Woodward Inc (WWD) 2004 Q3 法說會逐字稿

Ladies and gentlemen, thank you for standing by. Welcome to the Woodward Governor Company fiscal-year 2004 third-quarter earnings conference call. At this time, I would like to inform you that the conference is being recorded for rebroadcast and that all participants are in a listen-only mode. Following the presentations, you will be invited to participate in the question-and-answer session. Joining us today from the Company are Mr. John Halbrook, Chairman and Chief Executive Officer; Mr. Tom Gendron, President and Chief Operating Officer; and Mr. Steve Carter, Executive Vice President, Chief Financial Officer, and Treasurer. I would now like to turn the conference over to Mr. Steve Carter. Please go ahead, sir.

Thank you operator. We would like to welcome all of you to Woodward's third-quarter fiscal 2004 conference call. Most of you have probably seen a copy of the earnings announcement we released after 5:30 PM yesterday; or you may have received a copy by e-mail or fax. For those of you who have not seen a copy, you can find one on our website at www.woodward.com.

An audio replay of this call will be available through Friday, July 30. The phone number was on the press release announcing this call and will be repeated by the operator at the end of the call. In addition, a replay of this call will be accessible on our website for 30 days.

Before we begin, I would like to provide our cautionary statement. In the course of this call, when we present information and answer questions, any statements we make other than actual results or business facts may contain forward-looking statements. Such statements involve risks and uncertainties; and actual results may differ materially from those we currently anticipate.

Factors that might cause a material difference include, but are not limited to, future sales, earnings, business performance and economic conditions that would impact demand in both the industrial and aircraft markets. We caution investors not to place undue reliance on these forward-looking statements as predictive of future results. In addition, the company disclaims any obligation to update the forward-looking statements made herein.

For more information about the risks and uncertainties facing Woodward we encourage you to consult the press release and our public filings with the Securities and Exchange Commission. Now, I will turn the call over to John to discuss our third-quarter results and progress towards strategic goals throughout 2004.

Thank you, Steve. Welcome to those who have joined us for our call today. I will be discussing our third-quarter performance and our outlook for the full year. When we open the line following the presentation, Steve, Tom, and I will welcome your questions. I would like to begin by discussing the third-quarter performance of our business segments individually, and then our consolidated performance.

Sales for our Industrial Controls business rose 36 percent from the depressed levels in the third quarter of last year. Organic growth, which was fairly broad spread, accounted for approximately half the increase, while acquisitions and foreign exchange the other half.

Segment earnings for the third quarter of 2.7 million compared favorably with a loss for the year-ago quarter, but slipped from the second quarter level of this year. Lower profitability reflected some normal quarterly variations in sales mix and costs and combined with the underperformance of one of our operations. Industrial Controls customers remained upbeat about the near-term outlook, but with few exceptions are still reluctant to discuss their long-term views on the level and duration of the recovery.

Product development activity, representing upgrades of Woodward's installed products as well as systems designed specifically for customer applications, remained high. The drivers for product development include a strengthened interest in new products, increased need for higher operating efficiencies due to the rising fuel costs, and impending compliance deadlines that mandate lower emissions.

The marketplace for large gas turbines continues to show signs of firming and stabilization. With our large installed base of products, our spares and aftermarket services have been showing some signs of increased activity. Industry observers expect overall demand in gas turbines to pick up towards the end of 2005 and into 2006.

We recently acquired Adrenaline Research Inc., a specialist in combustion sensing and ignition. Combustion control, part of Woodward's systems integration strategy, helps our customers reduce emissions and improve fuel efficiency. While the acquisition is not material in terms of current earnings impact, Woodward expects the acquisition of Adrenaline Research and its technology to have significant contributions to our combustion controls strategy.

Our Aircraft Engine Systems sales for the third quarter were up 15 percent from the third quarter of last year. Normal, again, normal quarterly variations in our sales mix drove the very high performance, which was led by aftermarket sales and service in the commercial and military markets.

Military spares and aftermarket services for the quarter and year to date, were up over last year, which was a very strong year. Military sales will represent roughly a quarter of our Aircraft Engine Systems business for the full year. We expect military sales in fiscal year 2005 to be as strong as it is this year.

With the general economic recovery and the persistent strength in revenue passenger miles, aftermarket sales and services for commercial aircraft have been bright spots for Woodward. Recently, preliminary signs demonstrate a firming in demand for narrow-body and business jets, which seems to indicate continued potential industry recovery.

Looking at our business as a whole, our target markets have made substantial progress towards stabilization and recovery. Our highest priorities are to improve profitability in our industrial business, through continued growth and productivity improvements, market share gains, and greater efficiencies, while maintaining profitability in the cash flow generation in the Aircraft Engine Systems.

As we enter the fourth quarter, we have not changed our outlook for 2004 earnings as stated last quarter. We currently expect earnings for the second half will approximate the quarterly average earnings for the first half, and we remain optimistic about our position in the recovery cycle for power generation and our other industrial markets as well as in the aircraft industry. Now, I will turn it over to Steve to discuss the financial results in detail.

Thank you, John. As I review financial items today I will first talk about our third-quarter results, followed by the 9-month results and some comments on balance sheet items.

Net sales for the third quarter of fiscal 2004 were 180.5 million, compared to 145.6 million in the third quarter a year ago. Net earnings were 8.3 million or 71 cents per share for the quarter, compared to a net loss of 165,000 or 1 cent per share last year.

Third-quarter sales for Industrial Controls were 113.1 million, an increase of 30 million over the same quarter last year. Organic growth in the context of the strengthening of industrial markets provided 15 million of the sales increase or half of the increase. The other half resulted from the effects of the fiscal year 2003 business acquisitions and changes in foreign currency exchange rates. In 2003, we acquired Synchro-Start Products and Barber-Colman Dyna Products, which together provided 12.1 million of incremental sales this quarter.

Industrial Controls recorded third-quarter earnings of 2.7 million, compared to a 4.5 million loss in last year. Their earnings improvement is due to the increase in sales and related operating leverage. Also as part of last year's third-quarter loss we expensed a total of 2.8 million for workforce management activity and other charges. The 2.8 million of expenses consisted of 1.1 million for workforce reductions, 1 million to write off certain advanced license fees, and 700,000 for the transfer of an overseas pension to a different plan.

Industrial Controls third-quarter earnings, while greater than last year's third quarter, were lower the preceding 2 quarters. The difference in earnings primarily reflected normal quarterly variation in sales, in particular the specific mix of sales; and the effects of an underperforming operation during the most recent quarter.

Switching now to Aircraft Engine Systems, sales for the third quarter were 67.4 million, an increase of 15 percent over the same quarter last year. The sales increase is due to overall strengthening in the aircraft markets, compared to the same period last year. In addition, last year's third quarter was impacted by concerns over the war in Iraq and SARS.

Segment earnings for Aircraft Engine Systems increase to 15.2 million, compared to 8.8 million in the same quarter last year. Our improved earnings were attributed to the increased sales and related operating leverage and cost savings associated with consolidating our Servovalve operations into one facility. Also during the third quarter last year, we expensed 2.2 million for expenses related to the facility consolidation and workforce management activity.

Now let's look at the year-to-date results. Net sales for the 9-month period ended June 30 were 512.4 million, up from 432.6 million a year ago. Net earnings were 24.7 million or $2.14 per share, compared to 10.6 million or 94 cents per share last year. Year-to-date sales for Industrial Controls increased 70.9 million, 314.8 million.

The acquisition of Synchro-Start Products and Barber-Colman Dyna Products in 2003 added 37.9 million in incremental sales in 2004, accounting for more than half the increase. Organic sales increases driven by marked demanded provided 20.1 million; and the effect of changes in foreign currency exchange rate increased sales 12.9 million.

Industrial Controls earnings were 12.7 million, compared to losses of 4.7 million in the first 9 months of fiscal 2003. The increase in earnings is due to the increased sales and related positive operating leverage associated with higher sales, as well as cost reduction efforts made in 2003 including workforce reductions. Last year's results include a 3.1 million of workforce management cost, 1.1 million in lease termination charges, 1 million for the write-off of an advanced license fees, and 700,000 for the transfer of an overseas pension to a new plan.

Aircraft Engine Systems sales year-to-date were 197.6 million, a 4.8 percent increase from 188.7 million in the first 9 months last year. Aircraft Engine Systems earnings increased 19 percent to 40.3 million, compared to last year's 33.8 million. In fiscal 2003 Aircraft Engine Systems recorded 3.5 million in workforce management cost, primarily related to the consolidation of our Servovalve operations, and an additional 2 million in other costs related to the consolidation. Our results this year reflect the cost savings on that consolidation.

As viewed from a total Company perspective, year-to-date cost of goods sold decreased as a percent of sales from 83.6 percent last year to 80.5 percent this year. The decrease reflects the positive operating leverage effects of higher sales, and results of cost-saving initiatives such as the consolidation of the aircraft Servovalve operation and other workforce reductions.

As a percent of sales, SG&A expenses are 10.2 percent this year, compared to 10.9 percent last year. The dollar increase in SG&A expense of 5.3 million, or an 11.2 percent increase this year compared to last year, is due to acquisitions and the accrual of performance-based variable compensation plans.

Interest expense year-to-date is 4.1 million, compared to 3.5 million a year ago. The increase is due primarily to an increase in average outstanding levels of debt. Depreciation and amortization expense for the 9 month is 25 million, an increase of 1 million over last year. Amortization expense increased as a result of acquisitions made in 2003, but depreciation expense decreased because of lower capital expenditure levels in the past few years. Capital expenditures were about 14 million in the first 9 months this year.

We currently expect capital expenditures for fiscal 2004 to be approximately 20 million, compared to 18.8 million in fiscal 2003. Depreciation expense is expected to be around 27 million. Our effective income tax rate was 38 percent for the 9-month periods in both 2004 and 2003. We currently expect our income tax rate to be about 38 percent for the rest of the year.

Now, I would like to make a few comments on the balance sheet. Comparisons are to the September 30 year-end amount. Accounts Receivable increased 4.7 million to 92.6 million. Inventories increased 15.3 million to 141.6 million, and accounts payable increased 10.1 million to 36.8 million. These increases are all associated with higher sales levels that we are currently experiencing.

Total debt has been reduced by 31.8 million and now stands at 93.9 million. Of this, 75 million is represented by Senior Notes that do not become due until the fiscal year 2006-2012 time frame. That completes our comments on the business and results for the third quarter of fiscal 2004. Operator, we are now ready to open the call questions.

(OPERATOR INSTRUCTIONS) Tyler Hojo, Sidoti.

I was hoping you could go into a little bit more detail as far as what is going on with the Industrial Controls unit. I know in the press release it says, based on sales mix and underperformance at 1 operation. I mean it seems like the operating margins have slipped quite a bit on a sequential basis. Is this a level that we should just expect? Or like where do we go from here?

I think what the situation is, we had basically some unfavorable variances; and I will call them kind of normal quarterly variations that were unfavorable on the industrial side. I would say that we had some very favorable quarterly variations on the aircraft side.

Absolutely.

So the aircraft side has 22.5 percent of sales operating earnings. That is also not a number that we would expect to sustain over a long period either. So, I would like to characterize the industrial as just some unfavorable operating variances that took place in the month.

We would fully expect that in the near and I would say intermediate term, that we will operate at the levels of our first and second quarter in our industrial business from an operating margin percent. Then we do understand that we need to get that up to historical levels of where we have been, which is in the double-digit range, and we will be working on plans to ensure that that happens. As well as I think with some sales volume growth, we will get some leverage that will move us in that direction as well.

It seems like on the industrial side at least, that the sales side of the picture seemed pretty strong.

Right.

Can you go into a little bit more detail as to exactly what you mean by underperformance at the operation? At 1 of the operations?

We made an acquisition a couple years ago of a diesel fuel operation. What we have been doing is integrating that with another division that we had with very similar products. R&D in that area is pretty heavy right now. We have been struggling a little bit with some of the integration issues, resourcing some of the raw material, trying to work on our cost. And all those things together -- just we are struggling with that right now. I am confident were going to get our arms around it. But the numbers in the third quarter were not all that high.

Okay. Just one more question for you regarding the 77. I know you haven't mentioned anything about this yet, but where do we stand with the engines, the Rolls-Royce and the GE, as far as bidding? And when you might expect to know a little bit more about what is going on there?

We're right in the middle of detailed system proposal, and with respect to GE, the proposal is due next week. And usually that will be down (ph); there will a down select and another round. My anticipation is that we will see selections on the engine by October.

By October?

It may be a little earlier, but by October we should have a decision made.

We should probably expect the R&D will go up quite a bit?

Not necessarily. What we do, we have been preparing for this for a long time. We have a dedicated team on it right now. You know which we hope to be selected, we will just continue to move that in place. So I guess what I would say is the majority of our expense is already being reflected in our numbers.

Great. I will let somebody else ask a question. Thank you.

Mike Harris, Robert W. Baird.

Just staying on the theme of the Industrial Controls segment and the margin performance in the quarter. I know this may be tough, but regarding the negative sales mix and class mix that you saw, as well as the issues with that, that 1 operating facility; can you quantify the incremental negative impact from these issues? Just to give us some perspective of what maybe normalized margins would have been?

Like I said earlier, I think the normalized margins for the business as we are running them today are in that 5 plus percent. I think that is normal. So, these variations were about $2 million, 2, $2.5 million that kind of hit us.

Okay. That is fair enough. Just staying on this theme here, when you look at the organic sales that you had in this segment during the quarter, which was 98 million, when I look back 2, 3 years ago in this segment, when you saw similar sales levels, you were reporting double-digit operating margins. You know you made it clear on your expectations in the near term as to where you think margins can get back to, which is about 5 percent.

I just want to ask the question, when considering all the cost-cutting you have implemented in the past couple of years, I guess I was just expecting more leverage here. What has changed in the past couple of years with the businesses in this segment? You have previously talked about having a negative mix impact, but what else is the issue? Do you really think getting back to double-digit margins is possible in a reasonable time frame? Is there further restructuring needed here?

I will take a couple of those questions. Maybe I will start with the last question. Is there more restructuring needed? The answer is yes. I will go back. One of the things that you have to look at -- there's several dynamics going on -- is that Woodward industrial business today is quite different than it was 5 years ago. If we had only the portfolio we had 5 years ago, our sales would be dramatically smaller than they are today.

So we've had to do -- and that is just the shift in technology, the shift in business. We saw that coming, so we started our strategies. That is where you see we've entered into combustion control; we have entered into more how we do fluid systems. So, we've had to rebuild our portfolio, and that has added some costs in certain areas in the meantime where the sales have dropped. We haven't removed the cost fast enough. So we're looking at the whole portfolio. You can understand we have had a shift in the type of products we're making, where we're making them, and we are going to have to address that.

The second that is occurring that is affecting our business, but I think we're making the right moves, is we are seeing a major shift of work that traditionally has been in Europe, in terms of engine building, that is moving to Asia. What we have been doing and we have right now is we have been building our operations in Asia, particularly in China. We now have 2 wholly-owned operations in China. We are in Japan, and there is still a fair amount of work going on there; and in Korea.

So that shift has also affected how we are running the business. So what we are have to do is take into consideration the portfolio; the shift in where our customers are; bring our business into alignment with that; and we are going to do that. The margins available in the business are good enough to get us back to double-digit operating earnings.

So it is our responsibility to get there. We fully intend to. So those are the dynamics that are hitting the business. I don't know if that hopefully will answer your question. Obviously there is a lot of detail behind that to get full understanding.

Understand. That is helpful. Just to follow up on 2 items here. When you talk about this shift of work from Europe to Asia, I am assuming that that is being driven by key customers?

That is right. We deal -- I know if you have seen our customer information, which we always publish -- we deal with great customers. But they are all global. These customers are moving to where the business is, and we have to respond to that.

Also, we see as an example, we see the Chinese OEM as a great opportunity, a great growth market. And they're coming on strong. So you have got to look at where the business is going to be in the next 10 years, and we need to adjust. We think both our Western customers and our Asian customers are moving more towards Asia, and that is where we have to be as well.

Maybe if I can just maybe look at this from just another angle from what Tom said, as we have been adding these technologies the last 2 or 3 years, we have added some infrastructure costs to our business. Our organic -- like Tom said -- our traditional organic business is really not at the levels that it has been. So we have really gotten squeezed in a double whammy here.

Some of our core sales have gone away, and we have added infrastructure cost. So, we have to get those, that cost back in alignment with our level of sales. That is the task before us. It is not new, it's the same task we had -- we knew we had last year, and we're working toward that; and we will be doing more things to get that back in alignment.

That is all very helpful. Just 1 last question on this segment. Can you just talk about pricing trends in this segment? Like are you able quantify year-over-year what the pricing impact has been? Has is been down? What have the trends been recently?

What I can tell you is that we are not really able to increase price at all. So, in certain areas we have some downward pricing. But I would not say downward pricing has not been a major impact on the operations. But we have had to in the last year absorb some of the material price increases. Hasn't been real significant, but those type of things we have had to take.

So there is some pricing pressure if you add up what has gone on in raw materials, and in also our inability to raise prices. That is not an option right now.

Okay. All right. Fair enough. Just on a companywide level, John, obviously in my opinion we're in a pretty strong industrial environment here ever since really Q3 of last year. I just wanted to get your thoughts on a macro-basis companywide level how overall order trends progressed during the quarter. Did you see sequentially improving trends? Maybe did June weaken from May? What are you seeing thus far in July? Any thoughts would be helpful?

I would say what we are seeing in general is that the markets that we play in -- we are seeing steady improvement. We have been seeing that. The macro indicators, if we look at trends and some studies in the markets that we serve, most of those indicators tell us that those markets are still going to be in recovery for a few more quarters at least.

So, we are certainly hopeful that that is true. But like I said earlier, our customers are very cautious about giving us any kind of forecast that really indicates that that is going to happen. We're cautiously optimistic that that will happen, but we do not -- they do not give us orders ahead of time, and we are basically guessing. But the general trends and the macro indicators that we look at, says that there is a few more quarters of some fairly steady growth in our industries.

When you look at just the top-line demand outlook, are you incrementally more positive today than you were last quarter? Or are you neutral?

I think if we broke it up into our two major segments, the aircraft business definitely feels better today. I'm sure you have seen some of this, where like Airbus and Boeing have stabilized their outlooks and their forecast. We even see possibly some increases in their production rate. Bombardier and Embraer have done the same on the commercial side, the regional jet side. We feel much more comfortable about our aircraft market segment for the next 18 months.

On the industrial site, as John said, we don't have as long a vision on the industrial side due to the way the markets work. But they are holding fine. Our order book is holding well, and going forward we expect to be in good shape. In sales, we have not quantified a sales increase but we're definitely not predicting a decrease. So, we are neutral to up on the industrial side, with the aircraft looking better.

So, I guess from my perspective, looking at the business in terms of the top-line, we are in pretty good shape for foreseeable 12, 18 months.

That is helpful. That is kind of where I was going with that. Just a couple quick questions here. Last quarter you talked about increased initiatives on sales and marketing and R&D programs in the second half in which you expected to incur some incremental cost. I just want to get a feeling for how much incremental expense fiscal Q3 saw from these initiatives. Do you expect these incremental costs to continue in the near term?

I think where we highlighted that -- it was an earlier question, it was on the 77. There was an example where we knew we were going to be spending money and we are going to continue to be spending money through the fourth quarter and into next year.

Some of the other areas that we were planning on were around our combustion control strategy. We acquired Adrenaline Research, as John mentioned in his opening comments. We're spending some money there. That is an exciting area for us. That is where what you're going to see happen in the future -- for any of our customers to meet the emission regulations that are going to start happening -- this may sound like a long way out, but 2010 -- that development is occurring today.

To meet those regulations you're going to have to have either in cylinder or in the combustion chamber feedback. That is what we have with this technology. So we're spending money there. So those are the areas where we're spending, but I don't see that rate going up from where we are right now. So we did know that was coming. We're spending the money on it. But, we do not plan any incremental increase on that going forward.

Okay. Last question here. Raw materials inflation obviously has been a big issue for industrial companies in the first half this year. Fortunately, you don't have too much exposure to steel; that is not a major portion of your cost of sales. Can you just talk about what you've seen in the last couple of quarters in raw materials? And your outlook in that area? Has it been a meaningful or notable impact on your profitability?

I can give you a number. For the first 3 quarters of the year we saw approximately $600,000 raw material impact. So it is not real material. I mean real large. But that is the impact we have had to absorb.

Okay. That is helpful. That is all I have, and great quarter in the aircraft engine systems segment.

It is a great business.

Take care.

(OPERATOR INSTRUCTIONS) Tom Lewis, Rockhouse Research.

Should we understand the -- what I guess you termed a bit of an outlier margin performance on the aircraft side of things, as being driven predominantly by the pickup in the aftermarket? Or is there something else you would point to?

I just think it is probably driven more -- we had a strong aftermarket this quarter and our margins are a little higher there. You get some skewed margins when that happens. So, that is really the extent of I think the great performance.

Okay. As far as the aftermarket goes, does the volume -- do you get much variation from quarter-to-quarter in profit contribution based on the volume in your repair and overhaul activity?

It could be. Yes. I mean it is not a grinded out steady month after month number. We do have some variations.

The repair and overhaul as you highlighted, we have pretty good models that we can correlate with how the airlines are flying and the like. So from that there we have pretty good predictive tools.

Where you get the bigger variations is when we sell spare units and on military spares. The reason those are more difficult is you don't get the outlook and sometimes they come in chunks. We get sometimes (ph) an increase and not. That is where John was referring to normal variability quarter-to-quarter.

Our core repair and overhaul business is pretty steady, so we have pretty good ability to predict that based on how the airlines are doing. What we would say is the airlines flying -- I know all of you are aware of this -- but the amount of flying hours is doing quite well right now, and so that is good for our business.

Okay. Those replacement units are typically going out at an aftermarket price as opposed to an OEM price?

Exactly.

All right. Thank you.

Mr. Halbrook, there are no further questions at this time. I will now turn the conference back to you.

Okay. Thank you. Steve, Tom, and I would like to thank you for your interest in Woodward and your participation in the call. Our next call will be for the fourth quarter of '04. We do look forward to reporting on our results and providing additional information about the outlook. Thanks for joining us today.

Ladies and gentlemen, that does conclude our conference call today. If you would like to listen to a rebroadcast of this conference call, it will be available at 9:30 AM Central Time by dialing 888-203-1112 or 719-457-0820 and by entering the pass code 255-780. A rebroadcast will also be available at the Company's website, www.woodward.com, for 30 days. We thank you for your participation on today's conference call and ask that you please disconnect your lines at this time.