Woodward Inc (WWD) 2012 Q2 法說會逐字稿

Thank you for standing by. Welcome to the Woodward, Incorporated second-quarter fiscal 2012 earnings call. At this time, I would like to inform you that this call is being recorded for rebroadcast, and all participants are in a listen-only mode. Following the presentations, you will be invited to participate in a question-and-answer session. Joining us today from the company are Mr. Tom Gendron, Chairman and Chief Executive Officer, and Mr. Bob Weber, Vice Chairman, Chief Financial Officer and Treasurer. I would now like to turn the call over to Mr. Weber.

Thank you, operator. We would like to welcome all of you to Woodward's second-quarter fiscal year 2012 earnings call. In a minute, I'll cover the financial highlights of our second quarter and Tom will comment on our results, strategies and markets. I'll then comment on today's earnings release, and at the end of our presentation, we will take questions. For those who have not seen the release, you can find it on our website at Woodward.com. As noted in the press release, we have included some visual presentation materials to go along with today's call that are also accessible on our website. An audio replay of this call will be available through April 28, 2012. The phone number for the audio replay is 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 14 days.

Before we begin, I would like to summarize our cautionary statement, as shown on slide 3. 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 the aerospace and energy 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 on risks and uncertainties facing Woodward, we encourage you to consult the press release and our public filings with the Securities and Exchange Commission, including our 10-K for fiscal 2011 and 10-Q for the quarter ended March 31, 2012, which we expect to file shortly.

Segment earnings, EBIT, EBITDA, and free cash flow are non-US GAAP operating measures that we use in the press release and during this call. A description of these measures and a reconciliation of each to the most comparable US GAAP measure is included in the appendix to our slide presentation, and in our earnings release and related schedules, all of which are posted on our website. Management uses this information in monitoring and evaluating the ongoing performance of Woodward, and each business segment.

Now, let me turn to our financial highlights. Woodward revenues reflected continued share gains and modest improvements in our markets. Financial highlights include, sales for the quarter were up 12% to $469 million compared to $419 million in the second quarter of last year, and earnings per diluted share were up 20% to $0.55 for the second quarter, compared to $0.46 for the second quarter of last year. I will comment in more detail on our financial results a little later. Now, I will turn the call over to Tom to comment on our results, strategies, and markets.

Thank you, Bob, and welcome to those joining us today. Our quarter reflected solid revenue growth from both market share gains and modest overall improvements in our underlying markets. Earnings grew while absorbing substantial increases in product development expenses, as we prepare to deliver on our share gains. We are continuing to focus on executing the numerous recent programs we have won, while delivering improved financial and operating performance.

Now, turning to our markets, with respect to our aerospace markets, commercial aerospace production rates continued to improve, and industry backlogs remain robust. Airbus is increasing its A320 build rate this year from 40 to 42 aircraft per month, and in March, the first GEnx-powered Boeing 787 was certified and delivered to a customer. These are two important programs where we have significant content.

Global air traffic continues to increase, supporting the demand for our aftermarket products and services. Our commercial aerospace aftermarket sales improved by 21% over last year's second quarter. Signs of a modest business jet recovery continue to appear, with improved statistics for utilization and used aircraft inventories. Defense sales reflect the headwind and uncertainty surrounding government budgets. Our broad exposure to a combination of fighters, weapons, rotorcraft and transports provides a diverse platform base, which should allow us to maintain relatively steady defense sales in the near future. We are aggressively pursuing and are optimistic about being awarded additional content on a variety of platforms, including the A320neo and 737 MAX. Our teams remain focused on collaborating with customers on their needs, and demonstrating the extensive capabilities of Woodward on both awarded programs and future opportunities.

Now, turning to the energy market. We continue to expect long-term growth in energy demand. Also, we see the shift in the energy supply mix, driving new opportunities in growth in the global energy infrastructure. For example, the shift to natural gas from coal is creating demand not only for gas turbines and engines to drive generators, but also for the entire gas value stream. We are well-positioned to benefit from the global increase in natural gas demand and gas infrastructure development, with a significant portion of our energy sales being associated with the production, transportation, or consumption of natural gas. Our turbine, engine and compressor control solutions are found widely throughout the natural gas landscape. We are aggressively pursuing market share gains here.

We continue to see significant share gains in the wind market, as well as strength in the US, related to the Production Tax Credit expiration. While our exposure to the US market remains well below the industry average, as a result of our customers' geographic focus, we are seeing increased shipments in orders related to the US market. We expect that uncertainty regarding government renewable mandates and subsidies will contribute to continuous volatility around renewable energy.

We remain engaged in a wide spectrum of projects to improve the efficiency and emissions of diesel and multi-fuel engines, steam turbines and electrical power equipment. In each of these areas, we are pursuing opportunities with new and existing customers to provide systems that reduce fuel consumption emissions, provide greater flexibility and reliability, and ultimately increase the value of our customers' equipment.

In summary, our revenues are benefiting from increased share and modestly improving markets. We expect most of our markets to grow at similar rates through 2013. Our control systems are found on some of the most successful platforms in the aerospace and energy markets, and we believe our recent awards demonstrate that our strategies will deliver long-term shareholder value. Now, let me turn it back over to Bob for the financials.

Thank you, Tom. Woodward's net sales this quarter were $469 million compared to $419 million for the 2011 second quarter, an increase of 12%. EBIT, or earnings before interest and taxes, was $61 million for this quarter compared to $53 million in the prior year's quarter. Net earnings for the second quarter were $39 million, or $0.55 per diluted share, compared to $32 million, or $0.46 per diluted share in last year's second quarter. Free cash flow for the second quarter of 2012 was negative $3 million, reflecting increased capital expenditures and increases in working capital.

Our Aerospace segment sales for the second quarter of fiscal 2012 were $224 million, compared to $205 million for the second quarter a year ago, an increase of 9%. Sales benefited from strength in both demand for both commercial and military aftermarket, as well as demand for commercial original equipment and price increases. Aerospace earnings were $34 million in the second quarter of 2012, compared to $33 million in the second quarter of 2011. As a percent of segment sales, segment earnings were 15% this quarter compared to 16.2% in the same quarter a year ago. Segment earnings benefited from the increased sales volume, price increases, and reduced variable compensation, largely offset by increased research and development costs, and somewhat higher than anticipated manufacturing costs associated with sales growth and investments in manufacturing productivity.

Moving to our Energy results, our Energy segment sales for the second quarter of fiscal 2012 were $244 million compared to $214 million for the second quarter a year ago, an increase of 14%. The sales increase was greatest in control systems for wind turbines, and industrial gas turbines. Energy segment earnings for the second quarter of 2012 increased to $34 million from $27 million for the same quarter last year. As a percent of segment sales, segment earnings were 14% this quarter, compared to 12.6% in the same quarter a year ago. Segment earnings were positively impacted by sales volume and reduced variable compensation, partially offset by unfavorable product mix impacts.

Now, I would like to focus on certain specific elements of our consolidated financial statements. Gross margin, defined as net sales less cost of goods sold, was 31.2% of sales in the second quarter of 2012, compared to 30.2% for the second quarter of 2011. Research and development costs were $37 million for the second quarter of fiscal 2012, compared to $27 million for the second quarter of 2011. As a percentage of net sales, research and development was 8% in the second quarter of 2012 compared to 6.5% in the second quarter of 2011. The recent increase in awarded programs has given rise to corresponding increased levels of research and development spending. Additionally, quarterly variability is to be expected due to the timing of prototype hardware builds and other project costs. I would like to point out that Woodward expenses its research and development costs as incurred. It is our strategic intent to continue improving earnings while absorbing this higher level of spending. The quarterly variability in expense levels may impact comparability from time to time. While our spend levels overall will remain elevated from historical norms, we anticipate that our full-year 2012 research and development expenses will be approximately 7.5% of sales.

Selling, general and administrative expenses were $41 million, or 8.7% of net sales this quarter, compared to $38 million, or 9.2% of net sales in the same period of 2011. Variable compensation decreased approximately $8 million this quarter compared to the same quarter last year. We accrued variable compensation expense, based on performance to date. Our full-year guidance implies a strong second half.

Our effective tax rate for the second quarter of 2012 was 28.3% compared to 31% for the same quarter last year. This reduction contributed $0.02 to earnings per share when compared to the prior year quarter. We now anticipate a full year effective tax rate of approximately 31%, down from 33%. Our anticipated rate continues to assume the US Research Credit is not extended during 2012.

Looking at the balance sheet, working capital, defined as current assets less current liabilities, was $607 million at March 31, 2012, and $537 million at September 30, 2011. We generated $10 million of cash flow from operations and negative $3 million of cash flow for the second quarter of 2012. We now anticipate full-year 2012 free cash flow of approximately $90 million. Capital expenditures were $13 million for the second quarter of 2012, compared to $10 million for the second quarter of 2011. For 2012, we continue to anticipate capital expenditures of approximately $80 million, compared to $48 million in 2011. Total debt increased to $443 million at March 31, 2012, from $425 million at September 30, 2011. The ratio of debt-to-debt-plus-equity was 31% at March 31, 2012, compared to 31.6% at September 30, 2011.

Lastly, let me turn to our outlook. Our overall fiscal 2012 outlook is largely unchanged. We believe our markets remain relatively stable with modest improvement, although macroeconomic uncertainty may have increased somewhat. We continue to expect our sales to be between $1.85 billion and $1.95 billion, and earnings per share to be between $2.20 and $2.35 per share for fiscal 2012. That concludes comments on our business and results for the second quarter of fiscal 2012 and our 2012 outlook. Operator, we are now ready to open the call to questions.

(Operator Instructions). Our first question comes from Tyler Hojo.

Just the first question, I guess, you mentioned some opportunities to take up your existing content on the next generation narrow bodies. I was wondering maybe if you could expand upon that a little bit?

Sure. We still have opportunities on both the CFM LEAP engine, as well as the Pratt & Whitney PurePower. We expect some of those awards to occur, or we expect the awards to occur in the third quarter, fiscal third quarter, so we still anticipate that there's some more content on both engine platforms, as well as we're working both Boeing and Airbus and their supply chains for additional content. The engines were ahead of the airframe in some of the opportunities, so we see those ones maybe materializing over the rest of the fiscal year into early first quarter. So by the end of calendar year 2012, we expect all the opportunities to be solidified.

I see, and are these opportunities that you were speaking of, are they incremental to the conversations that we've had about 3X content on next generation versus current generation, or is this inclusive of those comments?

That would be incremental.

Okay, and I mean, where do you think it could go?

How about if I tell you after we win? (laughter)

That would certainly be the easy way to do it.

We've got to wait and see. There's a fair amount still out there and we win some, we might not win at all, but we should know shortly, Tyler.

Okay.

But it will add to the portfolio and add to the numbers we shared with you in the past.

Right, and so what I'm trying to ultimately get at is when we look at the R&D spend kind of creeping up here a little bit, I mean, is it possible that we could be talking about R&D going from 7.5% to 8.5%, say, over the next 12 months? Just trying to gauge that.

Yes, what I would highlight, Tyler, is we're spending money on those opportunities today, and in anticipation of securing the business, and we're also spending money to pursue the business. So I don't see much change in that rate, though being at around 7.5% is probably likely for the rest of the year, and maybe moving into next year. It will be a little bit lumpy at times, and we wanted to get that across, because as you go through these major programs, different milestones, you spend a certain amount of money or you have hardware deliverables that are quite expensive. So you're going to see movement in that rate, but if you average out over the year, we're still thinking around 7.5%, and carrying into next year about that rate.

Okay, great. And just one last line of questioning for me. On the wind inverter piece of the business, you mentioned strength. I was wondering if you could quantify what exactly we saw in terms of a growth rate this quarter.

Sure. If you take the first half of the year, we're up about, up over 60% from last year.

Okay. Well, okay.

Yes, so it's strong.

And are you still looking for that to be up about 40%, or has this tax credit --?

We're going to probably be higher than the 40%. And what you have is it will run strong through the fiscal year and into the first quarter of next year. And then with the production tax credit running out at the end of this year, we do expect a slight drop-off going into calendar year 2013.

Yes.

Obviously, our first quarter will still be in calendar year 2012. We don't have as high exposure to the US market as a lot of the companies in the wind industry, but we do, we are seeing increases this year. Going into next year, we still feel good about it, but there's going to be heightened uncertainty and volatility, so it's a little hard to predict when you get into our second quarter of 2013.

But you would expect the inverter, your inverter sales to be down next fiscal year? That's a fair statement, right?

We're right now expecting slightly down, but not -- slightly. And that could change to either direction, but just a little bit down.

Does slightly down forecast, does that anticipate additional share gains, or is that just how you view the market?

Well, what I would say right now, Tyler, we've been picking up share and we're starting to deliver. We've won share in India, further share in Europe, and in China and some of that's ramping up right now. So that will help offset some of the US, which we do expect a big decline in the US market. But the rest of the world, we don't see that same type of a decline occurring, so some of those gains should offset some of the US business. That's where there is some uncertainty.

Understood. Great. Thanks for all the color.

Our next question comes from Fred Buonocore.

My first question kind of just follows along with the discussion that Tyler was talking about, with the wind converters. So clearly, this is just going gangbusters this year and stronger than you had anticipated, going into the year and stronger still after the second quarter. And with the guidance unchanged, I guess that would imply maybe a little bit more softness in another area than you would have expected, going into the year. I guess the puts and takes. Is there one particular area on the Energy or Aerospace side that's falling behind what you had expected, as the converse to what's happening with wind?

I think in total, it's not too much variation off of plan. Wind is up. We have seen a little slower ramp, as of the first half of the year, in some of our engine sales, but the outlook is strong. And that also goes associated what we call the associated package controls that go around those engines. So a little bit, but it's minor. So, yes, wind is pushing on the higher end. The Aerospace side still looks very strong for the year. Sales are within the range, and wind has picked up. But maybe a little softer on some of those areas but I would call it in the couple percent.

Sure.

In the noise level.

Yes, absolutely. And then on the Aerospace side, another quarter of strong growth on the aftermarket side, can you give us a little bit of color on the involvement of the airframe business in that growth in Aerospace aftermarket?

Yes, well, the airframe aftermarket continues to increase, so some of our strategies on developing the channel and packaging, together with the turbine side is working. The sales were strong, but I would also highlight -- we were seeing some push out, just to give you highlight, the airframe sale aftermarket was up about 12% year-over-year. So I think that's good progress on that. We did see some spare initial provisioning sales that were in our quarter plan, moved to later in the year, tied to delays in the 787 and 747 entry into service. That's the first time I've seen some of that move. Even though we had a very strong quarter, there was some movement of initial provisioning out, which should bode well for the later quarters, because it will move into the third and fourth quarter.

Okay, great. That's helpful. And then, you also talked in Aerospace just about somewhat of a margin headwind due to higher than anticipated manufacturing costs related to this growth and investments in improved productivity. Can you talk about that a little bit for us, please?

Sure. We're putting a big push on lean manufacturing and optimizing our value streams. Part of that is we've added to our manufacturing personnel, that will help implement some of these new strategies. What you really have happening is, we're investing in improving productivity, improving our margins. Right now, we're having some higher overhead expense tied to that. As the sales ramp up in the second half and moving into 2013 and 2014, we'll be absorbing that overhead as planned. But ideally, also for our plan is higher margins associated with being able to optimize our production processes for these higher volumes associated with the narrow body program.

Okay, great. That's very helpful. Thank you.

The next question comes from Peter Lisnic.

I guess first question, a numerical question on the guidance. You took the tax rate down, looks like a couple hundred BPS, but leaving the EPS number unchanged. I'm guessing there is some element of conservatism elsewhere to offset that. Can you maybe give us a feel for where that might be?

Yes, probably ties most closely back to the previous question with respect to some of the manufacturing costs. So we do see -- I commented on the uncertainty and with respect to the increased R&D being the biggest portion of the spend, and then the manufacturing costs being the second item, that's the offsets.

Okay, and those manufacturing costs are outside of R&D envelope?

That's right.

Okay. All right. That's fine. And then I'm wondering if you could give me a little bit of color on the Energy business. I think in the presentation, you put that gas is 40% of that segment. I'm just wondering if you could give me a little color on the order trends in that piece of the business, and then if you carve out LNG and what that's meant to either order trends or backlog or just any color on that piece of gas would be very helpful.

Sure. In terms of the volume coming across gas, we describe it as the entire gas value stream. We're actually seeing orders pick up in every category of the equipment from orders, we're seeing drill ship activity, oil and gas rigs going up, we're seeing a lot of work on pipelines, so the distribution. We're seeing a lot of requests coming out of petrochemicals, and definitely a shift in power generation is occurring. And we're seeing more demand and increases both on gas turbines and on gas reciprocating engines. Those are both -- what we have in both order book and forecast is increasing those categories.

LNG is definitely an increasing market for us. We're seeing -- right now, we're seeing a lot of requests coming in for new equipment, both on the compressor side, so there's huge amount of compressors and, in the whole LNG value stream. But also on the ships for transportation and the order inquiries and order book are increasing, wrapped around LNG. So we think over the next few years, that's going to be a good trend for us and a continually growing one.

Okay, all right. And just so I'm clear, it sounds as though both, if this is the right way of putting it in the buckets, both short cycle and long cycle order trends on that Energy non-wind piece of the business looked pretty strong?

That's correct.

Okay, all right. That is very helpful. Thank you very much.

The next question comes from William Bremer.

Most of my questions have already been answered. Let's go right into the underlying pricing of the bookings coming in right now. Could you give us a little color there, both on the Energy side and Aerospace?

Yes, I guess if you say underlying pricing, I'll just kind of remind the audience most of our OEM business is under long-term agreements. Those go from 3 to 10 years. So a lot of the pricing we have is locked in. I would say we're not seeing any real shifts, if you want to say in the current book of business. I also don't really see any major shifts in pricing on proposal activity, it's in the sweet spot of where we have most of our business. That on the OEM side.

The aftermarket side, we're still able to pull through some increases, that we can tie to commodity price increases or material prices and the like. So we're able to put a little there. So it's all modest, but there is a little bit on the aftermarket. That's OEM kind of stable. We have had on the cost pressure -- now, I want to say this is price, but on the cost pressure side, in the first half of the year, we had some pressure on magnets, rare earth magnets and some materials, gold which we use in some of our brazing processes tied to our combustion products. Those commodity prices were on the cost side. But on the pricing side, pretty stable.

The margins on Aerospace this quarter, 15% slightly down quarter over quarter -- year-over-year, I should say, is that pretty much just the initial provisions that you called out?

Some of it's tied to that. Bill, we did plan on some of those in the second quarter and they moved out. The other thing is a very high R&D expenditure that we had, and I guess just to share, the majority, or I would say over 80% of the increase in R&D was on the Aerospace side.

Okay.

So it's very high expenditures in the quarter. Again, there would be lumpy from quarter to quarter, so you got to recognize that will occur, because we had a lot of deliverables this quarter that just -- we had to spend quite a bit to get completed and going. So you will see that vary from quarter, but I would say the biggest issue, a little bit on provisioning, but a lot on the R&D expenses in the quarter for Aerospace.

Okay, Tom, I got it. Thanks.

The next question comes from Greg McKinley.

Yes, thank you. It seems like you might be paying a little -- I would just say a little more disciplined on corporate infrastructure costs, given the higher spending in your segment expenses. Could you give us a sense for whether that in fact is true? It seemed like there wasn't that much growth in non-segment expenses year-to-date. How should we think about those expenses as the year progresses? Then I wonder if you could also tell us, just remind us how much of your wind business is domestic versus international.

Yes. Well, first thanks. I'm going to let Bob answer this. But thanks for the question. It's always a real passion of ours to keep corporate expenses as lean as possible, so we try hard on that, and will continue to try hard on that as the year goes on. So that was more ongoing, keeping the overhead expenses in check.

Tom is squeezing us very hard, but we did have, last year, we had some of the IDS-related acquisition expenses there.

Okay.

But that is not to take away from overall cost control.

Okay. So where do you think that non-segment expense would end up coming in for the fiscal year? I think we were at about $31 million last year. Seems like we're on a lower run rate so far this year.

We should be, yes, because we won't have any of the acquisition-related, for starters. Other than that, I can't say there's anything that pops out from a comparability standpoint.

Okay. And then in terms of your wind segment revenue mix, domestic versus international?

It's less than 15% that comes into the US.

Okay. Will that be much higher this year?

I think that's about what it will approach this year of total sales.

Okay.

Or total wins.

Total wins, okay. Thank you.

The next question comes from Gary Farber.

Yes, I just was wondering if you could speak to your individual sort of major geographies, what kind of trends you saw moving through the quarter. Was there any real changes in the bigger geographies? And has there been any change since the quarter ended?

Well, Bob will chime in here as well. The US is up a little bit. A little pressure in Europe. Asia is still up, but we're not as up as it has been in the past, and then our South American sales are up, a little bit. So where the pressure is, is really a little bit in Europe and not as fast of growth in Asia as we had seen in years past. But still coming through.

Yes, and I think in terms of the part about have we seen significant change, probably not. We called out kind of the cloud overhanging the European situation. I think it's still largely that. We're not seeing any big order volume changes in Europe, but it just seems to color what's going on there.

And so you would say it's, it's not specific to any product line, it's sort of broad?

That's right.

Okay. And as you move through the quarter in North America, did you see it, month-to-month, did you see it strengthen? Did it come in stronger in some areas you would have thought, or not really?

Well, what we're seeing, I guess a couple of areas of strength, as the quarter progresses. We saw the reciprocating engine business starting to increase in North America, and I think that will continue through the fiscal year. And we're starting to see gas turbines increase as well. Those are two highlights. And that's on that side, on the Aerospace side, I should say those previous comments I would say were more on the Energy side.

The Aerospace side, if you just track particular commercial Aerospace sales, it's still heavy Asia, Middle East impacting the current level of sales. The entire global air traffic is up, so that affects the aftermarket, so I would say that's spread evenly. But the deliveries are still heavily focused in Asia and Middle East. You'll start to see next year and as some of the new aircraft come online, obviously a lot of replacements for the North American market are being ordered, but those will start showing up in the 2015 to 2018 timeframe.

And then just on Europe for a second, your comments, are you saying that it's sort of -- is it sort of customer caution, or do you think it's sort of some slight changes in demand you're seeing?

Well, it's a little tough to tell. I think there is a lot of caution --

Right.

-- in the market. And when I say Europe, it's sales going into Europe and I think it is a little slower. It's not way down, but just a little flat.

Right, okay. All right. Thank you.

The next question comes from JB Groh.

Could you maybe talk about sort of your attitude on the acquisition front currently? Got a lot of nice market share gains and a lot of work to do, but how are you looking at the acquisition opportunities out there?

Yes, I mean, right now I would continue what we highlighted back December at our investor day. We're putting our focus on organic growth right now. We have a substantial amount coming. And we still believe the multiples are still pretty rich, and unless something very, very special comes up, we're going to stay concentrated on organic development in the near term.

Okay, and so when does -- with these gains you've got on the narrow body stuff, when -- those deliveries are obviously a couple years out, but when would you start to -- when would the R&D trend down and some sales start to trend up? Would that be late fiscal 2013?

No, it's actually -- sales will start happening in 2015 to 2017.

Okay.

The Airbus neo, A320neo will be coming online in late 2015, and the 737 MAX will be 2016 to 2017. So we will be spending a lot of R&D money between now and those entry into service dates.

But it wouldn't lead, it wouldn't lead those entry into service by any meaningful amount?

It does. (multiple speakers)

But small numbers, because--

Right.

Okay. I think that's all I had. Thanks.

The next question comes from Peter Lisnic.

Back again, with one quick one, I hope. The manufacturing costs, can you give us a sense as to what that may have cost you, either in gross margin or op margin?

Yes, it would be very difficult to give you anything precise on it, Pete.

Okay.

But we probably could have seen a couple more points on the gross margin level.

A couple -- okay. So you were up 100 BPs up year-over-year on gross margin, and probably had 200 basis point impact from what I would call non-recurring productivity-related kinds of costs?

Yes, that would -- like I said, I'm very uncomfortable giving you a number on that. It has -- I'm sorry. Okay. So maybe $2 million. I'm trying to read my notes here.

Okay.

With my team. Not 2 points. $2 million of impact.

Okay, all right. That's helpful. And then do you expect sort of the same run rate as we kind of progress through the back half of the year and into 2013, at what point do you kind of catch up? I know it's almost a never-catch-up kind of situation with some of these costs, but at what point do you kind of anniversary the growth costs?

We anticipate we'll be very close to that level for the full year, so not a lot of impact.

Okay, and presumably not much next year, either?

That's right.

Okay, all right. That is perfect. Thanks for your help.

Your next question comes from Tyler Hojo.

Yes, I was hoping that maybe you could talk a little bit about, what used to be called the airframe businesses, the MPC and HR Textron. Where are those businesses tracking from a profitability standpoint? I think last you reported, somewhere in like the 5% or so range. Are we materially north of that now?

Yes. First, we do kind of shy away from getting specific on those two now, only from the standpoint that we've juggled the segment a lot. But I think from the standpoint, I think we characterized as being on track with our improvement plan. That is still true. It will also suffer from that variability that Tom has mentioned with respect to its own levels of R&D. We talked a lot about moving more into the commercial space, and a lot of the costs that would be associated with programs on, for example, the 737 MAX and the neo that capture strategies with respect to that. So that is increasing somewhat, offsetting some of that improvement, but it is improving nevertheless, and we talked earlier about the aftermarket as well.

Okay, but it's safe to say that everything's tracking how you thought it would in terms of those acquisitions?

Yes, they are tracking and we also highlight in the prepared comments there, Tyler, that we are seeing improvements in the biz jet market, the regional markets is actually increasing. Those were two big exposure areas. Rotorcraft is increasing, but it's slightly offset by defense going down. So some of the markets that those are in are picking up, so we're starting to see the sales increase and the margin improvement projects we expect will be impacting the second half more than the first half. So as we said, we're on track, moving ahead well.

Okay, great. And just in regards to the segment guidance, I think previously we were looking for 8% year-on-year growth in Aerospace and roughly a 17% margin. Does everything still hold on the segment level as well, or have there been minor changes there?

We think they are largely still directionally correct. We would say that some of the uncertainty and some of the R&D could have a downward pressure on that. So maintaining that will be a challenge, because of predominantly the R&D.

Do you care to update it now?

I think it's so much in the in the tolerance span, Tyler, that we would hold to the numbers we gave before, on both Aerospace and Energy.

Okay. That's fair. And just last one for me, certainly the aftermarket growth, you put up 21%, is impressive. I guess what I'm wondering, I think GE [spares] growth was actually down 2% or so in the quarter. I'm just wondering perhaps why you guys did so well.

Yes, I couldn't comment on anybody else's, but what you have again is the, the mix of applications we're on, plus we did increase the airframe side, so that helped push up. The mix of products, product applications is very good. They're flying a lot of hours. We're seeing a good amount of repair and overhaul coming through, and we did have initial provisioning. And looking forward, I think the aftermarket is going to remain a very strong part of the portfolio because with the new programs coming on, you're going to continue to see more initial provisioning orders. The flight hours are doing great, so should keep the repair and overhaul coming through. It's just a nice mix that I would say was the last 20 years worth of work coming through, really.

Okay. Okay, great. Thanks for that.

The next question comes from Greg McKinley.

Thanks. Just a quick follow-up on your expense structure. I know for the quarter, you said you were down almost $8 million year-over-year in variable compensation expense. Could you remind us where you are for the first two quarters? And then, given the ramp you anticipate in your business in the second half, how should we think about the change in variable comp for the full fiscal year? Thank you.

We're down on the half, not as significantly as the quarter impact. So for the full year, it's down about 5. And it will pick up. I think we called earlier we said that the variable comp would increase slightly on a year-over-year basis related to head count. We would still anticipate that, and as you've seen, our back half -- we are strongly back half-focused.

And that's always been the case I think in your business, but is it more back half focused than typical, and any reasons that you could call out for that?

So I would say we're more back half focused from an operational standpoint this year than in the past. We have a real strong second half looking forward to.

And are there just a couple drivers of that? Is it simply delivery of product here from these recent content wins, or any one or two things that stands out for a little more revenue concentration there than typical?

When you look at our variable comp package, we definitely accrue as we perform, and some of the metrics that we have, as you recall, are things around cash flow and others, and as you see, we have first half was low, anticipate the second half. So you got to look at entire performance, heavily weighted to the second half this year. So as we book and accrue variable compensations tied to performance and the ramp, and always say it's heavily back-end loaded this year.

Thank you.

The next question comes from Fred Buonocore.

Yes, just a follow-up on what you're seeing in Europe. Could you remind us, what are the biggest or most significant product lines or end markets or both, that you serve in Europe?

I have to answer almost in two ways. One, we shipped probably the entire range of our portfolio to European OEMs. Those European OEMs may not be selling those products in Europe. A lot of them are being exported to Asia, Middle East, and elsewhere around the world. So when we look at first our shipments, and some of that will be around, could be aircraft, turbines, airframe control systems, gas turbines, reciprocating engine controls, huge customer base in Europe, but a lot of those are going elsewhere around the world. Then what we try to do is dissect what's happening in the end markets, and we just see a little bit of softening in the end markets tied to some of the industrial equipment, a little bit on power generation and the like. So our key European OEMs still doing well in exporting, but the European demand had softened for the whole range of products, if you follow that.

Right. So as you call that really, just broadly, industrial equipment within Europe, as well as power generation, those would be two kind of broad application buckets that you see softening for direct sales into Europe that are being used or distributed throughout Europe. Is that the right way to think about that?

That is correct. And then the export arm of our major OEMs in Europe is still strong. I want to highlight that. They are still doing well, but those sales are going, like I said, outside of Europe.

Okay. That makes sense. Thanks.

The next question comes from Steve McNeil.

I just wanted to touch base on the free cash flow guidance. I think the previous number you had out there was $120 million, right?

That's right.

Can you just talk about the delta there versus the $90 million you're expecting currently?

Yes. The predominant would be related at this time to receivables. Inventories have tapered off a bit. Before, we commented on working capital in general, we said it was largely in the inventory side. This side's been largely in the receivables side, related to both the geographic locations of our sales, predominantly in Asia, for example, increasing some of that -- timing, as well as the timing of some of the customer releases being later in the quarter.

Later in the year, you mean?

Later in the year as we go forward, and particularly this quarter later in the quarter.

Got it. Okay. And then just taking a step back and just thinking more broadly, as you look at the next year, is there any reason why you wouldn't be able to grow your earnings 20% next year?

None whatsoever. (laughter)

I mean, I know that dovetails with the goals you articulated at the analyst day in December, but I know there's some dynamics around some of the incentive comp and then R&D. Doesn't sound like you're expecting much of a headwind there or perhaps not much of a tailwind either. But I mean, as things look to you today, do you feel like a 20% earnings growth number is a good number to think about next year?

Looking into 2013, I first would highlight that we always have the broad economic indicators that we track, and for our markets, look positive. So we would say looking into 2013, we believe our sales trend and forecast will continue. And we do believe we'll be able to leverage earnings on those sales. So getting towards that number is feasible, but we haven't quantified that for next year. But I would say all the trends are moving in the right direction for us at this time. So the only negative we got on our horizon is defense spending in the US and --

And wind in the US?

And wind in the US, yes. And my prediction is that the defense spending will not get hammered as much as is being discussed, and with our portfolio, we still think we'll be approximately flat in 2013 on defense sales, as long as that huge defense cut does not occur. And we don't believe that will happen. So that's still an unknown. And then the wind, yes, it will be down some, but overall, I think our wind sales will be holding into next year. Not the substantial increase we saw this year, but still holding. So you get all of that, we got a pretty positive outlook still moving to 2013, which we'll start quantifying more next quarter.

Okay, but you don't think we'll get much of a tailwind from R&D going down next year, based on what you're seeing currently?

No, the percentage we'll give you, because sales will be up, but one of the things, just to remind everybody, these programs take several years to develop and we've ramped, we're ramping up the engineering resources, and both full-time people, contractors, and stuff to support the variability and the R&D expenditures and how programs progress. So I think that's going to be with us for a while, until sales start materializing for these new programs. But we have some good things, especially on the Aerospace side. That's where we have the biggest R&D.

I do want to remind everybody, we're finally going to start seeing the 787, 747, A380, these things ramping up along with 777 rate increases and A320 rate increases. There will be timing issues, but we believe those ramps will help us absorb all this R&D, and still deliver the earnings projections that we gave you. So we're confident in that, but we may have quarter-to-quarter variability. But on an 18-month, two-year outlook, it will track what we gave as guidance earlier.

Thanks, guys. Have a good night.

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

Okay. Well, appreciate everybody joining us today and thank you for your questions and discussion and we look forward to seeing you over the next quarter. Thanks.

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