Moog Inc (MOG.A) 2019 Q2 法說會逐字稿

Good day, and welcome to the Moog Second Quarter Earnings Conference Call. Today's conference is being recorded.

At this time, I would like to turn the conference over to Ann Luhr. Please go ahead, ma'am.

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 future 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 April 26, 2019, our most recent Form 8-K filed on April 26, 2019, and in certain of our other public filings with the SEC.

We've provided some financial schedules to help our listeners better follow along with prepared comments. For those of you who do not already have the document, a copy of today's financial presentation is available on our Investor Relations homepage and webcast page at www.moog.com. John?

Thanks, Ann. Good morning. Thanks for joining us. This morning, we report on the second quarter of fiscal '19 and update our guidance for the full year. Overall, our underlying operations performed well this quarter and the year is shaping up nicely. Unfortunately, we had the supplier quality issue in the quarter, which negatively impacted our results.

Let me start with the headlines. First, another good quarter for our operations. Sales were up 4% and adjusted earnings per share of $1.40 were up 21% from last year and above the high end of our guidance from 90 days ago. We took a $10 million charge for a supplier quality issue in the quarter, which resulted in a $0.20 hit to earnings per share using GAAP EPS of $1.20.

Second, free cash flow was relatively low in the quarter due to a buildup of working capital and some accelerated CapEx spend.

Third, the grounding of the 737 MAX has not had any direct impact on our company to date. Based on Boeing's outlook for production and return to service, we're not adjusting our forecast for the year at this stage. Our ship set value on the 737 MAX is about $50,000.

And finally, the macroeconomic conditions remain positive across Defense and Commercial and are stable in Industrial. This supports our continued confidence in our revenue outlook for the full year.

Now let me move to the details, starting with the second quarter results. Sales in the quarter of $719 million were 4% higher than last year. Underlying organic growth was 5%, offset by 1% in ForEx movement. Sales were way up in Space and Defense, modestly stronger in Aircraft and about flat in Industrial Systems. This quarter, our P&L was affected by the supplier quality issue, while last year's numbers were affected by the decision to exit the wind pitch controls business.

Adjusting for both these effects, our underlying gross margin from operations this quarter was more or less in line with last year at 29%. Both R&D and SG&A were down as a percentage of sales relative to a year ago. Our effective tax rate was 23.8% to yield GAAP net income of $42 million and earnings per share of $1.20.

Fiscal '19 outlook. At the halfway mark of our fiscal year, we're comfortable keeping our sales guidance of $2.9 million, unchanged from last quarter. Absence the charge in Aircraft this quarter, we're also on track to meet our original EPS guidance of $5.25. However, including this charge, our new EPS forecast for the year is $5.05 per share plus or minus $0.20.

Now to the segments. I'd remind our listeners that we provided a 3-page supplemental data package posted on our website, which provides all the detailed numbers for your models. We suggest you follow this in parallel with the text.

Starting with Aircraft. Sales in the second quarter of $321 million were 3% higher than last year. Commercial OEM sales were up a healthy 11%, with growth on the 787, A350 as well as several business jet robots. The Commercial aftermarket was down from last year and the aftermarket story is almost the inverse of the OEM growth story with lower activity on the 787 and in our business jet product line. The A350 aftermarket was up slightly from a year ago.

On the Military side, sales were about flat with last year, slightly higher F-35 sales were more than offset by lower sales in our helicopter product line. In last year's Q2, we had an unusually strong quarter for Blackhawk sales and this year, they returned to a more normal run rate. In the Military aftermarkets, we had higher activity on both the F-35 and V-22 platforms.

Fiscal '19 Aircraft. We're keeping our full year sales forecast unchanged from 90 days ago at $1.3 billion, up 6% from fiscal '18. We're adjusting the mix slightly, reducing the A350 sales by $8 million and increasing sales to Gulfstream by the same amount. At the halfway mark, sales are tracking nicely to plan.

For the second half, we expect a slight acceleration in the A350 sales, but a slightly lower commercial aftermarket. On the Military side, we should see marginally higher OEM sales and aftermarket sales pretty much in line with the first half.

Aircraft margins. Margins in the quarter of 8.5% were adversely impacted by 300 basis points due to the supplier quality issue I mentioned in the headlines. This issue was caused by one of our suppliers changing one of their subsuppliers. This new subsupplier introduced a defect in their process, which got through our supplier's manufacturing and in turn was passed on to us. We discovered this issue in our operations and over the last few months, have worked to rectify the problem going forward. And the charge we took this quarter is associated with the cost to correct that issue. Absence the charge, underlying margins from our operations are up 60 basis points from both the first quarter and from the same quarter last year. Lower investment in R&D drove the improvement year-over-year. We expect an acceleration in R&D spend as we move into the second half of the year, which will result in full year R&D at just over 5% of sales. Excluding the $10 million charge, we're keeping our margin forecast for the year unchanged. However, including the charge, the revised margin for the year will be 10.6%.

Turning now to Space and Defense. Sales in the quarter of $165 million were 15% higher than last year. Similar to the first quarter, the growth is all coming from the Defense side. Sales into Defense were up across all our major business lines. We saw growth in volumes on our Hellfire and TOW missile products as well as increased sales for funded missile development work. Sales of our new turret system were also up nicely from a year ago. And in general, we're benefiting from the increased tempo of Defense spending across the complete range of applications we serve.

Sales in the Space market were down from a strong quarter too a year ago. The drop was primarily in our satellite components and avionics product lines with sales into NASA applications flat year-over-year. We're leaving our full year forecast for Space and Defense unchanged from 90 days ago at $681 million. We're adjusting the mix slightly within the Defense portfolio. The ramp up of new programs for our turret system are moving a little slower than anticipated, so we're moderating that forecast for the year down to $40 million. However, we are forecasting increased sales of Defense components and security products that will make up this shortfall. So net-net, no change.

Our full year sales forecast assumes an acceleration in the second half for both our Space and Defense product lines. We're comfortable with this outlook as the macro picture for both Space and Defense remains bullish.

Margins in the quarter of 12.4% were up 50 basis points from last year. For the full year, we're keeping our margin forecast unchanged at 11.8%.

Turning now to Industrial Systems. Sales in the quarter of $233 million were in line with last year. Real sales were up about 3% in local currencies, but the strengthening dollar offset this gain. Sales into the energy market were down as a result of last year's exit from the wind pitch control business, but sales in the energy exploration applications continue to grow as the price of oil remained strong. Sales into Industrial automation were higher on the acquired sales of our large motor facility in the Czech Republic and sales into the simulation and test end markets were about flat with last year, while sales into medical devices applications were up and stronger Enteral Pump sales.

For the full year fiscal '19, we're keeping our sales outlook unchanged at $931 million. Sales into the Industrial automation market will be about flat in the second half with a slight acceleration in sales in our other 3 submarkets. Our book-to-bill in the second quarter remains slightly above 1, supporting this positive outlook.

Margins in the quarter were strong at 13%. We enjoyed a particularly favorable mix this quarter and our expenses were slightly below flat. For the full year, we're keeping our margin forecast unchanged at 12%.

The summary guidance. Q2 was another good quarter for our operations with adjusted earnings per share at the high end of our guidance range. Through the first half, sales were up 6% and adjusted earnings per share of $2.65 are up 23% from an adjusted number last year. Our Aircraft group is on track for 6% sales growth this year, driven by strong growth across the Military portfolio and the continued ramp up of production on our key Commercial platforms.

In our Space and Defense group, we're anticipating modest growth in our Space applications and very strong growth in our Defense business, spread across our complete range of applications. The overall macro picture for Defense spending remains very positive, while the Space community is anticipating strong growth in future years on the back of the GBSD program, hypersonic missile developments and NASA's plan to return to the moon in 2024.

As I said last quarter, we're feeling comfortable with our fiscal '19 outlook for Industrial Systems, but the low growth in Europe and the risks of the slowdown in the U.S. over the next 12 months are reason for caution as we look out beyond this year. We'll keep a close eye on these macroeconomic trends and adjust our business accordingly.

As always, there are upside opportunities and downside risks associated with our forecast. I believe there continues to be opportunities for upside in our Defense businesses, although the war for talent remains a real challenge to realizing these opportunities. Similar to last quarter, I think the longer-term downside risk is more in our Industrial business. And as usual, we tried to provide the market with a forecast, which balances these pluses and minuses.

Last quarter, I finished by saying that the optimist in me would hope that when we report out our second quarter results, the government shutdown would be long over, there'd be a sensible Brexit strategy and the trade dispute with China would have been resolved. Well, we're 1 for 3. So let's hope that when we report out in our third quarter, we'll have a better score.

Overall, fiscal '19 is shaping up nicely. Our sales forecast of $2.9 billion is unchanged from 90 days ago and our underlying operating margin is on track absent the supplier issue. For the third and fourth quarter, we expect earnings per share of $1.30 plus or minus $0.10.

Now let me pass you to Don, who'll provide more details on our cash flow and balance sheet.

Thank you, John, and good morning, everybody. Free cash flow for the second quarter was $9 million, bringing our 6-month total to $49 million. This represents a year-to-date conversion of less than 60%, reflecting growth in receivables, inventories and capital expenditures. Receivables and inventories have increased due to our top line growth and due to the timing of shipments to our customers. Capital expenditure activity has been significant, largely related to a building addition for our Aircraft operations, which we need to do to accommodate the growth in our Military Aircraft business and the growth-related investments in machinery and test equipment. Demographic trends and the hiring challenges have resulted in us making a bigger investment in our automation sooner than we had been projecting.

Looking ahead to all of 2019, we're moderating our forecasted free cash flow to $160 million, down from our previous forecast of $185 million. The previously described $10 million reduction in our projected operating profit in combination with a $15 million increase in our forecasted capital expenditures accounts for the $25 million free cash flow reduction for all of 2019. This update reflects a revised cash flow conversion of 90%. In recent years, we've enjoyed average free cash flow conversion well in excess of 100% and this year, increases in working capital and capital expenditures to support our top line growth are offsetting the benefit of not making any contributions to our U.S. defined benefit pension plan. We remain focused on generating a respectable long-term free cash flow conversion that will average at least 100%.

Net working capital, excluding cash and debt, was 26.8% of sales at the end of the second quarter compared with last year's 25.5%. The adoption of the new accounting standard for revenue recognition in 2019 inflated this ratio in the second quarter of 2019 by about 70 basis points. After making net adjustment to get numbers comparable, the residual 60 basis point increase reflects the growth in the balance Sheet elements that I've just described. We're expecting this ratio to decline to between 25% and 26% by the end of this fiscal year.

Net debt increased $7 million compared to free cash flow of $9 million. The difference relates primarily to the payment of our quarterly dividend. Capital expenditures in the quarter were $36 million, while depreciation and amortization was $22 million. Year-to-date, CapEx was $60 million, while D&A was $43 million.

For all of 2019, we're increasing our CapEx forecast from 3 months ago to $110 million for the reasons that I described earlier. Depreciation and amortization in 2019 will be about $87 million.

Cash contributions to our global pension plans totaled $10 million in the quarter compared to last year's second quarter of $80 million. Last year included incremental accelerated contributions to our U.S. DB pension plan to take advantage of some tax benefits related to the Tax Act passed by Congress in December of 2017. For all of 2019, we're planning to make contributions into our global retirement plans totaling $36 million, nearly unchanged from our forecast 3 months ago.

Global retirement plan expense in the second quarter was $16 million compared with $15 million in 2018. Our expense for retirement plans for all of 2019 is projected to be $63 million, an increase over the last year's $57 million and essentially unchanged from the forecast 3 months ago.

Our second quarter effective tax rate of 23.8% compares with our forecast for all of 2019 of 26%. The lower rate this quarter is due to a residual impact related to last year's decision to exit from the wind pitch control's business. Year-to-date, our tax rate is 24.1% compared with last year's 79.2%, which was complicated by the significant effect of the Tax Cuts and Jobs Act enacted last year in the wind business restructuring. We're still projecting our tax rate for all of 2019 to be 26%.

Our leverage ratio net debt divided by EBITDA was 2.1x at the end of the second quarter, unchanged from last quarter and from a year ago. The free cash flow that we've generated over the past 12 months has been consumed by acquisitions and share buybacks. Net debt as a percentage of total capitalization at the end of the second quarter was 35% compared with 34% a year ago.

At quarter end, we had $520 million of available unused borrowing capacity on our $1.1 billion revolver that terms out in 2021. And our $300 million of 5.25% high-yield debt matures in 2022.

Interest expense in the second quarter was $10 million compared with last year's $9 million, up due to higher borrowing rates. Our forecasted interest expense for all of 2019 was $38 million, essentially unchanged from our forecast last quarter.

With respect to leverage, we've previously shared that our target leverage is between 2 and 2.5x as net debt divided by EBITDA. We're within our target range of 2.1x at the end of Q2 and with respectable free cash flow forecasted for the balance of 2019, we expect to be below our target range by the end of the year, everything else unchanged.

We just announced today our fifth consecutive quarterly cash dividend to our shareholders. We continue to look for M&A targets strategically and share buybacks opportunistically. We're off to a pretty solid first half of 2019 with sales up 6% and adjusted EPS up 23%. And our backlog has increased over 20% in the last 12 months.

In summary, our businesses are growing. We're seeing improvement in margins, and our longer-term free cash flow outlook remains encouraging.

So with that, I'd like to turn you back to John, open up for any questions you may have for us.

Thanks, Don. April, we'll be happy to take questions now.

(Operator Instructions) And we'll take our first question from Robert Spingarn from Crédit Suisse.

Just a few different things, but, John, I wanted to start, I know you opened mentioning the MAX and I think you essentially said there's been no major impact. But I just wanted to clarify a few things. You're at 52 now, you've stated rate?

Yes.

And are they paying suppliers or are they paying you specifically for 52? It's been unclear, I think, from supplier to supplier. We've seen receivables build elsewhere and your receivables are up a tick and I think Don said that was timing of payments. Any relationship with MAX here?

No. And keep in mind, Rob, as I said, it's about $50,000 of content we have on the MAX. So even if you are talking about then drop in 10 ship sets a month, it's $0.5 million to $1.5 million over the course of a quarter. So it's in the noise, but there's been no change to our supplier arrangement, payment arrangement, et cetera, with Boeing to date. Depending on how long this all goes on, perhaps that will change in the coming quarter or 2. But even if it does, as I say, the numbers are relatively small.

Understood. I just want to get an idea of the behavior and what's actually happening here. So that's very helpful. The -- you mentioned higher R&D spend and I was hoping you could talk a little bit about the future and what areas you're targeting, particularly the end markets.

No. I think I said that we're anticipating some higher spend in the second half. Let me do a kind of a general piece on R&D spend. So we spend about 4% per year on R&D across the whole company. We've had times over the last decade, of course, where the Aircraft spend was particularly high, it was getting up north of 10%, but that's now back in that kind of 4% to 5% range and across the company, typically about 4%. Our forecast for this year is about $140 million on sales of $2.9 billion, so around that 4% mark.

Over a long period of time, we think it's very important to maintain that -- pretty much that spend rate. And so we're seeing a little bit of a pickup in Space and Defense spending there, particularly, in the second half and that's driven by some of the big things I mentioned. There's the GBSD program, where we're working on a variety of -- at this stage, it's still early stage. So there's no real funded development of significance yet. Over the coming years, that should change to funding, but right now, we're spending our own money to try to make sure we're well positioned. There's the hypersonics. And again, most of that is funded, but what you really want to do in these circumstances is make sure that there are particular pieces of IP that you want to retain, and so you fund that yourself, plus you want to be in a position because of the shift in the way Defense contracts are being allocated, you really want to put some of your own money in first to make sure you're available to take advantage of the faster pace at which they want turnaround. And I talked about our turrets in the past. That was very much our own development work, where we spend our money and then we're now in a position where we can move quickly and have our products already available as the programs come -- there's urgent needs. On the Military side -- sorry, on the Aircraft side, much less spending on the Commercial, clearly, but there's still some ongoing spending. When you've got major programs like the 87, the 350, E2 starting to ramp up, there's still something to work. And even on the other ones, there's a maintenance level of spend on those that you have to assume is going to continue year-after-year. There's money that we're spending on the Military Aircraft side, and again, this is about positioning ourselves for our new programs and also about positioning ourselves to retain IP on some of the programs where you've got partial funding. And then there's our Industrial business continues at kind of what I call the normal run rate, but we are focusing also on trying to invest a certain amount of money in what I call next-generation technologies, additive manufacturing. We've talked about this in the past. We're spending money there. We're also spending money more now on autonomous systems. And when I say autonomous systems, this is not competing with the Teslas or the Googles. It's really looking at autonomy in the context of what we do, which is high reliability, well-designed environment-type applications. And whether it's on the Aircraft side, there's the Uber taxi-type stuff that folks are doing. It's in the Industrial business where there's construction equipment or agricultural equipment or it's in Space and Defense and you can imagine lots of ground vehicles, submarines, lots of opportunities for autonomy in the future. We're carefully spending in a couple of particular areas to develop our capabilities and components and systems in autonomy to position ourselves for the future. I would say, well, that falls into the category of a little bit like the turret that I think we've described in the past. Our turret is an overnight success that we invested in for 10 years and never talked much about it. I think the autonomy stuff, I'm sure we're going to run down a bunch of blind alleys, but I hope in 5 or 10 years' time, we'd be talking about, "Hey, here's new applications that are building on the capabilities we have and the investments that we've made over the last decade." So they are early-stage exploratory, but we are spending money, we're investing engineering time and we think that's important for the long term.

Okay. A couple of follow-ons. I was going to ask you a couple of follow-ons on that because that was very interesting and then I'll step back in the queue. But on the Defense side, should we think about your business as tracking the budget or it sounds like it's more about your specific areas of expertise and what's happening in those specific lanes, particularly now in space as well. So when I look at Defense budget, that is very strong in '18, slightly softer in '19 and then getting down to inflation levels in '20. Should I disregard that when I think about your next few years?

So when we put together our outlook for next year and we do a 5-year outlook every year, we're doing it program by program, Rob. It's not the Defense top line. And so it very much depends. So the F-35 is a big program for us, the V-22 is a big program, the F-18 is a strong program, but the F-18 is winding down. We look at the military vehicle. So the new turret we have is brand new application. So it doesn't necessarily reflect the spending on military vehicles in total. It reflects the opportunities around that turret. Missiles were big on Hellfire and TOW, but we're not on JDAFs. The hypersonics, we're spending -- we're on a lot of new program opportunities there. It's all early stage funded development and who knows which of them are going to be a real success. And so yes, for us, it's definitely a program-by-program makeup and sometimes that might line up with the Defense budget, other times, it may not. Generally speaking, positive Defense spending or strong Defense spending is a good thing. And there's no doubt we saw through the sequestration period a slowdown in our business and in the last year or 2, we've seen a significant uptick. And so that definitely does reflect the macro picture, but it's more the micro level individual program, I think that -- so if the F-35 took a huge cost, even if the Defense budget stayed strong, we'd see a drop and so I think it's more program by program.

Okay. And then just to close this and I'll step out. The 17% growth you're looking for this year, can we stay double digit for a while beyond that?

I would love to say double digit, but I don't know whether Mr. Biden or Mr. Trump or somebody else is going to be in office in a year's time. So I honestly don't know. The Defense was I remember being an -- the Aerospace Industries Association meetings few years back and this whole sequestration thing was being talked about and even Obama at that time. Well, that's never going to happen, we're never going to do that. And so forecasting the future, I think, is a tough thing to do. We would definitely hope so. We think we're well positioned at F-35. We're working on the next-generation helicopter stuff. The hypersonics seems like there's a real push to do that. There's been an announcement that says, we got to get back to the moon. We've got thrust vector control. We're all over those types of products. So the macro picture looks good, but I just don't know what the future could hold. I wish I did.

And we'll take our next question from Kristine Liwag from Bank of America Merrill Lynch.

John, in the past few years, you've implemented many processes to improve the quality of your supply chain. Can you provide us an update of where you are today and what's left to do? And broadly speaking, what are the new risks that have been introduced to your business as you're starting to look at subcontractor risk of your suppliers?

So you're right, Kristine. As we've ran production, we have been developing the supply chain over the last, I'm going to say, decade. I would say, that's a never-ending journey. It's a bit like lean or any of these process improvements and you keep going, you keep putting one step in front of the other. You never get to the point where you're at an end. And of course, it's a changing environment. And so over time, some suppliers, you'll have to change out suppliers because of performance issues, because of pricing issues, because they decided that they want to do something different, because a supplier gets bought by another supplier or gets bought by a competitor. And so it's a dynamic system that you can't just say, well, now we fix this and now it's done. And so we put in an enormous effort over the last decade and we will continue to do that this year and next year and for the decades to come.

And actually, we're spending money as well on outside experts to continue that journey with us, people that are -- that's what they do for a living to continue to build our learning as we go through that. And so in terms of what's left to be done, I don't know that I have a good answer for that. Is there ongoing potential to continue to see improvement? The answer is absolutely yes. We are still -- I would say, if you look at the ramp in our production over the last 5 to 6 years, which is really when this has happened, the 87 really only started ramping 5 or 6 years ago, the 350 has been ramping over the last 2 to 3 and then the E2 is coming behind that. We've doubled our Aircraft business through that period of time in terms of these major programs, also the F-35. And so that's an enormous step-up in terms of our operational capability and that's not done without paying some struggles and challenges and setbacks along the way. And so we are in that process. We're seeing our Aircraft business perform nicely, but it'll continue to be an ongoing process. So I don't have the specifics that I'd say, oh yes, we'll just have to do this or do that. I would just say, it's a continuing process of improvement. I don't know if that answers your question, Kristine.

That's very helpful. And just circling back on the $10 million charge that you took in the quarter, if the issue you've identified is a supplier switched out their supplier, is the fix as simplistic as going back to their old supplier, therefore their problem is finished? Is that a way to think about that?

No, they don't even have to do that. Once you identify the problem that subsupplier can fix it, it was just that it wasn't. We -- they didn't understand and we didn't understand that they introduced that nonconformance at the subsupplier. So it's not a -- it's a problem that has been fixed. Once it was identified the problem has been fixed, the cost is just associated with reworking stuff that's already in the supply chain.

That's very helpful. And switching gears to Space, you put together your original report Space and Defense, but is there a way for you to give us an idea of how much pure space is for you as a percent of total revenue? And how much of that work is Military versus Commercial?

So if you look on our supplemental, Kristine, we have a Space forecast for this year of $220 million, and so $220 million, that's our sale forecast for Space out of $2.9 billion is 7%, 8%. So our Space business is a kind of a $200 million plus $200 million to $250 million business. And the split out between military and nonmilitary is tough because it's really a split out between what's government-funded and not government-funded. And most of Space in the end is government-funded, whether it's -- some of it is Commercial satellites that's true, but all of the NASA work, we have a lot of -- that's the work I'm -- was looking for then -- secret work at this stage, classified work for military satellites that we can't obviously talk about, but even all -- a lot of the launch vehicle stuff is in the end, it's the government who's paying for that because they launch military satellites as well. So it's -- I would say, well over half of it is government-related funding, but it's about a $202 million to $250 million business and as I said, this year, we're forecasting about $222 million and that's all. I said in the quarter, Space was down from a year ago and that's true in the quarter. If you went back to last quarter, 2018 second quarter, we actually had a blowout quarter in Space. Ironically, Defense was about flat and Space was way up a year ago. This year, the Space is down a little bit, but that's off a very strong Q2 and for the year, we're actually anticipating Space will be up 3% relative to last year and I've said at the Space Symposium in Colorado Springs a couple of weeks back and there is an enormous amount of activity. And as I say, it's really been driven by 3 things: the GBSD program; hypersonics, which is getting an enormous amount of attention. And we, for us, hypersonics is -- it's -- a lot of that is in the Space because hypersonics are launch vehicles and so we put that under our Space category. And then, this announcement to return to the moon in 2024. Everybody was going around scratching their head saying, "Oh my gosh." Vice President just announced we're going back to the moon by the end of 2024 and nobody knows how we're going to do that. So they are scrambling to let contracts get work out there. And so the Space outlook looks pretty bullish at the moment.

Great. As launch costs come down, there seems to be more interest in Space for commercial entities. Is there more opportunity for you in the next few years to pursue Commercial business in Space?

Absolutely. I mean that's not new. We've been pursuing -- we've been working with Blue Origin. SpaceX has been more difficult. They are

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integrated, but we work very closely with Blue Origin, whom I call commercial space. And so the reduction in their cost of launch, I think, that's putting pressure on the whole supply chain. And we worked hard with our customers who are traditionally very strong with the ULAs of the world, but we've also worked hard to get our cost down and so we are working with Blue Origin as well. And so that creates pressure on the cost side. On the other hand, it potentially drives volume, which, of course, is an interesting word in spaces. Instead of 2 a year, it's even 5 a year, 8 or 10 a year, but it is driving that. And the more launch capacity you have, the more satellites get put up. And when satellites get put up, we've got several -- we've got lot of products that go on satellites. And then we have one of our areas of investment that we've not talked a lot about is what we're calling the OMV, which is the Orbital Maneuvering Vehicle, and essentially what that is, is it's a space tug. It's a ring that goes on the top of a launch vehicle and you bolt on 10, 15 small sats onto that, there's various configurations of it. And the idea is right now, if you put up small sats on a regular rocket, the rocket -- the ferry opens and the small satellites are deposited where they're deposited because typically small sats don't have any kind of propulsion. And the idea of an Orbital Maneuvering Vehicle, which is a vehicle essentially, it's a ring holds all of these satellites, but has propulsion baked into it is that you can then move to chosen orbits and release individual small sats at the orbit that you want to do. So instead of having a propulsion system on each individual satellite, you have a singular propulsion system, but that can place 10, 15, 20 small sats in the particular orbit. That's also an area of investment. The Space business moves very slowly. We've got our first contract and we're hoping to fly that in the next year or so. So again, it's not something that's going to be a huge number in the next year or 2. But again, it's thinking about the opportunities that we see when you get into commercial space and we have all of the components to build something like that in-house. So it's like a mini-satellite in its own right, delivering small satellites to particular orbits.

And we'll take our next question from Cai von Rumohr with Cowen & Company.

So to go back to the quality issue, was it that you didn't specify what you should have specified because if your specs were correct and they didn't meet those specs, theoretically it's on your supplier or on your subsupplier?

So there's always a discussion around what's what. So it was a nonconformance that was introduced when our supplier changed their supplier. And so there is some opportunity for a discussion with our supplier and potentially for them with their subsupplier in terms of is there some recourse, some recovery. However, if you think of it, the way our industry works, Cai, is if I'm that subsupplier, I'm providing a parts to our supplier and I'm going to pick a number that costs $100. Our supplier is putting that into their product that costs $500. We're getting that product and we're putting into our actuator that costs $5,000. And eventually, we would send actuators to customers and they're selling airplanes that costs $50 million or more. And so as hiccups happen through the supply chain, typically what happens is that each level in the supply chain tries to contain their liability to some reasonable number that reflects the risk and the profits, the gain that they can make through that supply chain. And so it's -- there are opportunities to obviously talk and work with the supplier, find some share in the costs, but I -- we've not anticipated any significant recovery of that. And it's -- we will have those conversations, but that is -- we also supply, we are a component supplier to other customers as well and so we are -- we've been on both sides of this over the years. And so typically, subsuppliers and suppliers will try to -- each tier has to -- by virtue of the nature of their business, has to try and limit their exposure, plus sometimes as you get down through the tiers, you end up with very small companies and they literally don't have the resources to cover the types of costs these things could generate. So...

Got it. And then, so was this issue -- so of the cash on this issue, when does it get spent? And it gets spent what, to rework the problem?

Yes. It will be spent -- some of it would have been spent in Q2 and it'll probably be mostly Q3 and maybe a little bit into Q4.

Got it. Okay. And then your R&D, you're still at $140 million, which is quite a large number given you've only been going at a $31 million rate. So the big uptick you mentioned, Space and Defense, where is Aircraft for the year? Is that still $65 million or is that down to $60 million?

No, no. We have that at $65 million. So through the half, Aircraft is about $30 million, second half, we're thinking it's about $35 million. Part of what's happening, Cai, I've mentioned a few times that one of the challenges for us on the Defense side is just having the staff to take the opportunities that are there. And so we've been working very hard to ramp up staffing over the last 6 to 12 months. And as we've been ramping that up, we've become more successful in our ability to do that. And so we are seeing an increase in our staffing. And as I mentioned, some of those staffing will end up going to expense because we will choose to spend. It is not that it's all going to be funded. So we're anticipating that we will spend more in the second half. The ramp-up on the Space and Defense side is particularly strong. That goes from about a less than $10 million in the first half to about $15 million in the second half. Whether that's possible or not, we don't know. I mean when we get all the engineering talent that we need to make that or not, I don't know plus there continues to be opportunities to work on funded programs, and so that typically is drawing away from it. But we are cautious about [NAS] neglecting that company-funded R&D even in what I call the really good times when there's a lot of funded work out there as well, so that we don't wake up in 2, 3, 4 years' time and say, "Boy, we missed some opportunities by not investing in our own stuff." So maybe we've come in for the year a little bit below what we're anticipating right now, but as I say, we have been staffing up to try and make sure we can spend the money prudently to invest for the long term.

Got it. And then -- so it sounds like Aircraft also is higher in the second half. Is that commercial work or is that military and perhaps classified work?

Yes. It's more -- I mean it's not that the -- as I mentioned before, when you've got an 87, 350 north of $100 million sales program, there's just ongoing activities around that, that you're going to spend. But that -- those are fairly fixed at this stage. The E2, we spent some money on that. But again, that's kind of winding down. The Chinese airplane is there, some of the business jets. It's more really around -- it's a plethora of smaller programs, Cai. Everything from -- the V-280, there's a bunch of classified work in there and then there's this new technology that I've talked about where we spend a little money on looking at autonomous systems, added manufacturing capabilities, digital -- various digitalization of some of these things, new materials, new actuation technologies. So it's a long range of stuff. And so we're moving past this. Here's the 3 big programs that make up 80% of that spend. The major programs, I would say, at this stage are making up, like, about half of the spend and the rest of it is a very long list of things that we've -- and to some extent, we have, I don't know if the word is neglected, but in the investment in the major programs over the last decade, we've not spent as much on those as we would have perhaps liked. So there's a little bit of a catch up there in terms of making sure we're current and leading in terms of technology.

Got it. And if we go to Industrial, I think you mentioned that the book-to-bill was over 1 in the quarter?

Yes, I said it's slightly over 1.

But was the book-to-bill in automation over 1?

Actually, no, that was -- the report was a little bit under 1 for the Industrial automation.

Got it. Okay. And then lastly...

I think that's where we're -- I think that -- as you know, Cai, that's the kind of the backbone of that is the German machine builders and there's no doubt that those guys are slowing down.

Got it. Okay. And then, so the aftermarket, it looks like your projections, we get a deceleration in the Commercial aftermarket in the second half and we get -- we don't get any real pickup. We actually get a lower level also -- actually, we don't get much change in the Military aftermarket. Do those numbers have opportunity?

I think the Military aftermarket has opportunity. I think the Commercial side, again, I mean, you do the run rate, the run rate through the first half is about $140 million, we're forecasting about $130 million for the year. We have seen a slowdown. There's no question about that the 87, IP software, we're seeing that slowdown from the last couple of years. So is there opportunity? Perhaps. Fleets continue to grow, there continues to be a lot of activity. But at this stage, this is our best estimate as to what we think the outlook looks like.

(Operator Instructions) We'll move on to our next question from Michael Ciarmoli from SunTrust.

Maybe just to kind of tie in some of Rob's and Cai's initial questioning, I mean you put up a great margin quarter adding back the supplier charge. You've got a very good demand backdrop on Defense. The R&D portion of the Defense budget was up significantly. You're talking about a lot of spending on new programs. How do we think about the mix shift and what that may do to margins on a go-forward basis? I know you wanted to get specifically Aircraft back into low to mid-teens. I mean do you envision as some of these programs really start to ramp up, whether it's GBSD or you get on the some of these hypersonic opportunities that you're going to be dealing with some of this legacy versus new market mix that might have a little bit of a headwind on you going forward?

Yes. I mean the funded developments, so I think we described -- if you go back '17, '16, '17, funded development in Aircraft was $20 million, $25 million. We're up to $60 million to $70 million now, so that's a real positive. On the other hand, that typically comes with very low margin and then when I add the fact that the R&D is going to -- we're supplementing that with our own R&D in particular areas, it is a margin headwind in that respect. And on the Space and Defense side, there is -- the mix as you shift to cost plus development tends to bring down the margin. But it's a portfolio thing. The hypersonic stuff, I think we're a few years out before that gets to production. And the GBSD, that is a long ways out, Michael. That is a decade before that turns into real production. There's a lot of development work, initial production work, a variety of things that could provide sales, but with relatively little margin over the next -- depending on what we win and who wins the program itself, but that won't be a margin enhancer, I would say, in the next decade. Beyond that, when it gets into production, I mean, we think that, that could be for the Space business, that's the GSF for the Space business. That could be over a 10, 15, 20 odd year period, that could be $1 billion plus program for us. So it's a big potential program that's worth investing in now. But it's not going to be a margin driver until it gets into production, and as I say, that's I think it's 2028 where you -- before you really start to see that kicking in. So yes, there is that mix, but there's also nice mature missile programs that are doing well. The turret is developing now, but it's quickly switching into production units there. So it's a balance. I don't know that I would draw any broad conclusion at this stage. But it's for sure, the higher Defense spending right now, a lot of that is going into new technologies and that is typically lower-margin contribution.

Okay. And then the pricing environment on Military, I know you talked about that maybe mid last year. Anything changing on the pricing environment? I mean it just seems like you're getting good trajectory here on the margins and I know you wanted to keep driving them higher. And it sounds like you're managing all of these, if there are potential headwinds. But any color on Defense pricing?

I would say, the environment, I described last year an environment, they have the better buying. There is -- the Defense Department continues, as every one of our customers, to want to get the best possible value from their suppliers and so that continues. I think what's changing a little bit is that there is this various new contracts mechanisms that they are introducing, which reward you if you can move very quickly and perhaps have already spent some of your own R&D. And so they're trying to move away from the -- let's spend 5 years trying to spec out what this new military vehicle is or this new hypersonic weapon should be and then another 5 years developing it and maybe in a decade's time, we've got something too. We want something in the next year or 2 and if you've already got some of your own R&D invested, we're going to move quickly on that. And so I think there's -- that the traditional pricing pressure on the big programs, that's going to continue. There's no question about that. I think the luckies of the world are seeing that, even the President comes out and says everything is too expensive. So I think that environment is just there. It's there on the Commercial side, it's there on the Military side, but there are -- I think, there are opportunities to be rewarded for those who are willing to spend their own money, so you take the margin hit on your own side and are able and willing to move quickly and that's an area that we're looking to try to make sure that we're well positioned for it.

Got it. And then just last one on the 737. You're at 52. Who are you shipping your product to? Who's holding the inventory?

We ship to Boeing, but we also typically in a situation like this, there are safety stocks that you would hold in our own location as well. And so keep in mind that the 777 and most of these airplanes -- they've been ramping up over the last few years. And so I think Boeing even made the point that if they slowed their production, it's a chance for their suppliers perhaps to catch up with their acceleration and gives us a chance to build some of that safety stock, build a little bit more stock. But right now, we're continuing to shift to Boeing. And I think there's plenty of -- again, there's relatively small concept. This is not like wings or bodies that they're going to be stacking up at small price. Who's holding it and where it is, it's not a big space issue. All contents of the 737 if you had attendants, they'll fit inside a small little room, so it's not a big deal.

Okay. And then maybe the other side of it, just the last one for me, the bigger opportunity, I mean, it sounds like some of the U.S. carriers might not take delivery of trainers, but you've got a lot of content on the aircraft trainers. If we see more demand for 737 MAX trainers globally, is that something that can move the needle for you guys?

I think you're talking about the flight stimulators.

Yes, flight stimulators, yes.

Yes. We're hopeful that, that's the case, although they would be more current on that, Michael, than I am, but it would seem that Boeing at least and the FAA are trying to avoid a whole-scale retraining of pilots on the new MAX software versus the old 737. I think that was one of the big positive aspects of the 777 MAX. And I know some of the international guys, maybe that will change. The time to build a simulator and get it out into the field, that's not something that, that our customers -- the CAA, the flight safeties are going to do overnight. So yes, I would say, over a longer cycle, if this drives more training, that's a real positive and we would end up selling more simulation basis to that because we've got a dominant share of that market and so that would be positive for us. And we actually have talked to our customers to say, "Look, can we sit down with you folks because if that's coming, if you think there's going to a big surge in your demand, let's get ahead to that right now and make sure we're prepared to meet your demand." And so far, there really hasn't been a strong reaction to that. So I was hoping that, that's coming, but it's not moving the needle at this stage.

I just want to add a perspective on that too, Michael. The total volume of activity we've got on a flight simulation in our company for all of 2019 is in the $70 million range. And that's not too different from the last couple of years. When talking to some of our guys recently, they are talking about CAE's business. Sounds like it's pretty robust and we would certainly benefit from whatever uptick CAE is going to see, but it's only $70 million and not to diminish if it's a really important product line and it's great success story. But it's not going to drive the needle at a macro level for our business.

Yes. And actually adding to that, ironically, Michael, in '16, it was about $80 million; in '17, it was about $80 million; in '18, it was about $80 million; and this year, we're forecasting, it will be down to around $70 million. So I think there was an enormous build up as the 87, 350, E2 are ramping, but they got ahead of that, and so I'm not sure that we see a big jump there.

April, do you have any more questions with you?

There are none.

Thank you very much indeed. Thank you for joining us, and we look forward to reporting out again in 90 days' time. Thank you. Thanks, April.

Ladies and gentlemen, this does conclude today's presentation. We thank you for your participation. You may now disconnect.