Hexcel Corp (HXL) 2017 Q2 法說會逐字稿

Good day, and welcome to the Hexcel Corporation 2017 Second Quarter Earnings Conference Call. Today's conference is being recorded. Hosting today's conference are Mr. Wayne Pensky, Chief Financial Officer; and Mr. Nick Stanage, Chairman, Chief Executive Officer and President. At this time, I'd like to turn the conference over to Mr. Pensky. Please go ahead, sir.

Great. Thank you. Good morning, everyone. Welcome to Hexcel Corporation's Second Quarter 2017 Earnings Conference Call on July 25, 2017. Before beginning, let me cover the formalities. First, I want to remind everyone 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 involve estimates, assumptions, judgments and uncertainties caused by a variety of factors that could cause future actual results or outcomes to differ materially from our forward-looking statements today. Such factors are detailed in the company's SEC filings and last night's press release. Lastly, 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.

With me today are Nick Stanage, our Chairman, CEO and President; Patrick Winterlich, our soon-to-be CFO; and Michael Bacal, our Investor Relations Manager. The purpose of the call is to review our second quarter 2017 results detailed in our press release issued yesterday.

Now let me turn the call over to Nick.

Thanks, Wayne. Good morning, everyone, and thank you for joining us today. As you have seen in last night's release, our second quarter sales were $491 million, 5.4% below our second quarter 2016 sales in constant currency. While overall sales were below our original expectations, thanks to strong operational execution and good cost control, we delivered second quarter operating income of about $90 million with an operating income margin of 18.3%.

Our adjusted diluted EPS of $0.67 was $0.03 below last year's record second quarter. Free cash flow for the first half was a source of $13 million versus a use of $21 million last year, a $34 million improvement. We are now expecting 2017 sales of about $2 billion, in line with 2016 and have lowered our sales guidance accordingly.

I'd like to take a moment to put this revised guidance in context. First, as we have discussed in the past, we are very successful in partnering with our customers on innovative technology and process solutions to optimize material usage, thereby enabling improved operational efficiencies on their end and providing us with a more competitive solution for next-generation programs.

We undertake an annual deep dive with our customers to update our estimated usage per program. This is typically part of our strategic planning process, which we are now in the process of completing. Based on our latest review, we are revising our estimated A350 shipset content to $4.8 million per plane. This is the expected weighted average per shipset of the DASH 900 and DASH 1000. The impact on 2017 sales as compared to our initial guidance is nearly $20 million.

In addition, the inventory adjustments for most widebody aircraft in various business jet programs that we described last quarter extended longer than we anticipated. As a result, we now expect 2017 Commercial Aerospace sales to be slightly lower than our 2016 results.

Our Space & Defense sales are better than initially expected and are now forecasted to be up mid-single digits compared to 2016. This increase is not expected to fully offset lower projected wind energy sales.

Despite the lower sales outlook for the year, we remain committed to delivering our earnings and cash forecast for the year and are holding our guidance for 2017. That is, EPS in the range of $2.64 to $2.76 and free cash flow of more than $100 million. Our operational discipline enables us to respond rapidly to these temporary variations in our markets, even as we continue to increase our investments in research and technology to drive next-generation advancements and also continue to fund CapEx required for future growth.

Lastly, we are benefiting from various tax initiatives as our 2017 estimated effective tax rate is lower than our initial guidance.

Our Board of Directors' endorsement of a 13.6% dividend increase reflects confidence in our ability to consistently deliver strong operating performance and generate increasing cash flow.

Now let me briefly provide more detail on our markets. As usual, I will discuss year-over-year comparisons in constant currency. As you are aware, currency movements influence our reported results and some of this impact is not intuitive. But the bottom line is that when the dollar strengthens against the euro and the British pound, our sales translate lower while our income increases and so our margin percentages improve.

Commercial Aerospace now accounts for 71% of our total sales. And for the second quarter, these sales were 5% lower than second quarter of 2016 and almost 3% lower for the first half versus last year's first half. Sales growth from the A350, A320neo and 737 MAX over 2016 were in line with our expectations and offset by legacy widebody rate reductions, supply chain adjustments and productivity initiatives as previously discussed. Sales to other Commercial Aerospace, which includes regional and business aircraft, were down about 8% from last year's strong first half. The decline was primarily in business jets.

Space & Defense sales for the quarter were about $88 million, up 8.4% compared to the second quarter of last year. The increase was driven by growth in all key programs. Rotorcraft sales were at their highest level in 2 years. Rotorcraft accounts from just more than 50% of Space & Defense sales with more than 85% coming from military sales. Sales for the first half of the year were up 3.5% versus the first half of 2016.

In Industrial markets, sales for the second quarter were almost $55 million, which is 22% lower than the second quarter of 2016 due primarily to lower wind energy sales. Sales in the quarter were roughly in line with revenues we have seen since the back half of 2016. We believe 2017's Industrial sales will be more level loaded and our year-over-year comparisons get easier in Q3 and Q4 as sales for the second half of 2016 were nearly 20% lower than the first half of 2016.

Wind energy sales were down more than 30% as compared to a particularly strong second quarter in 2016. While we forecasted wind sales to be lower in 2017, we continue to expect wind energy sales to rebound in 2018 to exceed 2016 levels as various legacy blades with lower composite content transition to longer, high-efficiency blades with higher composite content.

Finally, in the rest of Industrial business, we did see continued growth in the automotive market.

Now let me turn the call over to Wayne to discuss some of the quarter's financial details.

Thanks, Nick. For the quarter, gross margin was a solid 28.5% as compared to 28.8% in the second quarter of 2016. Strong cost control and productivity performance went a long way to mitigate the impact of the lower sales and offset the training and startup cost at our new facilities in France and Morocco.

As expected, we had about $5 million of training and startup cost in the first half at these 2 new facilities and we remain on track with the construction and startup activities. In addition, depreciation and amortization for the first half was $5 million higher than the first half of 2016 on a constant currency basis and we expect depreciation to continue to increase in the second half as new additions are placed in service.

For the first half of the year, SG&A expenses were 3% lower in constant currency than the prior year as we maintained tight cost control across all support functions. Research and technology expenses were $25 million in the first half or about 10% higher in constant currency as we continue to invest in innovation to support new technologies, products and process developments.

For the quarter, operating income was $90 million or 18.3% of sales compared to the record $100 million or 19.2% of sales in 2016. For the quarter, exchange rates contributed about 70 basis points to 2017's operating income percentages as compared to 2016. And for the first half, exchange rates contributed about 50 basis points to our results.

Overall, we've done an excellent job of managing headcount. Our total headcount is lower than year-end and 1 year ago, even including the more than 100 people we have in training for the startup of our new French and Moroccan facilities.

Our Engineered Products segment comprised of our structures and engineered core businesses, delivered 12.9% operating income margin for the quarter as compared to the 12% margin in 2016. To remind you, although margins across the businesses in this segment are lower than those for composite materials, the Engineered Products segment employs a much lower level of capital and the return on invested capital for this segment continues to be very attractive.

The tax provision was $22 million for the quarter for an effective tax rate of 26.7%. The quarter included benefits from state tax return to provision adjustments as well as deductions associated with share-based compensation payments. The first quarter provision included a nonrecurring discreet benefit of $9.1 million from the release of evaluation allowance from Luxembourg. Excluding this discrete benefit, Hexcel's first half effective tax rate was 25.7% and we now expect the full year effective tax rate to be around 27% as additional discrete benefits are expected in the second half of 2017.

Free cash flow for the first half was a source of $13 million as compared to the use of $21 million in 2016. Working capital decreased $33 million in the quarter resulting in a use of $7 million in the first half of 2017 as compared to a $72 million use in the first half of 2016. The primary driver was an improvement in receivables due to lower sales and continued strong collections. We do have seasonal fluctuations in our free cash flow with the second half tending to be a significant source of cash compared to the first half.

Cash payments for capital expenditures was $169 million for the first half. The midpoint of our CapEx guidance for the year is $280 million as we have now spent about 60% of our 2017 capital expenditure plan in the first half of the year.

Our capital expansion program is currently quite active as we are in the process of starting up new carbon fiber panel lines in the U.S. as well as being fairly far along in completing our greenfield sites in France and Morocco. As previously announced, we still expect that 2016 was our peak year in the current cycle of capital investment. 2017 will see modestly lower expenditures, as we just discussed, followed by much lower spending in 2018 and '19.

During the quarter, the company used $57 million to repurchase shares of its common stock, bringing our buyback program for the year to a total of $121 million. We now have $272 million remaining under the authorized share repurchase program.

Before I turn it over to Nick for some final thoughts and before we take your questions, I would like to make a few personal comments. As many of you know, this is my last earnings call as CFO. We spent a lot of time on the management development and succession planning. And as a shareholder of Hexcel, I'm pleased to say we got this transition right. I couldn't be more pleased that Patrick was chosen to succeed me. Patrick's a long-time Hexcel employee with broad experience in finance, operations and IT and he knows the business better than I do. I've no doubt that this will be a seamless transition since Patrick has been a member of our leadership team for years and has been involved and part of any decisions we made in recent years. The overall passion and industry knowledge at Hexcel is second-to-none. It's been a great team to work with and I wish the best for the company going forward as it continues its journey to build on its world-leading position for innovation, advanced composite market growth and operational excellence. And in fact, I'm counting on it.

Thanks, Wayne. By staying aligned with customer demand while keeping costs under control and operational excellence at the forefront, we delivered a solid start to 2017. We are committed to achieving our earnings plan for the year and remain bullish on the long term. Our performance this quarter demonstrates our operational discipline to respond rapidly to changing circumstances as well as our strategic commitment to ongoing investments in research and technology, acquisitions and funding CapEx required for future growth.

I also want to remind you of our announcement during the second quarter that we have reached agreement with Safran to acquire their structural business and we expect this to close later this year. As with our other investments and acquisitions, Structil will bring leading-edge composite technology that will further enhance our strong portfolio, particularly in the areas of adhesives, prepregs and pultrusions. Before opening it up for questions, I'd like to personally thank Wayne for his tremendous support and contributions throughout his 24-year Hexcel career and I'd like to wish him and Kim all the best in retirement.

Warren, we'd now welcome questions.

(Operator Instructions) We'll take our first question from Myles Walton with Deutsche Bank.

Congratulations on the retirement, Wayne. Enjoy it. So maybe just to start off the obvious. So you've lowered the sales guidance here again. And last quarter, I think $20 million of the lower sales guidance was due to the legacy widebody destocking. And it looks like a similar amount here. So it doesn't look like it slowed down at all. Is that right? So $20 million is effectively the -- you're rebasing with the A350 and another $20 million is continued destocking?

Okay, Myles. So you're close. On the first quarter, we revised our guidance down about $60 million, $20 million FX, $20 million -- or approximately $20 million on the 777 and then about $20 million on destocking or inventory supply chain adjustments. The second quarter is really made up of approximately, think of it, approximately shipset related A350 volume $20 million, approximately $10 million on supply chain and approximately $10 million on a net between the negative headwind on wind versus the positive in Space & Defense. So we have seen the supply chain slow down. And given our view on the backlog and working with our sales team on what's forecasted in Q3, we do think it has tapered off and majority of it is behind us.

So you've also, I think, a couple of quarters ago talked about double-digit growth into 2018. And I'm just curious, given what you're seeing on the ground now and the destocking you're seeing, are you looking more into high single-digit levels of growth? I know you reiterated your Industrial business sales target. But I'm curious on your others too.

Yes. So again, we'll give specific guidance, updated guidance, towards the end of the year. But fundamentally, we remain very optimistic on 2018 with regards to continued growth with the A350, the narrowbodies, which continue to not only grow but the rates are continuing to go up. Upside on the military with very strong performance on JSF, A400M and V-22 Blackhawk and then a big rebound in wind going into 2018. So a little early for us to really get to zeroed in on the exact numbers, but next year is going to be good.

And one last one. So you'd lowered the shipset content based on kind of roll up. So does that mean, it wasn't based on negotiation with the customer, it's based on recalibration of what you're actually seeing go out the door for each aircraft?

Yes. This topic warrants a little bit of a discussion. So I think we're going to spend a couple minutes on it. So in general, every year, as part of our strategic planning process, we work with our customers and we understand the best we can on what material goes to what customer for what application. So you got to keep in mind, we're shipping materials in multiple forms that can go in all different directions. Let's just talk about the A350 alone. We have 60 ship-to locations with various material forms. So through strap process, we work with our customers, we look at their usage in the plants, we look at their inventory levels. And then when we get to plan, we basically build our plan with our customer forecasted orders and what they're telling us they need to buy. We then check that, do a sanity check with our shipset and we tweak that and adjust it continually. So we're always working with our customers, number one, to find new opportunities to replace heavier parts, weaker parts with advanced composites. So we see application increase and our numbers go up. We also work with our customers on productivity initiatives, finding ways to reduce scrap, waste within the supply chain and that affects us on the downside short term but helps us position our materials much more competitively for the long term. So to get back to your question, it had nothing to do with customer negotiation. At the end of the day, it was good productivity work with our customers to help them be more competitive and help us our -- position our materials for future opportunities.

Our next question comes from Gautam Khanna with Cowen and Company.

And I echo Myles' sentiments to you, Wayne. It was a pleasure to work with you.

All right. Thanks, Gautam.

So to that point that that Myles just raised, is there -- I mean, do you think the A350 content you guys will have is going to continue to shrink over time? And if so, sort of what is the limit? And any thoughts there? And then I'll follow-up.

Well, I'm certainly -- and the team is certainly working to increase the shipset content. So there's no doubt we're focused very intensely on new opportunities, new applications. Now as an aircraft matures and you get into a steady state production, the likelihood of introducing a change becomes less. So it does tend to stabilize. Having said that, I'm hopeful we can continue to find opportunities to make our more -- our materials more competitive. But I don't see a dramatic move here.

Okay. And was the reduction largely the function of yield improvement downstream, i.e. people are cutting the parts literally more efficiently? Or what actually drove the reduction?

Well, I don't know that there was one item. Clearly, we're always working to help reduce scrap in the supply chain, that was one element. The technology has continued to evolve. So if you look at when the A350 was developed and the first parts were made, we have more efficient ways of making some of those materials. So some transition to a new higher technology, more efficient material form, some in scrap reduction and throughput rate reduction. So it really was a combination, not one factor.

Okay. But we should consider it a reduction in also profits, right? It's not like you keep the value of the technological leaps that are allowing you to save your customers' money, is that right? So a lower profit dollar on the A350 is expected?

Let's just -- we look at it as it may impact the sales, but we're always pushing to enhance and expand our margins.

Fair enough. And just one last one. In terms of the destocking across a number of the programs. How broad-based is it within the subcontract manufacturers that you supply to? Is it 1 -- isolated to 1 or 2 of the subcontract manufacturers you sell to? Or is it broad? And how confident are you that it's not going to spread? I.e. some people are hesitant and some people are still behind?

Yes. Well, we do think it is fairly broad. It's not 1 or 2 driving it, whether you're talking about Airbus or whether you're talking Boeing. And again, remember, the supply chains are extremely complex with 60 plus 4 the A350 and similar types of numbers on other programs. And each one of these can be at different points in the part assembly process for the final aircraft. So there's a lot of variation there. So again, we think we have very good insight. Although not perfect, we'll continue to refine it and try to get better. Our backlog view helps us gain confidence that the supply chain corrections are subsiding and we're really getting to a more steady-state position. That's basically where we think we are today.

Our next question comes from Howard Rubel with Jefferies.

Patrick, I think Wayne set a heck of a high bar for you, but I'm sure he knows that and you guys will do well and, Wayne, it's been a pleasure.

Okay. Thanks, Howard.

Nick, you talked about going through this study on product and looking at the change in volume. How does that play through to the capital spending plans that you're working on?

Yes, that's a great question. As Wayne said, we're still on track for our midpoint this year of $280 million and then pretty substantial drop over the next couple of years with a total of $320 million. We -- Howard, we've got what I think is one of the best-in-classed capital management organizations and processes. And I'd tell you, every day, we look at our spend versus the demand and it's continually tweaked. So having gone through our strategic -- internal strategic review and getting ready for our board review this fall, we still feel very good. We do not see anything that changes. As a matter of fact, there are some areas we are actually accelerating some of our CapEx. I'm thrilled with the fact that we're bringing online our assets in Salt Lake City and Decatur and very soon, we'll have our assets in Roussillon and Morocco up, and we'll get that headwind behind us. As you know, that's been roughly $5 million for the first half of the year and it will taper down in Q4. But at the end of the day, I still feel good about our CapEx spend. It's still required. And again, I love having our assets running 100% filled and that's what we have line of sight to.

But you've basically said, you're -- well, I'll use the word debottlenecking and your suppliers have done the same thing. And if we just look at the 350 and sort of spread it across a number of other opportunities, wouldn't it really say that as you scrub your plan or as you scrub your volume demands that there is some lower capital requirement for the enterprise because it's got productivity and other factors? And we might not see it this year, I recognize that, but next year and the year after, it should have some spill.

Absolutely right, Howard. And I can tell you, we have various small and even a few very large programs that can significantly change our go-forward capital profile. When we talk about R&T investment, that's a combination of material science, chemistry, as well as new processes and manufacturing technologies. So that's a big focus for us because you know how expensive these capital assets are and the long cycle time we have. So the more efficient we can make those investments, the broader we position our materials for entitlement and positioning for new programs.

And so your acquisition of the small Safran business, in talking to you folks, it looks like it has some pretty interesting and unique capabilities that I'll just call it you can drop into your portfolio and offer multiple solutions to a host of customers. How fast do you think you can integrate it? And when do you think it could turn into something that's more than just a modest contribution to results, Nick?

Well, I -- Howard, I have to give you credit. You summarized the benefit and why we bought this perfectly. The overlap is almost nonexistent. It fits right into our core. It provides qualifications and technology that enhances our position. So we're thrilled with this. I can tell you, we have a team on the ground. We are already into our integration plans and how we're going to organize, structure. We are already looking at sales synergies and a few transitions that are going to help us. Now to put some numbers around what it could mean going forward, I need to buy a little more time for us to really get in there. Otherwise, I'd afraid I'd understate it.

Ouch. Just 2 quick questions. One is, did I hear you say or did Wayne say tax rate for the year on a reported basis would be 27%? Or was it another number? I'm sorry.

Howard, that's correct, the 27%. But that excludes that first discreet -- the discreet benefit in the first quarter of $9.1 million. So the GAAP rate is a little bit lower.

And then -- thank you. And then finally, Nick, you talked about auto being a little bit better or larger. Is it new platforms? Or can you elaborate a little bit on the forward look that you have there?

Well, auto has -- I have to go back and look quarter-over-quarter has done very well. On a percentage basis, very nice double-digit growth on a very small base. So Howard, we continue to look at niche opportunities with some of our key customers, including BMW, the DASH 7, B-pillar continues to do very, very well. Our roof business continues to do very well and then we're being successful in various other pursuits. So it's a combination. Still feel good about it. I'm really excited about the technology that the teams working with respect to production rates, snap cures, manufacturing processes that just help us become even more competitive against the metals.

Our next question comes from David Strauss with UBS.

Congrats, Wayne, and thanks for all the help over the years.

Thanks, Dave.

I wanted to ask about narrowbody rates. In Q2, did you see the full impact of the higher narrowbody rates this year actually flow through your numbers?

Well, I can tell you, we, on the NEO and the MAX, we actually were slightly above our forecasted sales. So we did see that come through. We do believe there is still some transition between 320neo and CO based on engine ramp rates. But working our numbers back on what we're shipping in materials based on the rates that they're climbing to, which I believe, Wayne, this year is 47 for the 737 and 50 for the A320, we believe we're aligned.

Okay. All right. Great. And in terms of your -- and what you've talked about for 2018, what do you -- I know A350 isn't big volume numbers but you've got a pretty high shipset content there. What have you kind of been thinking on A350 when you had made those comments on 2018 -- sorry, A380.

Well, we're in the -- are you talking 380 or are you talking about 350?

Sorry, yes, 380.

Oh, the 380.

So as you know, David, they dropped from 2 a month down -- basically down to 1 a month and our assumption is that's what we're expecting for 2018. Now I suppose there's a little bit of risk in that number. But essentially, it'd be flat for this year.

Okay. And I guess the same question on 350. If your view is changed or modified at all in terms of the -- and I think you have been talking about previously getting to 10 a month by the end of 2018, is that still your current thinking?

Yes, it is. We think we're right around 8 and we'll ramp up sometime mid second quarter, third quarter next year to the 10.

Okay. And Wayne, last one for me. Obviously, tax rate is running lower this year. I think, the last several years, you've had some items that have pulled out that could come in lower. How should we think about tax rate in 2018? And then also, any potential impact from the change in the revenue recognition standard?

Okay. So with respect to 2017, just to remind you, we went in expecting a 30% effective rate and we're now expecting about 27%. 3% is worth $10 million or $0.11, so it's been a meaningful contributor to this year. A lot of that difference between 30% and 27%, some of it will carry over into next year but most of it won't. So we're not ready to opine on the 2018 tax rate. But if you're thinking, don't think 27%, think towards 30%, absent any change in tax rates. With respect to revenue recognition, we're firmly committed to adopting it on January 1, 2018 and we'll advise of any impact later on. But it's not obvious to us that there will be a significant impact, but we're in a heavy midst of going through the implementation process now. But I'd say we're hopeful that there's not a big impact.

We'll go next to Robert Stallard with Vertical Capital.

Wayne, I'll echo everyone else's comments, have a great retirement. Before you go, we've got a couple of questions for you. First of all -- is not a colleague or 2 easily. First of all, on this inventory destocking that's been going on, you mentioned there's lots and lots of different customers you're talking about here. And what's your sense of the reduction if only to bring it down to current rates rather than anticipating any further production cuts that could be coming on, things like say, 777?

Yes, so I mean, I guess, you step back and say why are we having destocking in the first place, it really is about -- most of it, the legacy widebody rates being reduced. So remember, you've got to think about last year, you've had 777 going from 8.3 a month to 7 to 5 and now on its way to 3.5. And so we probably accounted for the build rate drops but you also have that destocking as you go through it because people need less inventory. And the same for the A330, has dropped down, the 747 has dropped down, the A380 has dropped down. So it's really all those. Now to your point, do we know whether the drop down system reflect the new rates or is it beyond that? That's probably beyond our scope to figure that one out. But in general, it's really why it's happening so much this year as opposed to any other year. And I guess the last one I'd add just is the 787 is probably one in that latter category where there isn't been a drop-in rate but there's been a steadying of rate. And now they've been at 12 a month for a while, I think, everybody has been able to operate much better and more cleanly and therefore you're seeing some inventory go down there.

Okay. And, Nick, you had some pretty positive comments about wins heading into next year. I was wondering how much of this optimism is reflected in the orders of the backlog that you currently have or whether that still has to flow through the system?

Well, if you look at Vestas' backlog, it's strong. Their performance continues to be strong and we're working with them daily. They've recently announced some of their new blade launches, which we're excited about and those are some of the exact blades where they're bigger, they're longer, they're more efficient and we have significantly more content. So I am not betting against Vestas, they're doing very well, they're still the market leader and they're going to require our materials to ship those turbines. So we feel very good. Now the timing and how quick the ramp up, again, we'll refine that as we get into latter part of the year and provide our guidance. But everything we're seeing with respect to Vestas' efforts, with respect to their positioning, their plans, we're getting ready for the upswing.

Okay. And then just a final one from me. I was wondering if you can you give us any update on any discussions you might be having with Boeing or related customers on a mid-market aircraft and what the materials could be on that plane?

Well, I always am careful about what we're talking to our customers about specifically. I can tell you, we're very excited with some of the communication and increased excitement around the new aircraft announced during the -- or at least positioned during the airshow and also some of the derivative-type platforms that could follow as well. So I can tell you, we're actively working with the engine manufacturers, then the cell manufacturers and the primary OEs on new materials, new solutions, new options for next-generation platforms. So we're -- it's not officially launched, we're hoping that happens. We'll be ready when it does happen and look forward to capturing more than our fair share of content.

(Operator Instructions) We'll go next to Robert Spingarn with Crédit Suisse.

Congrats, Wayne and Patrick. I wanted to go back, I think Gautam asked you the question on the lost sales. An in the context of lost profit, you held your guidance but you have this $0.11 -- I think it's an $0.11 tailwind from tax. So clearly, there was some lost profit. Does it allocate the same way that the sales guidance in the same proportions as the sales guidance decrease? Or do you have greater detrimental margins in certain things than others?

No, Robert. I guess, a general answer to your question, it's proportional to the drop in sales but that's not easy to do. We've had to do an excellent job of controlling our headcount as we've talked about to make sure we dropped. I mean, one of the things we do well is respond to the drop in sales and we did that accordingly. We don't have a lot of discretionary spend but the limited amount we have, we've done a good job of balancing there. So we've been able to offset it proportionately so we didn't get incrementally hit harder than that.

Okay. All right, so about average margin. So moving on, this was asked about earlier as well. Is there a natural, decay is maybe the wrong word, but decline in the buy to fly ratio for composites over time that we could use as a rule of thumb? So I understand that you said, in some cases, your content rises. But it sounds like that's because scope would increase. But what I'm talking about is just greater efficiency on the part of your customers where you just have to build in some expectation of shrinkage overtime.

Yes, I think you summarized that quite well. I mean, productivity is here to stay for everyone, not just us. I mean, you can see Airbus and Boeing. And for that matter, everyone in this space, are looking to drive profitability up, recognizing that they have to get cost down and get more productive. And what that means is use materials more efficiently, reduce scrap rates, increase cure times, cure time speeds. So to give you a general number is very difficult to do given the complexity of the supply chain. I would say, the more mature a program is, the more it is learned and the less likelihood there would be adjustments whereas a new program that's ramping up like the 787 or A350, there tends to be a little bit more opportunity on the front end as customers in the supply chain get more accustomed with handling materials, they get more efficient. And it certainly has a curve to it and a slope to the level of opportunity and improvement while staying within the qualification window because that's really where the difficulty comes in deviating from the qualification window and making major changes.

Okay. And then Nick, if I could just ask you going back to the 797 discussion. I know you don't want to get too specific and frankly, I don't know how specific your customers gotten yet. But could you give us some sense of what new technology means relative to the composites that are out there on today's platform? How significant a leap are we talking about that maybe puts you into the contest for a customer where you haven't -- where one of your competitors has dominated in the past?

Yes, so again, I know what we read in the magazines. And I think Boeing on the NMA or 797, whatever you want to call it, they're really leaning toward a unique configured fuselage and I believe they've declared or close to saying it will be composite, which was music to our ears. We've always been trying to position our materials to maintain those positions. Clearly, the material choice has not been made. What gives me great hope and optimism is the multiple opportunities and options we're providing. So when you think of technology advancements, the next-generation aircraft, my belief, will have materials that are lighter, are stronger and will be much more efficiently made, i.e. the cure rates will be faster. They may or may not use an autoclave, which will reduce capital for the customer base. The cure rates will be faster. So overall, not only the materials will be advanced or a derivative of what's existing, really, the manufacturing processes will go to the next level.

Okay. And is Hexcel positioned better for the material or the manufacturing process? Has it been -- what are you going to lead with?

Well, we're certainly working on the material side, but we're working with manufacturing equipment, designers and makers to make sure our materials are ready for those. It's really a combination. The material and the processing equipment designed for that material have to work hand in hand and we work integrally with them throughout the process.

We'll go next to Noah Poponak with Goldman Sachs.

Congrats, Wayne and Patrick.

Thanks, Noah.

Can you guys elaborate on what drove the upward revision to the defense revenue growth guidance?

Well, I can tell you, the -- our key programs were all up nicely, JSF probably the biggest. Although A400M, V-22 and the Blackhawk was up nice. Rotorcraft in general rebounded on the military side and even the commercial side was sequentially up. Still, year-over-year, it's a fraction of what it was in '16. But it gives me hope that maybe on the commercial side, we'll turn the corner. So I think you just look around and you read and you see what others are reporting, there's a lot of optimism in the Space & Defense market. I know some of that optimism and excitement will take time to transition down through the supply chain and translate into hard sales. But the programs we're on are very good. We're seeing great growth projections going forward. And I'm looking forward to doing a roll up for 2018 plan and having good news to share with everyone.

Yes, so maybe on that point. I mean, you have the 3% to 5% CAGR for this segment through 2020. And I know you just mentioned looking forward to doing the roll up but it's a long cycle business where you have some visibility. Would you be willing to maybe speak to where you're preliminarily seeing 2018 shakeout versus that range just because '17 we're now talking mid-single-digit and you have a negative quarter in it. You've got another big step up in JSF next year. You just mentioned the easy comparison at least in the commercial helicopter side. It would seem like there's decent prospect for being ahead of that range in 2018.

Well, I sure hope you're right. I sure hope you're right. I would tell you, you have to keep in mind, the fact that we're on a 100-plus programs. And remember, a lot of these volumes in aircraft terms or platform terms are relatively small volumes and it tends to be lumpy. So I don't want to get ahead of ourselves and talk about what we're seeing in Q2 being the trend long term. I am optimistic and I sure hope we can give you a number above our prior range for guidance going forward. But again, it's just a little earlier than I want to declare.

Okay. And then just lastly on margins. I know you said that you still have a 25% incremental running through the business on an underlying basis. But '17, it's not going to be that way on a reported basis given the FX moves and the investment changes. How should we think then about how 2018 margins compare to 2017 margins as those items normalize?

So with respect to incremental margins, since '17 sales are going to be flat with '16, it doesn't become exactly a meaningful number. I'm hoping that you're right on 2018 sales. And the bigger the sales increase, obviously the easier it is to hit the 25% target. We're not backing off of that and we fully expect to do it as long as there's meaningful sales increase.

Wayne, have you quantified in millions of dollars what -- exactly how much is hitting the P&L this year for investment that doesn't recur beyond this year?

I'm sorry, are you talking about the startup of new facilities or are you talking about depreciation?

I'm talking about either of those or really anything that's unique to this year.

So depreciation going up isn't unique to this year. I mean, we've had it this year and last year and we'll have another big increased step-up next year as well. But obviously, we'll have more assets to use and hopefully it will be up and generating revenue. With respect to the 2 startup locations, what Nick mentioned, it's $5 million for the first half of the year and we expect that run rate to taper as we go into the fourth quarter. But hopefully, that doesn't recur at that magnitude next year.

We'll go next to Chris Kapsch with Aegis Capital.

A couple of questions. On FX, and I apologize if you touched upon this, but the dollar suddenly weaker vis-à-vis the euro. Just remind us how hedged you are for the balance of '17 and perhaps '18? And then also just, have you provided an approximate op income EBIT sensitivity to FX? And I realize we're talking about primarily the euro and to a lesser extent, I guess, the British pound.

Right. So Chris with respect to the second half of the year, we're hedged enough and there's not that much time remaining to the year that most movements of the euro and the pound for the last 6 months are going to have a whole lot of impact on our operating income. They will impact the sales translation but with respect to operating income, probably not much. As you go into next year, we're probably 50%, 60% hedged at this point and the rates get worse that will hurt next year a little bit as we continue to hedge into it. But think about it this way, we hedge out 10 quarters and we sort of -- we roll in every quarter roll into that number so we're not completely hedged to where we want to be for 2018 but we're fairly far along.

And is there a sensitivity number assuming kind of an unhedged environment?

Yes, so think about -- yes, just an order of magnitude, think about -- and this is the combination of the euro and pound together. We're at about -- at the operating income line, we're about $250 million of exposure. But if we had no hedges and the rates move 10%, that's a $25 million impact. But that's the size of the magnitude we're trying to hedge.

Okay. And then just a follow-up on this discussion about the efficiency that are now being passed along. And I guess your commentary suggests that those efficiencies are mostly in the form of material, reduced scrap, maybe less content. But I would've thought maybe some of that is also just pricing that you might pass along as particularly for the advanced programs as the production volumes ramp, they achieve certain thresholds that might hit price points where you pass along efficiencies in the form of price. So -- but I think what you're saying is it's more of the former and not the latter. Could you just elaborate on that? And also discuss any implications associated with whether it's material or pricing that is being passed along and described as the efficiencies?

Yes, Chris. So just to be clear, it's not price. Having said that, just to also be clear, when we've given out shipset content, we've given that the price when it's at the highest rate and therefore the lowest price. So that price hasn't changed and that's always been built in whether that was $5 million or $4.8 million. So the change between the $5 million and $4.8 million does not have anything to do with price.

Okay. And then, I mean, is this enough that it would affect your anticipated margin profile as you ramp up the assets that are being used to produce these advanced materials for some of these key programs like the A350?

On a margin percentage basis, we're -- so we're trying to hold on to as much margin dollars as we can as it's gone down. Having said that, as a margin percentage, we don't expect it to get worse whether it gets better, that's obviously our goal. But we don't expect it to get worse.

And that's all the time that we have for questions today. Thank you for joining the call. We appreciate your participation. You may now disconnect.