Moog Inc (MOG.A) 2015 Q3 法說會逐字稿

Good day, everyone, and welcome to the Moog third-quarter FY15 earnings conference call. Today's conference is being recorded.

(Operator Instructions)

At this time I would like to turn the conference over to Investor Relations Manager, Miss Ann Luhr. Please go ahead.

Good morning. Before we begin, we call your attention to the fact that we may make forward-looking statements during the course of this conference call. These forward-looking statements are not guarantees of our futures performance and are subject to risks, uncertainties and other factors that could cause actual performance to differ materially from such statements. A description of these risks, uncertainties and other factors is contained in our news release of July 31, 2015, our most recent form 8-K filed on July 31, 2015, and in certain of our other public filings with the SEC.

We've provided some financial schedules to help our listeners that are following along with the prepared comments. For those of you who don't already have the documents, a copy of today's financial presentation is available on our Investor Relations webcast page at www.moog.com. John?

Thank you, Ann. Good morning. Thank you for joining us.

This morning we report on the third quarter of FY15 and update our guidance for the full year. We also provide our full look for FY16. Let's start with the headlines.

First, earnings per share of $0.94 in the quarter were slightly ahead of what we were projecting 90 days ago. Included in this total was $0.11 of restructuring charges. It was also another good quarter for cash flow.

Second, we continue to see sales and margin headwinds in many of our businesses corresponding with additional restructuring activities and ongoing reviews of our products and business portfolio. Third, we decided to look for strategic alternatives for our European Space operations. These three operations of total sales of about $15 million in FY15.

Fourth, we are reengaging in our sales process for our medical pump business this coming quarter. Fifth, we continued our buy back activity in the quarter and we're on track to complete our current $9 million share authorization around the end of the fiscal year.

Finally, we are providing a personal look at FY16 today, for next year we are projecting 1% sales growth and earnings per share of $4, up 14% over our FY15 forecast. Let me provide you with some numbers starting with the third quarter results.

Sales in the third quarter of $635 million was 7% lower than last year. Two-thirds of the decline was due to the affect of the stronger US dollar. Setting the currency affects aside, sales were down in our Aircraft and Space and Defense segments, slashed in Industrial and Components, and up in our Medical Devices business.

Taking a look at the P&L, our gross margin is in line with last year. R&D is up and higher Aircraft spend on the E2 development program, while SG&A expenses are lower as we continue to manage our costs. Interest costs were up due to last November's sale of high yield [des] and increased borrowing as a result of our share buyback activity.

We incurred almost $7 million of restructuring expense in the quarter. Our effective tax release was 28.4% and the overall results was net earnings of $36 million and earnings per share of $0.94.

FY15 outlook. With three quarters behind us, we are refining our sale's forecast for the year very slightly. There are some puts in pace in each of the groups but nothing of significance.

Full year sales should be $2.53 billion. We are updating our earnings per share forecast to reflect higher restructuring charges than forecasted 90 days ago, as well as the impact of our ongoing share buyback program.

90 days ago, we provided a full-year forecast of $3.55 per share. We are on track to complete are authorized share buyback around the end of the fiscal year, adding $0.05 to that total, to putting us to $3.60. Our forecast of $3.55 90 days ago assumes $5 million in restructuring in Q3 and Q4. We are now increasing that restructuring total to $11 million, or about an additional $0.10 per share. The net result is full-year earnings forecast of $3.50 per share.

FY16 outlook. For next year we're projecting sales of $2.57 billion, up 1% from this year. We anticipate commercial OEM sales will continue to grow as the A350 rounds up. State Sales and Station Defense, Industrial and Medical will be in line with FY15, but sales in our Components segments will be slightly lower as a result of continuing lowering oil prices.

Operating margins in FY16 are forecasted to 10.7%, up from our forecasted 10% this year. We are projecting earnings per share of $4, up 14%. We're not including the effect of any further share repurchase plan in this total. Cash flow next year is projected to be $150 million, or just over 100% of net income.

Now to segments. I'd remind our listeners that we provided a two-page supplemented data package posted on our website which provides all the detailed numbers for the your models. We suggest you follow this in parallel with the text.

Starting with our Aircraft segment, Aircraft Q3. Sales in the quarter up $270 million, or 8% lower than last year. The familiar pattern of lower Defense sales continued this quarter, but unusually, commercial sales were also lower this quarter.

On the military side, sales were lower in both the OEM and aftermarket areas. Sales of the F-35 development program declined to below $1 million this quarter, but sales on various foreign platforms were also down from a year ago.

On the commercial side, sales were lower in every submarket except Airbus. Sales to Boeing were down from a record quarter last year as a result of the timing of orders and deliveries. Sales to Airbus were up on the continued wrap in the A350 program and sales into the commercial aftermarket were lower on general market softness as well as lower 787 initial provision.

Aircraft FY15. The three quarters behind us, we are finding our sales mix for the year to include slightly higher military sales and slightly lower commercial sales. More specifically, we believe the F-35 and the B-22 production sales will be higher while A350 production sales will be lower on a slower ramp than anticipated. The total remains essentially unchanged at $1.09 billion.

Aircraft FY16. We are projecting FY16 sales of $1.3 billion, an increase of $43 million over this year. The increase is all on the A350 program, which will be up $47 million from 2015 to 2016.

Other commercial OEM sales should be more or less in line despite slightly lower business shift sales. We are forecasting the commercial after market to be down 5% in FY16 and 787 initial provision continues to moderate. On the military OEM side, higher F-35 sales will make up for lower B-22 and Blackhawk sales. The military aftermarket will be down 3% as our refurbishment program on the C-5 winds down.

Aircraft margins. Margins in the quarter, up 10.5%, were up from 10.3% last year despite the adverse mix. We also have $2 million higher R&D costs this is quarter driven by our ember air program. We continue to make progress on our commercial book of business with declines in unit costs this quarter on both the 787 and A350 programs as planned.

Despite the margin improvement this quarter from 12 months ago, we are behind our plan for the year, and therefore are moderating our full year margin forecast to 9.5%. For FY16, we are forecasting an adverse shift in their sale's mix with lower aftermarkets in both the military and commercial markets. R&D next year should be in line with FY15 as spending of the A350 and A2 programs continues at an elevated level. In total, we anticipate that the continued improvement in the commercial book of business will compensate for the negative mix shift to yield full year margins of 9.5%, in line with FY15.

12 months ago, we reached that expectations for the trajectory of our Aircraft margins over the following few years. At that time, I described the following challenges: Margin pressure on our domestic military book of business and lower sales on a variety of foreign military platforms. And: Ongoing cost challenges as we ramp up production on our new commercial programs combined with continuing high R&D spend for a few more years.

I said we would continue to see margin headwinds for a couple of years and that when we got out to -- FY17, we should start to see margins expand again as our commercial book of business matures and R&D spending comes closer to 5% of sales. 12 months later, today, the story has not changed, although the magnitude of the head windows has proven to be bigger than we projected. We anticipate that FY16 will be a low point for Aircraft margins and in FY17 we'll turn the corner on a path to higher margins over the following years to get to the mid-teens by the end of the decade.

Before I leave our Aircraft segment, let me put our short term margin headwinds into a longer term perspective. Over the last decades, he have become the leading supplier of flight ConSyst control systems globally. We've moved from a tier 2 component supplier into a tier 1 systems supplier. This has been a patient and deliberate strategy, a multi-program strategy, not a single airplane project. It is a 20 year strategy, and perhaps inevitably, is not without its challenges along the way.

Since the early 2000s, we've invested heavily in R&D, which has compressed our margins. The 787 and A350 programs have taken longer and cost more than originally planned. We've learned a lot from these programs and our more recent development programs are performing very close to plan.

We are now in the relatively early stages of the production phase of our strategy. Similar to the development phase, it is turning out to be more expensive than we anticipated. We're introducing new products and technologies to production and learning about building a global supply chain by leading unprecedented vamp-rates.

The margin headwinds associated with our heavy R&D phase are now starting to shift to the early production phase. As with our development programs, we are learning along the way and we are seeing favorable results at the production start-up on our newer programs are performing much better than the earlier programs.

We are clearly disappointed that the margins have not started to improve as quickly as a few years ago. However, our strategy remains solid and the long-term payoff will be worth the wait. The path to higher margins remains the same.

On the commercial side, R&D will assuage as we look out to FY17 and beyond, production costs will come down and the aftermarket will grow. On the military side, the F-35 program will continue to grow, and as the hardware matures and the aftermarket develops, the margins will expand.

We should also see some of our foreign programs pick up again and we are positions ourselves for the future with our content on the typer program and our teaming arrangements on the next generation helicopter and long range strike rovers. Day-to-day, the team remains focused on delivering on our customer commitments and working all of the cost elements to meet our long term financial goals.

Turning now to Space and Defense. Sales in the third quarter of $95 million were down 7% from last year. Following the pattern of last quarter, the weakness was all on the Space side of the business.

The wind-down of various satellite programs continued this quarter, and combined with lower activity at NASA on the soft capture program, resulted in a 21% overall sales reduction in the Space market. This type of sales fluctuations in the Space market is familiar to us and is the natural cycle of program shifting from development into production, and then back to the next development phase over time.

In contrast, in the Defense market sales were up 13% as strong sales on vehicle programs and into the neighbor market more than compensated for lower security sales. Based on Defense FY15, we are reducing our full year forecast by $5 million to $384 million. The reduction is all in the Space market as we anticipate the continued weakness in both our satellite and NASA businesses.

Space and Defense FY16. We are projecting FY16 sales slash with FY15, although we anticipate a continued shift in the mix from Space to Defense. We're forecasting a further 7% decline in our Space sales next year on top of the anticipated 11% decline this year.

On the Defense side, we are projecting an 8% increase in sales in FY16, on top of an anticipated 8% increase in FY15. The underlying drivers in each market are the same in both 2015 and 2016.

On the Space side, two affects are driving the declining sales. First, the natural program cycle of shifting between production and development, and second, the result of our internal review of the product portfolio to focus on our most profitable products.

On the Defense side, we also have two major affects over the 2015 to 2016 period. First, missile sales have continued to improve, and second, the military vehicle sales have recovered from their loads of a few years back with nice gains in both domestic and foreign markets.

Space and Defense margins. Margins in the quarter were 6.5%. However, this margin includes $6 million of restructuring charges taken in the quarter. Exclusive of this restructuring charge, margins in the quarter were a healthy 12.9%.

For the full year we are now projecting margins of 8.1%. Excluding the restructuring charge, this full year margin projection is up 70 basis points from our projection 90 days ago as the underlying business continues to perform well. For FY16 we are forecasting margins of 11.5%.

As I mentioned in my opening remarks, over the last few months we have done a deep dive review of our Space business. Back in FY11, our sales in the Space market were $136 million and were based on mature products and technologies. Over a 12 month period from December 2011 to December 2012, we completed three small acquisitions which brought our sales in FY13 up from $136 million to $220 million. Our strategy was to expand our footprint in components and to broaden our market opportunities by acquiring sites in Europe.

During FY13 and FY14, we struggled to integrate these acquisitions and learned that small independent space businesses often do not have sufficient capabilities and controls in place to meet their program commitments. Over this time, we made the necessary investments to complete the commitments to customers which we had acquired by reevaluating the portfolio to focus on the most profitable products going forward. Coming out of our recent review, we decided to focus our future investments on opportunities in the US market, and in particular, the mid management refurbishing program.

As a result, we are reviewing the strategic alternatives for our European Space sites. These European operations will have combined sales of about $15 million in FY15. We anticipate it could take up to 12 months to complete this process and will keep you informed as events unfold.

Turning now to Industrial Systems business. Sales in the third quarter of $131 million were 12% lower than last year. Excluding the impact of the stronger dollar, real sales were essentially flat at last year. Again, setting the ForEx to one side, we saw sales decline in non-renewable energy markets, compensated by slightly higher sales in our Industrial Automation and Simulation businesses.

Industrial systems FY15. We are adjusting the full year forecast down $6 million, to $524 million. We are tweaking the forecast in each category. Sales in our energy and simulation markets will be slightly lower with sales in our Industrial automation markets slightly higher.

Industrial systems FY16. We are projecting flat sales for FY16 at $525 million. Over the last several quarters, sales in the segments have been very consistent at about $130 million.

The macro economic outlook for FY16 does not suggest any improvement in the general industrial arena. And while we have several internal initiatives underway to drive sales growth, we are not comfortable at this stage forecasting how successful they may be.

Industrial systems margins. Margins in the quarter were 10%, consistent with prior quarters and with last year. The absence of organic growth, combined with our ongoing investment in the wind energy business, are making margin expansion difficult. However, we believe we will see improvement in FY16 to 10.7% as a result of our continuing focus on managing our costs.

Before I leave the Industrial segments, let me offer some comments on a couple of the opportunities we are pursuing. The first is in wind energy and the second is in the aftermarkets.

As our listeners are aware, we have had a roller coaster ride our the wind business over the last five years. Due to our Space business, we recently completed a thorough review of the Wind business and considered the various options and alternatives to maximize shareholder value, including the potential sale of the unit.

Our analysis of the future opportunity made it clear that the best options to maximize shareholder value was to continue to invest to grow the business. The Wind market is projected to grow between 5% and 10% over the next five years and the profitability of the market participants is improving after several years of losses. The competition in our Space of pitch controlled systems has suffered over the last few year, as have we, and we may be the only Company prepared to make the investments in new products.

We have a product road map laid out and have already fielded the first inter integration, what we call our AC system. We are well underway with our second product iteration, which will further enhance functionality and improve profitability. We anticipate having first units of the second iteration in the field during 2016 and we believe we have an addressable markets over time of several $100 million. It will be late 2017 or perhaps even into 2018 before we'll know for definite if our strategy has been a real success, but we believe the upside opportunity justified the investment we are making today to stay the course.

The other area of opportunity is in the aftermarket. Over the years, we've placed hundreds of thousands of hydraulic and electric components in the field. Over that time, we've enjoyed aftermarket in this business, but we've never built an aftermarket organization focused on capitalizing on this install base opportunity.

We have done this very successfully in our Aircraft segment and are now bringing that same learning to our Industrial markets. The organization change has been relatively recent, and it is too early yet to gauge the potential gains, but we believe there is a lot of opportunity that we have not exploited in the past.

Turning now to our Components segments, sales in the third quarter of $107 million were down 3% from last year. The weakness was all in our non-Aerospace and Defense markets. Sales into the energy sector were way down as weak oil prices impact the pace of offshore exploration. We also saw lower sales into our Medical markets and demand from a major customers from sleep apnea equipment fell.

On a positive note, sales in our general Industrial markets were up on strength from our Aspen acquisition. In the Aerospace and Defense markets, sales were up 4%. We continued to see a trend of firming missile and vehicle sales as well as some improving demand for slip ring assemblies used on military aircraft.

Components FY15. This quarter, sales came in ahead of expectations, so we are adjusting our full year forecast up by $5 million to $415 million. We believe military aircraft sales will be higher and despite the continued low price of oil we think our full year sales into the energy market will be slightly higher than our conservative estimate from 90 days ago.

Components FY16. We are projecting a modest sales decline of 2% in FY16 to $405 million. However, we anticipate some significant swings in the mix.

Within our Space and Defense market, we see some nice gains on foreign vehicle programs, as well as continuing strength in our missile programs. On the downside, we anticipate our sales into the energy sector will be off by over 20% as the full year impact of lower oil prices filters through the lower demand for our components.

Components margins. Margins in the quarter were 12.7%, similar to last quarter. Our Components segment is going through a period where their mix of business is less favorable than in the past and the top line is coming under pressure. We are taking action to respond to the situation, but we are likely to see relatively soft margins for this segment until the top line recovers and oil rebounds.

For all of FY15 we are forecasting full year margins of 13.5%. And next year, we see the impact of a full year of lower oil prices, and therefore are forecasting full year FY16 margins of 12.6%.

Turning now to our Medical Devices segment. Q3, this was another very good quarter for our Medical Devices segment. Sales were up 10% with continuing strength in both pumps and sets.

We continue to see growth opportunities in our IV pumps as competitors remove some older products from the market. Our set business was also stronger across both our IV and Enteral product lines. The global sets comes as we place more pumps in the market for the install base goals.

Medical FY15. Given the strong sales in the third quarter, we are inching our full year sales forecast up by $1 million to $122 million.

Medical FY16. Full year sales in FY16 are projected to be flat with FY15 at $122 million. However, you may remember in FY15 we had approximately $3 million in sales from our life sciences operations which we sold in March this year. Adjusting for these last sales, we are projecting a 3% organic growth rate in FY16.

Medical margins. This segment continues to outperform our expectations with excellent margins in the quarter up 15.4%. Given this strong performance, we are adjusting our full year margin forecast up to 12.8%. For FY16, we are forecasting further margin improvements to 13.6%.

Before leaving our Medical segment, let me remind you where we are in our strategic review process. In July 2013 we began this process. At the time, our Medical segment was facing significant challenges.

A planned sell of the segment fell through in March of 2014, and over the last 15 months we have focused on refining our strategy and improving profitability. Today, we have a very healthy business with the highest margins in the Company. However, we continue to believe that medical pumps are not a long term fit for Moog and therefore we are restarting the review process in the coming quarter and testing the market's appetite for our asset.

In contrast, however, to the process we started in 2013, we now have a business which is growing and nicely profitable. Therefore, we will be seeking a price that reflects this is new reality and will not hesitate to keep this business for longer if we cannot realize full value for shareholders in the sale.

So, let me provide some summary comments. After all the various tweaks, our FY15 sales forecast is now $8 million lower than our forecast from 90 days ago. Full sales from FY15 should be $2.53 billion. Our updated operating margin is 10% and earnings per share will be $3.50. This EPS number includes the total of $11 million in restructuring charges in Q3 and Q4 and also assumes we complete the present buyback program around the end of September.

In FY16, we are projecting 1% increase in sales and a 14% increase in earnings per share. The most significant change from FY15 will be higher sales in our commercial aircraft business as the A350 production ramps up. We are projecting earnings per share of $4. Net earnings will be $148 million and our free cash flow compression should be just over 100%.

FY15 is turning out to be much tougher going than we anticipated 12 months ago. On our third quarter call in July of 2014, I offered some thoughts on the risks and opportunities associated with our forecast for FY15.

On the risk side, we thought that slowing Defense spending, combined with cost challenges in the early stages of our new commercial aircraft programs, could cause us to miss our numbers. On the other hand, we thought there might be some upsides in our Industrial and Space forecasts. It is turning out that our risks have materialized while our upside opportunities have not. In fact, both our Industrial and Space forecast for FY15 are now well below what we thought 12 months ago. In addition, we had not anticipated the dramatic shift in exchange rates or the sharp drop in oil prices.

All in all, FY15 is turning out to be a year of headwinds across the board. Our Medical Devices group has been the real bright spot in the portfolio. Looking to FY16, we don't anticipate a significant change in the macroeconomic environment. Therefore, we are proactively adjusting our cost structure now to size our business and meet our goals for next year.

Historically, our Company has enjoyed the benefits of diversification across many different end markets. Typically, these end marks were counter typical. Where we had tailwinds, we pushed for earnings growth, and where we had headwinds, we reduced our cost and prepared for the next upswing.

Today, we find ourselves in the unusual situation where we face headwinds in almost all our markets. We are addressing this situation proactively and as we see the challenges mount in a particular business we are taking all necessary steps to restructure the business for success. Two years ago, we had a struggling Medical Devices business. We took a step back, we focused the business, and today it is performing much better.

Over the last two years, our Space business has also faced significant challenges. Over the last 12 months we've refocused the business and taken some significant steps to reduce the cost base. As a result, we are forecasting improving margins for FY16, even in the face of declining Space sales.

Our Aircraft business is now facing bigger challenges than we had predicted. As with our other businesses, we are taking all of the necessary steps to insure we get back on a margin expansion trajectory as soon as possible.

Folks across the Company remain focused on the long term health of the business. We continue to pursue our lean journey and maintain our investments in new innovation that will provide the next wave of goals. We're generating strong cash flow and following a capital allocation strategy which maximizes shareholder value.

We are forecasting $4 per share in FY16 on flat sales and another year of good cash flow. This will be a 14% increase in EPS and a record year for the Company.

Now let me pass you to Don, who will provide some color on our cash flow and balance sheets.

Thanks very much, John, and good morning, everyone. Free cash flow in third quarter was $56 million bringing the year-to-date total to $149 million. This represents a cash conversion ratio, which is free cash flow divided by earnings, of 153% for the third quarter and 144% for the nine months ended June 2015. While free cash flow was strong, our net debt increased by $29 million over the last 90 days as we used $91 million to continue our share repurchase program.

With respect to free cash flow, we are seeing some benefits to focusing on our balance sheet. These 2013, we are averaging 200 basis points of lower trading working capital annually, grown from 34.4% of sales in 2013, to 30.6% presently. Our forecasted free cash flow for 2015 is unchanged at $190 million, while cash conversion of 138%. And in 2016, our initial forecast of free cash flow is $150 million, or a conversion ratio of 102%.

Through the end of June, we repurchased under our existing board authorization approximately 7.9 million shares at an average per share price of just under $7, resulting in the total return of capital to shareholders of $549 million since January, 2014. Our plan is to complete the authorized buyback program by repurchasing the remaining 1.1 million shares by around the end of our fiscal year.

Capital expenditures in the quarter were $20 million and depreciation and amortization totaled $25 million. For the nine months ended June, CapEx was $58 million, while D&A was $78 million. While reducing our 2015 forecast for CapEx to $80 million, which compares with projected depreciation and amortization of $105 million. For 2016, we're forecasting CapEx of $90 million and D&A of $107 million.

Cash contributions toward global defined benefit pension plan totaled $27 million in the quarter. Our forecast for all of 2015 is unchanged at $62 million. For 2016, we are pointing to contribute $71 million. Our affected tax rate in the third quarter was 28.4% compared with last year's 25.6%. The low rate in last year's third quarter resulted from the a tax deductible loss associated with the sale of the FX Medical operations in the prior June of 2013.

We lowered our projected effective tax rate for all of 2015 to 27.7%, resulting from a full [move] shift in taxable income. For 2016 we are forecasting an effective tax rate of 28.5%.

Our financial ratios at the end of the quarter affect the effects of our stock repurchase program. Net debt, as a percentage of total cap, is 42% compared with 27% a year ago. Our leverage ratio, net debt divided by EBITDA, is currently 2.45 times, compared to 1.6 times 12 months ago. At the end of our third quarter, we had $350 million of available unused borrowing capacity from our $1.1 million revolving credit facility.

2015 has turned out to be a more difficult year than we forecasted a year ago. We met with numerous unexpected challenges by critically reviewing our portfolio of products, restructure when appropriate and focusing on generating strong cash flow. We have seen some solid success with cash flow, affording us the opportunity to return value to our shareholders and informed of our share repurchase program.

Lastly, M&A is still an integral part of our growth strategy. We have not done acquisitions since the second quarter of 2013, but we have been busy assessing opportunities and we've seen a recent increase deal flow. We intend to remain disciplined in our capital allocation decisions, focusing on what will provide an optimal return for our shareholders.

And with that, I would like to turn it back to our moderator to facilitate any questions that you may have for us.

(Operator Instructions)

We will go first today to Robert Spingarn, Credit Suisse.

Good morning John and Don. I have a couple of guidance questions and then an after market question. John, for 2016, it sounds like your authorization completes this year. Any buyback contemplated in the guidance?

No, not in the guidance. In the text I said the guidance for next year does not assume any further buyback activity. We anticipate that we will complete the present $9 million authorization around the end of this fiscal year.

Let me do a broad answer to that. Our focus is on trying to make sure we are doing the right capital allocation strategy to create value. There's a couple of pieces that go with that. We have, obviously, over the last couple of years, returned value to shareholders with (inaudible) full of the buyback, but there's also, we continue to believe that long term M&A is an important element of our growth, and we just haven't seen anything interesting. But as Don said, it seems like there may be a little bit of pickup activity there, so we've been making the decision on the basis of the right opportunity for our shareholders. But there is obviously M&A versus buyback opportunity.

The other thing is that, we have certain limitations in terms of our competence. And what we have said to folks who have asked the questions in terms of the capital allocation strategy-- and leverage ratio is that, typically, around the 2 1/2 times is the limit that we feel comfortable with, our confidence goes to 3 1/2 times. But that the 2 1/2 gives us enough flexibility to respond to perhaps an interesting acquisition opportunities or to make sure that's it's indicated for a rainy day, you just are not too close to the limit.

That is our strategy at that 2 1/2. We are kind of close to that right now, so that may an automatic governor in terms of next year, what we might be able to do. But in addition to that, our Board authorization runs out at the end of September. We have not yet had proto-conversations with our Board, so I don't want to get ahead of what our Board's thoughts may be.

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

Well, we anticipate next year that there may be some -- at this stage it is early. Of course it all depends on how some of the businesses come in. We anticipate there may be some small amount of restructuring in next year's number.

Now, having said that, 12 months ago I could not have anticipated the amount of restructuring that we did this year, so we will respond appropriately if the business softens. But the underlying margin position is not changing significantly this year to next year, particularly if you back out the structuring charges this year. Plus, the accounting correction that we did in the second quarter. You get to underlying margins that are not significantly different.

Now, between the groups, of course, the margins do shift. We are seeing Aircraft margins about flat, we are seeing a pickup in Space and Defense margins. Industrial margins a little bit of a pickup. Our Components margins are going to be down next year, and that really is the impact on the lower oil prices, we saw margins this year compressed by that and we think next year, with a full year of that, we are going to see some further compression. And our Medical markets are forecasting to be up a bit. There is organic margin shifts between the businesses, but overall, as I say, if you back out some of the specials this year the total margins for the Company are fairly similar to what they are this year.

Okay, and then just a last one, I guess it's for Don. With the free cash flow decline into next year, the lower conversion, just what is behind that?

I think we are starting out with a conservative estimate. We have said that we want to see some respectable and strong cash flow. I mean that said, is with the 100% conversion. We are starting out with around 100%. I am optimistic it could turn out to be better than that, but we don't want to get ahead of ourselves.

Thanks, I will jump back in.

And we will go next to Cai von Rumohr, Cowen.

Good morning, John, I am intrigued in your comments about FY17. So, R&D, what is your target for this year? Is it still $130 million? I assume the target would be about $130 million for FY16, of which about $80 million is in Aircraft? Is that the way to think about it?

Yes. I think we bumped up the total for the year by a couple of million dollars, and it's in the Aircraft, so we go from about $130 million to $132 million. That $2 million increase is really what we saw this quarter, we saw the MWare business R&D a little bit higher. Next year it is pretty much flat with this year. Aircraft is around the $81 million, $82 million mark. It is really a continuation -- There will be a little bit of shift. We think Airbus, --the A350 will be about the same. We think the E-jet will come down a little bit but we see some more activity on the 919 program. And then there's a couple of other things like the 525 and B-280 we see a little pickup on. We still have heavy spend on what I call the new commercial programs, A350, Embraer Air C-919. In 2017 we should see that fill out fairly significantly.

Okay, now you said R&D. -- So, basically your numbers imply R&D to sales in the Aircraft group of about 7% next year. And you talked of going down to 5% in 2017. That would imply that R&D would be down $20 million sequentially, is that what you are really thinking?

No, that is not what I said, Cai.-- What I said is we will head down to 5% over a period of time. What I said is, if R&D spending comes closer to the 5%, but this is expand margins on the commercial book of business matures and R&D comes down, but I said starting in FY17--

We have seen it come down in the percentage of sales over the last couple of years, so this is not a commitment that it going to get to 5% in FY17, that is probably out a couple of years beyond that. So I wouldn't like to leave that --hanging in the air. I do think if we continue down next year into 2017, but at this stage we are not giving specific guidance for 2017 on the spend or the sales percentages other than to say it will come down as a percentage of sales again in 2017.

Got it. So your commercial aftermarket forecast calls for a second year of decline. This year you're down about $12 million to $118 million. Next year another $6 million. Is that conservative, given that we should see some build in provisioning on the A350 and the 787 was down this year? What are your assumptions in that assumption?

Over the last-- three or four years, Cai, kind of 2013, 2014, 2015, 2016, if you back out initial provisioning, you get about a $100 million run rate underneath that, more or less, been fairly flat, and as we've talked over the period, it has to do with a mix of airplanes that we're on, the fact that it's non-scheduled maintenance, et cetera. So in this fiscal year, in 2015, we have actually seen a softening underneath that.

If I put the 87 provisioning, it's $20 million, that is down from $30 million a year ago. There is a little bit of pickup of about $5 million on the A350, but if I combine the A350 and 787 IP, I'm getting to about $26 million. Next year, that drops off to about, we think, $17 million. For the 87 we are dropping down to half of that, and a little pickup on the A350.

Really it is an impact that is almost $11 million drop on the IP. We are reflecting that in the overall total, which we are not bringing down quite that much. That is what is happening. We are thinking IP will drop off. In the past we have been pleasantly surprised by the amount of IP we sold, We are doing the best we can in terms of trying to put a conservative estimate on it. I would love it if it would be better, but at the end of my script as I described last year, I thought there was upside on some things and it turned out that that wasn't the case. Perhaps there is an upside there on the IP, it is very hard to predict. On the A-7 we were way off in terms of what we thought. We are trying to take that experience into the A350, but it still is an IP a story next year in terms of why it is down.

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

Well, let me give you this update. We didn't take any adjustments in the third quarter, so that is a positive. I would say in terms of what we are dog, we are doing everything humanly possible Cai.

There is a team of folks working this on a day-to-day basis, have been working it for the last couple of years. So, it is not as if there is a magic quota that we can pull on to say: now let's focus on doing this. We have added some additional talents at the top of the supply chain organization. We are looking at all of our processes and systems. We continue to look at all of the vendors, we look at the strategy we are employing. And we continue to focus on incrementally, quarter after quarter, coming down the cost curve.

As I said, in this quarter we have seen that cost reduction. We continue to see it this quarter. There were no negative variances in this quarter on those major programs, the A7 and A350 in particular.

So there continues to be a lot of work in that area, there continues to be a lot of focus in it. It is going to be a grind day-to-day, month-to-month, and quarter-to-quarter. It is probably going to take us another couple of years to really get a mature supply chain in place.

But the newer programs, as we look at the early stages. We are not in production yet on the E-2, but as we are forecasting out and we're seeing what is happening there, we've learned a lot and we think we be much closer to the curves that we are laying out and they are much accelerated curves from our experience in A7. A350 is better than A7, but we see the future as continuing to be better. It will remain a challenge. And as I said, over the last couple of quarters, each quarter we've discovered that there is a little bit more of a challenge than we had predicted. But we hope that we are starting to see the low end, the bottom of that, in terms of margin compression as we look out into 2017 and 2018, we will start to see that come back.

Thank you very much.

Thank you.

And we will take our next question from Steven Cahall with RBC.

Thank you. Good morning. First one on the Aircraft margin, both for the balance of this year but more importantly in FY16. With the flat margin, I imagine you have mix moving against you in terms of less aftermarket and more A350. I am guessing the improvement comes in kind of the commercial portfolio and around learning curves? A, is that right, and B, can you walk us through what you need to achieve next year in order to hold that margin flat in the face of those headwinds?

Your analysis is exactly right. If you look at the total Aircraft sales next year, they are up almost $50 million, and essentially it is $50 million of additional A350 production. As you might imagine, we are in the very early stages of that, steep ramp, a lot of learning curve, so that is not going to be a significant margin contributor next year. It will be, if anything, obviously a margin headwinds in terms of the total margin.

That is the challenge. On top of that you have the commercial Aircrafts aftermarkets going down, which is usually a real positive, and you have the military aftermarkets up a little bit. And we're seeing on the military OEM side, we are seeing F-35s replacing some of the more, in terms of sales, more mature programs, F-18, B-22 back up. As you might imagine, earlier on, even on the military side, typically you don't have quite the same margin performance as you do when you get into mature production.

So there is natural headwinds from a mix shift on the military OE side, military aftermarket and commercial aftermarket, and then there's the headwind associated with their sales growth on early production. What we are doing, the strategy in terms of making the margin, is making sure that we achieve the cost reduction plans that we have for those early production phases of the A7 and, in particular, the A350, where we see the growth next year. That is really what the both the opportunity and the challenge next year.

As I mentioned to Cai, there is a team of folks that are laser focused on making sure that we do that. But we can predict whether or not an individual supplier will have challengers, whether there is a technical issue. This year we, a quarter or two ago, we talked about an O-ring issue that was a complete surprise, a vendor-related issue that we could not have anticipated that caused a hiccup. That typically happens in these types of programs. Something comes up and it's a surprise. We are trying to make sure we have enough opportunity to cover that and make sure that we continue down those curves. Does that help, Steve?

Yes. Would you be willing to quantify what that cost reduction impact is, so essentially, if the sales project forward just as you got in the guidance and you didn't do any cost reduction, how big of a margin headwind is that?

No we wouldn't. We don't break out our margins by commercial or by program. If we head down that path, we start to do that, that is competitively sensitive data that we don't think is appropriate to share at that level.

Fair enough. Maybe on the restructuring effort, the $4.4 million we have left, will we see the preponderance of that again in the Space and Defense control segment? Is some of that also going into the business that you are looking to divest?

In the quarter, in Q3, we took about $6.6 million. Most of that was in the Space and Defense business. Then a little of it in our Components business.

When we project restructuring, we're loath to get into discussions as to where it will be because it is kind of a reserve that we haven't yet walked through all of the details, and we definitely have not had an opportunity internally to communicate what that might mean in the various businesses. Therefore, it is inappropriate even in our guidance and supplements. We carve it out and we say we haven't yet allocated it back to the segments. However, I would say given the size of the restructuring we've already taken in the Space and Defense business, we feel we have most of that behind us in that business and it is not really focused necessarily on the European operations that we are looking to find alternatives for.

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

Yes, Steven, your math is correct and we do expect, just because of the mix of things and the way things are coming together, that the tax rate in the fourth quarter slowly, by itself, would be a little over 30%.

Great. Thank you.

Thanks.

We'll take our next question from Michael Ciarmoli with KeyBanc Capital Markets.

Good morning, thanks for taking my question. Just on aircraft margins, as we move into 2017. Certainly you are not the only supplier out there whose talked about a ramp or just improvement in 2017, but how much visibility do you have? You talked about a couple programs, long-range bomber, I think some other helicopter programs. What else is out there that might come into the fold in 2017, that might either create some more R&D if you're successful in winning business on the program? I'm just wondering how you're contemplating the margins in the out period when you're not sure, or, if you could give us a sense of what you think there's a high probability that you'll win? Is that contemplated into the margin improvement?

In our outlook, when we do a multi-year outlook on the business, we do typically reserve a certain amount of funding in our R&D line, in aircraft in particular, for unknown or unnamed or on one programs. Some of those you can anticipate, so for instance, Long Range Strike is obviously a big opportunity that a lot of companies are pursuing. We think we're reasonably well positioned on that.

That's something that we hope to know about within the next few months is to what position we've won. We actually are on both teams, so depending on which team wins we have a better understanding of what concept we may have on that. And we have a value reserve for next year, but that's a sales number, because that's a cost plus development, so it would be in the sale line, probably no margin type of business. But nonetheless, it doesn't go through the R&D line.

On the military said, typically a goes more into the sales and absorbs engineers that come out of some of the commercial programs. We are putting in a little bit of investment on some other military programs to position ourselves, the B-280 that replaced the helicopter program, we think that's important so we're doing some work there. And then on the commercial side, typically we might reserve a bucket of money for major programs coming up, and assuming that there may be some other opportunities.

However, it's hard to see, I think we've already mentioned that we don't have any significant contest of the 777X. And there's no major starts that we can anticipate, it seems as if the primes, particularly in Boeing and Airbus, are getting into an evolutionary type of development on their airplanes, on the 37 of the 320. Perhaps, that will generate an opportunity for a surface here or a surface there, but is probably likely to be a much smaller amount of R&D. The Chinese are talking about a wide-body jet, the 929, very early stages. We typically found that we can, there's some opportunity to recover some of the R&D if you work with the Chinese. Who knows how that might play out?

And then there's talk, I guess, of a 57 replacement. Again, I think it's way too early, we don't have any specifics on that. Typically we reserve some bucket of money to make sure that-- we built a tremendous capability, we obviously don't want to lose that capability. Part of the capability would go to hopefully building military programs, and I'm ready strike in particular, and then some of it we'd reserve to make sure that we got capacity to respond to ongoing commercial opportunities. But it's -- a source on estimate at this stage because it never quite plays out at exactly as you think.

However, our commitments overall is to getting that R&D spend more in line with what I call a long-term run rate, is definitely there. We've made a huge investment over the last decade and we don't anticipate that we would need to continue at that pace in the future.

Got it, that's helpful. And then just on the-- You've obviously got the business jet revenues forecasted down next year. How comfortable are you maybe with some of the risks there? Specifically with Bombardier or --line of sight into that market, maybe creating more pressure?

Yes, that's a good question, Michael. Typically what we do is we try to forecast on the basis of what our customers are seeing. Obviously, Bombardier is going through some challenges. Our focus with Bombardier is on the Challenger 300, that seems like it's a fairly solid program, has been for the last couple of years. We're projecting that that will be 30 solid next year, so it's a production program. And hopefully that will continue to be a staple in their diet.

Apart from that, Gulfstream is a big part of our business, but we are not anticipating growth on Gulfstream next year. And then there's a couple of other bits and bobs in the biz jet. So overall, this year, were anticipating that it's going to be around $50 million, next year we're anticipating that it's going to be up $3 million or $4 million. It's not in the scheme of the $1.2 billion business. $1.1 billion, $1.2 billion, it is not a huge number in the shift from one year to the next, it is pretty small. So our exposure to business jet is relatively contained.

Got it. And then, just the last one if I could? Maybe a bigger, broader strategic question. As you guys conduct your restructuring, it seemingly comes and goes on a quarterly basis, and it seems to be more reactionary, its driven by end market. Do you guys have some broader, more holistic, operating improvement plan that is just looking to permanently right size the operation? In addition to -- I know you're putting the RP system in, but it just seems like the consistency of the restructuring just seems to be more end market driven rather than more of a lien constant improvement. Is there any more detail you can give us on what you guys are doing to kind of structurally just improve the business in the absence of end market dynamics?

You're right in that -- a lot of the restructuring that we're doing is in reaction to end markets impacts. But I would suggest that that's probably the case with almost any business. So we just, on restructuring in our business in Halifax, because the price of oil collapsed over the last 12 months. Up until then, we were expanding there and adding people. Restructuring is almost always the result of lower sales because, for whatever reason, our customers are buying our products. Underlying structural long-term improvement is based on improvement systems and processes, and we are on a lean journey, we've been on it for a couple of years. It's proving to be a cultural shift, which is taking quite a while.

But we are seeing improvements from that-- and there's a lot of activity around this. And that is causing gradual underlying improvement in the business and we do look at how many facilities the structure, the underlying footprint of our business, on a repeated basis. So there -- are underlying things that are going on, Mike, but it's a little bit like the perturbations around market shifts are so much larger than that underlying, what I call steady, day after day, type in type improvements, that you don't see it.

I would say that the cash flow, we've had very strong cash flow for the last few years. We anticipate, even though next year we're seeing $150 million, if you average our cash flow conversion rates over the last three years in a rolling average, we are well north of 100%. So that is the result of a lot of these activities, resulting in lower working capital, continuous focus on improving net cash position. And there is continuing activity at the ground level to improve our operations.

We have only three major initiatives that we continue to push across the Company. It's a whole area of talent, which is all about the right people in the right jobs doing a great job. It's lean, which is all around operational focus, on-time delivery, great quality, constantly reducing costs. And then it's innovation, because we are a Company where engineering capability, new products, new technologies is the lifeblood of long-term growth.

And those three things, even in the face of all of the short-term restructuring shifts in the market, they continue to be the underlying theme across the Company, we continue to push them at every opportunity and there is a continuous movement to keep improving in those areas. But as I say, unfortunately when you see these big waves washing over the Company in a quick response, quick action that we're taking, which I would say is being very proactive, that tends to mask the underlying improvement that you might otherwise see.

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

Thank you.

(Operator Instructions)

We'll go to a follow up from Robert Springarn with Credit Suisse.

John, I just wanted to dig into aftermarket a little bit and ask about some of the things, the trends you're seeing, that have caused the forecast to go a little bit awry. You talk about provisioning being off. So I'm curious, both on the provisioning side and on normal aftermarket, what are you seeing lately and what are your expectations within the aftermarket guidance for next year?

So, Robert, you said: the forecast go awry. And I'm not sure that the forecast did go awry. I think the forecast is in line with what we're saying. But if you look at the forecast we made 90 days ago versus today, we opted up by a couple of million dollars but it's-- right in front of me now, I don't what it what we started the year at.

I might have misunderstood your comment on 787 provisioning coming into the year? Maybe I missed --

Well, coming into the, what we've been is, we've been -- I'd say, over the last couple of years we've been positively surprised by the 787 initial provisioning, but we've probably being a little bit negatively surprised by some of the other underlying aftermarket activities. If I look at this particular quarter, and I compare with what we said 90 days ago, we've increased the 787 provisioning, but we've taken down some of the other, we got some engine components and some other stuff, and we've taken that down. So within the number, there is a mix shift but the underlying overall aftermarket is not changed much.

So now, can you go back and ask me the second part of your question again? Because I'm not sure I remember it exactly.

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

Let me do the second part first. I think it's all of those, the fact that you mentioned. But our aftermarket business, there's the macro impact of which airplane programs are you are on, how many hours are they flying those airplanes and where are they in their lifecycle? As some of these programs get closer to the end of life, there's more of them that are in the desert, there's more of them that start getting parted out and you start dealing with competition there, which is hard to get your arms around as to whether or not-- How much of it you're getting and how much you're not.

So I think the book of business we have, 57, some of the bigger platforms 57, 67, 47. Those are some of the bigger platforms for us. Obviously you can imagine the flight hours on those airplanes is probably starting to come down. Our stuff is not scheduled maintenance so you start to -- it is difficult to say, for every flight, our specific amount of production. I think there's clearly a trend that the airlines are being more prudent in terms of how much money they want to spend in the aftermarket, and looking for best value opportunities.

But our stuff is not PMA. If they want a new component, or piece part, they're going to end up at buying it from us one way or another. The only competition there is smaller shops might decide to be rework a part, or somebody that's parsing out airplanes that are in the desert. So with that effect, I would say it's very difficult for us to get our arms around it. We can read the macro trends, we can see the flight hours on the airplanes we're on, but it's been tricky to anticipate exactly how that would play out. (multiple speakers)

Just before we go to provisioning, just a high level question, really just interested in your opinion. I think some of us have been surprised by the shortfall in aftermarket across the sector given where fuel prices are. And it seems what's happening is, given the inflow of new aircraft and the discipline on capacity, airlines may be reluctantly parking over older aircraft. And I'm just curious to see if you seen anything that would essentially endorse that view?

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

Okay, and then just on the provisioning.

Our underlying aftermarket, we've anticipated that it's not going to really grow. I think we've anticipated that for the last several years and we anticipated for the future that the underlying exiting programs would probably continue to be under a little bit of pressure. And of course the upside is the new programs. So I don't think that's fundamentally changed from what we were anticipating over the last several years. Even in the lines have kind of increased flight hours and utilizations.

Right.

But than the IP. I think -- let me talk about the 87, because right now the A350 IP is still relatively small. Its essentially this year was the first year we had any of it and it's about $4 million or $5 million.

The 87, the model on 87 is different from what we have traditionally done in our aftermarket. So if you go back, traditionally with our type of stuff, an airline boss an airplane, several airplanes, and they decided on how much initial provisioning they wanted to hold in their warehouse in order to be able to respond to any particular issues. What's happening with the 87 is that you have a shift from that kind of traditional model to where airlines are signing up for either the full airplane of maintenance with a third-party, with one of the big guys, in Lufthansa Technik as an example. And we have a contract with Lufthansa Technik.

Or they're signing up directly with the OEM, in this case ourselves, for a maintenance contract around their fleets. For the larger ones, some of them are interested in that. And because our stuff on an 87 and the A350, we now get to where we have a sufficiently large package that we're one of the bigger players in terms of the list of potential cost drivers in the aftermarket. We now get advisors in that party, where we never got invited before. Of course, the engine guys have been doing that for many years and Colin, I think, has been doing that.

So we're now offering both direct to the airlines and to our third-party MROs, options around what I call --service by hour type contracts. And with that comes various pooling operations where you provide aftermarket into pools. And I think what's happened is that some of the third parties have decided to stock their pools in anticipation of large fleet growth in advance of what we have historically seen. So the aftermarket model is shifting a little bit in the 87 versus the historical, and therefore some of what we've seen is just, we had no experience base to go on.

We think with the a A350 --we built some of that experience around the 87, so hopefully we are closer. It's been a positive surprise each year. Each year we said, well, based on all of our analysis, there can't be that much in additional provisioning still required, and we kind of drive the fact, but we've been surprised. Now in the end, the total amount of initial provisioning is probably got going to be dramatically different from what we anticipate as required, or a particular fleet, so I don't-- It's not as if there's a fundamental shift in the amount of initial provisioning that's going to be out there, we believe, so it's more a question of if you get it earlier than anticipated.

Very, very interesting dynamic. Appreciate your elaborating. And then one last one if I may. John, you may have covered it, but I don't think I heard it. The upcoming trainer program, what your thinking is, there, and the opportunity for the Company.

This is on the US trainer program?

Yes, this is TX. Yes.

Yes. --We've been engaged in pursuing it, at this stage I think it's too early for us to say what, if anything, we may or may not get on this. So I'm afraid I couldn't provide you with a lot of color on that.

Okay. Okay. Thank you.

Thank you.

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

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

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