $30 million a year that you had been paying it down?

Actually if you just use the $30 million, we'll probably be there but it's a good possibility that we'd pay more, yes.

Okay. And then finally, you mentioned some cost-saving plans, and I just wanted to get some clarity. First, what did you see in 2Q from that $4 million to $5 million annual expense savings? And then secondarily, you mentioned supply chains. Is that part of the $4 million to $5 million on the savings or is that an incremental over the $4 million to $5 million?

Okay. So let me answer both questions. So the first question essentially was did we see some of that in the second quarter and the answer is yes. I can't give you the number on that because the way that it works is you pick it up as the quarters go along, so we have pretty detailed cost-reduction initiatives and it's -- as we walk through the initiatives. You implement the initiatives in the early part of the Q2, you pick up some benefit and then you continue to pick up benefits in 3 and 4, if that makes sense to you. And then with regard to -- I lost my train of thought on your second question.

Supply chain part? Is that --

Supply chain part. We don't expect to see any of that until Q4. So we implemented that in the second quarter, and as you can imagine, the implementation takes time. So we have agreements, we have targets, we understand what we need to be doing, but now we have to flush through backlog and flush through the purchase and then the shipment's out the door before we realize any savings. So we think that by the fourth quarter we ought to start realizing some savings. And I would say the major portion of the initiative will take effect in 2016.

So -- but my -- I guess my question is -- is that included in the $4 million to $5 million in cost-saving initiatives that you've already put in place or is that incremental --

No. No. That's incremental. That will be incremental.

And what do you think happens from a margin perspective with that supply chain initiative?

So why don't you give me a couple of quarters to be able to work through that? So we don't have that -- we have the data but we're trying to see how it flows through, but we should see increases in the margin. We have projections on it, but we want to make sure that, as we allocate through, that it's -- we're truing up those margins. So I'd prefer not to predict that.

You don't want me to hold you accountable for it, huh?

I don't mind anybody holding me accountable. Just not when I can't manage it right now.

I'm joking. Hey, listen. Real quick. Airbus -- what's the amount of revenue on -- or maybe percent of your revenue from that business -- Airbus now? And you've been making some inroads there. Where do you expect it to go?

Well, Airbus is a tale of a couple things, Ed. With just 2, 3 years ago where the Airbus business was relatively small, and it was like $4 million to $5 million. We look at it now as it's probably $14 million to $15 million -- some directly to them and some on Airbus platforms. And we see that growing to an excess of $20 million to $25 million run rate by the second half of '16.

So about two-thirds of what Boeing, I guess, is for you.

For right now, yes.

Okay. Great. Thanks, guys. I really appreciate it.

Okay, Ed.

Thanks, Ed.

(OPERATOR INSTRUCTIONS.) Our next question comes from the line of Mike Crawford, B. Riley & Company. You may proceed.

Thanks. Just to continue with Airbus, I think that would be kind of your organic path within, given some of the development programs you're on and are pursuing. But wouldn't it be attractive, given your stronger balance sheet and maybe others' weakness, to pick up something opportunistically from an M&A front, even though you're not all the way down to your target leverage ratios yet?

I think we would do that, Mike, if something jumps out at us and it's in the right range for what we think we can handle, but we haven't see that. We are looking in the marketplace now and putting together a strategy. But yes, we certainly would look to pick up something that has more Airbus content. There's no doubt about that.

And further in M&A, given the defense market weakness overall and all the headaches (inaudible) in that sector, is -- I'm sure there's some competitors that are starting to hurt more, but would you not be interested in getting more defense exposure because of all those headaches or is that something that you think is a core competence that you'd like to take on?

I think that when you look at the defense market, given that there may be some jewels in the -- diamonds in the rough, if you will, we would certainly not shy away from it. At this point in time, we're not actively pursuing that market, but we believe that the -- obviously the multiples would be more attractive in that marketplace and we think that, given the business -- that the technology capability will enhance our technology and/or bring us some IP, I think we would definitely look into that marketplace.

Particularly on the defense electronics or technologies side of it. With the modernization programs going on with demand from foreign allies of ours and those kinds of things, it particularly attractive long term. And we see going into the '17 budget an expansion of the budget here domestically, and so strategically, we find those very attractive markets and margins.

As I've stated, though, I think, Mike, I just want to make it clear that we're not actively pursuing acquisitions at this time.

Right. And then maybe just to summarize on all of these operational and supply chain improvements and program maturation on the commercial front where you're getting better margins on more productive builds, do you think that -- what are the odds you could get up to a 20% gross margin in 2016, or is that a bridge too far?

Well, the way we look at is we have had -- in the last eight quarters, we've had a couple quarters where they were 20%. The key is to get sustainable margins at these levels of demand from our customers that are certainly higher than the 17.8% now. And certainly -- we've talked before a year ago that we wanted to get those sustained at 19%, 19.25%. I think we have to have an interim look at them, doing all the things we can, and then further refinement and change in our product mix to continue to enhance it. So it's a journey.

Yes. But I think it is -- it's truly a target, Mike. It's not something that's too far, and it's something that we think we can achieve as a company. And we have the initiatives that are -- we think are in place to help us get as close as possible, if not there.

Okay. Great. Thank you very much.

Okay, Mike. Thank you.

And we have no further questions at this time. I would now like to pass the call over to Mr. Reardon for any closing remarks.

Thank you, and I'd like to thank everybody for joining us today, and we sincerely thank you for your interest and your support and we look forward to talking to you next quarter. Thank you very much.

Ladies and gentlemen, that concludes today's conference. Thank you so much for your participation. You may now disconnect. Have a great day.