Hexcel Corp (HXL) 2005 Q4 法說會逐字稿

Good day everyone and welcome to the Hexcel Corporation 4th Quarter 2005 Year-End Earnings Release Conference Call. This call is being recorded. With us today are Mr. Stephen Forsyth, the Executive Vice President and CFO and Mr. David Berges, Chairman, CEO, and President. At this time, I would like to turn the call over to Mr. Forsyth. Please go ahead sir.

Thank you. Well good morning everyone. Might I welcome you to Hexcel Corporation’s 4th Quarter and Full Year 2005 Earnings Conference Call today, January the 26th, 2006. With me today are David Berges, Hexcel’s Chairman, CEO and President and Michael Bacal, our Communications and Investor Relations Manager.

The purpose of the call is to review our 4th quarter earnings release distributed last night. As always, we’ll be happy to take your questions at the end of our prepared comments.

Well before beginning, let me cover the formalities. First I would like to remind everybody about the Safe Harbor Provisions related to any forward-looking statements we may make during the course of this call. Certain statements contained in this call may constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. They may involve estimates, assumptions, and judgments and uncertainties caused by a variety of factors that could cause the future actual results or outcomes to differ materially from our forward-looking statements today. Such factors are detailed in the SEC’s, in the company’s SEC filings including our 2004 10-K, the risk factor section of the prospectus dated August 3rd, 2005, and today’s press release.

Lastly, might I also remind you that this call is being recorded by Hexcel Corporation and is copyrighted material. It cannot be recorded or rebroadcast without our expressed permission. Your participation on this call constitutes your consent to that request.

Well with those comments, now could I turn the call to Dave.

Thank you Stephen. I’m sure you’ve noted by now that the $134.8 million of net income had a couple of special events included. Our performance and prospects in the U.S. allowed us to release a $117.6 million of valuation allowance against our U.S. deferred tax assets. We also had a $13.1 million charge in the quarter associated with the December conversion of the remaining preferred shares of stock to common stock by our holders. As a result, we now have $209 million of net worth, positive for the first time since 2001.

Putting these non-recurring events aside, our operations put up a solid performance in a quarter when we got less help from revenue than we expected. While we were only able to hold our year-over-year gross margins, we did expand our operating margins by 120 basis points from 7.9% to 9.1% of sales to reduce SG&A spending compared to last year. Delivering 18.4% operating income increase on only a 2.4% sales increase.

We also had a great cash flow quarter generating $31 million before paying the litigation settlement we reached last quarter. Some of the cash inflow came from inventory reductions we targeted in the quarter, an $8.9 million decrease in cost and currency. You’ll see that we’ve added extra detail to our cash flow statement this quarter so you can see the component changes in working capital. But clearly our sales growth rate of 2.4% was disappointing and less than we expected at the start of the quarter, due for the most part to temporary circumstances.

In the third quarter, you saw the first impacts of the six-month A380 launch delay and the Boeing strike that resulted in a 30 airplane schedule shift, where we had expected an aggressive recovery schedule. As almost all of our sales are for new airplane builds at the OEMs, you would expect the disruption to continue in the fourth quarter and it did. In fact, the combined result of the second half, year-over-year, commercial aerospace growth was under 8% after our first half that was over 20%.

Airbus sales for the quarter were about flat year over year primarily as a result of the negative swing in the A380 materials shipments. Sales for Boeing aircraft were up a modest 10% from last year in the quarter, despite the impact of the strike as we begin to see the impact of the planned 2006 ramp-up. It is worth noting that our sales to other commercial aircraft applications as a whole increased by 20% for the quarter. This group includes engine and the cell producers and regional aircraft as well as those revenues we could not trace to a specific program. With over 1800 new aircraft orders last year, we don’t view the second half as representative of real demand nor are we discouraged with the prospects.

Industrial market revenues were down $2.9 million or 3.2% on a constant currency basis, with the continued growth in sales to wind energy applications, not quite offsetting the softness in ballistics markets. Sales to ballistics or soft body armor applications were at a level of comparable to the third quarter but lower than the fourth quarter of 2004. Revenues from wind energy applications were up only modestly in constant currency compared to the fourth quarter of ’04 because of customer operating and supply chain difficulties.

Market share gains won in the fall of 2004 combined with market growth to push sales for the full year of 2005 up over 50% in constant currency compared to the prior year. The company lapped the benefits of its share gains in the fourth quarter of 2005. So the growth rate for 2006 will more closely align with growth rates of our customers, which should remain strong globally.

Constant dollar sales to space and defense were up $6.7 million or 13.3% higher than last year’s fourth quarter, driven by a wide range of programs in the U.S. and in Europe. Of note was continued strength in the sale of materials for U.S. and European helicopter programs, including the V-22 Osprey, Blackhawk, Tiger, NH90 and also blade replacement programs.

Electronic sales for the quarter of $12.5 million were comparable to the third quarter levels but down 10% from the fourth quarter of 2001. Stephen will cover our recent restructuring announcements that are intended to better align our capacity of this demand.

A disappointing top line for sure, but let me put it into perspective after Stephen covers some of the financial details.

Thank you Dave. Well let me cover a few of those details. First, let me touch on some operating matters. You, we’d like to the continuing electronics revenue trend, in January we’ve announced plans to consolidate our North American production activities related to the substrates for printed circuit boards in the electronics industry. We will be moving our activities into our Statesville, North Carolina plant and closing our plant in Washington, Georgia. In December 2005, we had also announced plans based on the same desire to rationalize our electronics production to consolidate certain of our glass fabric production activities in France too.

These programs aimed at matching regional production capacities with anticipated demands for these products. The estimated 2006 business consolidation and restructuring expense associated with these programs is $4 million. In addition to these costs, the company expects to record approximately $2.5 million of accelerated depreciation in 2006 which would be embedded in the normal depreciation rate. An additional $300,000 of business consolidation restructuring expense was actually recorded in the fourth quarter in 2005, relating to those French actions.

The company expects to earn its return on these investments during 2007 as this sort of restructuring can proceed much more quickly than we, than we, with and when we tackle an aerospace plant.

On the SG&A front, SG&A was $2.5 million lower than the fourth quarter of last year. Last year’s expense reflected $1.1 million of transaction costs related to the secondary offering in December of that year as well as the peak of the spending in Sarbanes-Oxley compliance activities.

Capital spending for the quarter was $34.5 million, almost double the level in 2004 and much of that spending related to our previously announced carbon fiber expansion.

Next let me move to the subject of taxes. As Dave noted, we released $117.6 million of the valuation allowance against our U.S. deferred tax assets in the quarter. Among the factors that contributed to this reversal was the continuing improvement in our U.S. operating profitability. And that in part helped by reductions in interest expense from the leveraging refinancing as well as other market factors.

Going forward starting in 2006 in the first quarter, Hexcel will now start to provide a full tax provision on its earnings from its U.S. operations. We noted in the release that we estimate the effective tax rate in 2006 for the company’s worldwide income, pretax income that is, were in the range of 37 to 39%. This will start to make it much simpler for people to project our after-tax profitability as you will not see the same quarter-to-quarter variability in the tax rate as you’ve seen in the past.

Additionally, we estimate that of those deferred tax assets we put on our balance sheet this quarter, we’ll be able to utilize $27 million of them in 2006 alone to reduce our 2006 cash taxes. In subsequent years, we’ll have further assets to release so they will decline over time.

While we have released the valuation allowance in the United States, we continue to provide a valuation allowance against the deferred tax assets of our Belgium subsidiary until such time there a balance of evidence supporting their ability to utilize those assets.

Moving on, let me address cash generation. During the quarter, total debt net of cash decreased by $15.2 million to $398.8 million. Reduction came despite the $15.8 million payment agreed in the carbon fiber litigation settlement we entered into in the third quarter. For the year, if you exclude the cash costs in the first quarter, our debt refinancing of $42.1 million and the payment of litigation settlements, net debt would have decreased by $40.8 million in 2005 despite the higher levels of capital spending in the year.

In the three quarters since we’ve, we refinanced our balance sheet, our interest expense has settled at a quarterly rate of $7.2 to $7.4 million, about a 35% reduction in the run rate that we saw in 2004 and clearly this is helping strengthen our cash generation.

Looking to 2006, we expect to fund our capital expansion from operating cash flow and as a result, we expect the total debt, net of cash, should still show a modest reduction at the end of the year.

On December 29th, the holders of our convertible preferred stock agreed to the company’s request to convert their remaining shares of preferred stock into common shares of Hexcel in accordance with the original terms of their agreements. The preferred stock would have probably converted the company’s option in March of this year, so long as the price of Hexcel’s common stock remained above $9 per share. As a result of the early conversion, we took a charge of $13.1 million during the fourth quarter. The hereafter, there will be no further need to see charges in that deemed dividend increases line, also simplifying our reporting.

After this transaction and so you’re not affected by the averaging that goes into the EPS calculation in any one quarter, the basic number of shares outstanding of common stock after the beginning of 2006 is $92.6 million. To get to the diluted count, you’d add two to three million additional shares based upon the treasury valuation of options outstanding.

Talking of options, let me just briefly touch on the subject of stock option accounting. Like most companies, Hexcel is adopting the provisions of FAS 123(R) as of January 1st. In the earnings release, we have provided guidance that we expect the incremental non-cash expense will result in a charge, result from this change of accounting in 2006 will be in the range of $5 to $6 million. That’s a non-cash expense. And you obviously have the full details when we report our first quarter results.

Lastly as Dave noted and if you’ve not had a chance to review it, I draw your attention to the additional detail provided in the cash flow statements related to working capital.

Well that concludes my comments. If I could turn the call back to Dave to talk about the year and the prospects going forward.

Sure thanks. Before we close the book on 2005, there are a couple of things that I think are worth note. Our sales for the year were up $87 million or 8% led by a 50% gain in wind markets and almost 15% growth in commercial aerospace, our two most promising markets.

But beyond the specials outlined in Table F, we delivered great leverage again this year. With that $87 million of sales growth, we delivered $25 million more of gross margin, for an incremental rate of almost 29%. We reduced $4 million of overhead costs to yield almost a 34% incremental operating income gain. And thanks to gains from our refinancing and our joint ventures, net income is up $45 million or 53% on the incremental sales.

As we look at the comp, at the accomplishments of the year, it’s also worth remembering that in addition to completely revising our debt structure and lowering interest costs and extending maturities, we also increased our float and diversified our investor base by moving almost 50 million shares out from private equity investors.

And finally we were delighted to announce the addition of David Hurley and Lynn Brubaker to the board vacancies that resulted from these secondary offerings.

Given the noise in the second half, I’d like to share some guidance for 2006. We expect another year of revenue growth and earnings expansion. We expect sales to grow at about 10% this year. This will be the outcome of another year of double-digit growth in aerospace and wind, offsetting some of the uncertainties in ballistics. While we don’t handicap space and defense sales today, our tremendous global platform and customer diversity in this market has resulted in a five-year growth trend of 12.5% with very little variance. If we continued to deliver operating leverage, that 10% of growth can help us achieve gross margins of 23% and operating margins of 11% for the year despite expense in options, if you exclude restructuring.

Beyond 2006, the prospects for composites in aerospace just keep getting brighter. The record large aircraft orders booked last year filled our customers’ near term production schedules and they continue to steadily increase aircraft build rates. The growth in global air traffic continues unabated. It is led by economic development and deregulation in every region, particularly in Asia where the per capita use of air travel in regions with enormous populations provides a great counterbalance to the legacy U.S. airline problems.

Higher fuel prices and custom preferences for new aircraft are pushing airlines to replace their older aircraft with modern fuel-efficient models. Low cost carriers on every continent are emerging with large orders for all new aircraft and offering ticket prices that bring a whole new segment of the population to the world of flight.

But that’s only the start of the story for Hexcel. The second air penetration composites as a material of choice going forward changes what is already a great cyclical recovery. By the end of 2006, we’ll see the delivery of the first A380, with at least triple the dollar composite content of any aircraft in production. The A400M, a turbo prop military transport aircraft, with composite wings and propeller blades will enter into initial production in late 2006 when EADS begins the building of development aircraft. By 2007, Boeing will start the first 787 aircraft with over 50% composite content. And the A350 from Airbus follows 18 months behind with a 39% composite content. And for the first time, the CEO of the EADS, the Airbus parent, suggested publicly that the next generation A320 was likely to be primarily composite.

Our margin and cash delivery records through good times and bad demonstrates our commitment to manage what we can control. The prospects for organic growth should provide Hexcel the opportunity to continue its great leverage start.

We’d be happy now to take your questions.

Thank you. The question and answer session will be conducted electronically. [OPERATOR INSTRUCTIONS] We will begin with Steve Binder from Bear Stearns.

Yes good morning. Dave can you just touch on the Airbus-related sales. I mean it’s a, couple second quarter in a row where you had some weakness and softness. I know you’re attributing to the A380 but if you look at Airbus’ build rates outside of the A380, it’s still up compared to a year ago, pretty much across the board. So just maybe can you have, is it really just isolated the A380 or are there any other factors there?

Yes, the base business for Airbus as best we can dissect it is up. It’s at the A380 year over year is down. So there’s a distinct drop in the A380 because of the ramp delay. And once that comes back, you’ll be able to see the top line Airbus growth.

So shouldn’t you see to some degree a, because you had that A380, if you look at build rates for Airbus right, you’ve, they’ve not delivered the A380. So shouldn’t you actually see better than, shouldn’t your Airbus growth in ’06 be better than their overall growth rate cause you’re seeing that phenomenon this year, lower A380 sales?

Yes it should be.

Yes. And the other thing is as far as the inventory, you did reduce inventory by $9 million, was that pretty much out of aerospace? Was that Boeing or can you isolate what that was?

I don’t have that level of detail and it might have gone further down if Boeing had elected to try to recover those airplanes by year end, which is what we were hoping for. But I’d say it was across the board as we sort of manage to year-end targets in most of the plants.

Then lastly if you looked from the third to fourth quarter, I mean you’ve isolated a number of different events that have been affecting gross margins throughout the year, more recently the utility costs, energy costs, expedite costs, labor/productivity costs, all throughout the year there’s been a variety of issues. I’m just wondering if you look sequentially from the third to fourth quarter, what got better? What got worse?

Well I think I mentioned in the last call that the productivity and expedite issues of the second quarter had started to moderate. And I would say that that because the fourth quarter had a full quarter of the improvement and the third quarter only was partially improved, I would say that got better. Input costs to the extent they’re oil-based obviously didn’t get better. Natural gas costs were a full quarter of the impact after Katrina, so that got worse.

Okay and how about like expedite costs?

I don’t have the details but I’m certain they’re down from the second quarter. The ramp was going so strong for four quarters in a row, the lull in the third and fourth quarter depending on which plant was affected, obviously took some pressure off that as well as getting the shifts on board that we needed.

Okay, thank you.

Credit Suisse’s John McNulty has our next question.

Yes, good morning guys. Three questions. The first one, the wind power growth in your, in your press release you had indicated that you were expecting it to be in the teens. It’s my understanding that in the past, the industry’s really been focusing on a 25% growth rate or 20 to 25% range. I’m wondering if there’s a fundamental change that’s going on or is, is your guidance a little bit on the conservative side, given that some of your, some of your customers have had some supplier issues?

Well the growth is only moderated for us compared to our history because we lapped the share gain that we made last year. So I think we actually put up two years of 50% growth. The overall growth of the industry has been going at between 50 and 30% over the years. We haven’t seen the final numbers for 2005 yet, but because of the production tax credit release, the U.S. is likely to record a record year. There’s obviously some lag in timing and when we ship materials. And there were some difficulties meeting the demand at a couple of our customers. So I think we’re just suggesting that we expect good strong growth, but probably not as strong as it has been in the last two years.

Okay, second question on the, when you look quarter to quarter from the third quarter to the fourth quarter, you saw your sales were up a few percent, you know somewhere in the 2% area, at some of your higher profit businesses like commercial aerospace where we’re up a little bit more than that. And yet your margins sequentially were down 80 basis points, which seemed like a lot. And I’m wondering if there were certain mix issues in this that we should be thinking about or if it’s, if raw materials or maybe and energy are a bigger component than what we thought in terms of, in terms of the pressure on the margin?

I think John that when you have such a little move, it’s a little bit hard to dissect. On the big moves, it’s a little easier to pinpoint. We clearly have some timing things that happen between third and fourth quarter, particularly on SG&A. But we don’t have anything specific to point to that would suggest some radical shift in the trends. I expect that we’ll get continued year-over-year leverage and year over year I think is the safest way to look at it so that you get the seasonality issues out of the way.

Okay and then the last thing, you had, you had said before because of the closure or the improvement or restructuring on the electronics business that we might see some accelerated depreciation in 2006, I assume that’s factored into the, into the margin guidance that you’ve put out there for 11%. And I’m wondering what it would be if you didn’t have that accelerated depreciation there, if you might actually have more operating leverage than what your margin forecast would necessarily be indicating?

Let me tackle that one John. Yes it is factored into the guidance that we provided. And so you’d $2.5 million more of operating income. So you’re looking at, what? 10 or 20 basis points. I would note that if you look at depreciation number as a whole, you’re going to be comparable this year to ’05, it will step up in ’06 though because you then got to bring those carbon, in ’07 I’m sorry. Will be comparable in ’06 to ’05. It will step up in ’07 when we commission the carbon fiber assets. So you’re probably not going to sort of quite see that additional $2.5 come and go in the numbers. It just sort of gets wrapped up.

Okay great. Thanks for your help.

Thank you.

Our next question comes from Al Kaschalk from Wedbush Morgan Securities.

Morning guys.

Hi Al.

Real quick on the, going back to John’s question on the energy prices. It seems like they caught up to us in the quarter relative to I guess the low volume of sales growth. But is there anything that’s changed there that we shouldn’t see either those costs being passed along or someway to improve how we’re affected by any volatility in those prices?

Well I would hope that we’ll, we’ll stabilize and not be surprised like we were after Katrina. We obviously work on some long term contracts to try to be it bit of a hedge. Katrina just sort of caught us all off guard. Fourth quarter was a tremendous spike. It moderated a little bit in the first quarter and we’ve been able to stabilize some of that.

I didn’t make much of an issue of it because I just recently read the Alcoa release where they talked about an $800 million increase in input costs. And our $5 million problem from energy for the year seems to pale in comparison. At the end of the day, they’re our competitor. So, I’d see whatever energy costs are going up are probably net/net, helpful though I’m not really rooting for them.

On the wind energy side, again I don’t want to belabor the point here, but do we see any from your standpoint, can you give us a little bit more color on the lag or the timeframe from when you ship to ultimately gets into the final product? And if there’s any six-month ahead of schedule like you do on the commercial aerospace side in this segment of your business?

I would say it’s a shorter cycle than that because we’re shipping directly to the blade manufacturer. So it’s probably tighter from their building of their towers, from when the tower gets installed and it comes online for energy, that’s probably a much longer cycle. And I’m not really even familiar with it.

Okay, so you don’t see any inventory build the blade manufacturer from your side and you should continue strong in ’06 in light of your other previous comments.

With respect to our materials, the velocity and the volumes that are moving into this business and the fact that our products generally have to be refrigerated really limits the inventory in the supply chain from our perspective. To the extent our customers are having supply chain problems with say a gear maker or something, I can’t really speak for their inventory situation. What I do know is the demand is, the demand is enormous. All of these guys are backlogged, sold out and the demand remains very strong. And so it’s a matter of time for production problems and supply problems to be worked out before we get to see the real excitement again.

And then on the deferred taxed assets Stephen, can you add a little color on how we should see that be released over time. Is that incremental over the next couple years or how should we see that DTA come down over time?

Well as we said, in the first year you’re going to see us use about $27 million of it. As I said in my comments, it will then slow. These assets are to the tie, or released over time by the nature of the underlying assets. And in fact, some of them run out all the way into the next decade. But you could comfortably assume that if we release $27 million this year, we’ll release something in the mid teens next year. And that in effect is whatever tax rate you compute, you could take that off and trying to work out what the cash taxes are.

Thank you very much.

Okay.

[OPERATOR INSTRUCTIONS] We will now take a question from Steve Levenson with Ryan Beck.

Good morning Dave and Stephen.

Good morning.

You mentioned of course the 787 going into production in the not too distinct future, but there hasn’t been much aside from what your competitor has said about what sort of composites and what other suppliers might be there. I know there have been some subcontracts released and I’m curious if your material is going in there? And if you’re hearing anything about supply issues from your competitor if you think you have an opportunity to supply some additional material to Boeing for that aircraft?

Well I’d say it’s probably early to be talking about supply issues since everything is just still being specked. So I’m not sure, I’m not aware of any issues. As for our participation, I continue to be excited and encouraged. I continue to expect this will be our best Boeing aircraft. I continue to expect that this aircraft will have more composites on it than the aircraft that it replaces by an order of mag, by a multiple I should say of an integer multiple. There are subcontractors that have won big parts of things like engines in the cells that are very important customers to ours. And I’m very happy with our progress.

Okay thanks. And in relation to R&D, do you expect that to continue at the same dollar sort of level or similar percentage of sales level?

I think generally now that we’ve incorporated qualification costs into R&D it will likely creep up, maybe stay level as a percent of sales. But I would expect that it would start to climb as so many new aircrafts start to come online.

Okay. And last I appreciate all the information you supplied on the energy situation, the operating margin you talk about next, for 2006, what sort of energy price increases have you built into that?

Well our assumption is, it’s not going to get much worse. In fact, we’d expect just because of seasonality, once you get out of the winter, it’s going slow down. You, our biggest exposures are to gas and to electricity. So they’re not going to necessarily move directly proportional to oil prices.

Thanks very much.

Thank you.

Our next question comes from Brad Rosenberg with OSS.

Actually it’s [Pete Grondin]. Hi guys. Good morning.

Good morning.

A quick question either Stephen or David, I just wanted to understand the 33.7% incremental sales operating leverage on incremental sales. Is that an operating income number or how should we think about that? Is that gross margin?

That was operating income after adjusting out some of the specials that are listed in Table 4.

Okay.

Year-over-year comparison.

That was, yes, if you look at Table 4, look at the change in operating expressed over the change in sales.

Year over year.

Okay. Great. That’s it. Thanks guys.

Sure.

Our next comes from [Chris McDonald] from Kennedy Capital.

Good morning guys. Just wondered if you could give us an update on the timing of the carbon fiber capacity expansion? And when would you expect to see the first revenue come from that expansion?

No change from where we were before. We’re doing it as fast as we can. We’d expect to have the first line up and operational in the early part of 2007. While we might get some revenues from that line as we sell product to industrial markets, it’s really intended to get qualified for aerospace. Much of that fiber will end up being used by Hexcel so you wouldn’t see top line growth. You’d only see margin expansion once it gets aerospace qualified. The second line that’s going into Spain would be later in the year. But there’d be some, some modest sales showing up in the mid part of 2007. But again the main purpose is for aerospace, which would be a year later.

Okay, so up and running in ’07 with sales to, on the industrial side, in ’07 and then however long it takes to qualify would be from--

Correct.

The aerospace level.

Correct. Which is typically about a year.

And then with SG&A down a little bit this quarter, do you see that as sustainable level going forward or how would, how should we look at that?

Well we try to hold SG&A all the time that’s just sort of something we talk about a lot. This quarter’s a little bit of an anomaly because last year we had the Sarbanes-Oxley, the big push on that at the end of the year. So, I don’t know that we’ve given guidance on it. I think overall the operating income leverage is how I’d like to look at it, because that includes all overhead including factory overhead, SG&A, R&D coverage and so forth.

If you look at our historic quarterly results, you’ll see a little bit of seasonality from quarter to quarter in the SG&A spend. So, we need to, not always going to be the same absolute dollars. But as Dave says, the primary focus is containing it.

Okay thanks guys. And then just one final question, the restructuring expenses Stephen I think you mentioned you ought to make that up or see the return on that in 2007.

Correct.

Are you expecting savings roughly, the ’07 savings roughly in line with what the charge will be this year? Is that how--

Yes, we’d expect payback in ’07.

Okay, thank you guys.

[OPERATOR INSTRUCTIONS] Our next question comes from John McNulty from Credit Suisse.

Yes just one, one follow-up question on your, on your energy exposure. I know you guys in the past have hedged some of your natural gas out and electricity contracts tend to be rolling three-year contracts. So that kind of smoothes some of this out. But I’m wondering how much if any you are hedged on the natural gas front right now? And I’m also wondering what the lag is in terms of kind of when you actually are using the natural gas relative to prices? Because obviously natural gas prices come in quite a lot over the last few months and I’m wondering when you might start to see the sequential benefit of that?

Well we actually took advantage of that dip down to put in some three and six-month hedges. So you’ll see that benefit in the first and second quarter. I don’t want to overplay energy. Energy is significant in this quarter simply because you had very little incremental increase in sales and therefore, you didn’t have much to play with. But over in the relative order of magnitude of things I wouldn’t overplay its impact on this. But yes, we’ll see some reductions in the first and second quarter on gas.

Sequentially though year over year, it’s--

It’s still, it will be higher than the periods the year before, correct.

Sure. Okay, great thanks.

Our next question comes from [Adam Horwich] from [Calstin] Management.

Hello?

I’ll handle that one.

Your line is open.

Adam? I think we lost him operator. Any others?

Our next question comes from Edmond Griffin from BlackRock Capital.

Just follow-up on the incremental margins when you, when you say you like to talk about incremental operating margins. I was just wondering if you take out the stock option expensing of $5 to $6 million, what sort of incremental operating margins should we expect in ’06?

Well if you back into the arithmetic we gave you--

Yes.

You’d find that the incremental gross margins are in the sort of around the 30, low 30’s range. And incremental operating margins are around 20. That’s not to say that we expect to give up that much between those two lines. But in setting targets, one picks numbers that one thinks is approximate it and rounds them to, rather than giving decimal points.

Okay. And then just as a, looking at SG&A as a percent of sales where do you guys expect to be able to keep that flat or should it continue to go down?

We’d expect SG&A to go down as a percent of sales.

As a percent of sales.

You know our operating leverage model is built around really two key factors. The first thing is keeping the growth in our fixed costs way below the rate of growth in revenues. And secondly, obviously, getting leverage out of our infrastructure, pushing more volume through the same plants and the same customers. And those are the two pivotal drivers of our ability to expand our margins with whatever revenues are delivered to us.

Okay and then on, just looking at let’s see R&D or research and technology expenses, if, if you look at the typical annual creep, it looks like, I don’t know $3 million roughly. Is that, is that, should we expect that in ’06?

I would say typical annual creep is not a phrase we’re familiar with at Hexcel.

I expect it (inaudible) but clearly we hope to spend a little bit on more certifying new materials and products.

Okay. Great. Thank you.

Thank you.

[OPERATOR INSTRUCTIONS] We will now go to [David Sachs] with [Hockey] Capital.

Yes thank you. David if you could try to frame the opportunity as you see it for Hexcel over the next three years is in one bucket, which looks like the cyclical recovery in plane builds. And then if one were to look at the next three to five years, which looks like this secular story you infer with the increased carbon fiber percentage per plane and how you see that playing out through Hexcel’s financial statements in the context of our 10% operating margin, going to 11% as you talk about it for 2006. What kind of leverage does this cyclical and then dramatically increased content story have to the operating performance of the company over the next 5, 7, 10 year cycle as you look at it? Thank you.

Boy I thought we were being pretty bold here giving you a little bit of guidance for 2006. So I’m not sure I can quite go there.

You know the door’s ajar. We’re just jumping.

The, what I like about the aerospace story in particular is that the cyclical rebound is clearly underway. But the secular thing is not just three to six years out. It starts to get real interesting out there. But you know there’s been a pattern of this secular penetration of composites. Our sales of materials per airplane has grown a little bit herky jerky but steadily on a trend basis over the last four or five years and we haven’t wrapped up that detailed sales to Boeing and Airbus yet for our 10-K. But when we do, I’m pretty sure you’re going to see it again this year. So we get to enjoy better than cyclical recovery in the short term. And long term, as you get to, as you move from sort of an average of 10% composites into fleets that start to be populated with 30, 40, 50% composites, we get pretty excited.

I mean if you could let me talk about beyond five years, if you were to take the A320 and the 737 families and talk about those as new composite aircraft, things really get exciting. Because we’ve built three times as many of those as we do all the other aircraft combined in the large air frames. So we’re pretty excited about that.

If I could just add an addendum, I’d say while we’re not in a position to forecast what the margins might be in those periods. And the basic operating philosophy remains the same, which is we’re seeking operating leverage. So we want the margin and incremental sales to be higher than the margin we’re already earning. And if we can keep doing that, we’ll keep nudging those margins up. And we don’t view ourselves as limited. You know we’ll work with the cloth we have, but we’re going to keep pushing to expand those margins wherever we can.

Yes, I’ll accept that as a decent no answer.

Thank you.

Our next question comes from Brendan Hartman from Cramer Rosenthal.

Yes, good morning guys. Just quick question on the corporate expense, is $32 million kind of run rate is that a reasonable number to use going forward?

Well one of the complicating factors going forward is you’re going to have the stock option expense is going to sort of turn up part of it in that. But we’re not, it’s planning to have any significant expansion in our corporate activities. And so we look at that as the place where we lead by example to the rest of the business. We constrain that expense. We’re not looking to put any ivory towers here. And so we’re going to keep that expense as close to where it is today as we can.

Okay. And then just on the ballistics side of the business, can you just give us a little bit more of the history in terms of that order surge you talked about but what did it do from a percentage of your mix if you go back over the last couple of years, what was, what was kind of a normal rate? And then we had the surge, due to the Iraq conflict. And then when should we start seeing kind of reorders as the shelf life of those vests is obviously limited?

Well we don’t give the numbers for those markets. So I can only give it to you sort of--

Ballpark’s fine.

Vaguely, the, there’s sort of a cycle over the years of 20 years or so of re-outfitting going to a newer, modern, more, more capable vest. Either because the thread has changed or because we want to decrease the load on soldiers so they can carry more electronics or munitions. That cycle of a new vest was sort of in a transition mode in the summer of 2000 as I recall. If you were with us back then, we talked of a transition from a certain order pattern to a new vest that was going to be developed and offered. So we had a bit of a hesitation as bids were let and negotiations went on for six months or so. And then as the Iraq War became something more than a one-month route, there was a massive influx of orders, of the, of the vest that we’re currently in design. So it ran real strong for all the quarters from then until about, I don’t know, about the first quarter of--

This year.

2005. When it, when it finally started to sort of peak and moderate. So it was down this year some. It is not at the level that we would call the sustaining rate. The sustaining rate would be just replacing vests that are worn out or for new conscripts. So we’re not sure where it’s going to go because it’s been pretty, pretty well saturated we think at the, at the top level in the army. There’s been a lot of pent up demand for the use of Kevlar and other aramids for other applications that we’re not able to sort out yet. There’s a lot of news in the press recently about the side panels that they’re wanting to add to the soldiers that’ll add a vest like pouch and additional ceramics. We’re sort of in the transition phase from what was to what will be and we’re not clear on what that’s going to look like.

Do you have anything interesting in the R&D pipeline that has significant performance enhancements to the current vest?

Well there’s always work going on with that, but it generally is requires sort of the start-up by the, with the spec from the government. There are a lot of other applications for ballistics that are very interesting. None of them though have the real high velocity, all alike kind of look of the outer tactical vests that’s been the main source of growth in the recent years.

Got you. All right. Thanks a lot.

That is all the time we have for questions today. This does conclude today’s presentation. Thank you for your participation and have a wonderful day.