Moog Inc (MOG.A) 2014 Q2 法說會逐字稿

Good day, and welcome to the Moog Q1 2014 earnings conference call. I would like to introduce Ann Luhr, IR. Please go ahead, ma'am.

Good morning. Before we begin, we call your attention on the fact we may look forward-looking statements during the course of this conference call. These forward-looking statements are not guarantees of our future performance and are subject to risk, uncertainties, and other factors that could cause actual performance to differ materially from statements. A description of these risks, uncertainties and other factors is contained in our news release of April 25, 2014, and our most recent form 8K filed on April 25th, 2014, and certain of our other public filings with the SEC. On our web site at www.moog.com we prepared a two page supplemental data sheet for your convenience. John?

Thanks, Ann. Good morning. Thanks for joining us. This morning we look forward to the second quarter of fiscal 2014 and update our guidance for the full year. This is a good news quarter with results coming in a little ahead of what we forecast.

On this call we also provide a progress update on our strategic review of our Medical devices center. Let's start with the headlines for the quarter, update our thinking for the year, and then dive into the numbers.

Starting with the headlines. Sales for the quarter were up 1% and our operations did well delivering earnings per share of $0.82, slightly above the top end of the range we forecast 90 days ago. Given the challenging conditions in several of our markets we consider any sales growth a real positive.

In general the macro picture remains unchanged. Commercialaircraft market is very strong. Our industrial markets are essentially flat and our Defense markets continue to be soft with some bright spots outside the U.S. In total our Defense sales across all our segments are down 6% from the same quarter last year with our older markets making up the shortfall.

We had another quarter of good cash flow. During the quarter we commenced our share buy back program which Don will describe in more detail later. Based on the results of the second quarter, we're edging our sales forecast up very slightly for the year, by keeping our earnings forecast unchanged at $3.65 per share.

This earnings forecast is exclusive of the impact of the share buyback which could add an additional $0.05 per share to the total.

Let me provide an update on the strategic review of our Medical devices segment. You'll remember we entered the Medical devices segment back in 2006. We chose pumps as our area of focus. We believed a company like ours could be successful in this market through continuous project and innovation, the better mouse trap strategy as we like to call it.

Between 2006 and 2009 we completed five acquisitions of small medical devise companies, and proceeded to integrate them into a single segment. Sometime around 2010, the regulatory environment changed and the FDA started to put increased scrutiny on all Medical costs. As a result the length of time to get a new product approved by the FDA went from month to years. With the increased time the cost of new product development also went up significantly. In the face of this new regulatory environment, our strategy of continuous innovation became very difficult.

Last July we announced we were partnering with RBC to conduct a strategic review of the segment including the potential of a sale. Over the last nine months, we have gone through an intensive process to seek a suitable buyer for the complete segment. Unfortunately late in the quarter an anticipated sale of the business to a prospective buyer under an exclusive arrangement fell through. This was a disappointing setback but does not change our overall strategy for this segment.

The Medical pumps is not core for Moog and we believe this business will be more successful in the long run under alternative ownership. Our strategy up to now has been to find a single buyer for the complete segment. However, the business consists of several product lines and we have learned the different buyers have different interest levels in the various product lines.

As we move forward, we continue our process of seeking a suitable buyer for the whole segment but will also broaden our approach to consider options for each of the product lines if appropriate. We will provide the market with updates as newsworthy events occur.

Now, let me move to the details starting with the second quarter results. Sales in the quarter of $650 million were up 1% from last year. Sales were up in our Aircraft, industrial, and component segments, but were lower in our Space and Defense and Medical segments.

Taking a look at the P&L our gross margin is down slightly from last year on the less favorable mix of sales in our aircraft business. R&D is also down slightly but administrative expenses are higher as a result of our SAP start up activities. In the quarter, our SAP investments suppressed margins by about 100 basis points. Q2 was a peak spend rate for this project in this fiscal year and we're anticipating the expenses in the third and fourth quarters will be about half the expenses in the second quarter.

Interest expense was $4 million lower than last year due to the retirement of our 7.25% high yieldbonds which we completed in the first quarter. Taken all together, net earnings of $38 million and earnings per share of $0.82 were both about 3% higher than last year.

Fiscal 2014 outlook, we're increasing our sales force cast for the year slightly to $2.64 billion, we're also adjusting the mix based on the second quarter results. Relative to our forecast from 90 days ago, sales in our industrial and Aircraft segments will be up marginally while sales in our medical devices segment will be lower. These sales tweaks will not affect our earnings per share forecast, which will remain unchanged at $3.65 per share.

Now, to the segments. I would remind our listeners that we provided a two page supplemental data package posted on our web site which provides all the detailed numbers for your models. We suggest you follow this in parallel with the text.

Beginning with Aircraft Q2. Sales in the quarter were up 6% from last year to $275 million. The sales story remains unchanged. Strong, organic growth on the Commercial side, compensation for slowing Defense sales.

Commercial sales were up 17% in the quarter with strength in both the OEM and aftermarket segments. Sales to Boeing and Airbus continue to grow driven by the 787 ramp, and the start up of production on the A350. Commercial aftermarket also had another good quarter, helped by strong initial provisioning of the 787.

In the Military markets sales were down 3% from last year F-35 production was up nicely in the quarter, but the development contracts continues to a base down about $2 million from last year. Helicopter sales were down as activity slowed on the B22 black hawk and several other smaller programs.

The KC46 tanker program remains a bright spot with lower foreign Military sales this quarter resulted in a net reduction in the other Military OEM category of about 4%. The Military aftermarket was down in the quarter but up from our first quarter. Last year we had some unusually strong foreign Military aftermarket sales in Q2 which did not repeat this quarter. On a positive note, we're starting to see the first signs of F-35 aftermarket as the fleet hours start to accumulate.

Aircraft fiscal 2014. We're increasing our sales forecast for the year by $10 million, the increase is all in the Commercial after markets. 787 initial provisioning is running well ahead of our forecast although the rest of our Commercial aftermarket is a little faster than the forecast. The net result, is a $10 million increase for the years Commercial aftermarket total. There is no change to our military forecast.

Margins in the quarter were relatively soft at 9.4% anunfavorable mix combined with higher operating expenses resulted in relatively soft margins.

R&D is up relative to last year driven by the Embraer Air program. Administration expenses are also up as a result of our SAP initiative. Despite the relatively soft second quarter we're maintaining our margin forecast for the full year at 12.1%.

Turning to Space and Defense, sales in the quarter were down 10% to $95 million. Weakness was all in the Space side of the business. We had lower sales on both satellites and launch vehicles and various production jobs wound down and the follow on jobs have not yet ramped up. On a positive note we had very strong bookings in our Space segment over the last couple quarters and our backlog supports a much stronger second half of the year.

Defense sales in the quarter were about even with last year. Sales on U.S. Military vehicles were lower with sales on foreign vehicle programs were higher. Taken together, vehicle sales in total were down about 10% in the quarter. Balancing this out were higher security sales which were up about 10% in the quarter.

Space and Defense fiscal 2014. We're keeping our sales forecast for the year unchanged at $420 million. This forecast assumes stronger second half in both our Space and Defense markets. In Space we should see higher sales on a variety of satellite programs and on the soft capture and Space launch systems for NASA. On the Defense side we're anticipating a sales uptick in the second half on Missiles, naval systems, and various Military vehicle programs.

Margins in the quarter were 9.4% compared to margins of 7.3% a year ago. We're seeing the benefit of the restructuring we completed in the fourth quarter, as well as better performance in some of our recent Space acquisitions. We're forecasting second half margins of 9.5%, to yield full margins of 9.1%.

Turning now to industrial systems. Sales in the quarter of $151 million were 5% higher than last year. We're starting to see pockets of good news in some of our industrial markets, although not enough evidence just yet to turn bullish on the overall segment.

Sales into the energy market were up nicely in the quarter with wind energy sales up 17% from a year ago. The strength in winds came from some recent contract winds in Brazil for our new AC system, as well as slightly higher sales in Asia. The wind business has been a real challenges for us over the last two years but we think we may be turning a corner for the better.

Industrial automation sales were also up nicely in the quarter with increases across all our major market categories. In particular, we had a strong quarter for our formula one business in Q2. This is a seasonal business which got a boost this year as the F1 governing body changed some of the regulations which resulted in additional Moog content on each car. This F1 business will not repeat in the next quarter.

Finally, our simulation and test business was down in the quarter as several of our large simulation customers continue to adjust their inventory levels.

Industrial systems fiscal 2014. We're inching our sales forecast for the year up by $15 million to $590 million. This forecast assumes a second half about even with the first half.

Margins in the quarter were 9.9%, up from 5.4% a year ago. Overall margins are benefiting from the restructuring actions we took last year. For the full year fiscal 2014, we're forecasting margins of 11%, up from fiscal 2013 operating margins of 7.1%.

Components. Sales in the quarter of $101 million were up 2% over last year. Our Apen Industrial Motors acquisition, which we completed in Q2 2013, contributed an incremental $8 million in sales over the same quarter a year ago. Excluding acquisitions, organic sales were down 5% in the quarter.

Sales in the aerospace and Defense markets were lower as a result of reduced sales on a range of Aircraft and vehicle programs. The (inaudible) Missile program was a bright spot in the portfolio but across the rest of the programs we're seeing push outs and continued declines in production rates.

Sales into the Energy and Medical markets were about flat with last year, but sales for industrial applications were up strongly, as a result of the acquired sales from Aspen Motion Technologies. Overall the markets across cross our component segments remain challenges as a result of the declining Military budgets and the slow industrial recovery.

Fiscal 2014. We're keeping our sales forecast for the year unchanged from 90 days at $438 million. This forecast assumes a pick up in the second half of the year based on higher foreign Military sales, completion of some large projects in our energy sector, and an improvement in the industrial markets.

Margins in the second quarter were unusually soft at 13.4%, excluding the costs associated with our SAP project margins would have been 14.4%. Declining organic sales and an unfavorable shift in the mix away from Military sales is having a negative impact on our margins. We're continually adjusting our cost structure in response to these challenges. For the year we're maintaining our margin forecast at 14.7%.

Medical. Q2 was a very mixed quarter in our Medical segment with weak sales but with respectable operating margins. Sales in the quarter of $27 million were $8 million lower than last year. $3 million of the difference is due to the disposal of the Buffalo facility which we completed in June of 2013.

Excluding the effect of the divestiture there are two reasons for the decline in organic sales. First, similar to what we're seeing in some of our industrial markets one of our medical device distribution partners is going through an inventory adjustment process. Second, the management team in this segment has been very busy with the strategic review process over the last few quarters, and this distraction from the day-to-day business has taken a temporary toll on the sales performance.

Fiscal 2014. Given the stock sales in the second quarter, combined with the outlook that the inventory adjustments underway at our distribution partner will take another quarter to walk through, we're moderating our sales forecast for the full year by $10 million, down to $127 million. The reduction is split evenly between pumps and sets.

Margins in the quarter of 5% were 130 basis points higher than the same period last year, despite the significantly lower sales. Given the lower sales forecast for the year, we're moderating our full year margin forecast to 6.9%, down from 7.1% 90 days ago. As I said in my opening remarks, we determined that this segment is not core to our business long term. As we move forward, we continue our process of seeking a suitable buyer for the full segment but would also broaden our approach to consider our options for each of the product lines if appropriate.

Now, to the summary. Our second quarter was a fairly quiet quarter, earnings came in a little ahead of what we forecast and we experienced a temporary set back in the strategic review process of our Medical devices segment. Coming out of the quarter we're increasing our full year sales forecast slightly while keeping our earnings forecast unchanged from 90 days ago. The Defense markets remain challenging and we continue to look for signs of sustained improvement in our industrial market. Commercial Aircraft remains the bright spot. Just to remind you our full year sales forecast of $2.64 billion is up about 1% over fiscal 2013. Earns per share should be $3.65. We're anticipating a stronger second half with earnings per share in the third quarter of about a dollar, plus or minus a nickel, and earnings per share in the fourth quarter of about $1.13. Our earnings forecast of $3.65 per share is exclusive of the effect of our share buyback program which could add an additional $0.05 per share to the total. Now, let me pass you to Don who will provide some color on our cash flow and balance sheet.

Thank you John, and good morning everybody. Free cash flow in the quarter was $32 million compared with the reduction in our net debt over the last 90 days of $9 million. The difference relates to cash used to repurchase Company shares during the quarter under the buyback program we announced three months ago.

On a year-to-date basis, free cash flow was $81 million, reflecting 116% cash conversion ratio. Our free cash flow outlook for the year remains unchanged since our last forecast at $165 million, reflecting a cash conversion ratio of just about 100%.

Our share repurchase program began late in the quarter, due to the timing of events associated with our efforts to sell the Medical devices segment that John briefly described. During March we repurchased approximately 357,000 shares under our 4 million share buyback authorization. The impact of our weighted average shares outstanding in the quarter was negligible. We expect to complete our buyback program by the end of the calendar year.

Looking at the balance sheet, cash free debt free working capital was relatively flat compared with the last quarter end on sales that were up modestly. Accounts receivable were up $16 million due to the timing of collections on late quarter and invoicing, which we expect will improve next quarter. This was offset by increases in a number of miscellaneous accruals, inventories were flat, customer advances were down $9 million over the last 90 days, to $137 million, and losses declined by $4 million, to $35 million.

Capital expenditures were $15 million and depreciation and amortization totaled $28 million in the quarter. We're leaving our forecast for CapEx and depreciation and amortization for all of fiscal 2014 unchanged at $105 million, and $113 million respectively .

Cash contributions to our defined benefit pension plans, globally, totaled $14 million in our second quarter, in line with our projected contributions for all of fiscal 2014 of around $55 million.

Our effective tax rate in the second quarter was 29.6%, up from last year's 26.9% due to higher R&D tax credits a year ago. Our forecasted effective tax rate for all of 2014 is 31.5%, unchanged from our last forecast 90 days ago.

Our financial ratios at the end of the quarter were solid. Net debt as a percentage of total capitalization was 24.3% down from 32.8% from last year's second quarter. Our leverage ratio is 1.47 times. At quarter end we had $295 million of unused borrowing capacity on our $900 million revolver that terms out in 2018.

In summary, as John described, we projecting 2014 earnings per share of $3.65. Before consideration for the effects of the share buyback program. We're optimistic we'll end up reporting record sales, record net earnings, and record earnings per share by the time this fiscal year is complete. With that, I had like to turn it back to John for any questions that you may have.

Thanks, Don. And Jessica. Can you see if they have questions in queue, please?

Thank you. (Operator Instructions). Our first question comes from Julie Yates Stewart, with Credit Suisse.

Good morning, Julie.

On Aircraft margins, John, can you just talk about the levers for improvement in the second half of the year? It looks like you need to average nearly 14% to achieve the guidance of 12.1% which is well above the historical run rate.

Yes, so there is two effects I would say on the second half, Julie, that will drive the improvement in margins. One is a reduction in the R&D spend if we go through the second half, and the other is an improving mix which we have in the backlog which is driven by some of the foreign militaries sales that we have. Those are the two really big effects that drive the second half.

And then I realize it's a little early to be talking about FY 2015, but that is the run rate we should assume will go into 2015 or will you have a similar H1/H2 dynamic next year as well?

I would agree it's a little bit too early to talk about 2015 and we'll provide that guidance at our next call in 90 days, Julie.

Okay. And then on aftermarket, your comment that the core aftermarket was a bit soft. Can you just give us a little color on what might be contributing to that?

When you say the core aftermarket, are you talking Commercial or Military?

I'm sorry, Commercial provisioning.

We have aftermarket on a variety of older programs, and some of those programs are being replaced by some of the newer jets and we're seeing a slow decline in some of that underlying aftermarket that we have. It's something that we've been anticipating happening, and it's been replenished by the newer programs as they come online. It's not a surprise, I would just say it's part of the change out in the fleet.

Okay. And then on Military aftermarket, I know visibility has been limited there and I think you had guided to down 10% for the year. Are you still expecting that?

Yes, total Military, that's right, down about 10% for the year. My prepared remarks said it's down from the second quarter of last year. But it was actually a very strong quarter at $59 million. It was way up from the first quarter, which was about $50 million. It's just that last year we had a particularly strong second quarter, so it was actually better than the run rate that we had last year. So, I would say Q2 was a strong quarter for the Military aftermarket. We anticipate the rest of the year will be a little bit lower. I wouldn't draw conclusion that the Military market was actually soft. I would say it was pretty healthy this quarter and this quarter will help to make sure we make the number we have anticipated for the year.

Okay. Great. Thank you.

You're welcome.

Thank you. And our next question will come from Cai von Rumohr, with Cowen and Company.

Good morning, Cai.

Yes. Thank you very much. So John, your guidance for the full year, you added $10 million of Commercial aftermarket, $15 million of industrial legacy. Your high margin business and taken $10 million out of Medical, which would I assume average, certainly not the same incremental margins. Your SAP expenses were $7 million in this quarter and I think you projected $10 million in the second half the same. So how come the guidance hasn't gone up? What's the offset to those positives?

I would say at this stage, Cai, it's too early to change the guidance. You're right, some of the improvements are positive effects. Having said that, we have had a low overall margin performance in the second quarter. We anticipate that will get a lot better in the second half. But it's too early at this stage given the increase we already forecasted in the second half to inch that up.

Okay. And then, so now we know you have been trying to sell Medical, you're still trying to sell it. Your financial position already is strong. What happens with the cash?

With the cash, which cash, Cai?

I assume when you sell Medical you will get a large check from someone. So that will substantially improve your already strong financial position. So as you think about cash deployment, even with your buyback, you're going to be very, very strong. Is the thought more incremental share buyback? Dividend? Special dividend? What's the thinking in terms of what you will do with the proceeds?

I think it's a little bit early to say, because I'm not sure at this stage. We thought we would have a deal, we thought we would be announcing a deal, to be honest, on this call. That fell through, so we got to regroup within the organization and we have to go out and start the process again. And as I said on the call, in my prepared remarks, one of the things that we have learned through this process is that because we developed this segment out of five different acquisitions, there are a couple of different product lines and different buyers have different interest levels, which may mean that we end up in a situation where we perhaps have to find different solutions for some of the different product lines.

That process is likely to take us well into 2015, given how long it's taken us so far and how long that process typically takes. So therefore, to determine what we would do with the cash at this stage, I think is a little bit early. I would say we've engaged in the buyback program as Don said that's probably going to last the next two to three quarters. At the present set of activities, that will increase our leverage ratio and at the end of that period of time we will take a look and see where we go next.

There is always the potential of acquisitions. We have slowed our acquisition activity over the last 12 months, but a lot of that is the fact that some of the markets that we're in haven't given us interesting opportunities, and also we want to make sure that we're looking at acquisition opportunities in the light of other capital deployment strategy. But we continue to be in the acquisition search mode and if an acquisition were to come along that may be where we would deploy some of that capital. I think it's just too early to tell. As opportunities come along we will evaluate them. We will also evaluate the possibility of using the money to give it back to shareholders. We just haven't got there, yet. So until we have that nice big check in our hands I think it's premature to say what we would do with it.

And last question, so you're going to buy the 4 million shares over the next two to three quarters. You bought a substantially slower pace in the current quarter, and yet you announced your quarterly results were towards the end of January, so it doesn't look like you did anything in February. How come?

Because we were in this agreement to sell the Medical devices business, and we felt that it was inappropriate to be in the markets with that new potentially coming out towards the end of March. What happened was when the deal fell through, in the middle of March we then engaged, we kicked in the share buyback program. So, that's why it was such a small number in the quarter and that's why we anticipate we can get it down over the next two to three quarters at the pace that we saw towards the back end of March. So that's the reason for that.

Good explanation. Thank you so much.

You're welcome.

And our next question will come from Tyler Hojo.

Good morning. I actually wanted to follow up on one of Julie's questions with regard to the Commercial aftermarket. So if you look at the core aftermarket growth rate in Commercial, so X787 provisioning. What would that growth rate have been in the quarter? And what is the expectation for the year?

I think if you do an X787 and you compare it to the same quarter a year ago, it's about flat. And actually, Tyler, if you go back 2011, 2012, 2013 and what we're forecasting for 2014, X787 initial provisioning that underline is about flat, as well.

Okay.

As I said to Julie,on the one hand you've got a lot of activity in the Commercial aftermarket, on the other hand what we're seeing is the change out of some of the older airplanes 57s, 67s that we have being part of our aftermarket, so we're seeing that be a little bit but we're seeing the positive of some of the new programs.

Okay. Got it. Very helpful on that front. And also, just with looking for a little bit more detail in regards to one of your comments in regards to the simulation and test business. I guess also, some inventory fluctuation issues impacting your outlook there. Could you maybe talk a little bit about your longer term expectations? Is there still a tail wind in that end market or do you see things starting to turn there?

So short term, we have an inventory adjustment, or at least our customers in that business are adjusting their inventory for whatever set of reasons they have. They got a little bit ahead in terms of their inventories over the last year, and they're now going through a period of adjusting for that. We have a very, very strong position in that market, and the answer to your question is really based on the outlook that the flight safeties, their view of the overall Commercial training simulation market. And I think right now that is still a pretty bullish outlook, if you think of the airplanes coming on line, you think of the commercial airplanes, you think of additional regulations that are starting and that are coming out in terms of pilot training, I think overall that market has a fairly positive outlook for the future and therefore we're optimistic that we should continue to see that as a very strong market.

Okay. Very good. And just lastly for me, on CapEx, in order to get to your guidance range for the full year, you're going to need to significantly ramp up CapEx in the back half of the year. What's that spending on and is it possible that you fall below the range?

Tyler, this is Don. It's a great question and you're right. We've got to spend in the second half to hit that forecast of $105 million. There are a couple of drivers, one would be we've got a facility that we're constructing in Europe, that will consume some of that growth, but not all of it, of course. It's a modest facility, it's under $10 million. And then the other thing is the SAP project, the capital part of that project begins to ramp up here in the second half of the year and that will consume some incremental capital. And as I think about it there's a third element, which is a program driven investment on some of the programs we invested in, A350 and Embraer Air will continue to kick in. So, you're right, we may end up with a number that's below $105 million. We thought it was too early with two quarters in to adjust it downward at this stage but it could be a positive from a cash perspective.

Perfect. I'll hop back in the queue. I appreciate it.

Thank you. (Operator Instructions). We'll take our next question from Ron Epstein.

Good morning, Ron.

Hi, good morning. Actually, it's Christine Lelog instead of Ron.

Hello, Christine.

Hello. So you paid down debt this quarter and your net debt to capital ratio is as low as it has been as it has been in the past ten-year. How are you thinking about your capital structure going forward? And a follow up to that would be how does the strength of your balance sheet change your priorities with regard to your capital deployment strategy between the M&A, or returning cash to shareholders?

Christine, it's Don. We have, as you point out, a very fortunate situation that we're in, strong balance sheet. Long term at this juncture we're probably clearly under levered from a optimal leverage perspective, cost of capital. We shouldn't lose sight of the fact we have a share buy back program just announced three months ago, that we're in the middle of, that we'll consume $250 million plus of capital. So that will moderate on some of that positive picture all by itself. And as John said earlier we're not out of the M&A market. M&A has been and I think will continue to be an important part of the future of our Company. We're in a little bit of a lull now. It's been about a year since we have announced any deal of consequence, and I expect that we'll continue to look for appropriate ways to deploy capital. That being one alternative. And, as John said, the other choices that we have particularly on the prospect of selling the Medical business, other returns to capital, returns of capital to our shareholders.

Let me add a little bit Christine. If you look historically, we have been levered, if you do to debt to EBITDA, somewhere around one and a half to 2.5 range. We have agreements with our bank in terms of 3.5 being a maximum in terms of some covenants and stuff but typically, that 1.5 to 2.5 is the sweet spot we've found our leverage. That's the sweet spot. Right now we're in the 1 1/2 and clearly we have low leverage compared with our historical averages. We have announced the buy back and I think that will start to creep that leverage up and what we would like to do is complete the buyback over the next two to three quarters, and then look at the next step and say okay, now what's the next step in terms of where do we go next with capital deployment?

We're generating some nice strong cash flow, that's a real positive. We have pensions opportunities if we wanted to pay down some pension expense, some underfunding there, and the results of the continued opportunity to return capitol to shareholders. So, we would like to get through this present buyback, and then what we would like to do is come back to the market and say here is the next phase of our capital allocation process. We would like to go through what we've already announced, get that done and go back to the market and say what the next step is.

Okay. Great. And a different question, a follow up to what I think was the 787 provisioning, I guess my question would be, when should we expect the 787 provisioning to actually begin being accretive to aircraft control segment margins?

It is an accretive to the margins, but the 787 initial provisioning is about 1% of their sales. No, I guess over the course of a year it's maybe 2% to 3%. So it's not a huge number. The initial provisioning is a positive affect on the margins overall. But you got to put it into the context of 100 other programs and the large shift of the mix away from the Military and more to the Commercial OEM side, and early on in the Commercial OEM side in the program history you tend to have rather lower margins.

So, there's multiple things going on, Christine, and therefore you can't single out just one thing on that side and determine you should actually see that drop to the bottom line. Our Commercial aftermarket runs about just over 20% of our total Commercial business. I think relative to some of our peers who have a more long term established position where they don't see as much growth on the OEM side it's a much higher percentage. But because we're in the significant growth phase, the after markets has yet to catch up. That's probably going to take three, four, five years before you really see the 787 kick in and the A350 kick in, and then you should start to see that aftermarket total as a percentage of the total Commercial OEM book really start to build, and see further margin improvement from that. But, I think singling out one piece is a thing you need to do carefully.

Great. Thank you .

Welcome.

Thank you. And our next question comes from Michael Ciarmoli.

Good morning, guys. Thanks for taking my questions. John, just quickly on the Medical. You know, if a sale doesn't seem to be imminent have you guys thought about just compartmentalizing this into non-core operations so we can start to maybe look and get a cleaner look at the business without if there is management distraction or noise something that impacts the bottom line that's not really relevant going forward?

I'm not sure I understand, Michael, your question in terms of what that separation, as you call it, would mean. I can tell you that it's a separate segment, it has separate facilities, it has separate management. It's run as a segment and actually over the year as we have gone down this process we continued to kind of separate it out and make sure that if and when we find a suitable buyer it will be relatively easy to transfer as a separate information systems and stuff. So I'm not sure can you help me understand your question?

Well I guess maybe from financial reporting purposes, if it's designated as assets and operations for sale and you pull it out of your consolidated operations.

This is Don, Michael. How are you doing?

Good. How are you doing?

That's an option we have I think going forward. I don't think right now we're on that path. I think we talked about it, and we know that option is out there. Right now as we're trying to sell the business it seems most appropriate to keep it isolated, but there may be an opportunity for us to take the component and slip it into some of the rest of the other segments.

Okay. Okay. That's fair. Just looking at the Space and Defense, you've got a pretty steep sequential, or second half ramp over first half, to get to that guidance. You talked about the booking strength. Can you maybe elaborate on actually some of those satellite and Space programs that give you that confidence?

The major drivers in the second half, I mentioned it in the text, there's a couple of NASA programs, (inaudible), and the Space launch system. We also have some additional activity on some ATK programs, some actuators for ATK. There's a variety of programs where we have the backlog. The challenge in that business because these are development programs, Michael, is to actually get the work done. And if you remember in the first quarter, our Space margins were relatively soft, even coming out of the fourth quarter where we done a restructuring, and what we described was we have a year that's two halves. In the first half it has relatively soft sales, and in the second half there is a huge ramp up in sales. Now that sales ramp up is an input based ramp up. In other words, it's engineers doing the work on these development programs and therefore we kept some of the staff. We needed staff in the first half in order to be able to realize the second half. So the challenge will be ramping up the engineering activity to achieve the sale. It's not the backlog, that's not the challenge. It's can we actually get enough bodies on the programs to incur the costs to actually drive the output on it. That's really the essentially the challenge in the second half. It's not that we don't have the backlog there on the Space side to meet the forecast, it's can we get enough of the engineering folks to do it. And a little bit is we see some engineers coming off some of the Aircraft programs and (inaudible) across into some of those Space programs.

Okay. That's very helpful. And just a last one to follow up on Julie's question on the Aircraft margins, the second half ramp. How do you guys contemplate it? It sounds like you got good mix in there. You got the E-Jets ramping up. You talked about the A350. How do we think about the 777X in there as we get later into the year? Is that contemplated in the margin assumptions? I'm just trying to balance the steady R&D that's happening there with these strong margins and this run rate.

The 777X does not have an impact on us in this year because the competition for the flight control systems have not yet happened. There will be a little bit of activity in terms of bid and proposal, but it's likely that any awards are probably going to be summer or maybe even into the fall. I don't have the exact timing on that.

Okay.

But even if that happens it wouldn't be any significant ramp in the R&D in this fiscal year. If we were to win a position on the 777X it would be a fiscal 2015 impact and 2016 and beyond, it really is not going to be a fiscal 2014 impact.

Got it. Perfect. Thank you very much, guys.

Thank you. Our next question comes from Steven Cahall, from Royal Bank of Canada.

Good morning. Maybe just a question on industrial. You said you saw some pockets of good news, it wasn't enough to turn you bullish. I know that last year this was a segment that maybe burned you a bit where it looked like things were improving and you put some of the cost in and the volume didn't come through. Can you give us some color on what you're seeing and what might change your mind actually seeing a recovery in industrial?

So the strength in the industrial business, if I compare the quarter let's say we do the sequential rather than the year-over-year, so if I look at it relative to the first quarter and I go back to the fourth quarter and even the third quarter, the strength is really in the industrial automation market. That was up nicely in the quarter. And we saw a little bit of a pick up across all of those markets, where metal forming, plastics, heavy industry, each one of them had a little bit of a pick up in the second quarter relative to the first.

Now, I also mentioned in the text the Formula One business we have. It's not a huge business. It's about $3 million or $4 million in the quarter. But it is a seasonal business, where before they start the season we need to driver all our products and then the next couple quarters it winds down significantly. So, you had a little bit of an uptick in Formula One business in the quarter that makes it look better than what I call the run rate of the underlying business. We want some additional positions it's just our Formula One business relative to last year but it's a seasonal effect. The run rate of the industrial automation business in the second quarter was $80 million, but we're not anticipating the 320, we're anticipating it will be about 300 for the year. Having said that, the first quarter was $72 million.

So little bit of an uptick, little bit of a positive picture, I would say, in Europe, but I was talking to somebody earlier today, we had an internal discussion yesterday about the overall economic outlook for our business, and one of the top points was that home builders are in the U.S. particular are kind of bullish at the moment and this morning the front of the "Wall Street journal" says mortgage originations are way up. So, it goes from little bit of good news to little bit of not good news, and so therefore we're a little bit cautious to go with one quarter and say it's actually starting to structurally get better. I think the economy in Europe are doing a little bit better, the economy in the states is doing a little bit better Asia is slowing down a little bit. The macro picture doesn't support a significantly bullish outlook. And what we said is we think the second half similar to the first. We would be delighted if we can report that kind of uptick that we're seeing in those businesses continues.

And just as a follow onto that, given the restructuring that you've done to right size that business, if you did start to see good volume growth, is there a target incremental margin that you think that business sees ?

If we start to see good incremental growth we would see a nice improvement in the margins. What the incremental margin is depends very much on which of the product lines you actually see that business in. At the moment we're seeing a little bit of an uptick in the industrial automation. On the other hand, we're seeing the simulation business come out significantly because of this inventory adjustment. It depends on which market. I would love to give you a number because it may turn out that we see some nice improvement in one market and not in a different one and the number turns out to be slightly different. But if you start to see a sales pick up given the fact that as you say we right sized the business we should see some nice incremental margin improvement.

Okay. Thank you. And just a final one as a follow up on some of the R&D discussion. Could you just give us a sense on a medium term view are you at peak R&D levels with 787 (inaudible) and you'll be here for some time? Are we past peak R&D for the cycle or are we still approaching peak R&D for the cycle? Thank you.

Okay. I'm not sure I can answer the cycle question, because there is a Commercial cycle, but in our business it's a program by program event rather than just a cycle. What we said is that we had anticipated that R&D would start to drop off post the A350 we will definitely see that but we replaced that with the Embraer Air job. We took that job because we think it's a very nice job for us in the long-term. It will be a very nice piece of business for us. That's going to keep the R&D elevated for the next couple of years then we should start to see it drop off again. But, it depends on whether or not we find some additional interesting opportunities that come along. So it's too early to say. Next quarter we give you an outlook for 2015, we tell you what we think the R&D is going to look like in 2015. We can also give you an update on the 777X. At that point we will have a much bigger picture how the outlook will look the next year or two.

Thank you very much.

(Operator Instructions). We'll take our next question from Neal [Deora].

Good morning thanks for taking the question. Specifically to the F35, I know Lockheed's talked about some kind of increases in production at a pretty rapid clip over the next couple years. Are you guys already seeing that? And I have a second question on the aftermarket opportunity. Are they the same dollar levels for the F35, 787, A350, all the other ones you talked about, as the OEM side was?

Let me do the F35 question first. First of all, we're on all the (inaudible) so whatever Lockheed says they're going to produce, our forecast is just a reflection of that complimented by the mix of content that we have. Our best knowledge at the moment is we're looking at this year, 41, 44 next year, and then 2016 ramping to 65 and 2017 to 99 airplanes. Those should correspond with what Lockheed is publishing and what the government is publishing and perhaps there is a little bit of a timing shift because our stuff obviously gets made perhaps six months, or more, in advance of when the airplane will actually ship so there may be some timing issues there. We are anticipating, we're hoping, that there will be a nice ramp up in 2016, 2017 and from there on out. So that should be a real positive for us. So that's the F35 OEM question. The aftermarket one I'm not sure I fully understood the question. Could you repeat the question for me, please?

Yes. Over various times in the past, you've said let's say the 787 OEM component was like around $1 million. Would the spare parts be around the same level? I'm asking the same question for the F35 and the A350. Are the OEM values for the aircraft the same as the aftermarket would be?

Let me do the Commercial piece first, it's quite different. When Boeing ships a 787 we have a shipped set of content on it which involves about 30 different actuators and a lot more components when you take some of the high lifts stuff into account. So we have a very broad range of components. When the airlines do what's called initial provisioning, what they're doing is they're saying I'm going to have five 787s, and I need to have one of this actuator, and one of these and one of those because those are the aftermarket parts that we deem as being very important, and that we want to be able to respond instantly if there's a problem or an issue somewhere that we need to repair or replace a unit. So it's a little bit like your car, you decide I need some wipers and I need brake pads but I'm not going to get myself a steering wheel because the steering wheel is not going to fall off, hopefully. It's a little bit like that. The aftermarket is very different. It's selective depending on some of the components, how big the airlines fleet is, and what they want to provision.

On the Military side I would say it's somewhat similar except of course, the Military typically it's a single customer or DOD, three or four customers, but they are coordinated as they feel appropriate. We've noticed in the past that it's very hard to correlate our spares. If I take some of the more mature programs, black hawk or the B22, it's very difficult for us to correlate the activity that we do for spares and repairs with the size of the fleet. They are running their airplanes much more intensely than the Commercial side, it's a much different type of duty cycle, a much different set of technologies and therefore the aftermarket calculation there is quite different from the Commercial side of the business. Really depends on the fleet hours. One more example, B22 was used extensively in the desert. When it's used in the desert that generates a lot of repair activity versus if they used the B22, say, in a more normal environment. So really depends on the Military side on the activity. Does that help answer the question?

Yes, that's very hopefully. Thanks a lot for the detail.

My pleasure. Jessica do we have any other questions?

Yes, we have a question from Cai von Rumohr.

Yes. Gentlemen, just a housekeeping issue. Why was interest expenses as low as it was in the second quarter? And maybe you could give us full year expectations for interest expense, equity comp and corporate expense. Thanks.

Okay. Interest expense was low in the quarter because we called in our bonds back in December, and so we were relying all on our revolving credit facility. Which is pretty low cost on facility for us. The outlook for the year for interest we got a forecast right now of around $14 million to $15 million, and corporate expense we got a forecast for all of 2014 of $27 million. And equity based comp we got about $7 million of forecast for the full year.

Thank you very much.

You're welcome.

And it appears that there are no further questions at this time. Ann Luhr, I would like to turn the conference back to you for any additional or closing remarks.

We have none. Thank you very much. See you next quarter.

Thank you. This concludes today's conference. Thank you for your participation.