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Edited Transcript of HXL earnings conference call or presentation 24-Jul-18 2:00pm GMT

Q2 2018 Hexcel Corp Earnings Call

STAMFORD Jul 25, 2018 (Thomson StreetEvents) -- Edited Transcript of Hexcel Corp earnings conference call or presentation Tuesday, July 24, 2018 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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* Christopher John Kapsch

Loop Capital Markets LLC, Research Division - MD

* David Egon Strauss

UBS Investment Bank, Research Division - Former MD & Senior Research Analyst

* John Patrick McNulty

BMO Capital Markets Equity Research - Analyst

* Krishna Sinha

Vertical Research Partners, LLC - Analyst

* Michael Joseph Sison

KeyBanc Capital Markets Inc., Research Division - MD & Equity Research Analyst

* Noah Poponak

Goldman Sachs Group Inc., Research Division - Equity Analyst

* Richard Tobie Safran

The Buckingham Research Group Incorporated - Research Analyst

* Robert Michael Spingarn

Crédit Suisse AG, Research Division - Aerospace and Defense Analyst

* Ronald Jay Epstein

BofA Merrill Lynch, Research Division - Industry Analyst

* Sheila Karin Kahyaoglu

Jefferies LLC, Research Division - Equity Analyst

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Presentation

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Operator [1]

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Good day, ladies and gentlemen, and welcome to Hexcel Corporation's Second Quarter 2018 Earnings Conference Call. (Operator Instructions) As a reminder, this conference may be recorded. I would now like to introduce your host for today's conference, Mr. Patrick Winterlich, Chief Financial Officer. Sir, you may begin.

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

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Good morning, everyone. Welcome to Hexcel Corporation's Second Quarter 2018 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 express 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 second quarter 2018 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 today.

We posted a solid quarter of revenue growth, earnings per share and free cash flow.

The business is demonstrating continued cash generation, with free cash flow year-to-date increasing approximately $42 million compared to the first half of 2017.

For the second quarter, sales of $547 million increased 10.3% year-over-year on a constant currency basis, with growth across all 3 of our markets.

Adjusted diluted EPS of $0.75 increased 11.9% year-over-year.

Our Commercial Aerospace market remains strong and continues to grow based on increasing global demand for passenger airline travel. Defense budgets seem likely to continue their upward trajectory, led by the U.S. And the world continued to adopt clean and affordable wind power, which strengthens our industrial business. The combination of our strong markets and our broad portfolio of leading-edge advanced composite materials, along with world-class innovation, positions us well for future growth and free cash flow generation.

Now I'll share some insight into each of our markets, and then Patrick will provide financial details for the quarter. As usual, year-over-year comparisons will be expressed in constant currency.

Beginning with Commercial Aerospace.

Key macro trends continue to be favorable, including air passenger traffic growth and continued order flow for commercial aircraft, which support increasing production rates by our 2 largest customers, Airbus and Boeing. While rising oil prices have generated some concerns that there may be increases in airline fares and temper air passenger traffic growth, high oil prices have historically led to the retirement of older, less fuel efficient aircraft, which then leads to demand for new, more fuel-efficient programs, and that's good for Hexcel.

Our advanced composites play a leading role in making aircraft lighter and more fuel-efficient. Considering that about 1/3 of airline operating cost is fuel, lightweighting and fuel-efficient technologies are critically important to the airlines and our customers.

We continue to benefit from the ramp up of new narrowbody programs which is now gaining pace, with sales for the A320neo and 737MAX increasing strongly in the second quarter of 2018 compared to the prior-year period.

We continue to see strong order trends for commercial aircraft. And together, Airbus and Boeing are reporting combined backlogs of around 13,000 aircraft.

Based on public comments, there is potential upside for future narrowbody rate increases beyond what has already been announced, and we are well-positioned to take advantage of that opportunity should it materialize.

The regional and business jet market maintained its recent strength, increasing about 45% year-over-year, though from a low comparable in 2017. The growth was driven by Gulfstream, Dassault and Bombardier, spread across a number of different business jet configurations.

Finally, there continue to be publicized supply chain constraints in the commercial aerospace sector, particularly among suppliers for narrowbodies. Hexcel continues to be unaffected by these issues, and we have not been asked to delay shipments for any commercial aerospace program.

Turning to Space & Defense. Sales grew just over 3% year-over-year, driven primarily by rotorcraft demand and continued strength in the F-35 Joint Strike Fighter program. Strong global interest continues in the F-35, which is a growth platform for Hexcel. And we were pleased to see the recent orders for the V-22 Osprey. The A400M program continued to weaken, in line with expectations, following previously announced production rate decreases.

We're also pleased to see that the first Sikorsky CH-53K King Stallion was delivered in May to the U.S. Marine Corps. This will be a key growth platform for us when production begins to ramp next year. The CH-53K illustrates the high composite solution secular penetration for new Space & Defense platforms. In fact, almost every aspect of the CH-53K that could use composites does use them, including the airframe, blades and rotors, doors and interior panels.

Sales of civil helicopters in the second quarter continued their recent positive trend, though they remain less than 10% of total Space & Defense revenue.

The trend for defense spending globally continues to increase, with NATO countries recently indicating a willingness to spend more. We have deep relationships with defense contractors around the world. And over time, we expect this upward trend in defense spending to benefit our Space & Defense business.

As expected, sales for our industrial market were up strongly, driven by our wind energy business. Wind energy makes up just over half of our industrial market revenue, led by our largest industrial customer, Vestas. Vestas is currently transitioning to new-generation blades, using greater quantities of our materials that we manufacture in Europe, North America and Asia. We continue to be confident in the outlook for wind energy sales based on our customers' strong backlog.

Also, within our industrial market, sales for automotive and other industrial recorded growth in the quarter.

In terms of our global manufacturing presence, I am pleased to share that our precursor and carbon fiber lines at our new site in Roussillon, France, are fully operational and aerospace qualification is underway. As a reminder, our additional fiber capacity will be used to support the A350 program and other growth in Europe.

In summary, we delivered a solid quarter, with strong revenue and EPS growth, combined with improving free cash flow. Results this quarter reinforce our key priorities, which include driving innovation and growth. We continue to grow sales and increase our investment in R&D to support next-generation programs. We are driving operational excellence. We grew adjusted EPS almost 12% year-over-year by focusing on execution, including productivity and throughput improvements. And we continue to follow disciplined capital deployment as we generate and return cash to our shareholders.

We remain optimistic for the year, and we are reaffirming our 2018 financial guidance.

With that, I'll turn it over to Patrick to provide more color on the numbers.

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

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Thank you, Nick.

I'm going to begin with a review of our markets. As usual, I will discuss year-over-year comparisons in constant currency. As a reminder, currency movements influence our reported results, and some of this impact may not be intuitive. The majority of our revenue is denominated in dollars. However, our cost base is a mix of dollars, euros and the British pound, as we have a significant manufacturing presence in Europe. As a result, when the dollar weakens against the euro and the British pound, our sales translate higher, but our costs also translate higher, resulting in a net headwind to our margins. Accordingly, we prefer a strong dollar to a weak dollar. In terms of currency hedging, we employ a disciplined hedging strategy that layers in hedges over a 10-quarter horizon. As a result, there is a smoothing impact to currency rate fluctuations.

The recent trend of moderate dollar strengthening has lessened the expected currency headwind in the second half of 2018 to a small degree and is now expected to be $0.04 or $0.05 headwind to EPS, a modest improvement from our estimates shared last quarter.

Sales of $547 million in the second quarter of 2018 were up 10.3% year-over-year. Our adjusted diluted EPS for the second quarter was $0.75, an increase of 11.9% compared to the second quarter of 2017.

Year-to-date, the impact of ASC 606 revenue from contracts with customers is less than $100,000. While there is the potential for fluctuations that may impact quarterly EPS by up to $0.01 or $0.02, as previously stated, we do not feel that the ongoing impact of this standard will be material to our financial statements.

Turning to our markets.

Commercial Aerospace represented 70% of total second quarter sales. Commercial Aerospace sales of $383 million increased 9.7% compared to the second quarter of 2017. Commercial Aerospace sales particularly benefited in the quarter from increases in narrowbody production rates. Increasing business jet demand was also positive, although it is a smaller portion of the Commercial Aerospace business.

Space & Defense represented 17% of total second quarter sales, coming in at $91 million, increasing 3.1% from the same period in 2017. Growth for rotorcraft in the quarter drove the increase in sales and continued strength in the F-35 Joint Strike Fighter program offset the A400M rate reduction. Civil helicopters continued their recent strengthening trends, though remain less than 10% of total Space & Defense sales.

Industrial revenues comprised 13% of the quarter 2 2018 sales. For the second quarter, Industrial sales totaled $72 million, reflecting a 24.8% increase compared to the second quarter of 2017. Wind energy drove the growth, consistent with our prior guidance, with the adoption that new generation blades would become apparent in our second quarter sales and would remain strong through 2018.

On a consolidated basis, gross margin for the second quarter was 26.4% as compared to 28.5% in the second quarter of 2017. The gross margin percentage, as expected, was impacted by higher depreciation expense, reflecting our recent capital investments, and also start-up costs associated with the Roussillon, France facility.

Additionally, as a result of recent increases in the price of oil, we are experiencing a modest headwind related to the cost of acrylonitrile, which is the base raw material for our carbon fiber.

I also want to mention that our wind energy business has been impacted as a result of measures taken by the Chinese authorities to reduce levels of pollution, involving the temporary closure of a number of chemical plants in China, including some which make the resins used in our wind energy business. This has led to a tightening in the supply chain for these resins, leading to cost pressures, which we have felt in the second quarter and will continue through the remainder of 2018. Please note, our long-term contracts include indices which we expect to align our costs over time.

Total depreciation expense increased $4.7 million from quarter 2 2017, reflecting prior capital investments. Depreciation expense will continue to trend higher in 2018. And as previously stated, the year-on-year increase is expected to be approximately $20 million.

Our focus on cost control drove a 4% reduction year-over-year in selling, general and administrative expenses against the backdrop of strong sales growth, thus providing positive cost leverage.

Research and technology expenses increased approximately 4% year-over-year, consistent with our ongoing commitment to invest in innovation.

For the second quarter, operating income increased $6.8 million to $96.5 million or 17.6% of sales as compared to $89.7 million or 18.3% of sales for the second quarter in 2017. The year-over-year impact of exchange rates was effectively neutral due to our currency hedging program.

The composite materials segment represented 81.4% of total sales and generated a 20% operating income margin for the second quarter of 2018 as compared to a 22.3% margin in the prior-year period.

The engineered product segment, which comprise of our structures and engineered core businesses, represented 18.6% of total sales for the second quarter. Engineered products generated a 15.6% operating income margin for the second quarter of 2018 as compared to a 12.9% margin in the second quarter of 2017. Year-to-date, the operating margin for engineered products is 13.1%, returning to the 12% to 14% range we typically expect to see, following the first quarter's below average margin percentage for this segment. While margins are lower than composite materials segment, engineered products requires a much lower level of investment, which yields a very attractive return on invested capital.

The effective tax rate for the second quarter of 2018 was 22.8%. This effective rate was favorably impacted by a discrete benefit and an adjustment related to share based compensation. We continue to forecast the underlying effective tax rate to be 25% for the second half of 2018.

Free cash flow for the quarter was $52 million compared to $44 million for the prior-year quarter and totaled $55 million year-to-date compared to $13 million for the first half of 2017. Working capital is expected to be a source of cash during the second half of 2018. We typically expect to see stronger free cash flow in the second half of the year, reflecting the normal seasonality of our business.

Capital expenditures were $44 million for the second quarter on an accrual basis. In comparison, capital expenditures in the second quarter of 2017 were $77 million. Year-to-date, capital expenditures are in line with our 2018 financial guidance.

We repurchased $151 million of common stock during the second quarter, bringing our year-to-date repurchases to $181 million, and we have $562 million remaining under our share repurchase program.

As Nick described, the Roussillon, France facility is now complete from an engineering standpoint. While the continued start-up and qualification of this facility resulted in incremental costs in the first half of 2018, we expect it to be relatively cost neutral for the second half of the year and to begin contributing margin as we enter 2019.

I will conclude by discussing the guidance that we reiterated in the earnings release issued yesterday.

As we now look forward to the second half of 2018, we believe our revenue guidance for the year of $2.1 billion to $2.2 billion is appropriate, with the potential to be above the midpoint of the range due to modestly stronger Space & Defense sales than previously forecast.

The Airbus A320neo and Boeing 737MAX narrowbody programs are key growth drivers, as both contain higher constant content than the legacy programs they are replacing and as narrowbody build rates increase. Our production continues to be based on the Airbus A350 ramping to 10 planes per month by the end of 2018 and the Boeing 787 moving to 14 planes per month early in 2019.

Other Commercial Aerospace is growing strongly year-over-year, as forecast. Key defense programs, such as the JSF and V-22 were strong, and general growth in defense markets across multiple programs is more than overcoming the announced Airbus A400M rate reductions. As previously forecast, wind energy sales are up double-digits, and we expect continued strength for the rest of the year.

For 2018, we expect EPS of $2.96 to $3.10, with an effective underlying tax rate of 25% for each of the remaining quarters in 2018. We continue to forecast capital expenditures in the range of $170 million to $190 million. Free cash flow is forecast to be greater than $230 million. I would also like to reiterate that we anticipate returning greater than 50% of our net income to shareholders through dividends and stock buyback.

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.

We have posted solid financial results for the first half of the year, and we remain confident for the remainder of the year to reaffirm our financial guidance. Our markets remain strong, and we continue to innovate and execute operationally. The transition from an investment cycle to a cash-generating cycle is clear. Our disciplined capital deployment priorities remain unchanged, and we are delivering on our commitments to our shareholders.

With that, Sabrina, we'll now take questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question will come from the line of Sheila Kahyaoglu with Jefferies.

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Sheila Karin Kahyaoglu, Jefferies LLC, Research Division - Equity Analyst [2]

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Just on coming out of Farnborough, just a lot of press surrounding the NMA. Can you maybe elaborate on potential material for the fuselage and wing and your thoughts for the investment case for composites and just applications as it regards Hexcel?

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

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Thanks for the question, Sheila. Lots of excitement at Farnborough with -- from what we perceive as orders exceeding expectations. Obviously, lots of moving parts on the NMA and lots of articles, some questioning the market size, some questioning the design configuration. I'm not going to take a position to predict what direction Boeing will ultimately take to position the aircraft. What I can say is we continue to work with our customers, Boeing included, providing materials and solutions, next-generation solutions for primary structures, for secondary structures, engines and the cells. And again, we remain confident, if and when a new plane is launched, we will get more than our fair share, and it will be more composite-intensive than the legacy aircrafts that are flying today.

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Sheila Karin Kahyaoglu, Jefferies LLC, Research Division - Equity Analyst [4]

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I asked Patrick, but I thought I'd try you, Nick, on the line. And then in terms of aerospace, can you just elaborate on what's going on in the other aerospace subdivision a little bit more with regards to regionals and biz jet?

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

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Well, again, the business jet market has been very robust as we saw last quarter, and this quarter was no different. Bombardier, Dassault, Gulfstream, very strong, specifically the G600, G500, and the Global 7000, those were probably the 3 biggest drivers, but I have to say it was pretty strong across the entire segment.

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Operator [6]

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And the next question will come from the line of Krishna Sinha with Vertical Research Partners.

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Krishna Sinha, Vertical Research Partners, LLC - Analyst [7]

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So can -- you talked a little bit about the material input costs rising in your long-term agreements. Can you just talk a little bit about the expected margin headwind from that and how the pricing recovery works under your long-term contracts?

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Patrick Joseph Winterlich, Hexcel Corporation - Executive VP & CFO [8]

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Okay. So Krishna, yes, we've got the headwinds I mentioned. So I guess just picking up your last point there. The wind energy resin is sort of directly related to the actions taken by the Chinese authorities. It has been called out by some other sort of blade manufacturers. It caused a tightness in the supply chain for these resins, which has sort of put pressure on the prices here, which is impacting us. We do have indices in our contracts. And so as we sort of move towards the end of this year and into '19, we will recover those movements, but it is a headwind this year. I mean, if you think the wind energy is 5% of our total sales, I don't want to overplay the headwinds, but there is some headwind for us. The other headwinds we're seeing, as I mentioned, oil, and I know I've said this to a lot of you before, we buy acrylonitrile related to a polypropylene formula, which is sort of driven by oil price movements. That's moved it up. It's right at the front end of our supply chain. And in the scheme of things, it's not enormous for Hexcel, but we are seeing some marginal headwind there. Within our commercial contracts, we do have protection if we see wild swings in oil price movements. So if that were to happen, we would be able to pass some of that impact through. The other thing I guess I would also call out just for completeness is around tariffs. At the current time, we see a tariff impact on an annual basis of about $2 million to $3 million. Now obviously, that could change depending on where things move on the tariff front, but that will impact the second half of 2018. That's related for material we're bringing in from China and to some of our aluminum supplies.

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Krishna Sinha, Vertical Research Partners, LLC - Analyst [9]

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That's great. And just one more follow-up on the Roussillon plant. You've talked about that being instrumental in sort of the A350 ramp. But you've also talked about other programs, like narrowbodies and the Joint Strike Fighter going into that plant. Can you give us a time line on when you expect that plant to hit full aero capacity utilization?

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Patrick Joseph Winterlich, Hexcel Corporation - Executive VP & CFO [10]

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So that plant should be running on aerospace qualification really from the beginning of 2019. As I think I called out, we see it as sort of cost neutral as it goes through the aerospace qualification. It's making material but going through the qualification in the second half of this year. What I would say is that plant will be primarily focused towards the A350, making the carbon fiber for that program, a little bit for, say, blade programs. Just to sort of reaffirm, on the narrowbodies, most of the material going on to those planes is engineered core and honeycomb, so separate from our carbon fiber facilities.

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Operator [11]

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The next question will come from the line of Richard Safran with Buckingham Research.

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Richard Tobie Safran, The Buckingham Research Group Incorporated - Research Analyst [12]

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Nick, first off, I wanted a follow-up about your comments about narrowbody rates. To the best you can, because I recognize you're not going to get out in front of your customer, would you be willing to comment on where you are with OEM discussions on higher rates? And by that I mean, is this something where you're still just supporting study efforts, or are there discussions about contracting for higher rates? And finally, from your opening remarks, do I take it -- I think I should take it that Hexcel's current capacity and the new capacity you're investing in actually covers, for example, what Airbus has been talking about, that rate 70, as well as the potential for higher rates on the MAX?

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

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So I'll take those. Starting with the narrowbody. Obviously, whether or not the narrowbody rates go higher than what have already been communicated will be a function of positioning in the market space, which I know you recognize that both Airbus and Boeing are trying to position their platforms to get more than their share of the growth. It will have to do with the backlogs, which continue to be strong, and the order intake continues to be strong. And then it'll have to do with the supply chain readiness. So I can say, we have been asked to look at various studies. We've done that. We continue to do that. I would also again remind you, and Patrick mentioned it, but remember, the neo -- the A320neo and the 737MAX are, in essence, metal airplanes. They're legacy airplanes with new engines and new nacelles, and the majority of our content are on the engines and nacelles, which is driving our capacity requirements. And I would tell you, that type of product coming out of Hexcel has a much lower capital intensity level and we can put it in place very quickly. So we do not worry about rates that you brought up in the order of 70. We could be well positioned for that when the OEs need it.

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Richard Tobie Safran, The Buckingham Research Group Incorporated - Research Analyst [14]

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Okay. Now Patrick, I heard your remarks about wind for the rest of 2018, and I know you're not going to be issuing a 2019 guide on this call. But I did think that you might comment generally directionally about wind in '19. Wind has been pretty strong thus far. You're guiding to continued strength for the rest of the year. So I thought maybe you'd comment on what -- how you think that might look in '19. And also, if you could comment on the adoption rate for these new blades, just wanted to know if they're still tracking to plan.

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Patrick Joseph Winterlich, Hexcel Corporation - Executive VP & CFO [15]

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Yes. Sure. I mean, as I called out, 2018 is doing exactly what we expect it to. We forecast it to be above the 2016 rates, which is obviously a substantial double-digit step-up from 2017, so we're very pleased to see that and very confident through the rest of the year. And what I would say is based on the backlog of our key customer, Vestas, we're confident at this point for 2019, without getting into the specifics. So yes, as we look out for the sort of 18-month period, we're feeling pretty strong right now. And in terms of adoption, as I say, I mean the backlog at Vestas is at record levels, so I have to believe the market is liking the new products that contain our materials. So again, that helps us to be positive.

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Operator [16]

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And the next question comes from the line of David Strauss with Barclays.

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David Egon Strauss, UBS Investment Bank, Research Division - Former MD & Senior Research Analyst [17]

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Wanted to ask about your guidance for Space & Defense. In the first quarter, you had a very good quarter. Second quarter, you're still showing some growth. I think the forecast for the full year had been flat. Are you now ready to move off of that halfway through the year?

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Nick L. Stanage, Hexcel Corporation - Chairman of the Board, President & CEO [18]

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Yes. I think we've seen the A400M come down. It didn't come down in the first quarter the way we expected. The second quarter, it's getting more aligned. And as you see, our second quarter growth was much lower than the first quarter. So given the performance today, David, clearly, we think we'll be in the low single digit growth for 2018 versus our original guidance of stable or flat.

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David Egon Strauss, UBS Investment Bank, Research Division - Former MD & Senior Research Analyst [19]

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Okay. Wanted to ask about A330. So you have a fair -- a significant amount of content on A330. Airbus has moved that or is in the process of moving that down from 60, 65 a year down closer to 50. How does that -- is that impacting you yet? Is that more 2019? And how does that impact your longer-term 6% to 9% guidance for commercial?

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

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Yes. So A330, obviously, there's a lot written about A330neo orders and positioning of that aircraft. We had the step-down build into our forecast, and it doesn't change our long-term forecast of 6% to 9%, David.

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David Egon Strauss, UBS Investment Bank, Research Division - Former MD & Senior Research Analyst [21]

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Where are you today on that, Nick, on A330?

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Patrick Joseph Winterlich, Hexcel Corporation - Executive VP & CFO [22]

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We're in pretty low rates at the moment, to be honest, David. It's not a significant program for us now. Obviously, it's going to ramp through '19 and '20. But on the neo, which is I think is what you're asking about, we're still at a pretty low rate.

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Operator [23]

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And the next question comes from the line of Mike Sison with KeyBanc.

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Michael Joseph Sison, KeyBanc Capital Markets Inc., Research Division - MD & Equity Research Analyst [24]

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Nick, you'd mentioned that you feel good about getting your fair share in potential new launches. Can you maybe talk about, on a technology basis, what's giving you an edge versus the competition? Are you coming up with new carbon fiber grades, resin structures? And what characteristics do you think the OEMs are really looking for in newer composites? Strength, lighter weight, manufacturing costs? Maybe just give us a quick thought there.

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Nick L. Stanage, Hexcel Corporation - Chairman of the Board, President & CEO [25]

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Yes. So I think the primary factor that gives me confidence is the breadth of our portfolio. To your point on coming up with new fiber grades that are more productive, more efficient for the applications, we're working those. Working material solutions that require out of autoclave or quick cure cycles to enhance processing, we're working those. Looking at engineered core and engine in nacelle and fab blade materials, we're working at next-generation materials that give us confidence that we'll retain positions we have and we'll win incremental business going forward. And then in the parts business, we continue to look at areas where it's high-value, complex, where we provide a value to the marketplace. So I think it's our portfolio. I think it's our positions with customers. And again, it's offering and developing multiple solutions, so that regardless which direction the customer ultimately decides to go, we're in a great position to get a portion of that business.

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Michael Joseph Sison, KeyBanc Capital Markets Inc., Research Division - MD & Equity Research Analyst [26]

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Great. And then you mentioned that there's some supply constraints in the commercial aerospace kind of supply chain, and you haven't been affected. Any particular reason that you haven't been asked to delay shipments? And is that normal that you -- that the carbon fiber composite tends to stay on track despite other areas of constraints?

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Nick L. Stanage, Hexcel Corporation - Chairman of the Board, President & CEO [27]

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Well, I think it's a function of our customers' confidence in being able to catch up. So as you know, and it's been well-publicized, that there are finished airplanes sitting without engines. And obviously, our materials are going into those airplanes, to some extent, and our materials are going into those engines. So I think the engine manufacturers have done a great job. And my sense is that they're on the recovery path to catch up and get on schedule. So I think it's a look at the entire supply chain, and the fact that the OEs understand, to reduce volumes, increase volumes, reduce some and to whipsaw the supply chain is not good for anyone.

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Operator [28]

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The next question will come from the line of John McNulty with BMO Capital Markets.

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John Patrick McNulty, BMO Capital Markets Equity Research - Analyst [29]

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With regard to the Roussillon facility, can -- it sounds like things are kind of going as expected in terms of the costs, the ramp-up and such, and it becomes kind of a neutral in the second half of the year, if I understood that. What was the headwind in the first half? And then I guess how should we think about that reversing as we look at 2019?

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Patrick Joseph Winterlich, Hexcel Corporation - Executive VP & CFO [30]

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Yes. So the headwind for each of the first 2 quarters was $2.5 million, so $5 million in total for the first half of 2018. And effectively, we're going to cover the cost in overhead in the second half, and then we should be running sort of standard margins, good carbon fiber margins through that plant in 2019. So that $5 million headwind essentially that we've had in 2018 should not be there in 2019, in simple terms.

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John Patrick McNulty, BMO Capital Markets Equity Research - Analyst [31]

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Got it. Okay. And then I guess, so when I think about the margin pressure that you saw a little bit year-over-year in 2Q, this obviously looks like it's part of it. I guess how would you bucket out the rest of it, whether it's raw materials or look, I mean, in some cases, I guess the wind power business has slightly lower margins, so it could be mix as well. I guess, how should we think about that and modeling out the margins as we look forward?

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Patrick Joseph Winterlich, Hexcel Corporation - Executive VP & CFO [32]

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Yes. I mean the headwinds, as we've called out, Roussillon headwind, depreciation step-up, with a headwind. FX against our guidance is a headwind. In the second half of the year, I mentioned the tariffs. The wind energy, resin costs, a relatively small part of our business, but there's some marginal headwind there. And then as I said, we've had some marginal, again, I don't want to overplay it, but some marginal headwind on acrylonitrile for our carbon fiber business. So those have been the headwinds year-on-year that we've called out.

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John Patrick McNulty, BMO Capital Markets Equity Research - Analyst [33]

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Got it. Is there a negative mix with wind being as strong as it is, or is the incremental margin there maybe bigger than what we (inaudible)?

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

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There's a small dilution, John. I mean, obviously, as wind grows at a lower margin, but I have to say a good return on invested capital, but at a lower margin, that -- because it's only 5% of sales of the total company, the dilution is there, but it's relatively small.

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Operator [35]

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And the next question comes from the line of Ron Epstein with Bank of America.

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Ronald Jay Epstein, BofA Merrill Lynch, Research Division - Industry Analyst [36]

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At Farnborough, you discussed a little bit thermoplastics and what you could do there. I was wondering if you could kind of maybe give us some more color on where thermoplastics could be an opportunity for you guys on future generation airplanes. So when we think about 797 or A322, where are opportunities for substitution for thermoplastics that are metallics today?

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Nick L. Stanage, Hexcel Corporation - Chairman of the Board, President & CEO [37]

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Yes, Ron. So thermoplastics, we're excited about thermoplastics from a couple of aspects. And you've obviously seen our acquisition of Oxford Performance Material, which is additive manufacturing using a thermoplastic PEKK system with carbon filled, which we're discussing with our customers. We're getting a lot of pull for new applications, new opportunities. That's one aspect. The other one, as you probably also recall, our announcement in collaboration with Arkema. Arkema is a world leader in the manufacture of PEKK, which is a thermoplastic resin system that we are partnering with to develop prepreg solutions that can go into next-generation aircraft. So the advantages of thermoplastics, they can offer faster out of autoplate manufacture for certain types of parts. I'm not a believer it will take over all aircraft components or all composite materials, but there is a niche where it will become very attractive for clips, brackets, smaller parts. Parts that possibly the customers may want to consider welding, in situ welding, where you're prevented to do that with epoxy resin systems, you can do that with thermoplastic solutions. So we're really excited about the next generation. Again, it's going to be a relatively slow adoption. But given our portfolio, we want to make sure that's part of it so that we have a full offering to support those new programs and customers.

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Ronald Jay Epstein, BofA Merrill Lynch, Research Division - Industry Analyst [38]

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Okay. And maybe just some -- 1 or 2 more follow-ons along that same vein. What do you think about ceramic matrix composites? Is that an area you guys would want to go? I mean, the products you make now are used in the big blades of engines. Ceramic matrix would be, I don't know what you would call it, the little blades of engines? I mean, any desire to go that direction?

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

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Well, first thing you have to recognize is that CMCs, the manufacturing process, it's really quite different. So there's very little synergy with respect to factories or technologies. Now we always love advanced materials and material solutions space, so I'm not going to say it's of no interest, but it really does not fit today into our manufacturing footprint or product offering.

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Ronald Jay Epstein, BofA Merrill Lynch, Research Division - Industry Analyst [40]

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Got you. And then just maybe one last question. We were talking with a large metallic materials company recently, and they suggested that they would like to move into non-metallics, right? So I mean how do you think about your -- I mean this is a big, big question, but how do you think about your competitive environment in that? Do you worry about others trying to come in and eat your lunch, be it that the materials that you have right now are really kind of desirable? I mean, it seems like that's what the industry is going for the most part, right? I mean, how do you defend yourself?

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Nick L. Stanage, Hexcel Corporation - Chairman of the Board, President & CEO [41]

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Well, I think if you look at carbon fiber composite solutions, they stand on their own. They're lighter. I don't care how you cut it, between any kind of aluminum, the density factor is lighter, so you always have a weight advantage. The corrosion resistance is superior. Crack propagation and micro cracking is nonexistent. So as the composite technology continues to evolve from a manufacturing standpoint, from a processing standpoint, as our customers become more familiar with it, they're becoming more productive. And I think the composite material, it's hard to say you want to go back to something that's heavier versus a lighter solution.

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Ronald Jay Epstein, BofA Merrill Lynch, Research Division - Industry Analyst [42]

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Yes. I understand that. I think we all do. But just the metallics guys actually getting into your market, doing non-metallics. Meaning they see the writing on the wall, right? I mean, nobody is going to want to go backwards, right? So do you worry about an Allegheny or a PCC or whoever trying to do more non-metallics as the industry moves away from metallics?

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Nick L. Stanage, Hexcel Corporation - Chairman of the Board, President & CEO [43]

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I think if you look at or if you've ever been in our Salt Lake City site and you look at our technology and the barriers to entry, I'm not going to say they can't do it. I'm not going to say it would take them too long. But I can assure you that the reason there's only very few players in the world that do this is because of the intellectual property, and we're very protective of that. We're not giving that away. They would have to gain that. They would have to ramp up. They would have to prove it. That is many, many years down the road. And to answer your question, I don't worry about that specifically.

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Operator [44]

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And the next question will come from the line of Chris Kapsch with Loop Capital Markets.

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Christopher John Kapsch, Loop Capital Markets LLC, Research Division - MD [45]

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You had a little commentary on regional jets. But my question, one of my questions was around the alliances between Airbus and Boeing with Bombardier and Embraer, respectively. Traditionally, those jets have been sort of, in terms of composite content, have been sort of under penetrated by the composites industry. I'm just wondering if, given these new alliances, if that portends, over time, the adoption of greater material on those platforms, how do you see that developing over time. And over what time period do you think something like increased content on those platforms could materialize?

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

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Yes, Chris. So you're right. There's less secular penetration in those markets. But I would tell you, it's been growing. We have very good position in the business jet market, and that includes positions with Embraer, which as you know, Boeing will take advantage and help drive new solutions, more rates, and hopefully, more composite penetration to make the aircraft more competitive. Similarly, we've got a great relationship and position with Airbus, and we're optimistic about the combination with Bombardier and look forward to even more opportunities at Bombardier throughout their business jet platforms and the C series.

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Christopher John Kapsch, Loop Capital Markets LLC, Research Division - MD [47]

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Okay. Got it. And then if I -- different subject. Maybe, Nick, you could just sort of update your strategic thinking on the role of carbon fiber composites in the auto industry and how you may address that longer-term opportunity in terms of either a technology play, maybe moving into that in a bigger way, if you think it's an exciting opportunity longer term.

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

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So I have always said that automotive is an opportunity for us. I like the space as long as we treat it appropriately for Hexcel, and that is, we're looking at the applications that are sustainable, that are growth platforms and not getting into the commodity space. So clearly, we are focusing on advancing our material solutions to make them more productive, so that adoption can be increased. That will happen over time. We've seen nice quarter-over-quarter growth in our automotive space. We're working on multiple new programs to position ourselves. But again, there are differentiated positions in special areas, similar to what we did with BMW for their roofs, for their B-pillars, working with Lamborghini. And it tends to be on the high-end vehicles that really drive those sustainable opportunities. So we're investing in it. I'm excited about it. It'll continue to grow. Having said that, it's not going to, in the near term, change the make-up of Hexcel and drive the business wildly over to the industrial or automotive side as a percentage of sales.

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Christopher John Kapsch, Loop Capital Markets LLC, Research Division - MD [49]

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Right. Makes sense. And then just one follow-up on the qualification and ramp of the facility in France. As you're in qualification mode and presumably producing fiber, are you currently -- I assume you're selling that currently into industrial markets. So the question is, did that contribute materially to the growth in the industrial segment and/or was presumably adverse mix associated with those sales? Did that affect -- was that contemplated in that $5 million headwind that you called out in the first half of '18?

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Nick L. Stanage, Hexcel Corporation - Chairman of the Board, President & CEO [50]

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Yes. So as you mentioned, as we qualify and as we're running the lines, as you know, we have a wide portfolio of fibers we offer to various customers. So that material is used to sell into industrial markets or other markets. The qualification effort underway, as you can imagine, qualifying for the A350, qualifying for LEAP fan blades, there is numerous product forms that we have to get it qualified on, and it just takes time for us to proceed through that. But in essence, our goal is to virtually scrap 0 amount of that fiber and feed it into the market. So that planning and those forecasts were all rolled up into our headwind that Patrick summarized earlier.

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Operator [51]

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And the next question will come from the line of Noah Poponak with Goldman Sachs.

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Noah Poponak, Goldman Sachs Group Inc., Research Division - Equity Analyst [52]

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Patrick, what's the right long-term incremental margin contract now? You've had the 25% for a while. Obviously, the first half wasn't there with some of the new moving pieces. And I guess, on the one hand, you had those moving pieces. On the other hand, I guess maybe you could keep having step-ups in depreciation given what's happened with CapEx. So just curious for your latest thoughts on the moving pieces and the kind of 2- to 3-year view on your operating leverage opportunity.

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Patrick Joseph Winterlich, Hexcel Corporation - Executive VP & CFO [53]

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Yes, Noah. I mean the way we look at it, we're always looking to drive our margins through productivity and yield and efficiency improvements. And as you know, over the last several years, we've moved our operating income up from sort of 11%, 12% up to 17%, 18%, so we've seen significant improvement through the period. And we're going to continue to keep trying to push that and grow that over time through the normal initiatives, working with our customers, driving our lines faster, and continuing to push our gross margin and our operating income up. So we believe we've got revenue growth ahead that will allow us to drive that, and so we're going to continue to push.

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Noah Poponak, Goldman Sachs Group Inc., Research Division - Equity Analyst [54]

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Are you still committed to the 25%?

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Patrick Joseph Winterlich, Hexcel Corporation - Executive VP & CFO [55]

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As I've said, we're going to continue to drive our margins. We've pushed them over the years from 11%, 12% to 17%, 18%, and that's what we're going to continue to do.

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Noah Poponak, Goldman Sachs Group Inc., Research Division - Equity Analyst [56]

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Okay. So should I interpret that as you are no longer specifically targeting 25% as a specific number?

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Nick L. Stanage, Hexcel Corporation - Chairman of the Board, President & CEO [57]

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I would say we're not going to communicate a number, but we're pushing our gross margins, our op income margins and our incremental leverage. Basically, our sales -- we view translating that, basically, we start with 100% right down through the plant. So it's why we're very stingy on when we need to add people or new plants. We try to leverage that top line through the bottom line. So really, to talk about a number as we're going through this growth curve, we really don't want to put that out there. But I can assure you, we're not limiting ourselves to a 25% number.

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Noah Poponak, Goldman Sachs Group Inc., Research Division - Equity Analyst [58]

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Okay. Got it. And then, Patrick, on the tax rate, I was not entirely clear, I guess, because the press release pointed to the second half number. I guess maybe it would be -- maybe it's cleaner in my brain if you just could tell me the new full year number versus the old full year number in the guidance for the tax rate.

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Patrick Joseph Winterlich, Hexcel Corporation - Executive VP & CFO [59]

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Well, I'm not going to tell you that number as such because we don't sort of redo our guidance. But what I would say, you've got the rate for the first 6 months, that average. For the second 6 months, use 25%. And you can do the math. So that's clearly going to come in as an average under 25%. But the basis for the second half is still 25%, but the average for the year will be lower than that now because of where we have -- what we've seen in the first half.

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Noah Poponak, Goldman Sachs Group Inc., Research Division - Equity Analyst [60]

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Got it. Okay. And one final one. On A350, it seems like it's the case that you are pretty close to 10 a month, and I guess it's not clear where Airbus plans to go with the rate, if anywhere else. And I know you've said in the past that if it were sort of 1 unit a month higher, you could fit that through, but if it were 2, 3, 4, you would need to invest for that. Is that something you could just turn on pretty quickly once they make the decision? Or I guess, how do you plan the business around, I don't know how much visibility there is into that happening?

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Nick L. Stanage, Hexcel Corporation - Chairman of the Board, President & CEO [61]

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So we talk with Airbus and our customers frequently and they give us insight into what they're thinking. So to your point, if they were to increase one, we have to have some capacity in our supply chain, given that we have sole-source positions. So you have to be at least a little bit long to handle surge capacity. We could manage that. If they went up 3 or 4, they're not going to do that in a 12-month period. It would be over a period of time. And we would compare that to our existing capital and capacity planning. We would compare it to our productivity improvements, which we're working aggressively on to get more throughput through the existing assets. And at that point in time, we evaluate if and when we need to invest in more high cost capital required for fiber.

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Operator [62]

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And as a reminder, this conference will end at 11:00 Eastern Time. Our next question will come from the line of Robert Spingarn with Crédit Suisse.

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Robert Michael Spingarn, Crédit Suisse AG, Research Division - Aerospace and Defense Analyst [63]

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Not to belabor the incremental margin question. But Nick, you just said you don't want to limit yourself to 25%. So does that imply that you're going to get -- go higher, or when at least will you hit 25% again?

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Nick L. Stanage, Hexcel Corporation - Chairman of the Board, President & CEO [64]

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So again, we are not reiterating any number. My point was, we're not limiting ourselves. We continue to leverage our business, leverage our spending, making sure we invest in the appropriate R&T going forward. Clearly, there's lumpiness, as you've seen historically over the years, and as we ramp up these new plants. So as the plants fill up, both Roussillon and Morocco, as the volume continues to grow, we'll balance that against the capital investments. And basically, our guidance is we're going to push margins as hard as we can, while positioning the business to grow as fast profitably as it can.

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Robert Michael Spingarn, Crédit Suisse AG, Research Division - Aerospace and Defense Analyst [65]

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Yes. And I just wonder how that all balances with the fact that both A350 and 787 will hit rate in the next 12 months, let's say, and then those lines will be relatively flat if they don't raise rates beyond, as was just suggested might happen with A350. In which case, do you then have the growth to leverage the incrementals once you've done all this work, at least in that business?

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Nick L. Stanage, Hexcel Corporation - Chairman of the Board, President & CEO [66]

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Your summary is spot on. Now that doesn't include an NMA getting launched and requiring potential investment down the road or new engine derivatives and applications coming along or new wing replacements. So there's a lot of moving parts. If you just look at the market today based on what's been communicated, to your point, if the A350 hits rate and the 787 hits rate, then it's really about narrowbodies, and new derivatives and new platforms going forward.

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Robert Michael Spingarn, Crédit Suisse AG, Research Division - Aerospace and Defense Analyst [67]

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Right. Okay. And then on the other side of the margin question. On SG&A, you've done well there, percentage of sales, particularly in this quarter. Patrick, is that sustainable? Is this the way to think about overhead going forward?

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Patrick Joseph Winterlich, Hexcel Corporation - Executive VP & CFO [68]

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I mean, it's going to be occasionally a little bit lumpy, but we're certainly going to do -- and I think you will see us leverage SG&A over time continually, yes. As our revenue grows, we will manage our SG&A costs, and you should see good leverage in that space. So a little bit lumpy. I'm not going to say every quarter is going to be the same, but we should be able to do that, yes.

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Robert Michael Spingarn, Crédit Suisse AG, Research Division - Aerospace and Defense Analyst [69]

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Okay. And then just lastly, on capital deployment. Obviously, the dividend's up; the buyback, very strong. You've already hit your target, I believe, for the year on capital deployment. So how do we think about this going forward?

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Nick L. Stanage, Hexcel Corporation - Chairman of the Board, President & CEO [70]

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So I would clarify, we never gave a target on capital deployment other than balancing our 3 priorities, so -- which we continue to do constantly, looking at new opportunities, new applications, looking at M&A, bolt-on, acquisition opportunities to enhance our portfolio or market positions, and then return to shareholders through buyback and/or dividends and/or both. So...

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Robert Michael Spingarn, Crédit Suisse AG, Research Division - Aerospace and Defense Analyst [71]

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Well, I guess I should focus it on the latter there, the return to shareholders, you've already -- maybe you didn't have a target there, but I believe you're at least ahead of where you've been traditionally.

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Patrick Joseph Winterlich, Hexcel Corporation - Executive VP & CFO [72]

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Yes. So obviously, this year, we're probably going to comfortably exceed our -- what we formerly called out last year to return greater than 50% of net income. That was our target. We said we were going to deliver more than 50%. We didn't tie ourselves down, so yes, we're doing well so far.

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Robert Michael Spingarn, Crédit Suisse AG, Research Division - Aerospace and Defense Analyst [73]

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Is Q2 a harbinger of things to come with the things like the buyback?

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Nick L. Stanage, Hexcel Corporation - Chairman of the Board, President & CEO [74]

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Again, I appreciate you testing us, but we've always said we're not going to provide any guidance on how we forecast or plan. And really, it's as simple as, we truly make this a -- every part of our everyday business in evaluating the opportunities and looking at how we optimize our capital. So we're not going to get ahead of ourselves. We'll always report it at quarter-end after the fact, and just that's what we have to do to maintain flexibility going forward.

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Operator [75]

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Thank you. This does conclude today's question-and-answer session. Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may all disconnect. Everyone, have a great day.