Moog Inc (MOG.B) 2018 Q2 法說會逐字稿

Good day, and welcome to the Moog Second Quarter 2018 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.

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 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 27, 2018, our most recent Form 8-K filed on April 27, 2018, 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 the prepared comments. For those of you who do not already have a 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'll report on the second quarter of fiscal '18 and affirm our operational guidance for the full year. Our operations continue to perform well, and at the halfway mark, we're nicely on track to meet our original targets for the full year. However, it's another complicated story this quarter with 2 specials, wind and tax reform.

This quarter, we concluded that we have to change course in the wind pitch control business and are taking a charge associated with that decision. In addition, there are some further refinements of the impact from tax reform, which are flowing through our numbers this quarter.

Our reported GAAP EPS of $0.39 per share is therefore, made up of 3 elements: $1.16 per share from operations, minus $0.72 per share for wind and minus $0.05 per share for tax reform. We'll do our best to explain all these moving parts as we move through the text.

Before going to the headlines, however, I'd like to recalibrate our listeners on our guidance for fiscal '18. Back in October, before any changes to the U.S. tax regime, we guided to $4.10 per share, ignoring the onetime impact of tax reform and adjusting for the reduction in the U.S. tax rate from 35% to 21%, our original $4.10 per share becomes $4.40 per share. This is the revised benchmark for our operations in fiscal '18, and we'll use it throughout the text.

Now to the headlines. One, our underlying operations had another good quarter, adjusting for wind and tax reform, our core EPS was $1.16 per share, ahead of our guidance of $1.10 per share from 90 days ago. On an adjusted basis, 6 months into the year, we're just about 50% of the way to our full year forecast. Free cash flow in the quarter was more or less in line with our expectations and included a $50 million additional payment into our U.S. DB pension plan.

Two, we announced a quarterly dividend of $0.25 per share starting in June. This is the next step in our strategy of ensuring prudent management of our shareholders' capital and reflects our confidence in the future of our business.

Three, we completed the acquisition of VUES on the 29th of March for a total consideration of $63 million. This company makes a range of electric motors and generators that complements our existing industrial product lines. They're based in the Czech Republic, and we anticipate sales of about $40 million over the coming 12 months.

Four, after several years of investments, we've concluded that we no longer see a viable business model for Moog in the wind pitch control business. As a result, we incurred a charge of 32 -- I'm sorry, of $31 million in the quarter or $0.72 per share. Of this $31 million hit to earnings, approximately $10 million is cash. I'll provide more details about this decision when I talk about our Industrial businesses later.

Five, we took $0.05 per share of additional charges this quarter in connection with the new tax legislation in the U.S.

Six, we have a very good new story on our U.S. DB pension plan this quarter. Over the last few years, the combination of regular contributions, prudent investments and higher-interest rates means that today, we find ourselves almost fully funded. Next quarter, we contribute $65 million and then we shouldn't have to make any further cash contributions to this plan for the foreseeable future.

Finally, our underlying businesses continue to perform well, and the macroeconomic outlook remains positive. We're, therefore, comfortable affirming our full year operational guidance exclusive of the wind and onetime tax reform impact at $4.40 per share, plus or minus $0.20.

Now let me move to the details, starting with the second quarter results. Sales in the quarter of $689 million were 9% higher than last year. About 1/4 of the increase was due to stronger foreign currencies relative to the U.S. dollar. Adjusting for both ForEx and the impact of acquisitions and divestitures, underlying organic growth was 6%. Sales were up at each of our 3 operating segments. Our wind restructuring charge of $31 million is split into $7 million of inventory write-down above the gross profit line and $24 million of other charges below the gross profit line.

Excluding these wind charges, our gross margin was down slightly from last year on a less favorable mix, while R&D expense was down on lower spending on the Aircraft group. SG&A expense was up on additional selling activity as well as ForEx effects, acquisition-related expenses and some higher medical claims. Similar to last quarter, there was considerable movement in the tax rate this quarter. Including the impact of wind and tax reform, net income was $14 million and earnings per share were $0.39.

Fiscal '18 outlook. Based on the stronger-than-expected first-half sales, we're increasing our full-year sales forecast by $70 million this quarter. We now anticipate full-year sales of $2.69 billion. Excluding the impact of the wind restructuring and tax reform, we're keeping our projected EPS unchanged at $4.40, plus or minus $0.20. Including these impacts, our full-year GAAP EPS would be $2.67, plus or minus $0.20.

Now to the segments. I'd remind our listeners again 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 Q2. Sales in the quarter of $311 million were 8% higher than last year. On the military side, sales were up nicely on the F-35 and across our portfolio of other OEM programs, including higher-funded development work on classified programs. Military aftermarket sales were slightly lower as work on standing up F-35 depot slowed.

On the commercial side, sales to both Boeing and Air Force were lower than last year. 787 is at full rate, but the legacy book of Boeing business continues to slow, driven by lower 777 shipments.

Sales of the A350 were slightly lower this quarter as some shipments pushed to the right, and sales of legacy Airbus programs were also down. Commercial aftermarket had a super quarter, with sales up over $11 million from a year ago. Higher spares for both the 787 and A350 as well as gains through aggressive actions to recapture past business drove the increase.

Aircraft's fiscal '18. Given the experience of the first half, we're increasing our military sales forecast by $20 million. About half of this increase comes from funded development jobs and the other half from strength across various legacy platforms. On the commercial side, we're reducing our forecast for sales to Airbus of the 350 by $10 million while increasing our forecast for the commercial aftermarket by the same amount. The net result is full-year sales of $1.2 billion.

Margins in the quarter were 10.8% and for the first half were 10.9%. Our gross margin was slightly lower on a less favorable sales mix while R&D was down by $4 million relative to a year ago. Through the first half, our R&D expanded aircraft is $35 million against a full-year projection of $80 million.

R&D spending will accelerate in the second half, but we need to -- we believe the full year will now come in at $75 million. This is down $11 million from fiscal '17 as programs ramp down and engineering resources are transferred to funded military jobs. Given the projected lower R&D spend, we're increasing our full-year margin forecast to 10.7%.

Turning now to Space and Defense, sales in the second quarter of $144 million were 3% higher than last year. Sales into the space market were very strong this quarter, up 19% from a year ago. Allowing for the loss of sales through space operations we divested late in fiscal '17, organic sales into the space market were actually up 29% relative to last year. Our underlying business is very healthy, although this quarter we also had the benefit of some favorable sales timing which will not repeat.

We saw strength in both our space avionics business and in our launch products. Avionic sales are being driven by classified work, while the launch business is benefiting from higher activity and NASA programs.

Sales into the defense market were down 5% from last year. Fiscal '17 was a very strong year for military vehicle sales in both the U.S. and Europe, and this year, we're seeing that business return to a more normal level. On a positive note, our security business was up 25% in the quarter on aftermarket activity from the DVE program, that's the Driver Vision Enhancement program.

Space and Defense fiscal '18. We're increasing our full-year sales forecast by $10 million to account for the strength we're seeing on the space side of the house. We now anticipate full-year sales of $557 million, up 5% from last year, a combination of 11% higher space sales and 2% higher defense sales. Margins in the quarter were 11.7%, bringing half-year margins to 12%. For the full year, we're increasing our margin forecast by 20 basis points to 11.7% on the strengthening outlook for our space business.

Now to our Industrial Systems. Sales in the second quarter of $234 million were up 15% from last year. About half of this increase was organic, and the other half was a combination of acquired sales from our Rekofa transaction and stronger foreign currencies relative to the U.S. dollar. Rekofa is a slip ring company we acquired in Europe in April 2017.

Underlying organic sales were up across our 4 major markets. In the energy market, sales were up nicely in both our exploration and generation businesses. With oil prices firming, we're starting to see our sales into the Marine market recover from their nadir in 2017. Sales were also up in industrial automation, as our customers for high-end industrial equipment continue to experience strong demand for their products.

Simulation and test sales were also up at strong shipments of test equipment, while sales into our medical markets were higher on growth in our medical components products.

Industrial Systems fiscal '18. We're increasing our sales forecast for the full year by $40 million. Half of this increase is the result of currency movements, and the other half is due to the additional sales from our VUES acquisition at the end of the second quarter. Full year sales are now projected to be $934 million.

Industrial Systems margins. Margins in the quarter were negative 2.6% due to the $31 million restructuring charge we took in our wind business. Absent this charge, margins in the quarter were 10.8%, about in line with last year. Excluding the wind charge, we're keeping our forecast for operating profit unchanged from 90 days ago at $100 million and this results in adjusted full year margins of 10.7%.

Let me now dive into the wind story a little. As I provide more color on our decision to fade out our participation in the market -- the wind market over the remainder of fiscal '18, I'd like to start though with a little history on how we got into this market and the strategy we pursued over the last 5 years. I'll then explain what has changed in our outlook and why we've decided to transition out of this business.

I'll finish with an analysis of the charge we're taking and the future implications for our P&L. However, before I jump in, I want to clarify that we have several different products that we sell into the wind market. We sell pitch control systems to turbine OEMs and, in addition, various electric and hydraulic components to both the turbine OEMs and to the wind farm operators.

The pitch control business is the vast majority of our sales into the wind market, and is the subject of our restructuring this quarter. Our sales of other electric and hydraulic components to wind customers are nicely profitable and will continue in the future. Therefore, the remainder of my analysis below is focused on the pitch control business only.

We got into the wind pitch control business with the acquisition of a German company called LTI back in 2008. At that time, the wind business was booming in China, and sales of pitch control systems were growing rapidly. In our first few years of ownership, our sales grew to over $150 million and were very nicely profitable. About 2/3 of these sales were to Chinese OEMs and the other 1/3 to European customers.

Around 2010, the market in China started to shift dramatically. Government subsidies had encouraged the creation of too many turbine OEMs and excess capacity drove prices down dramatically across the supply chain.

Over a period of about 3 years, our wind sales in China dropped from $90 million to $15 million and profitability evaporated. In 2013, we did a deep dive into this business and concluded that it was still an attractive opportunity for Moog, but that our success would be based on innovative new products, which would deliver a combination of significantly lower cost and increased reliability for our customers.

We embarked on a strategy which I call Invest to Grow. Since 2013, we've been following our road map for new product introductions and met all of our operational milestones. However, over the last 18 months, the market adoption of our new products has not been in line with our expectations. While we met our technical and cost goals, the market price pressure has intensified further and our strategy of offering increased reliability in the field is not sufficiently compelling to the turbine manufacturers.

At the end of fiscal '17, we concluded that we needed to shift our strategy from growth first to profitability first. Over the last 6 months, we've investigated a range of strategic alternatives for the business, and this quarter, we concluded that the best option is to phase out our participation in this market over the next 6 months.

Over that period of time, we'll continue to meet the product needs of our existing customers and develop a solution for the aftermarket to ensure our customers are serviced throughout the life of the product. We'll also work closely with our customers to ensure they can continue to exploit our technology in their products as required. We believe this is the best solution for our customers and the most cost-effective strategy for our shareholders.

Over the last 5 years, we had operated with an expectation of rapid sales growth once our new products came online. Consequently, we have maintained the infrastructure necessary to meet that growth expectation, and that infrastructure now drives a relatively large restructuring charge. A $31 million charge this quarter is made up of the following major elements: $13 million for intangible write-offs, $9 million for working capital and fixed-asset write-offs, and about $7 million for severance.

Our investment in the wind business has been a drag on our margins over the last few years. As we look out to fiscal '19, we see about $50 million into our wind energy sales, but we see a benefit coming through in our Industrial Systems margins of about 100 basis points.

Now to summary guidance. Q2 was another solid quarter operationally. Adjusted earnings per share were at the high end of our guidance range. Our Aircraft business continues to strengthen with company-funded R&D coming down and customer-funded R&D going up. OEM deliveries are strong, and the commercial aftermarket is providing upside surprises.

Our Space and Defense business is benefiting from strong demand in the space market and, given the outlook for increased DoD budgets, our Defense business looks well positioned for long-term growth. In our Industrial markets, our book-to-bill remains above 1, and the macroeconomic backdrop remains encouraging despite the recent rhetoric about trade barriers.

The conservative DB pension strategy we've been pursuing since the financial crisis is coming to fruition, and with our final planned cash contributions in Q3, we should see a significant improvement in free cash flow in fiscal '19 and beyond. We decided to wind down our wind pitch control business and, once fiscal '18 is behind us, should also see benefits from that decision.

Fiscal '18 earnings per share are projected at $2.67, plus or minus $0.20, which includes $0.72 of negative impact for the winds restructuring and a $1.01 negative impact for the onetime impact of tax reform. Adjusting for these effects, our EPS forecast remains unchanged from 90 days ago at $4.40, plus or minus $0.20. For the third quarter, we anticipate earnings per share of $1.10, plus or minus $0.10.

Now let me pass you to Don who'll provide more details on our cash flow and balance sheet as well as additional color on our pension funding and tax rates.

Thank you, John, and good morning, everyone. Free cash flow for the second quarter was a use of funds totaling $22 million. Year-to-date, our free cash flow is a source of funds of $1 million. Included in these numbers is a second quarter incremental defined-benefit pension contribution of $50 million that we described last quarter.

It's a relatively slow start -- slow first half, but more or less in line with what we're expecting. Net working capital, excluding cash and debt, was 25.5% of sales at the end of the second quarter compared with last year's 24.4%. The increase is attributed to top line sales growth and timing of invoicing and collections.

We began 2018 with a free cash flow forecast of $135 million or 90% conversion. That forecast is now affected by 2 items: first, $50 million of incremental pension contributions, net of cash tax benefits that we described as part of our funding strategy last quarter; and two, $10 million of the cash costs associated with our wind restructuring.

Accordingly, our revised free cash flow forecast for all of 2018 is $75 million or a conversion ratio of just under 80%. Our current projections show that our third quarter's free cash flow will be soft due to the acceleration of our U.S. DB pension contributions before filing our June tax return and, while Q4's free cash flow will be strong, partly due to us having no U.S. DB pension contributions as well as the timing of some income tax refunds.

Net debt increased $85 million compared to free cash flow usage of $22 million. The $63 million difference relates to the March 29 acquisition of VUES, headquartered in the Czech Republic. And as John described, VUES designs and manufacturers customized electric motors, generators and solutions and had 2017 sales of approximately $37 million.

The acquisition of VUES expands our product portfolio with capability in medium and large rotating machines and the addition of linear motor technology. It adds customers in similar adjacent markets, such as auto test, automation and robotics, and energy. It increases our sales channel strength in the Central European market. And, finally, it adds lower cost manufacturing presence in Europe.

We've increased our industrial segment sales forecast for the last half of 2018 by $20 million for this acquisition with no change to this year's operating profit forecast, reflecting near-term pension -- near-term purchase accounting charges.

Beginning in 2019, we expect operating margins for VUES to be roughly in line with the margins for the rest of our industrial businesses. We're excited to welcome VUES into the Moog family and integrate our respective businesses to take advantage of our complementary technologies and geographies.

Our Q2 effective tax rate was 45.6% compared with the 26.5% forecast that we provided last quarter for the balance of 2018. When we remove the wind restructuring and onetime tax reform effects, our Q2 effective tax rate related to our core operations was 26.7%. The wind-related accruals had a tax benefit of only 18% because of our tax situation in China, and we increased our tax accruals for tax reform in the second quarter by $2 million reflecting a refinement of estimated transition taxes.

For all of 2018, we're now forecasting our GAAP tax rate to be 47.9% with everything included. However, our 2018 adjusted effective tax rate for core operations, after removing the onetime effects of wind and tax reform, will be 26.7%. A very preliminary look at 2019 suggests that our effective tax rate will be in the 25% realm as we benefit from a full 12 months of the lower U.S. corporate tax rate.

Capital expenditures in the quarter were $23 million while depreciation and amortization totaled $23 million as well. Year-to-date, CapEx was $44 million while D&A was $45 million. For all of 2018, our CapEx forecast remains unchanged at $95 million and we've got a couple of facility expansion projects this year that are driving a slight increase in CapEx relative to recent years. D&A in '18 -- D&A in 2018 will be about $90 million.

Cash contributions to our global pension plans totaled $81 million in the quarter compared to last year's second quarter of $24 million. This includes the incremental $50 million that I've referenced, which is part of our U.S. DB funding strategy for 2018. For all of 2018, we're planning to make global retirement plan contributions totaling $182 million, unchanged from our forecast 90 days ago.

We've described how we're accelerating a total of $85 million of contributions this year into our U.S. DB pension plan, $50 million, of which was done in the second quarter. This results in total 2018 contributions for all of our U.S. DB plans of $145 million. As far as funding status, we're in very good shape. Our U.S. DB plan was closed to new entrants back in 2008, but continues to accrue benefits for active participants.

Just 18 months ago, at the end of fiscal '16, we were 76% funded with a funding deficit of over $200 million. Next quarter, we'll contribute an additional $65 million to this plan and move further down our investment strategy glide path to better align the performance of the assets and the liabilities.

As a result, the plan will be fully funded by the end of this year. Accordingly, after 2018, we won't be making any cash contributions to this plan for the foreseeable future. In summary, with all other things equal, we expect free cash flow in 2019 to be about $100 million stronger than our forecast in 2018.

So moving on, global retirement plan expense in the quarter was $15 million, similar to last year. Our global expense for retirement plans is projected to be $59 million for 2018, down from last year's $64 million.

I'd like to take a moment to clarify that we're currently expecting our global pension expense for 2019 to increase compared to 2018 as a result of our U.S. DB plan funding strategy. This may sound counterintuitive since having more cash in the plan should result in a greater return and, therefore, less expense. However, we've also previously shared that we've been contemporaneously pursuing a de-risking investment strategy that results in more of our total assets being invested in lower-risk investments with lower returns.

This LDI, or liability-driven investment strategy will end up lowering the overall return on plan assets and more than offset the good news of having more assets in the plan. This de-risking strategy is the right thing to do, and importantly, our future U.S. DB plan expense will be a noncash cost. We'll keep you informed as we do a more thorough review of 2019 in a couple of quarters.

Our leverage ratio, net debt divided by EBITDA, increased to 2.1x at the end of Q2 compared to 1.9x a year ago. Net debt as a percentage of total capitalization was 34.3%, down from 37.4% a year ago. And at quarter end, we had $466 million of available unused borrowing capacity on our $1.1 billion revolver that terms out in 2021. Last quarter, I described that we had just -- that we had just under $400 million of cash in our balance sheet, and that most of this cash was offshore.

As a result of the new tax legislation I described our plan to bring back to the U.S. as much offshore cash as possible and as soon as practicable. I'm happy to report that our cash balance is down to $256 million at the end of Q2. This decrease results from our use of offshore cash for the acquisition of VUES, while we also repatriated $91 million of this offshore cash to the U.S. during Q2, allowing us to pay down our revolver.

Our plan for the balance of calendar 2018 is to bring back an additional $160 million, which will also be used to pay down outstanding debt on the revolver. This cash repatriation has no impact on our leverage as our net debt position is unchanged.

Capital deployment. We announced on March 15 that we had initiated a quarterly dividend of $0.25 per share starting on June 1 to shareholders of record on May 15, for a yield of about 1.2%. It's been decades since Moog last paid a dividend. Many factors were considered in making this commitment, including the strong position we're in with respect to the funded status of our U.S. DB pension plan.

In the end, we felt that providing this consistent return of capital to our shareholders at this time was the right thing to do. In short, we're optimistic about our future. The annual cash cost of the strategy is about $36 million, and relative to our anticipated strong free cash flow, this will be very manageable.

Growth and margin expansion continue to be a priority, and this includes acquisitive growth. We're very happy to have announced the VUES deal, and we continue to see a lot of pipeline activity. We remain disciplined and are focused on both organic and acquisitive growth.

So in summary, despite all of the noise in our year-to-date numbers, our core business is performing as we had forecast at the start of the year. Our Q2 restructuring decision related to wind will make us stronger as we look out into 2019 and beyond. And although our 2018 EPS is negatively affected by tax reform, these tax legislation changes will also benefit us over the longer term.

So with that, I'd like to turn you back to John and open it up for questions you may have. Vicki, can you help us?

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

I really just have a couple of questions to clarify a few things that either were said quickly or I might have missed. But John, at a high level on the commercial aerospace, if I -- it seems to be a somewhat divergent trend here, stronger aftermarket, slightly weaker OE, and you touched on that.

But what it seems you're guiding to, if I did the math right, is for 52% of your commercial OE to occur in the second half of the year and the opposite, 45% of the aftermarket to occur in the second half. So aftermarket trending down, commercial trending up. And if you could just go into a little bit more detail on why you think that the aftermarket will slow, is it the provisioning declines? Or is there something else at work there? Or you're just being conservative?

So Rob, let me do the OE side. So the OE side is 87 is at rate, but some of the legacy programs, 777 in particular are, of course, slowing down as we go through -- as time evolves. So that's what's happening there. And on the Airbus side, the 350, I think we just got a little bit of a hedge relative to what they needed. And so that's pushing a little bit to the right, and so we're seeing the 350 sales slowing down a little bit from what we thought.

So nothing structural. It's just the way -- it's partially the way the customers are taking the products. It's also partially the way with long-term contract accounting material flows, et cetera. So nothing of unusual note there.

On the aftermarket side, we have been surprised on the upside a couple of times. Actually, over the last few years, 87 provisioning was higher than we thought, and provisioning -- initial provisioning this quarter was also way above what we thought.

We just keep believing -- all of our models say, that just doesn't seem to make long-term sense. And so we're concerned that the airlines are somehow getting ahead of it, maybe they've decided to order in advance of taking airplanes. But our models would suggest that there's more initial provisioning than we had anticipated.

Perhaps eventually, we recalibrate ourselves to a new norm, but for the moment, we just don't think that can continue. Now we are bumping up our aftermarket by $10 million relative to what we thought last quarter, so we -- last year, we did about -- just short of 120, start of this year, we thought we might do about 125, now we're saying it's going to be about 135-ish.

So we're bumping it up, but yes, you're right. We thought the first half is way stronger than we thought, and we're just not anticipating that that will continue. I mean, maybe we'll get lucky and it will, but we just don't want to get ahead of ourselves.

Okay, that's fair enough. And then I wanted to ask Don a little bit more about the free cash flow. You talked about how '19 is a better year. You don't have the pension contributions or at least I think that's the big swing factor. What's the right conversion number going beyond this year just as a rule of thumb for us?

And then, Don, as well, are you getting any cash flow from the new acquisition this year? It wasn't clear to me whether that's actually generating any cash for the period of time that you have it. And I was a little confused when you ran through what you're looking for, for Q3 specifically for the total company on free cash flow. So there's a lot in there, but it's all related to cash flow.

Yes. So let me take the last one first. The free cash flow from the VUES acquisition, I would say it's not discernible. It's not going to move the needle. So it's a relatively small acquisition, adding about $10 million of sales a quarter, and it's just not moving the needle. So it's -- so that's that one.

The free cash flow conversion in '19, you're getting ahead of us a little bit. What I did was I perhaps teased you with the pension issue because we've got a substantial amount of cash contributions, $145 million into the U.S. DB plan this year. I said that starting next year or into '19, we don't have that.

Now there are some tax benefit offsets related to those contributions so we've got to take that into consideration. But everything else equal, the point I was trying to make was the $75 million of free cash flow that we're forecasting this year, we're expecting right out of the blocks, we've got about a $100 million adder to that for '19 before we do anything else. So we'll take a harder look at that in a couple of quarters. But free cash flow should be a pretty good picture in 2019.

Is it fair to ask you what a normalized sort of long-term conversion is, ex the various types of noise you get from year-to-year, whether it's pension or tax? Is 90% a decent long-term number for conversion?

We've got a forecast -- that's not really a forecast, a target of 100% conversion over time. And certainly, in a growth period, that may be more challenged, but we're doing things like the fully funded pension situation that should help us with that.

Okay, last one. Forgive me for asking about wind again, but John, you ran through it in great detail, but just to make it a little simpler, could you remind us of what size the wind business was '17 to '18? Moving into '19, I guess you said $50 million down. But what are the wind sales numbers for those 3 years so we have a relative idea of what's happening?

It's in that ballpark, Rob. If you look over the last few years, it's kind of been jumping around $50 million to $60 million a year. Back in '16, it was a little bit stronger, it's continued to weaken into '17. This year, it's a little bit confused because our numbers, we include the other component stuff, but you can think of it in that $50 million to $60 million range.

And so I rounded that for next year to say we'll -- because there probably -- there may be a little bit of a hangover of sales as we go into '19 just with some aftermarket activities and stuff, so sales should be down about $50 million. We still have another maybe $10 million of what I'd call components into the wind energy market, but I'd put that to one side. So it's about $50 million this year and -- $50 million to $60 million, and next year, we'll probably see a reduction of about $50 million relative to this year on the wind pitch control systems sales.

Got it, so it's been about $50 million. It's going to nearly 0, and separately, you're going to hover around $10 million in the business you're keeping?

Yes, that's fair.

We'll go next to Kristine Liwag with Bank of America Merrill Lynch.

John, with the commercial aftermarket up a strong 39%, I'm a little bit surprised that margins in Aircraft Controls were flat year-over-year. Can you discuss the moving pieces in the margins in that segment? And also in your prepared remarks, you mentioned that you had gains to recapture past business. What does this mean?

So yes, Kristine, so the aftermarket was up very nicely in the quarter, but actually, if you -- I mentioned in the remarks, if you look at the gross margin in our Aircraft business it's actually down just fractionally from a year ago. I think the challenge with this is always that there is such a range of programs and it's always a mix story, which almost seems like a pretty poor answer.

But on the military OE side, we have more funded developments. Our military aftermarket was down, but on top of that, the military aftermarket -- actually a couple of the very nice programs that we had over the last couple of years have slowed down. And so while sales are down a little bit, the operating margins are down even more. Again, it's still nice business, but a little bit of an adverse sales mix there.

And then on the legacy book of business, particularly with Boeing 777, which is a big program for us, we see that slow down. So you'll see some of the negative impacts that have taken away from the improvement on the aftermarket. The aftermarket, commercial aftermarket was definitely a nice plus in the quarter.

So I think again, it always comes back to the broad range of mix we have. Actually, operating profit was actually up in the quarter, but margin sales are exceeding that. So it's a combination of slightly lower margins on the military OE, lower margins on the military aftermarket, much better margins commercial aftermarket, but a little bit of margin pressure on the commercial OE side based on a slowing on an old legacy book of business. And you put all that together and you end up with margins that are pretty much in line with last year.

Now I would say that if you look at this year in total, you'll start -- you're seeing that we're 50, 60 basis points up over last year, and that trend we think will -- we're looking to see that continue over the coming years that we've seen Aircraft margins continue to expand.

So one quarter to another is always tough. And in particular, in the aftermarket -- the commercial aftermarket, our commercial aftermarket, even if you go back over the years, has fluctuated quite significantly quarter-to-quarter. And so one quarter is not necessarily indicative for the whole year.

You asked about the older stuff, I'd say what we've done is that we've just been more aggressive on the selling side to see what can we do with some of the airlines and some of the older products. We've introduced a range of new opportunities in terms of the type of aftermarket things we provide from. Traditionally, we just did repair and overhaul to providing guarantees around availability, around spare turnaround times, all of these types of things. And with that, we've gained some subsets.

Now some of it is tied to campaigns around a particular airframe or some other things, and so you get a nice increment in a couple of quarters and then that campaign kind of winds down. So it's a bit of both. It's more aggressive selling, pursuing business that we had through offering new service opportunities, new types of product offerings, and then combined with that, winning some kind of what I'll call campaign type things with some older airplanes that have flowed through nicely this quarter.

So is this new approach regarding aftermarket a lower margin business than your traditional MRO?

Well, so -- when I -- let me be clear. So a lot of the 87 and 350 stuff, Kristine, we're going out and offering flight by hour type of contracts. It's still -- in the total scheme of things and in our aftermarket numbers, it's still relatively small. Over the next few years that will probably grow, but I think it'll still be -- it definitely will -- maybe it'll be around a quarter of that business as you go out 3, 4, 5 years and the 87 and 350 fleets grow.

The profitability around that is as yet to be determined. And the reason I say that is because, of course, we have models as to reliability, lead times between failures, average cost of repairs, et cetera. And so we would have priced it to make sure we didn't have margin compression over the long term. But so much of that will depend on how the actual fleet performs, how our products perform in the fleet. But I do not see this as an erosion of margin over time.

Great. And regarding your acquisition in the quarter, the VUES business, what's the overlap in terms of your existing product and end market? And how do you ensure that you don't have another medical-device-type business or wind a few years from now?

How do you make sure you never make another mistake, is it, Kristine? I wish I could tell you that for sure, but let me tell you about the VUES acquisition.

So it's a company based in the Czech Republic. It's been around for a very long time and they make large industrial motors and generators. Now over the last 5, 6, 7 years, we may have talked the odd time about large motors. This is an area that we've been investing in ourselves. We brought some products to market and this acquisition complements that. They have additional applications.

It's mostly -- it's traditional markets for us. It's Germany, it's industrial-type applications. It's just actually, many of it is with the same customers that we already serve where they would have one business perhaps that we would have one business. So it's complementary, it's adjacent products. Some overlap over time, we've kind of rationalized that and we take advantage of a better supply chain.

So it's a bolt-on acquisition to grow our industrial motors business, which is a nice -- nicely profitable business. So I think your question of how do you make sure that you don't make another mistake, I can't tell you that, Kristine. When we brought wind, it was a super business and for the first few years, it was very highly profitable. And then the world changed and that changed and we reacted to it. And now we made the decision that, okay, let's square up, and we just don't see the opportunity to really make it a success.

We had a wind business -- or we had an energy business and the offshore oil business, it was $100 million a few years ago, and it's now $30 million. We think that's going to be a recovering business in the future and so we think it's worth keeping. By the way, it's not in a loss position, that's a little bit profitable, but it's nothing like as profitable as it was in the past.

I think with any investment that you make, Kristine, there's always a risk. Hopefully, we've learned from past lessons, and you continue to try and refine that and do better, but I think no matter what business you're in, you have to take risks and you have to try and find the opportunities for growth and not all of them, unfortunately, are going to work out.

We'll go next to Cai Von Rumohr with Cowen and Company.

So 7 -- 777 -- is 777 now near 0 in terms of the OE?

No, no, no. Not yet, Cai. So I think we're anticipating shipments for our 777s of around 50 airplanes this year, that's down from kind of high 70s last year and then kind of winding down from there. That's our shipment rate so that doesn't tie exactly with Boeing's shipment of airplanes. But no, it's not gone away yet, but it's down quite significantly from last year.

Well, is that disproportionately profitable because your margins were flat year-over-year in aircraft and yet R&D was down over 200 basis points. So that's actually the worst margin before R&D that you've had in a couple of years despite the fact that commercial aftermarket was up. So I still find it a little hard to understand.

It's so -- it's disproportionately profitable. The legacy book of business is disproportionately profitable relative to the new business, Cai, which I think probably is not a surprise. Our 787 is not as profitable as a 777 and that's a lifecycle-related issue.

The R&D is down, that's true, but on -- we have funded development, and a couple of the funded development programs, we took some reserves, a couple of million dollars for funded developments. This is where -- these are fixed price. We're making sure that we're keeping the IP in-house and so some of them are running a little bit more expensive than we thought.

And then it's just the mix across the military, as I described to Kristine, the military aftermarket from a profitability perspective. Some of the very nicely profitable programs we had last year were down a little bit.

When you put it all together, the mix runs out that the margins are in line essentially with last year. You're right, the R&D is down, but we've also forecasted the R&D will come down for the full year. And as I said to Kristine, if you look at the full year, margins are ticking up over last year, and we anticipate that that will continue over the coming year.

So without going into a lot of different programs, each of which had a different profitability rate in the quarter, the overall story is a negative mix on the military side relative to the history and then a negative mix on the commercial OE, balanced out by a commercial aftermarket that was strong plus the lower R&D.

So the hit on the development programs was what, about $3 million, something like that?

$2 million or $3 million, yes.

Got it. And then for the year, it looks like the R&D came down for Aircraft by $5 million. Where is total R&D likely to be for the year?

Total R&D, we're bringing down by a couple of million, still in the kind of the $143 million range type. We're spending -- we're actually going to spend more on the Space and Defense side, and we are seeing significant Defense opportunities now on missiles and vehicles and we want to put a couple of extra million dollars into that, so that's ticking up a little bit, and that's on balances. So Aircraft down 5, Space and Defense up about 3 and, therefore, you get a net 2.

Got it. And so is there risk? I mean, are you relatively comfortable that on the military development programs that you've pretty much passed the milestone so that's not likely to be another hit? Or is there still a risk?

So we have -- this year, we've increased the forecast for the year in the military Aircraft side, and part of that is we started the year with about a $50 million development book on the -- of the development book on the military side. We now think that will be about $60 million, so that's a reflection of the strength in terms of the opportunities that we're seeing. Most of this is in the black water so we can't talk about it.

And when you're doing that amount of development work, some of it is cost plus, some of it will be fixed price. Part of that, as I say, is that we are very careful to try and maintain the IP -- out into the IP that we want to ensure that remain as part of Moog and therefore, we will invest some of our own money.

And if you're doing $60 million of development, I think Cai, there's always a little bit of a risk that may be some adjustments as you go through the contracts. I don't worry about it as anything significant. I mean the adjustment of a couple of million dollars over a couple of programs is not unusual, I would say. But it's part of the story this year, this quarter when you ask, so how come the margins weren't better. So that's -- it's just part of the story.

Got it. And just sort of housekeeping. The tax rate looks like it's 28% in the second half. Is it a little bit higher in the third quarter than the fourth?

No. I think it's closer to 27%, I hope in the second half. But no, it should be relatively consistent third quarter to fourth quarter.

Got it. And then -- okay. And so industrial, I'm a little bit confused. You talk of getting rid of the wind business as being 100%, adding 100 basis points. But is that mean just it adds 100 basis points just because the sales are going to be lower? So could you quantify what was ex-restructuring, the size of the loss in wind?

I don't think you'll get there if you just do the lower sales. But if you assume -- Industrial is about a $900 million business. It's about a $9 million loss, that's nice round numbers, pretty much.

So what I'm trying to do is what's the -- what has that business been losing if you take out restructuring and everything?

About $9 million is the proper pickup that we would anticipate next year, dollar -- just $9 million actual dollars and that's rounded to about 100 basis points.

But you pick up $9 million in profits, but you lose $50 million in sales, is that the math?

Yes.

Yes.

Okay. So and then, this acquisition presumably is breakeven this year because of inventory step-ups, correct?

Yes.

That's right.

And then you had a weak first quarter. So I mean, and you mentioned that book-to-bill is still above 1. I mean, should we position ourselves for a very strong lift in industrial margins?

When you say we had weak first quarter, Cai, I'm not (inaudible).

Well, your margin in Industrial was 8.9%. It was like 10.8%, this quarter. It's going to be 11-ish in the second half if I take your estimate. So it looks like it's 10.7, but with the weak first quarter. So I mean, you have these 3 plusses that are coming through.

Yes, we do anticipate that it's going to get stronger as we go through the second half of the year, Cai.

Got it. How concerned should we be? I mean, your 777 business ultimately goes to 0 since you're not on the 777X. How concerned should we be of that business? Is that sort of way disproportionately profitable because, while I recognize it was down, I would have thought it is not as profitable as commercial aftermarket?

Yes, I mean the OE side is not as commercial -- as profitable as the commercial aftermarket, that's clear in the type of business model we run. And I wouldn't single out the 777. I would say the legacy book of business that we have with Boeing over the next 5 years or so, obviously, will wind down. 777, the 67 obviously, although there will be some residual stuff on the tanker, but --.

So we actually do -- clearly, internally as we look out over the 5-year period, we forecast that, we adjust for that. And as we will provide numbers for '19, we will be taking all of that into account.

So yes, it does wind down. On the other hand, 8.7% will continue to improve in terms of profitability as we continue down the learning curve there. The 350 will get better. The E2 will come in and that will get better.

So we're comfortable with this notion of we see margins expanding over the next several years in our Aircraft business, as all of that plays out together with the military side of the business. So -- this is not a surprise and this is not news to us. And so I don't think you should be overly concerned that we've not taken it into account as we look out over the coming years.

We'll go next to Michael Ciarmoli with SunTrust.

Just some housekeeping. I think John, you may have mentioned the 787 being at rate. Are you guys at 12 right now? Are you guys kind of seeing the move up to '19 or to 14, in anticipation of the rate step-up or -- if you're still at 12, when do you expect that step up to occur?

We're kind of at about 12 and we anticipate that we'd see and accelerate a little bit of tick up as we get into '19, is where we start to see it picking up.

Okay, so into your fiscal '19?

Yes, yes. But I think that the way you should think about it, Michael, is we're probably 6 months -- 6 to 12 months ahead of Boeing's schedule for their ramp. But on top of that, it's very difficult because they don't order a plane's worth. It's not that -- they ordered the different components, and so how much inventory is in the pipeline, et cetera, it's always difficult to get it straight one-for-one.

But we're seeing a little bit of an increase this year. Last year, we did -- we shipped about 135 -- 135, this year it's like 145, next year we think it's going to be about 165 [ships]. That's the kind of the rough math for our shipments into Boeing.

Got it. And is that -- are those extra volumes going to be margin accretive for you? Or are you dealing with any incremental step downs at that higher rate?

There's no step downs in the Boeing business associated with rates. There are price adjustments as you go through the years and, obviously, we'd be looking at cost adjustments. But nothing out of the ordinary that we've not been seeing for the last couple of years, but there's no rate adjustments on pricing on any of the Boeing contracts.

Okay, perfect. And just back to Rob's question on aftermarket and provisioning. I mean, do you guys get the sense -- I think we heard from one of the larger suppliers earlier this quarter, that they had gotten some provisioning orders pulled forward, well ahead.

I mean, do you guys have the visibility to see that airlines are ordering in advance? Or it sounds like you're employing a bit of caution there. But I mean, do you have any additional visibility to see what the airline behaviors are? Are they are pulling in some orders ahead of schedule?

They're definitely ordering more and earlier than we had modeled and anticipated based on historicals, based on -- mean time between failure calculations, based on what we thought they would need. In addition to that, part of what we're trying to do is provide provisioning services.

So we hold some inventory and we will provide airlines, and we've teamed -- we're also supplier to Boeing on their gold care and to some of the other big MROs that are providing some kind of power-by-the-hour type offerings. And so we thought that that would mean a pooling of spares perhaps and so not each individual airlines would decide, well, I need a spare.

Part of it perhaps may be, Michael, that with the 787, it's a long-haul, point-to-point airplane, and our models were based more around perhaps relatively shorter haul into hubs. And so you all would have some spares at the hub. But now if you're doing point-to-point to what I call airline -- airports that traditionally would not have held spares, we think perhaps is a behavior that says, the airlines says, oh, I need a spare in some relatively distant location that wouldn't have been a hub and that perhaps they wouldn't have held spares in in the past.

So some of it may be associated with the way the flights -- the way the airplane is being used, and that's not something that we have properly or fully understood. So we can see when airlines are pulling ahead of what we think, or they are ordering more than we think. And I'd say that's a story that we've seen for the last while.

And as I said, perhaps that's more associated with how the airplane is being used, and that's different from the historical models that we had. But we're slow to get ahead of ourselves and say, well, that's definitely going to continue going forward, because in some states, we feel like they'll have ordered enough spares that it will slow down.

Got it. And to be clear, this is just 87, 350 provisioning because there really isn't anything on the NEO or MAX, right?

No, it's just 87 and 350.

Okay, perfect. And maybe just last one for me. Can you elaborate -- you raised the outlook on the space revenues. Can you just maybe parse out specifically what programs, I mean, is it on the launch side, are you seeing anything in satellites? I know that's been an area of weakness on the commercial side. But any specific areas of strength that you'd highlight in the space revenues?

Yes. What it really is, Michael, is it's avionics. It's space avionics, so it goes on satellite and it's mostly military driven. So we've just seen our space avionics business really take off, way beyond anything that we thought and a lot of it is, and it's -- of course, it's developed -- a lot of that is development work because it's not as if we're making a lot of products that will go into space. A lot of it is development work, and a lot of that is on the military side and it's probably development work.

Okay. And then, Don, just one more. I mean, you said that kind of long-term free cash flow conversion target of 100% and obviously, I guess it could oscillate in good times or bad times, but if we add that $100 million next year on the adjusted numbers, it would seem like certainly next year's conversion could be well ahead of 100%. Am I calibrated correctly on that?

Yes. We don't want to get too far ahead of ourselves, but yes -- we're optimistic about how that cash could be looking in '19.

And we have no more questions in queue at this time. So I hand the call back over to our speakers for any additional or closing remarks.

Vicki, thank you very much, indeed. Thank you to all of our listeners. Thank you for your attention and your questions, and we look forward to providing you the next update in 90 days. Thank you.

That does conclude today's conference. We thank you for your participation.