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Edited Transcript of HXL earnings conference call or presentation 22-Oct-19 2:00pm GMT

Q3 2019 Hexcel Corp Earnings Call

STAMFORD Nov 1, 2019 (Thomson StreetEvents) -- Edited Transcript of Hexcel Corp earnings conference call or presentation Tuesday, October 22, 2019 at 2:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Nick L. Stanage

Hexcel Corporation - Chairman of the Board, President & CEO

* Patrick Joseph Winterlich

Hexcel Corporation - Executive VP & CFO

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Conference Call Participants

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* Caitlin MacKenzie Dullanty

BofA Merrill Lynch, Research Division - Research Analyst

* Christopher David Olin

Longbow Research LLC - Analyst

* Christopher John Kapsch

Loop Capital Markets LLC, Research Division - MD

* Gautam J. Khanna

Cowen and Company, LLC, Research Division - MD & Senior Analyst

* John Patrick McNulty

BMO Capital Markets Equity Research - Analyst

* Katie Ann Copouls

Barclays Bank PLC, Research Division - Research Analyst

* Michael Joseph Sison

Wells Fargo Securities, LLC, Research Division - Senior Analyst

* Myles Alexander Walton

UBS Investment Bank, Research Division - MD & Senior Analyst

* Noah Poponak

Goldman Sachs Group Inc., Research Division - Equity Analyst

* Paretosh Misra

Joh. Berenberg, Gossler & Co. KG, Research Division - Analyst

* Robert Michael Spingarn

Crédit Suisse AG, Research Division - Aerospace and Defense Analyst

* Sheila Karin Kahyaoglu

Jefferies LLC, Research Division - Equity Analyst

* William W. Lee

Wolfe Research, LLC - Research Analyst

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Presentation

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Operator [1]

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Welcome to Hexcel's Third Quarter 2019 Earnings Call. (Operator Instructions) I would now like to hand the conference over to your speaker today, Patrick Winterlich. Hexcel's Chief Financial Officer, please go ahead, sir.

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Patrick Joseph Winterlich, Hexcel Corporation - Executive VP & CFO [2]

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Thank you. Good morning, everyone. Welcome to Hexcel Corporation's Third Quarter 2019 Earnings Conference Call.

Before beginning, let me cover the formalities. First, I want to remind everyone about the Safe Harbor provisions related to any forward-looking statements we may make during the course of this call. Certain statements contained in this call may constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. They involve estimates, assumptions, judgments and uncertainties caused by a variety of factors that could cause future actual results or outcomes to differ materially from our forward-looking statements today.

Such factors are detailed in the company's SEC filings and last night's news release. A replay of this call will be available on the Investor Relations page of our website. Lastly, this call is being recorded by Hexcel Corporation and is copyrighted material. It cannot be recorded or rebroadcast without our expressed permission. Your participation on this call constitutes your consent to that request.

With me today are Nick Stanage, our Chairman, CEO and President; and Kurt Goddard, our Vice President of Investor Relations. The purpose of the call is to review our third quarter 2019 results detailed in our news release issued yesterday.

Now let me turn the call over to Nick.

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Nick L. Stanage, Hexcel Corporation - Chairman of the Board, President & CEO [3]

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Thanks, Patrick. Good morning, everyone, and thank you for joining us as we share our third quarter results. It was a strong quarter, with our operating margin exceeding 19%. We delivered a 12.5% increase in earnings per share versus Q3 2018, and we continue on track toward a record year for cash flow.

These results reflect the commitment and the capability of our team to execute and deliver value to shareholders.

Let me highlight some of the results, and Patrick will then provide more details on the numbers. Sales in the quarter of $572 million were up 6.6% year-over-year in constant currency. Adjusted diluted EPS was $0.90 compared to $0.80 in the third quarter of 2018.

We delivered third quarter operating income of almost $110 million, which was up almost 14% year-over-year and resulted in an operating income margin of 19.2% compared to 17.9% in Q3 2018. Operating margin was robust in the quarter as we continue driving the efficiencies, increasing productivity and focusing on continuous improvement.

Our people are committed to constantly looking for opportunities to improve productivity and generate cost savings, which translates to improved margin quality.

Clearly, our commitment to operational excellence throughout the business is working and gaining momentum.

Now turning to our 3 primary markets. Commercial Aerospace sales in Q3 were $386 million, an increase of 3.6% in constant currency as compared to Q3 2018, driven primarily by the A320neo, Boeing 787 and Airbus A350 programs. We are encouraged by the strong growth of almost 17% in Other Commercial Aerospace, which includes regional and business jets.

The growth was primarily driven by Gulfstream programs. We continue to see growth in Commercial Aerospace, although slowed by the effects of the Boeing 737 MAX grounding. The decrease in MAX production did not significantly affect our sales during the first half of the year as we benefited from a few Boeing suppliers taking advantage of the grounding to catch up and build inventory in Q2. However, as the grounding extended, the channel inventory grew and as Q3 progressed, more than 2/3 of our 737MAX shipset sales were affected by the lower build rates.

Today, we remain optimistic for a 737MAX return to service and resumption of growth, with higher production levels following regulatory approvals.

Unfortunately, the uncertain timing of return to service has pushed sales to the right and required us to revise our sales guidance for the year as you read in our release last night.

Our revised guidance reflects lower sales volume for the 737MAX program, along with softening due to uncertainties in the global economy that are impacting some of our Industrial markets and a sustained stronger dollar, which leads to reported lower sales.

To add some perspective, our reported sales are now expected to be lower by approximately $30 million for the year as a result of the sustained strength of the dollar against the euro compared to our original guidance.

As a reminder, a stronger dollar leads to lower costs for our European operations and results in a net tailwind to margins.

We remain cautiously optimistic for the remainder of the year and more positive as we head into 2021 when we expect the 737MAX to return to service and build rates to increase, driving growth for more than 2/3 of our MAX shipset content.

Trails from other key Commercial Aerospace programs remain strong. We are currently at rate on the A350, and the A320 continues to grow steadily while the 787 continue to ramp during 2019 and will be at full rate for the first full year in 2020.

Backlogs remain robust at over 12,000 aircraft, composite adoption and secular penetration continue to accelerate and our market share is strong and growing.

Hexcel has a sustainable competitive advantage, excellent customer relationships and a leading sole source position in key markets, with high barriers to entry. With innovative technology, the broadest aerospace composite product portfolio in the industry and $3 billion of global gross value property, plants and equipment, there is no other company in our advanced materials space that is better positioned to take advantage of the growth opportunities ahead than Hexcel.

Now turning to Space & Defense. It was another terrific quarter, with a double-digit growth over Q3 2018. Sales were almost $110 million, reflecting an increase of 22.7% in constant currency.

Growth was driven primarily by the F-35 Joint Strike Fighter program, along with increasing strength in military rotorcraft. Our ARC Technologies business continues to perform well and is making strong contributions in our overall sales growth in our Space & Defense market.

Finally, Industrial sales were about $77 million for the third quarter, which was essentially in line with Q3 2018, though up about 3% in constant currency.

While demand for composite materials and wind turbine blades remains strong, growth in this market is stabilizing as we near the end of a steep ramp-up. For the past few quarters, Hexcel has benefited from strong growth in wind sales. Going forward, global demand appears to be leveling out at current elevated levels.

Coupled with short-term softness in both the automotive and recreational markets, these factors are likely to keep Industrial sales relatively constant in the near term, ahead of expected growth in 2020.

In summary, we continue to demonstrate year-over-year growth, margin expansion, exceptional cash generation and strong returns on investment. Backlogs are healthy, customer relationships have never been stronger, and Hexcel continues to win in the marketplace and create value for shareholders. Other than revising our sales guidance related to the 737MAX grounding and foreign exchange movements, the remainder of our 2019 guidance is unchanged. Now I'll turn the call over to Patrick to discuss more on the quarter's financial details.

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Patrick Joseph Winterlich, Hexcel Corporation - Executive VP & CFO [4]

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Thank you, Nick. I will provide a review of our markets and as usual, these year-over-year comparisons are in constant currency. As Nick already said, currency movement influenced our reported sales, and some of this impact may not be intuitive. The majority of our sales have denominated in dollars, however, our cost base is a mix of dollars, euros and British Pounds as we have a significant manufacturing presence in Europe.

As a result, when the dollar strengthens against the euro and the pound, our sales translate lower, but our costs also translate lower, resulting in a net tailwind to margins.

Accordingly, we prefer a strong dollar to a weak dollar. In terms of currency hedging, we employ a disciplined hedging strategy to protect our operating income that layers and hedges over a 10-quarter horizon.

Commercial Aerospace represented approximately 68% of total third quarter sales. Commercial Aerospace sales of $386 million increased 3.6% compared to the third quarter of 2018, driven by production rate increases, including the A320neo increasing to 60 aircraft per month and the 787 increasing midyear to 14 aircraft per month, tempered by the lowered 737Max production rate. Space & Defense represented 19% of sales. For the third quarter, Space & Defense sales totaled a $110 million, an increase of 22.7% compared to the same period in 2018.

Growth was driven by the F-35 program, supported by other fixed-wing programs as well as the Blackhawk and V-22, including the wide-chord rotorcraft blades. Industrial comprised 13% of third quarter sales. Industrial revenues totaled $77 million, increasing 2.7% compared to the strong prior year period.

Wind energy remains the largest submarket within Industrial, comprising just over 60% of Industrial sales. Our wind energy sales is stabilizing, following a very steep period of growth that began in mid-2018.

We have 32 different submarkets within Industrial and during the third quarter, we experienced fluctuations within some of these markets, notably automotive, which is not unusual for our business.

On a consolidated basis, gross margin for the third quarter was 27.6% compared to 26.5% in the third quarter of 2018. We continue to focus on operational excellence, which drives higher margins and when combined with the absence of some headwinds, we experienced last year, led to over 40% incremental operating margins year-over-year.

Total depreciation expense increased $3.2 million in the third quarter of 2019 compared to the prior year period, as we continue to invest to support future growth. For the third quarter, selling, general and administrative expenses increased 5.4% year-over-year in constant currency.

Research and technology expenses increased 4% year-over-year in constant currency. We continue to expand our leading technology positions through investments in research, supported by 7 global R&T centers of excellence located in Europe and North America.

Operating income increased 13.9% or $13.4 million year-over-year. The operating income margin expanded to 19.2% of sales for the third quarter of 2019, which is one of the highest quarterly operating margins ever posted by Hexcel.

This strong margin performance compared to an operating margin of 17.9% for the third quarter of 2018. The year-over-year impact of exchange rates was favorable by approximately 10 basis points.

The composite materials segment represented 78% of total sales and generated an operating income margin of 21.2% for the third quarter of 2019 as compared to a 20.6% margin in the prior year period.

The Engineered Products segment, which is comprised of our structures and engineered core businesses, represented 22.2% of sales and generated an operating income margin of 16.3% due to favorable program mix in the third quarter of 2019 compared to 14.4% in the third quarter of 2018.

Now the operating margin is lower than the composite materials segment, Engineered Products requires a much lower level of investment, generating strong returns on invested capital. The adjusted effective tax rate for the third quarter of 2019 was 21.4%.

We continue to forecast an underlying effective tax rate of 24% for the fourth quarter of 2019. Net cash from operations was $120.1 million in the quarter and is $277 million year-to-date.

Working capital represents the use of cash of $1 million in the third quarter of 2019. Capital expenditures on an accrual basis were $53.3 million during the third quarter of 2019 compared to $43.5 million in the third quarter of 2018.

Free cash flow is typically stronger for Hexcel in the second half of the year and was $114.6 million year-to-date compared with a $128.2 million in the same period in 2018.

We target a gross debt-to-EBITDA leverage ratio of between 1.5 and 2x. At the end of the third quarter, our leverage ratio was 1.9x.

This represents a continued decrease from the first quarter of 2019 as we repaid a portion of the debt used for financing the January 2019 acquisition of ARC Technologies combined with strong and growing EBITDA.

We repurchased approximately $56 million of our common stock during the third quarter of 2019 and now have $318 million remaining under our share repurchase program.

Our capital allocation priorities continue to be investing in organic growth, followed by targeted and disciplined M&A and our commitment to returning greater than 50% of our net income to shareholders through dividends and stock buybacks.

Before turning the call back to Nick, I would like to review the 2019 guidance included in the earnings release issued yesterday.

We released our 2019 sales guidance range to a forecasted $2.34 billion to $2.4 billion. When we first issued this sales guidance in January 2019, we were expecting the MAX production rate to reach 57 per month by midyear 2019, consistent with the publicly disclosed billed rates issued by Boeing. When we reaffirmed guidance last quarter, we were experiencing -- expecting the MAX return to service early in the fourth quarter of 2019, consistent with industry expectations at that time.

We have now reduced our sales guidance due to the expected MAX return to service being delayed further than initially expected, combined with some other unanticipated short-term headwinds, including foreign exchange rates and a general flattening of Industrial sales due to recent softness in the global economy.

We are maintaining our guidance for EPS, actual expenditures and free cash flow, reflecting our confidence in our employees and our focus on operational excellence to drive earnings and cash generation.

Our EPS guidance is a range of $3.43 to $3.53 per share. Recall that we raised our EPS guidance last quarter, increasing the midpoint by $0.03 to $3.48 per share from $3.45 per share.

Capital expenditures are expected to be in the range of $170 million to $190 million. Free cash flow is forecast to exceed $250 million as we again expect to generate significant cash in the fourth quarter of 2019. With that, let me turn the call back to Nick.

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Nick L. Stanage, Hexcel Corporation - Chairman of the Board, President & CEO [5]

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Thanks, Patrick. As we mentioned, we are on track to deliver record cash flow this year. So let me follow up by restating that our plans for that cash include growing the business organically and through M&A. Our teams are working diligently with our customers on next-generation materials to support future programs and growth opportunities.

Our business development pipeline is very active with multiple ongoing projects. We remain committed to finding areas and opportunities to expand our technology portfolio, to better serve our customers and deliver solutions that benefit the future.

We expect to share our 2020 guidance in January when we report our fourth quarter and full year results. We are at the beginning stages of rolling up our plan for next year and our initial view is that we have robust growth for the A320neo as Airbus moves toward a rate of 63 per month in 2021 and for the Boeing 787, which should achieve its first full year at the higher rate of 14 per month. And there is further growth expected next year in several additional programs, including the 777X and Airbus A220. On the 737Max, we remain confident in its long-term success and look forward to its to return to flight and gradual ramp up in production during 2020.

Currently, the largest part of our demand for the MAX is at a rate of 42, and we expect positive growth from that base as we move through 2020.

The outlook for our Space & Defense business continues to be extremely positive. Wind power, as a source of energy generation, continues to become more cost competitive, and we see many possibilities to support wind industry initiatives with further penetration of advanced material composites.

And more broadly, with significant numbers of electrification and light-weighting projects emerging, Hexcel's composite materials are becoming increasingly relevant to enable our customers to meet these challenges.

In closing, we expect our results this year will demonstrate solid growth, exceptional cash generation and a strong return on investment for shareholders.

We continue to benefit from aircraft program ramp ups, continued secular adoption of advanced composites and strong demand with continued long-term growth. We are achieving our objectives by staying disciplined, focusing on operational excellence, investing in the future and by delivering on our commitments to customers and shareholders. Julienne, that ends our prepared remarks, so we're ready to take questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Your first question comes from Gautam Khanna from Cowen and Company.

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Gautam J. Khanna, Cowen and Company, LLC, Research Division - MD & Senior Analyst [2]

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Sorry for the background noise, I'm on an airport. I just wanted to follow up on some of your comments on the MAX. Are you seeing any -- one of your customers below 42 at this point? Or are you saying, there is a mix at -- sum at 52 (inaudible) to it and then 42? And are you seeing some indications below that?

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Nick L. Stanage, Hexcel Corporation - Chairman of the Board, President & CEO [3]

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So Gautam, I think I picked up most of the question. There is a lot of background noise. We believe that the bulk of our customers on the MAX now are trending to the 42 level. We have a broad customer base, and it's hard to have an exact visibility into that. But when we do our sanity checks and we look at what some of the key suppliers to the MAX have stated they're at, it ties together where we're pretty comfortable that, that somewhere between 2/3 and 3 quarters of our shipset content is at the 42, whereas another portion, the balance, is somewhere between 42 and 52.

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Operator [4]

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Your next question comes from Mike Sison from Wells Fargo.

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Michael Joseph Sison, Wells Fargo Securities, LLC, Research Division - Senior Analyst [5]

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Nice quarter there.

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Nick L. Stanage, Hexcel Corporation - Chairman of the Board, President & CEO [6]

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Thanks, Mike.

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Michael Joseph Sison, Wells Fargo Securities, LLC, Research Division - Senior Analyst [7]

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In terms of your range this year, Nick, from the low and the high and the guidance, it's about $0.10. Is the delta generally within your control to get to the top or the bottom? Or is there -- is the top more driven by sales growth in either of the segments?

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Nick L. Stanage, Hexcel Corporation - Chairman of the Board, President & CEO [8]

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So we look at both the upside potential as well as the downside risk, and we believe it's very centered. So I think, there's as much opportunity for us to overdeliver. And depending what could happen, with the supply chains tightening, as they normally do in fourth quarter, how cash may become an issue within Commercial Aerospace, given the MAX issues, is a question mark. So we think we're covered. We think our guidance is accurate based on what we see and know today, and -- but believe we can deliver that.

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Michael Joseph Sison, Wells Fargo Securities, LLC, Research Division - Senior Analyst [9]

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Great. And then I know it's a little bit early to give specific, sort of, outlook for 2020. But if the MAX stays at 42, I guess, for the full year, it does sound like you have other programs that will drive growth for Commercial Aerospace. So is that really the case that you can still get pretty good growth next year at Commercial Aerospace sales, even if the MAX stays at 42?

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Nick L. Stanage, Hexcel Corporation - Chairman of the Board, President & CEO [10]

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Well, we certainly have growth in other programs and we're broader than the MAX. But let's not forget at $400,000 per shipset, the MAX is a meaningful program for Hexcel. And pick a number, if it's 10 down or 15 down from where Boeing intends to go, you can do the math on that and to what it would equate to for a full year impact.

But to answer your question, we are seeing strength in many programs across our markets, including other -- Space & Defense has been incredibly strong, and we're very bullish on that as well.

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Operator [11]

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Your next question comes from Robert Spingarn from Crédit Suisse.

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Robert Michael Spingarn, Crédit Suisse AG, Research Division - Aerospace and Defense Analyst [12]

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Just on that -- following that last question, not so much on MAX. But you've talked about the growth embedded for the 787 and you also mentioned the 777X. But there is some concern that 787 rates are going to have to come down, maybe not in '20 but in '21 and of course, the 777X has been shifting to the right. So how does that cloud your view for 2020?

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Nick L. Stanage, Hexcel Corporation - Chairman of the Board, President & CEO [13]

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So again, if you look at the build rates, even if Boeing stays where they are today and do not receive another order, we still have close to 3.5 years of backlog.

A350 is at 5 plus. So I -- we don't view 2020 being a risk item relative to those build rates in those programs.

We're also bullish on wide body replenishment being required. Now whether those rate start or orders start coming in 2020, 2021, but we're hopeful that they do and they can justify the existing build rates for both Boeing and Airbus.

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Robert Michael Spingarn, Crédit Suisse AG, Research Division - Aerospace and Defense Analyst [14]

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Okay. And then just as my follow-up, just switching to Industrial, you talked about growth resuming in 2020. What are your assumptions on what drives that? Does wind come back? Is it automotive? Is it something else?

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Nick L. Stanage, Hexcel Corporation - Chairman of the Board, President & CEO [15]

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So we're rolling up the plan as we speak, and I don't want to get ahead of ourselves, but seeing some lumpiness, especially in automotive and rack is typical. We see that. We'll have a big quarter and we'll have a down quarter, and it has to do with timing. And keep in mind, a lot of our business in the automotive is on the very high end premium cars where build rates are not necessarily x per month on a steady basis. Rack is similar with climate and with some seasonality in there. So we're comfortable that, that's going to come back. When? We continue to work that. There's been some restructuring with Vestas on their mix. We feel really good about our positions and our new technologies there. Having said that, we're not going to see the kind of growth we've experienced over the past few quarters, simply because they are at very high rates, and we expect those rates to continue going forward. So the growth rate will come down compared to where we have been over the last few quarters, but we're still looking for a nice business growth in those segments.

Thank you, Robert.

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Operator [16]

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Your next question comes from Myles Walton from UBS.

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Myles Alexander Walton, UBS Investment Bank, Research Division - MD & Senior Analyst [17]

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I'm wondering in this -- Patrick first. So Patrick on the implied fourth quarter margins, I'm just struggling with why they would decline against implied as much as they would if you are at the high end of the sales range? Perhaps, maybe, it's looking to the low end of the sales range and for a more modest margin decline. But maybe, just talk about the moving parts on margin in the fourth quarter? And also engineered products margins in particular, in the third quarter, if you can touch on that?

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Patrick Joseph Winterlich, Hexcel Corporation - Executive VP & CFO [18]

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Sure. Myles, I mean, I would say, as Nick said with the EPS, I would say, again, we're fairly centered in terms of the sales range. We're kind of trying to balance ourselves at the midpoint as opposed to the top or the bottom.

And based on those ranges, December is always a bit of a funny month in terms of the volumes and the overhead recovery and all the rest of it. But we expect to continue to drive decent margins going into the fourth quarter.

There is nothing exceptional in terms of cost. We will drive the incremental margin leverage as strongly as we can. And I would say, we are reasonably centered.

In terms of the Engineered Products, third quarter, the 16-plus percent, which does stand out, it was, kind of, exceptionally high. There's probably a couple of factors there. I mean, the ARC Technologies is all being reported through Engineered Products and that is starting to help and perhaps weight that segment up a little bit. And it was just then combined with a strong mix of program, which we can get a bit of lumpiness in Engineered Products. So it was those 2 things together that I would say that drove the 16%. Whether we'll be able to repeat 16%, time will tell, but that was certainly a higher outlier for now.

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Myles Alexander Walton, UBS Investment Bank, Research Division - MD & Senior Analyst [19]

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Okay. And then on ARC, Nick, I think, you mentioned the growth in Space & Defense, driven by the F-35. Was ARC a bigger contributor? Or was the F-35 a bigger contributor? I guess, I thought, maybe, ARC would've been the bigger.

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Nick L. Stanage, Hexcel Corporation - Chairman of the Board, President & CEO [20]

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Well, ARC was the bigger contributor. And keep in mind, when we talk F-35, ARC does have a good position on F-35, as well as legacy Hexcel before ARC.

So in total F-35, but the bulk was clearly the acquisition and the roll-in quarter-over-quarter of the ARC business.

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Patrick Joseph Winterlich, Hexcel Corporation - Executive VP & CFO [21]

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But Myles, I would also add, the underlying growth in Space and Defense was high single digits, even without ARC.

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Myles Alexander Walton, UBS Investment Bank, Research Division - MD & Senior Analyst [22]

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Yes. I've got it. And the last one, Patrick, on the FX effect on OI, operating income, was it a net push or a net tailwind to the adjustments? I know it helped margins...

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Patrick Joseph Winterlich, Hexcel Corporation - Executive VP & CFO [23]

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FX, at the operating income level was a slight benefit. It was a small tailwind, but only small basically because of the hedges we do. But we -- the hedges project the operating income and we got a slight boost.

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Operator [24]

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Your next question comes from John McNulty from BMO Capital Markets.

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John Patrick McNulty, BMO Capital Markets Equity Research - Analyst [25]

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Regard to the -- with regards to the incremental margins, they were clearly higher than we've seen in a long time, and it does sound like, maybe, there was a little bit of lumpiness in the Engineered Products. But anything else that was driving that? I mean, certainly relative to the first half, I mean, they were notably better, even though you had some, what I would have argued, were some easier comps in the first half. So I guess, how should we think about that?

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Nick L. Stanage, Hexcel Corporation - Chairman of the Board, President & CEO [26]

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I think you touched on the easier comps simply because of some of the headwinds we faced last year with AEN and resin. So those certainly have subsided. (inaudible) is up and running at full speed and getting -- is getting more productive every day.

So really, there wasn't anything unusual. I -- again, I have to applaud, and I'm very proud of the job that our team is doing with respect to productivity and efficiencies throughout our operations. That is helping the business, which, obviously, we're counting on sustaining that the level of performance and continuing to stretch ourselves. So the productivity improvements that we've seen have been fantastic, even causing us to look at our CapEx and some opportunities to push some of that to the right. So it's a combination of all those factors that give us confidence in continuing to drive margin strength.

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John Patrick McNulty, BMO Capital Markets Equity Research - Analyst [27]

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Great. And then with regard to the outlook for 2020. Look, you've had a huge margin to step-up this year. Is there more to come for 2020, if, kind of, things play out the way you think, where the MAX starts to get back on track next year and wind comes back? I guess, how should we be thinking about the potential for further margin expansion as we look to 2020?

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Nick L. Stanage, Hexcel Corporation - Chairman of the Board, President & CEO [28]

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Well, John, it's a little early for me. I -- we're rolling up the first pass. I haven't had my first look. But as I said, on this call before, and as my team knows, I expect continuous improvement and not only year-over-year but quarter-over-quarter, ideas and opportunities to drive productivity, and it's no different for 2020. With the MAX stepping back up, with some of our sites running as efficiently and full as they are, it just gives and provides opportunity for very strong leverage.

Thanks, John.

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Operator [29]

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Your next question comes from Chris Olin from Longbow Research.

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Christopher David Olin, Longbow Research LLC - Analyst [30]

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Okay. I just had a quick question on the Other Commercial Aerospace sales line and that 17% growth you guys posted. I think you highlighted Gulfstream. I guess, my question would be is that run rate sustainable? Or would that include some type of like channeled fill or inventory management? And then I guess, I would have the same type of question in terms of the growth rate on sales in Defense. I guess, thinking outside of the F-35, should we start thinking about the (inaudible) offer?

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Nick L. Stanage, Hexcel Corporation - Chairman of the Board, President & CEO [31]

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So let me start with Other. And you pointed out, as we did, Gulfstream drove a large portion of that. And it was pretty broad-based at Gulfstream, although the G500 was really big in the quarter. I wouldn't expect 17% quarter-over-quarter growth. But I would say, our positions in the engines and the cells and our positions on the new platforms being launched, continues to be very good. So we see Other continue to do well. On the Space & Defense, it's a combination there. Obviously, we expect more growth with the F-35. We expect more growth and contribution from our acquisition of ARC Technologies. And then we've got broad-based growth, with new programs like the CH-53K, continued steady performance and growth with the watercraft on the military side and other drones and unmanned vehicles that we're supplying materials to that -- probably won't be material in size, but they provide great opportunities because there's more and more of them being looked at, evaluated and ultimately, will translate into production.

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Operator [32]

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Your next question comes from Paretosh Misra from Berenberg.

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Paretosh Misra, Joh. Berenberg, Gossler & Co. KG, Research Division - Analyst [33]

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How big is this, the Commercial Aerospace business for you guys? Percentage of Commercial Aerospace.

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Patrick Joseph Winterlich, Hexcel Corporation - Executive VP & CFO [34]

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Sorry, Paretosh. So it's about 15% or so, of the total Commercial Aerospace.

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Paretosh Misra, Joh. Berenberg, Gossler & Co. KG, Research Division - Analyst [35]

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Got it. And then just a follow-up on your (inaudible) facility. Any updates, how is that coming along? And with the CapEx on that facility be largely done by the end of this year?

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Nick L. Stanage, Hexcel Corporation - Chairman of the Board, President & CEO [36]

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So to your question on how we're doing there, we're doing great. We're actually on track or maybe even ahead of schedule on that. There was never a plan for that CapEx to be completely spent or completed this year. What we had said was, we would have it completed next year with lines would come online and then qualified sometime in 2021.

But overall, the project has gone very well.

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Operator [37]

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Your next question comes from Sheila Kahyaoglu from Jefferies.

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Sheila Karin Kahyaoglu, Jefferies LLC, Research Division - Equity Analyst [38]

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Nick and Patrick. Nick, I wanted to turn to something you said in -- as you closed off the finishing -- the prepared remarks. You talked about growing the business organically and through M&A. It seems more and more that NMA will not happen and, maybe, the focus will shift to future small aircraft. Maybe can you talk about how you view Hexcel's technology, the maturity of the offering when it comes to high-volume composite manufacturing?

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Nick L. Stanage, Hexcel Corporation - Chairman of the Board, President & CEO [39]

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Sure. So we are always working with our customers whether it's Boeing, whether it's Airbus, whether it's the engine guys, Embraer, Bombardier, on next-generation materials, whether it's for primary structures, wings, fuselage, empennage, secondary structures, which could include interiors, or a growing market for us, where we have very good positions in engines and the cells. And that hasn't changed. We're working aggressively on materials that lay down faster, cure faster and provide a better economic package for the customers for expanded secular penetration.

Whether or not the NMA gets launched, I'm a believer that there will continue to be upgrades, there will continue to be neos and MAXs of next-generation airplanes. There will continue to be growth in the Other commercial. And I think, we're the best positioned in the marketplace to provide the solutions that our customers are going to need for those applications going forward. So I'm not as pessimistic on NMA not going. I'd like to stay optimistic, and we'll be ready if and when it does.

Thank you, Sheila.

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Operator [40]

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Your next question comes from Noah Poponak from Goldman Sachs.

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Noah Poponak, Goldman Sachs Group Inc., Research Division - Equity Analyst [41]

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Patrick, can you give us the old and the new tax rate inside of the full year EPS guidance?

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Patrick Joseph Winterlich, Hexcel Corporation - Executive VP & CFO [42]

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Well -- so the year-to-date is obviously just the average of the 3 quarters. I think it's just over 22%. I mean -- as I say, Noah, and as we go into the fourth quarter, the underlying starting point effective tax rate that we will use is 24%. Now obviously historically, we get tweaks and adjustments to that. But as I sit here today, I don't know what those will or won't be and how many, sort of, stock options, et cetera, get exercised will move that needle. But the starting point for the fourth quarter is 24%, and then you combine that with obviously the year-to-date average for the first 3 quarters. That's what the final year number is going to. So it's going to be under 24% in total but how much? I don't know.

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Noah Poponak, Goldman Sachs Group Inc., Research Division - Equity Analyst [43]

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Okay. Any reason you can't just give me the specific numbers to that question?

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Patrick Joseph Winterlich, Hexcel Corporation - Executive VP & CFO [44]

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I don't -- Noah. I never -- Noah, I don't know the number.

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Noah Poponak, Goldman Sachs Group Inc., Research Division - Equity Analyst [45]

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But you had a little insider on your guidance and you have new earnings guidance, and both of them had a tax rate assumption. Patrick, am I, kind of...

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Nick L. Stanage, Hexcel Corporation - Chairman of the Board, President & CEO [46]

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So I'll answer this, and then we'll move on. The first 3 quarters, 1, 2, 3 were the actual tax rates. And our guidance midpoint has 24% as the assumption for Q4.

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Noah Poponak, Goldman Sachs Group Inc., Research Division - Equity Analyst [47]

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Okay. On the MAX, I had interpreted your prior comments to suggest that you were closer to right-in-between 42 and 52, and I think, you've even suggested building a variance versus Boeing that would then need to unwind as Boeing was ramping back up. But today, your comments suggest closer to 42. And so I'm wondering if that is -- somebody like the engine manufacturers stayed close to 52 while they improved to their position in the supply chain, cleaned things up a little bit and then has gravitated lower. Or if it's that you've been closer to 42 all along and that's just an effort to better understand whether or not you have any variance that would the need to burn off as Boeing goes higher.

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Nick L. Stanage, Hexcel Corporation - Chairman of the Board, President & CEO [48]

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Yes. So just to clarify, to my knowledge we, never said that we were going to build access or capacity or inventory in anticipation of the market moving one way or another. We did not do that, did not plan to do that. We did say and we do believe and we did experience the fact that there was suppliers, we reported last quarter, that basically were behind. That their supply chain was empty, they weren't at rate. And we knew for a period of time that they would stay at an elevated rate i.e. above 42, in some cases, at 52, in some cases perhaps, even higher to catch up, and we saw that. And that's why over the first 2 quarters -- or the second quarter we basically saw little, if any impact. Third quarter it doesn't take long at 10 per month for inventories to build up, and we saw a pretty abrupt change with some big suppliers, especially around engines, that drove a change that swung our shipset rate closer to the 42 than the 52. So it's really timing and the amount of inventory that was built over the past quarter.

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Operator [49]

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Your next question comes from Chris Kapsch from Loop Capital.

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Christopher John Kapsch, Loop Capital Markets LLC, Research Division - MD [50]

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Yes, just following up on that. I'm assuming the guidance was based on continuing the shipset -- I'm sorry, the rate closer to 42 for the fourth quarter. And then also just I want to try one more time to, sort of, reconcile this delta between the reduced sales guidance and the reaffirmed earnings guidance. And it sounds like you said that not much really of a tailwind from the FX, given the rolling hedges. So a lot of it sounds like it's a combination of operating leverage as well as mix. I'm wondering if you -- and maybe, a little bit of tax rate. Could you parch out those contributors to the delta there?

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Nick L. Stanage, Hexcel Corporation - Chairman of the Board, President & CEO [51]

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So I'll take the first part, the easy part, and then I'll turn it over to Patrick. But your assumption is correct. We had built into our guidance that we'll stay pretty much at the current MAX delivery that we're on right now. And that's the guidance we shared at -- just over 2/3 being at the rate 42 and the balance being above that, towards 52.

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Patrick Joseph Winterlich, Hexcel Corporation - Executive VP & CFO [52]

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I mean, in relation to -- I mean, we moved guidance to 343 to 353, midpoint 348, at the end of last quarter, and we're standing by that. Essentially, we see where -- and you've seen the very strong incremental margins, the 19.2% absolute level of operating income in the third quarter.

We can just see if we sustain those levels, and there's no reason we won't, with the productivity efficiency and operations drive another strong fourth quarter of income.

We should be able to deliver that tax. As I talked about -- I'm not expecting anything exceptional on tax, but it's going to be more about cost control productivity even with the reduced level of sales. And you've obviously got to take into account where we were the first 3 quarters and just see we carry on doing that, it should be roll out, to be honest.

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Christopher John Kapsch, Loop Capital Markets LLC, Research Division - MD [53]

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Got it. And then just 1 follow-up. On the Industrial segment, you mentioned, sort of, broad-based weakness, but including weakness in automotive. I'm assuming that means the composite sales in the auto industry are more skewed towards Europe. And in Europe, there is pretty pronounced weakness in the auto-end market currently or maybe partly on Brexit but seemingly like the demise of depos is a bigger contributor there and there's an acceleration in the move to electrification. Just wondering, if you have an early view on the likelihood of composite adoption in a paradigm over there where there is this accelerated transition to electrification over time. Does -- Do composites play more? Or -- similar to what you've been seeing in some of the higher-end vehicles?

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Patrick Joseph Winterlich, Hexcel Corporation - Executive VP & CFO [54]

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Yes. I mean, I think in the medium to longer term, we would still be extremely positive about the opportunities for composite material adoption, with all the electric vehicles, the electrification, as you suggest, the light-weighting is still going to be a very important factor. It's a relatively short-termed lumpiness, market softness in Europe as you suggest that's hitting us in the near term. But longer term, as vehicles -- weight becomes more and more important, the battery adoption, the integration of batteries is an integral part of vehicles where composites have a lot to offer, we remain very optimistic for the future composites in the automotive sector.

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Operator [55]

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Your next question comes from Hunter Keay from Wolfe Research.

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William W. Lee, Wolfe Research, LLC - Research Analyst [56]

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This is Will for Hunter. Do you have a sense of -- initial sense of how much depreciation will step up in 2020, when the PAN line indicator come online?

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Patrick Joseph Winterlich, Hexcel Corporation - Executive VP & CFO [57]

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Well, those lines, as Nick, kind of, indicated, probably won't be qualifying and come online until actually 2021. So we shouldn't see much impact from those lines in 2020. Given a CapEx spend as we have called out, in the range of $170 million to $190 million, I would look at wherever this year's depreciation step-up has been. I would say about $15 million. Obviously, this year we had the ARC acquisition, which switched up the DNA a bit, but I would say about $15 million or so, next year.

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Operator [58]

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Your next question comes from David Strauss from Barclays.

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Katie Ann Copouls, Barclays Bank PLC, Research Division - Research Analyst [59]

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This is Kate Copouls on for David. I wanted to talk about the sequential drop in aerospace sales from Q2 to Q3. Was there anything else large in there, besides MAX?

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Patrick Joseph Winterlich, Hexcel Corporation - Executive VP & CFO [60]

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The major factor was the MAX as we called out. That movement, as Nick went into detail on really the shift in the engine guys and the demands moving towards 52 in the third quarter that was really that step change.

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Katie Ann Copouls, Barclays Bank PLC, Research Division - Research Analyst [61]

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Okay. And then you guys have talked a lot about productivity improvements. So I guess, I just wanted to ask, how you feel about working capital? How much you're carrying? And then, kind of, in the context of your, kind of, out year 2021, 2023 free cash flow targets? Does working capital grew proportionately with sales? Or do you see opportunities for efficiency there?

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Patrick Joseph Winterlich, Hexcel Corporation - Executive VP & CFO [62]

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I mean, we're always going to drive efficiency as much as we can in the longer term on working capital. I mean, in the near term we've undoubtedly drive -- as we nearly always do in the second half and the last quarter of the year, drive out some cash from our working capital. It's the normal cycle that you would have seen many times. And going forward, we will, as we grow, our working capital base will grow to some extent. Obviously, what we will try to do is to make that growth as efficient as possible and then improve our receivable days and improve our inventory days, which is what we're always striving to do.

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Operator [63]

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Your last question comes from Ronald Epstein from Bank of America Merrill Lynch.

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Caitlin MacKenzie Dullanty, BofA Merrill Lynch, Research Division - Research Analyst [64]

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This is Caitlin Dullanty on for Ron. Looking at this skyline for the Boeing 787, if Boeing doesn't get more orders, it looks like the production rate for the program have downsize risk starting in 2022. If they do kind production rate in 2022, which is year 2021, how should we think about your sensitivity to our long-term growth outlook of 6% to 9% CAGR?

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Nick L. Stanage, Hexcel Corporation - Chairman of the Board, President & CEO [65]

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Well, if you do the math and you pick a number, if they go from 14% to 12%, my math says that's about 1.3% on a full run-rate basis and basically, that'd be the impact.

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Operator [66]

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We have no further questions. This concludes today's call. Thank you for participating. You may now disconnect.