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Edited Transcript of MOG.A earnings conference call or presentation 1-Nov-19 2:00pm GMT

Q4 2019 Moog Inc Earnings Call

EAST AURORA Nov 15, 2019 (Thomson StreetEvents) -- Edited Transcript of Moog Inc earnings conference call or presentation Friday, November 1, 2019 at 2:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Ann Marie Luhr

Moog Inc. - Head of IR

* Donald R. Fishback

Moog Inc. - VP, CFO & Director

* John R. Scannell

Moog Inc. - Chairman & CEO

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Conference Call Participants

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* Cai von Rumohr

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

* George Anthony Bancroft

Morgan Group Holding Co. - Research Analyst

* Kristine Tan Liwag

BofA Merrill Lynch, Research Division - VP

* Michael Frank Ciarmoli

SunTrust Robinson Humphrey, Inc., Research Division - Research Analyst

* Robert Michael Spingarn

Crédit Suisse AG, Research Division - Aerospace and Defense Analyst

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Presentation

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Operator [1]

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Good day, and welcome to the Moog Fourth Quarter and Year-end Earnings Conference Call. Today's conference is being recorded. At this time, I'd like to turn the conference over to Ms. Ann Luhr. Please go ahead.

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Ann Marie Luhr, Moog Inc. - Head of IR [2]

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Good morning. Before we begin, we call your attention to the fact that we may make forward-looking statements during the course of this conference call. Forward-looking statements are not guarantees of our future performance and are subject to risks, uncertainties and other factors that could cause actual performance to differ materially from such statements. A description of these risks, uncertainties and other factors is contained in our news release of November 1, 2019, our most recent Form 8-K filed on November 1, 2019, and in certain of our other public filings with the SEC.

We've provided some financial schedules to help our listeners better follow along with the prepared comments. For those of you who do not already have the document, a copy of today's financial presentation is available on our webcast page at www.moog.com. John?

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John R. Scannell, Moog Inc. - Chairman & CEO [3]

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Thanks, Ann. Good morning. Thanks for joining us. This morning, we'll report on the fourth quarter of fiscal '19 and reflect on our performance for the full year. We'll also provide our initial guidance for fiscal '20.

As usual, I'll start with the headlines for the quarter. First, we had several noteworthy events for our flight control systems at our key customers, including the first deliveries on both the Embraer E195-E2 and the Gulfstream G600 as well as the first flight of the Boeing MQ-25.

Second, it was another good quarter for our operations, with sales up 9% and earnings per share of $1.31 at the higher end of our guidance.

And third, cash flow was soft as we continue to grow, invest in CapEx and acquire buffer inventory to safeguard our customer deliveries.

Looking back over all of fiscal '19, the following headlines stand out: first, it was a record year for our business in terms of sales and earnings per share. Over the last 2 years, our business has grown 16% organically after several years of flat sales.

Second, our defense portfolio was very strong this year, with growth across all major programs and continued investment in the platforms of tomorrow.

Third, it was a busy year for the acquisitions that didn't happen. We continue to look actively while remaining disciplined in terms of pricing and fit. Our focus is on good growth, rather than growth at any cost.

Fourth, we suffered a supplier quality issue early in the year in our Aircraft business. This taught us that some of our operational processes were not as robust as they need to be. And as a result, we began a multiyear investment program to upgrade our processes to what we're now calling operations 2.0.

And finally, we're providing a first look at fiscal '20 today. We're projecting sales of $3 billion, up 4% and 40 basis points of operating margin expansion, including a significant recovery in our Aircraft margins. Despite the headwind of a higher tax rate, our earnings per share will be up 9% to $5.55, plus or minus $0.20.

Overall, fiscal '19 was a good year for our company. As always, it played out a little different from what we anticipated going into the year, but our diversity across end markets helped us meet our goals.

As I do at this time each year, I'd like to express my thanks for the dedication and commitment of our 13,000 employees around the world who made all this happen.

Now let me provide some details on the quarter. Sales in the fourth quarter of $765 million were 9% higher than last year. Sales were up double digits in both Aircraft and Space and Defense, while sales in Industrial Systems were slightly lower.

Taking a look at the P&L, our gross margin was down on an adverse mix in our Aircraft business and some onetime charges we took this quarter. R&D was also lower, as our spending in Aircraft continued to moderate.

SG&A expense was slightly higher as a percentage of sales on increased investments in new business development and some consulting expenses.

Interest expense was about flat with the year ago. Our effective tax rate in the quarter of 21.3% resulted in net earnings of $46 million and earnings per share of $1.31, up 15% from last year.

Fiscal '19 in total. For the full year sales of $2.9 billion were 7% higher than last year. The story for the year is similar to the story for the quarter, with sales up nicely in Aircraft, very strong in Space and Defense and moderately lower in Industrial Systems.

Foreign exchange headwinds reduced the sales growth by almost 100 basis points.

Operating margins were up slightly from fiscal '18, after adjusting for our exit from the wind business. Adjusted net earnings were up 9%, and adjusted earnings per share were up 12% on a lower share count. Free cash flow for the year was $63 million.

Looking out now to fiscal '20. For fiscal '20, we're projecting continued organic growth, with sales of $3 billion up 4% from fiscal '19. The sales growth is primarily driven by our Space and Defense group, with sales in Aircraft up marginally and Industrial sales flat. We're anticipating full year operating margins of 11.5%, up 40 basis points and earnings per share of $5.55, plus or minus $0.20.

Free cash flow will recover from fiscal '19 to a conversion ratio of 80% for the full year.

Now to the segments. I'd remind our listeners that we provided a 3-page supplemental data package posted on our website, which provides all the detailed numbers for your models. We suggest you follow this in parallel with the text.

Beginning with Aircraft. Sales in the fourth quarter of $342 million were up 12% from a year ago, driven by strong Commercial OEM results. Sales were up nicely on the 787 and A350 programs as well as on the E2 and various Gulfstream jets.

Sales into the Commercial aftermarket were down on lower A350 IP and slowing activity on some legacy programs.

On the Military side, OEM sales were up on increased V-22 and Blackhawk work as well as higher funded development activity.

Military aftermarket sales were slightly lower than last year, a result of lower sales on various legacy programs, partially compensated by higher F-35 sales.

Aircraft fiscal '19. Full year sales were up 9% from fiscal '18 to $1.3 billion. On the Commercial OEM side, strong sales on the 787, A350, E2 and Gulfstream business jets drove a 15% year-over-year increase. OEM sales on the 737 program were down $5 million from the -- for the year. Aftermarket sales were off 7%, mostly the result of lower A350 IP.

Military Aircraft was up 9% for the year, with growth on both our OEM platforms and in the aftermarkets. The F-35 program continued to ramp up production and sales were also higher on the V-22 and some foreign programs. Funded development of over $70 million in the year was in line with the prior year.

In the Military aftermarket, sales of the F-35 and the V-22 were up strongly, compensating for lower sales on some legacy programs.

Aircraft fiscal '20. We're projecting next year sales of $1.33 billion, up 2% from '19. We should see continued growth in our military markets, with the F-35 driving both OEM and aftermarket growth.

Across the broader Military OEM portfolio, we anticipate that helicopter programs will be down from a very strong fiscal '19, but funded development programs should be up on continued investment in next-generation platforms. In total, our Military Aircraft business will be up 7% in fiscal '20.

On the Commercial side, we're forecasting moderating sales at both Boeing and Airbus next year. 787 sales should be in line with fiscal '19, but we'll see a significant drop in 777 sales as that program continues to wind down. We're forecasting 737 sales more or less in line with this year.

And Airbus A350 sales should be lower as a result of some accelerated shipments in fiscal '19. We're also anticipating A380 sales will essentially drop to 0. E2 sales are forecast to double to almost $16 million, while business jet sales should be close to the level of this year.

We anticipate that the Commercial aftermarket will be up slightly as the A350 fleet slowly emerges from the warranty period.

Combining OEM and aftermarkets, our Commercial Aircraft business in total will be down 3% next year.

Aircraft margins. Margins in the quarter of 8.2% included 3 unusual items. We made additional investments in operations consulting, incurred some severance expense associated with continued reorganizations and took a charge associated with the termination of the A380 program.

Taken together, these items depressed margin by about 200 basis points over the quarter.

Margins for the year were 9.4%, down 150 basis points from fiscal '18. And as we've discussed in the past, the contraction was in the gross margin line as a result of operational challenges.

During the year, we responded to these challenges by launching our operations 2.0 program, which includes a new organizational structure, support from outside consulting and additional investments in capital expenditures.

As we look out to fiscal '20, margins will increase to 10.5% as the impact of our operational improvements take root, and our gross margin starts to recover.

Turning now to Space and Defense. Sales in the fourth quarter of $190 million were up 23% from last year. We enjoyed growth in both the Space and Defense markets. Space sales were up 13% on strong launch vehicle activity, increased funding for hypersonic applications and work on the GBSD program.

Defense sales were very strong, up almost 30% from last year. The growth was across the entire portfolio of defense markets, with particular strength in missiles, vehicles and electrical components used in a wide variety of applications.

Space and Defense fiscal '19 full year sales of $683 million were up 18% from last year. The strength was on the military side of the house, with sales up almost $100 million from fiscal '18. The biggest contributors to the growth were missiles, ground vehicles, naval applications and our general Components business.

Sales of our reconfigurable turret product were up $20 million over last year.

On the Space side, sales growth of 2% masked some significant shifts in the mix. Sales of our avionics products were lower this year after a very strong fiscal '18. Our NASA work was mixed, with SLS work down but Orion work up. Finally, we had strong funded development sales for various hypersonic applications.

Space and Defense fiscal '20. Our forecast for next year projects another year of strong growth. Total sales of $770 million will be up 13% from fiscal '19. After a fairly flat year in '19, Space should be up 16% next year on strong growth in avionics, additional NASA work as we seek to return to the moon by 2024 and continued growth in hypersonic systems.

On the Defense side, we should also see nice growth across our portfolio, led by vehicles, missiles and naval applications.

Space and Defense margins. Margins in the quarter of 13.7% were particularly strong on higher sales and the favorable mix. For all of fiscal '19, margins of 13% were also strong.

For fiscal '20, we're expecting margins in line with fiscal '19 at 13%.

Before leaving our Space and Defense group, I'd like to reflect on the recent performance of this business. In fiscal '17, our Space and Defense group had $530 million in sales. In fiscal '20, we're forecasting $770 million, a 46% increase over 3 years. Space is up over 35%, while Defense is up over 50% over this period and essentially, all organic.

Over the same time period, the group operating profit was doubled from $50 million to $100 million, and operating margins will expand over 350 basis points.

Growing defense budget in the U.S. has helped, of course, but our success has been grounded in a combination of years of investment and the dedication to serving our customers with outstanding quality and delivery. As a result, we've been a preferred supplier across the markets we serve, winning market share and benefiting disproportionately as our customers' businesses have ramped up.

Turning now to Industrial Systems. Sales in the fourth quarter of $234 million were 4% lower than last year. Adjusting for the [lost] sales associated with our exit from the wind pitch control business, sales were about even with last year. Strength in our medical markets across both pumps and components was offset by slightly lower sales in both industrial automation and simulation and test.

Sales into the energy markets were down slightly from last year, a combination of slightly higher exploration sales with lower sales of components into power-generating equipment.

Full year fiscal '19 sales for Industrial Systems of $918 million were 2% lower than last year, a result of weaker foreign currencies relative to the dollar.

Underlying real sales were flat year-over-year, though with some notable shifts in the mix. Energy was way down on the absence of wind energy sales, following our decision to exit that business in fiscal '18. Sales into industrial automation were stable as global capital investments continued through the year. Sales of medical products were up on strong growth in our enteral pumps product line.

Finally, sales into simulation and test applications were slightly lower. Included in this test and simulation market are sales of motion bases for entertainment systems. These tend to be very lumpy and unpredictable. Fiscal '18 was a strong year for entertainment sales, while fiscal '19 was a soft year.

Industrial Systems fiscal '20. We're projecting flat sales for next year. We anticipate continued growth in our medical applications and slightly stronger sales of flight simulation systems. We're forecasting energy sales would more or less be in line with fiscal '19. And finally, we're projecting industrial automation sales will be down 5% as global economies slow and capital investment spending contracts.

Industrial Systems margins. Margins in the quarter were 11.1%. Full year margins of 11.9% were up from last year as a result of our decision to exit the wind business. For fiscal '20, we're forecasting margins of 11.5%.

Summary guidance. Fiscal '19 was a good year for our company. Our plan for fiscal '20 builds on that base with full year sales of $3 billion, up 4% organically. The growth is led by our Space and Defense group, with strength in both markets.

Aircraft sales in total will be up marginally, with good growth on the Military side, but slightly lower sales in our Commercial book of business.

Industrial sales will be flat to fiscal '19 as growth in niche markets compensates for the slowing investment in industrial automation across the global economies.

Free cash flow conversion in fiscal '20 should recover to 80% of sales, as our growth in net working capital slows and our operational improvements starts to bear fruit.

We're forecasting earnings per share of $5.55, plus or minus $0.20, a 9% increase over fiscal '19.

As always, our forecast does not include any projection for future acquisitions or potential share buyback activity.

As with any forecast, there are both opportunities and risks in our plan. In fiscal '20, the major opportunity to do better lies in the pace of operational improvements in our Aircraft business, while the major operational risk is the potential slowdown in our industrial markets.

As we wrap up fiscal '19 and look to a new year, we believe it's helpful for our investors to look at our business through an end market lens. We're organized in 3 operating groups, but our business serves 5 major markets: defense; industrial, including energy; commercial; space; and medical.

Defense is our largest market, with almost 40% of our sales. 2 years ago, at the end of fiscal '17, I commented that we're coming out of a multiyear downturn in Defense spending, and we're optimistic that fiscal '18 might see increased budgets. Closing out fiscal '19, the defense market has performed better than we could have imagined, and we are set to see that strong performance continue this coming year.

We've seen growth in almost every defense market we serve from aircraft to missiles to ground vehicles. Through the multiyear downturn earlier in the decade, we continued to invest in our defense portfolio, a combination of R&D spending on new products such as our reconfigurable turret, and investments in operational improvements.

As we enter fiscal '20, we have a full book of new development programs for next-generation aircraft -- from next-generation aircraft to hypersonic missiles. Our present production programs combined with our strong development pipeline give us confidence that despite the ups and downs in defense budgets, we continue to prosper in the long term.

Industrial, including energy, is our second largest market, where we serve a wide range of applications across many niche markets. This is a global business and at a macro level, our fortunes tend to move with the capital investment cycle of the major world economies.

Coming into fiscal '19, we anticipated a good year, but worried about the impact of trade wars. The year played out pretty much as we expected, although the outlook for the major economies has weakened from a year ago. Uncertainty around tariffs and Brexit have added to the challenges of continued expansion late in the economic cycle. We're cautious about the outlook for the coming year, but remain optimistic that lower interest rates, a resolution of Brexit and the potential of a trade détente with China as we approach an election year in the U.S., could mitigate the potential slowdown in our business.

Commercial aircraft is just over 20% of our business. Fiscal '19 saw strong growth in our major OEM programs and a modest slowdown in the aftermarket. Our flagship programs, 787 and the A350, will continue to be strong in fiscal '20, while our legacy programs, particularly the 777, will slow.

We're anticipating the 737 MAX situation will resolve itself early in 2020 and production rates will be in line with Boeing's forecast. Our R&D expense in '20 will be down to sustaining levels, and we're not anticipating any major new development programs for the next couple of years.

Overall, the focus in this business remains on operational excellence and as execution improves, we'll see our margins expand over time.

The Space business is strong, driven by increased defense spending and NASA's plan to return to the moon. After a modest increase in '19, we're anticipating strong growth as we move into fiscal '20. Over the course of this coming year, our major investments will continue to be hypersonics and the GBSD program.

Finally, our medical market had another good year of growth in fiscal '19, and we believe that growth will continue this coming year. In particular, our pump products had a strong year as we captured share in the enteral market.

In summary, we continue to leverage our core controls technology successfully across diverse end markets, where we solve our customers' most challenging problems. Our strategy remains unchanged. We work to create value for our customers by tailoring our products to meet their specific needs. Customer intimacy is at our core, and we enjoy multigenerational relationships with most of our customers. When there's a problem, we always seek to do the right thing by our customer, sometimes at the expense of short-term financial results. We believe this is key to building a great company over time.

We have a laser focus on our core technologies at motion and fluid control, but a wide lens on end markets which can benefit from our capabilities.

We continue to be prudent stewards of our shareholders' capital by maintaining a strong balance sheet and a disciplined approach to capital allocation. We believe growth is a core element of long-term value creation and continue to pursue aggressively adjacent acquisitions. However, we remain disciplined in terms of pricing and strategic fit. As a result, we've walked away from many opportunities in the last year instead of overpaying.

With 3 corporate-wide internal initiatives around talent, lean and innovation, our innovation spending is focused around 3 key themes, which cut across all our major markets. And they are electrification, autonomy and connectivity.

In a year where we celebrated Moog's contribution to the 50th anniversary of the Apollo 11 moon landing in 1969, we're reminded of the very long-term nature of our business and the importance of continuing to invest for the future.

Finally, our culture of trust and collaboration remains the cornerstone of our business. As we look to fiscal '20, we're optimistic about our business. Next year, we anticipate sales of $3 billion and earnings per share of $5.55, plus or minus $0.20. As usual, we expect a somewhat slow start to the year, with the first quarter earnings per share of $1.30, plus or minus $0.10.

Now let me pass it to Don, who will provide more color on our cash flow and balance sheet.

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Donald R. Fishback, Moog Inc. - VP, CFO & Director [4]

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Thank you, John, and good morning. Free cash flow in the fourth quarter was $25 million and for all of 2019, it was $63 million, representing a conversion ratio of 35%.

Growth in our businesses explain most of the soft free cash flow performance in 2019. We've had to support our top line growth with a corresponding increase in net working capital, where every sales dollar has a corresponding investment of about $0.25 in inventories and receivables. And the increased demand for CapEx spending is noticeable.

As we've transitioned from a relatively stagnant period of top line growth from 2012 to 2017, to the more recent upward trend driven largely by the exposure to defense markets, the increased demand for capital in our businesses has been significant.

Isolating these effects, we would have expected our free cash flow conversion for all of 2019 to be in the 75% range. The rest of the story is the incremental growth in our physical inventories, some of which appears in unbilled receivables. Inventories have increased with a faster pace than our normal net working capital investments. This has been necessary to ensure we're supporting our customers' delivery demands while we're working through our operational process investments that John referenced.

With our current focus on upgrading our operations, we expect inventory turns to get slightly worse before they get better, with improvement starting in the latter part of 2020.

Despite the relatively soft 2019, our free cash flow conversion has averaged better than 100% from the period 2013 through 2019, while our top line revenues have grown 18% over the same period, and most of that coming in the last couple of years.

Our free cash flow conversion target remains 100% over time. For fiscal 2020, our free cash flow forecast is $155 million or a conversion ratio of 80%. We expect a soft start to free cash flow in the first half of 2020, but as our processes around inventory management strengthen, we expect a good finish to the year.

Our year-end net working capital, excluding cash and debt, as a percentage of sales was 27.9% compared with 24.9% a year ago, up 300 basis points. This largely reflects the growth in inventories that I've referenced.

The $63 million of free cash flow for the year compares with an increase in our net debt of $4 million. The difference is mostly explained by our quarterly dividend payments and share buyback activity. During the fiscal year, we repurchased 302,000 shares for $23 million, and there were 241,000 shares of which we acquired during our fourth quarter.

Capital expenditures in the fourth quarter were $27 million and depreciation and amortization totaled $21 million. For all of 2019, CapEx was $118 million, while D&A was $85 million.

Capital expenditures in 2020 will continue to be at the high end of our historical spending range or around $120 million, which is 4% of sales. We're engaged in various facility expansion projects, and we're investing in machinery and test equipment to improve our operational efficiencies. Our normal sustaining level of CapEx is between 3% and 4% of sales. Depreciation and amortization in 2020 is forecasted to be $86 million.

Cash contributions to our global retirement plans totaled $10 million in the fourth quarter, resulting in $37 million of contributions for all of 2019. This compares with contributions of $181 million in 2018, when we fully funded our U.S. DB pension plan.

For 2020, we're planning to make contributions into our global retirement plans totaling $37 million. Global retirement plan expense in 2019 was $65 million compared with $57 million in 2018. And in 2020, our expense for retirement plan is projected to be around $70 million, up from 2019, largely related to lower discount rates.

Our Q4 effective tax rate of 21.3% is down from last year's Q4 rate of 26.7%, reflecting the absence of last year's restructuring impacts, in addition to lower state tax accruals in the U.S. this year. For all of 2019, our effective tax rate was 23.1% compared with last year's 47.4%. When we remove the onetime effects of tax reform and wind restructuring that took place in 2018, our adjusted 2018 effective tax rate related to our core operations was 25.1%.

For 2020, we're forecasting our tax rate at 25.3%, up from 2019's rate of 23.1%. 2020's tax rate assumes lower U.S. foreign tax credit benefits, as the timed phasing of a provision in the 2017 tax law begins to negatively affect us, in addition to a less favorable mix of global earnings.

On October 15, 2019, so just a couple of weeks ago, our treasury team closed on the refinancing of our $1.1 billion revolving credit facility, extending the term through October 2024. We've got 13 committed partners in our facility, with competitive terms and conditions. And we have a $400 million accordion feature, providing us with the option to expand the facility.

The other major piece of our debt financing is our $300 million of 5.25% high-yield debt that matures in December of 2022.

Our leverage ratio, which is net debt divided by EBITDA, was 2.1x compared with 2.2x a year ago. With the recent modifications made during the October revolver refinancing, the revised leverage ratio would have been 2.0% (sic) [2.0x] at the end of the fiscal year as the definition has been modified to exclude letters of credit.

Net debt as a percentage of total capitalization was 35.9%, down from 37.6% last year. And at year-end, we had $670 million of available unused borrowing capacity under the terms of our updated revolver that includes an increase in permitted leverage.

Regarding capital deployment, today, we announced our quarterly cash dividend of $0.25 per share payable to our shareholders. We continue to look at strategic M&A targets, and we repurchase our shares opportunistically.

As we reflect back on 2019, we've been engaged in a lot of M&A activity, with not much to show for it. But we continue to exercise patience and discipline throughout our processes, looking for targets that fit well strategically, culturally and of course, financially.

We're excited to shift our focus to 2020 and beyond, continuing the trajectory of record sales and earnings per share. Sales will eclipse the $3 billion mark for the first time, up 4%. Our consolidated operating margins are forecasted to improve 40 basis points to 11.5%, with importantly, our Aircraft margins improving 110 basis points to 10.5%.

Free cash flow will be respectable for a growing business, with 80% conversion. And finally, our EPS will be up 9% to $5.55 a share.

It's worth pointing out that our 2020 EPS forecast reflects higher pension costs of about $5 million or roughly $0.10 a share. And our 2020 effective tax rate is forecasted to increase 220 basis points or about $0.15 per share, relative to 2019.

So with that, I'd like to turn it back to John, and we'll take any questions that you may have.

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John R. Scannell, Moog Inc. - Chairman & CEO [5]

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Thankfully. Thanks, Don. Stephanie, any questions? We'd be happy to take them in queue.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from Cai von Rumohr with Cowen.

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Cai von Rumohr, Cowen and Company, LLC, Research Division - MD & Senior Research Analyst [2]

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Yes. John, so maybe you could give us an update in terms of the work that consultants have been doing in your Aircraft area? Basically where are you? How long is it going to take to get this done? What recommendations have they made? And when can we expect to see the financial results of all of that?

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John R. Scannell, Moog Inc. - Chairman & CEO [3]

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So we engaged with our consultant friends in the second quarter. If you remember, at the end of the second quarter, we reported that we had that quality issue. And that was essentially what triggered us to say we got to take a step back here. Because granted, it was a quality issue with a particular supplier, but what it demonstrated to us was the operational processes that we had in place, which were working fine with [Moog], but were not robust enough to take into account a hiccup on the outside. And so you had the proverbial straw that broke the camel's back. So that was the process then that said we got to start upgrading those processes to the next level of sophistication.

We engaged with them in March, April. It's the usual type of process. There's a several months of review, then there's several months of laying out new processes. And then you get into pilot testing and from there, you get into systematic implementation across the company.

And so where we are right now, Cai, is that we've kind of gone through that diagnostic phase. We've gone through that testing phase. And now we're starting the work of actually pushing that out across the whole organization within the Aircraft business. And that will take, as Don reported, it will take probably before we start to see the impact on the financials and we start to see it on inventory turning down, probably the second half of 2020. And then into 2021 we should really see the benefits coming through.

But once you get into a situation where you've got these types of challenges, it just takes quite a bit of time to dig your way out of them. And it's a lot of hard work, a lot of focus, but that's where we are right now. And so we are starting to see the internal benefits, we're definitely seeing the benefits to our customers in terms of making sure that we're getting everything done on time. But we won't see the impact on the financials until we get partway through 2020, probably towards the back half of the year.

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Cai von Rumohr, Cowen and Company, LLC, Research Division - MD & Senior Research Analyst [4]

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Got it. And so clearly, the inventory and receivables have been impacted in the fourth quarter. I think, clearly, for the full year, they're going to be impacted this year. Why only 100% for future cash flow conversion? Don't you have -- you're way out of whack on those 2 ratios and just to get them back to normal should take you comfortably over 100% conversion in fiscal '21?

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Donald R. Fishback, Moog Inc. - VP, CFO & Director [5]

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So I'll try to take that one, Cai. I think we are focused on improving our cash flow conversion. As I reported, over the span of the last 7, 8 years, we've actually been around 100%. Last 1.5 years have been tough. But in all fairness, last year, we spent 100 -- almost $150 million to fully fund our pension plan. But if I include all that, we're close to 100%, just a little over 100% over the past 7, 8 years. As I look into 2020, we've got to remember -- which I know we all do, but we've got to remember that our growth trajectory also consumes some working capital.

And as I said, about $0.25 on the dollar is a natural increase in working capital, largely because of inventory and receivables. So if I look at 2020, and I acknowledge that we've got some growth in working capital just naturally because of our investments in -- or I should say, because of our growth, investments in working capital.

I've also got capital expenditures that we're forecasting right now that will be in excess of our depreciation and amortization of about $30 million as well. And when I capture all of that, it does say that we are still consuming in 2020 a disproportionate amount in inventories, which is kind of reflecting what John just said, that we're not going to see the benefits of all this process focused -- process improvement focus that is ongoing right now. It's not going to start to show for us until the latter part of 2020.

So when you add all that up, it does suggest that we should be coming in at about the 80% conversion range in 2020. Could it get better in 2021? Let's wait for a little bit and we'll report out as this year unfolds. But we are focused on bringing the working capital back into alignment with where we were happy with the trajectory a year ago because it was declining. We reversed that trend most recently, but we are focused on trying to bring net working capital back down over the next couple of years.

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John R. Scannell, Moog Inc. - Chairman & CEO [6]

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Maybe another way of thinking about it, Cai, is that we -- '19 was a growth in working capital, '20 we see as a stabilization, but not an improvement in the working capital percentage. And so if you do that, then you're at the 80% with the growth of the top line. And then as you get into 2021, we start to see that working capital as a percentage of sales come down. And so we would hope to see that improvement as we get out into 2021. But right now, we don't want to get ahead of ourselves and we need to start seeing those new processes really taking root and having an impact. And so we're cautious about the '20 outlook at this stage.

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Cai von Rumohr, Cowen and Company, LLC, Research Division - MD & Senior Research Analyst [7]

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And just a last one, and I'll get back into the queue. So maybe give us a little more color on the trend in receivables, in payables, in customer advances, just in terms of the ratios relative to sales? And what are you doing to kind of pull some of those levers to improve the results?

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Donald R. Fishback, Moog Inc. - VP, CFO & Director [8]

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I'll try this, John, and maybe you can pipe in. But receivables actually on -- the trend in receivables is not bad. Our days outstanding has been holding pretty good and our folks are doing a really good job as we invoice and collecting in accordance with the terms of sales. So that's not our challenge.

I think you referenced customer advances, customer advances are certainly a focus of ours and we're focused on trying to get as much cash upfront as possible. But we, not surprisingly, have customers that aren't interested in giving us a lot of cash upfront. So that's a negotiation, but I can assure you that our teams that are out there seeking business, are out there using cash as a negotiating tool to try to get as much cash upfront as possible.

And then the last thing is inventories and it really is reflective of our operations. We actually -- we're doing a pretty good job of bringing inventories down, increasing the terms of inventories up until, I'd say, 1.5 years or so ago. And that trend has started to show in a negative way, where it's increasing.

So right now, we're expecting, as I said, the -- that negative trend to continue into the first half of 2020. And I think that will start to reverse as we get things settled. As processes improve, I would expect that we'd see that to start to come down. So cash flow for '20 anyway, might be a slow start, but I think it'll be a good second half. And overall, I think we'll get to the 80%.

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Operator [9]

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Our next question comes from Kristine Liwag with BAML.

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Kristine Tan Liwag, BofA Merrill Lynch, Research Division - VP [10]

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So following up on some of Cai's earlier questions in Aircraft Controls, you ended the quarter at operating margin of 8.2%, and you're expecting 10.5% for fiscal year '20. Can you provide more color on the specific initiatives you're putting in place in the supply chain? And also, what are the milestones that would drive margins higher for next year? And when do you expect margins to start inflecting positively?

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John R. Scannell, Moog Inc. - Chairman & CEO [11]

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So Kristine, we did finish the quarter at -- with the quarter at 8.2%. For the year, it was 9.4%. And as I described, in the quarter, we took some additional charges. We spent more on consulting, we took some restructuring charges, and we took a charge on the A380. So that depressed the margin in the quarter by about 200 basis points.

So let me jump off the year at 9.4% rather than the quarter and the 9.4% to the 10.5% next year.

If you go back, we've had the -- we had that supplier quality issue. So that was a real hit in the year, but if we don't have that next year, and we're assuming that we don't have that and we just start to see some gradual improvement in the margin, you can get to the 10.5% pretty quickly. And so, it's a bit of an improvement next year. It's definitely an avoidance of some of the challenges that we had this year, but that's how you get there. It's starting to see those operational improvements come through. But it's not a huge jump from where we've just been in '19. And definitely, it's only -- it's still down a little bit from what we were looking at in '18.

In terms of the timing of it, that really depends -- there's a couple of things that will affect that. The operational improvements will start to happen as we go through the year. So you'll get -- we'd see an improvement as we go through the year. However, we also have mix issues that happen typically quarter-to-quarter, which could have a -- an influence over and above that. And so I'd prefer not to say, it's going to be 8 -- 1, 2, 3, 4, because I think that will all depend on some of it is the mix that -- of business that comes in and then ships out, and some of it will be the operational improvement.

Underlying structurally the operational -- so we'll get better as we go through the year. Not a lot of -- I don't think you'll see a lot from it in Q1, Q2 and then 3 and 4 is where we will see it. Mostly on the cash will be the first thing before you'll see it on the earnings, I think. But then as I say, there's an overlay of the product mix and particularly, some foreign programs and stuff that will be on top of that. And so that may affect the margins beyond just simply the operational improvements. So I don't want to give you right now a forecast that says how each of the quarters lay out because I think that will be a big -- that could be a big effect as well.

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Kristine Tan Liwag, BofA Merrill Lynch, Research Division - VP [12]

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And then on the specific initiatives that you're putting in, can you provide color there?

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John R. Scannell, Moog Inc. - Chairman & CEO [13]

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So these are process-related initiatives which are based around, I mean the entire suite of processes that you've got, from your planning processes; your sales and operations systems; your processes with suppliers, in terms of improvement process; your quality systems, it's a whole suite of processes.

And essentially, what we're trying to do is upgrade each of these processes. We've had processes around all of these things for many, many years, and they served us very well as long as a what I'd call a Tier 2 supplier. It served us okay as a Tier 1 supplier, until we discovered that strains in the supply chain, something happening on the outside, created an effect that then we couldn't absorb. We did not have sufficiently robust processes and additional excess capacity to absorb these perturbations.

And so now what you do is you take all of those processes and you look at them and you say, "We want to upgrade each of these processes". So it's not a singular, we're just going to install a sales and operations planning process, or we're just to going to modify our inventory management systems, or we're just going to put in a more advanced supplier quality program. It is a range of processes across all of those.

And that's why we're calling it operations 2.0, because it's broad-based, it's not a singular thing, it's not a singular issue or a singular problem. It's a broad-based upgrade from a series of processes that served us well, but now we need to move to the next step as we become a really strong Tier 1 supplier.

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Kristine Tan Liwag, BofA Merrill Lynch, Research Division - VP [14]

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That's helpful. And switching gears to Defense, you highlighted growth in hypersonics. Can you describe, to the extent that you can, your capabilities in hypersonics and the long-term opportunity that you're seeing in that end market?

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John R. Scannell, Moog Inc. - Chairman & CEO [15]

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So many of the hypersonic stuff we can't talk about, Kristine. But our capability is similar to our capability in the missile businesses. We're really in the motion-, steering-control type of area. That's our technology, it's motion control. And if we look at, say, the traditional missile programs, it's the steering of the fins on the back of the missiles. And so you can imagine that our capability, as we look at hypersonics, is an extension of that core technology.

And in terms of the long term, I actually can't, because I don't know that anybody can. I don't know that we know. I think at this stage, like happens in many of these government programs, is there's a range of applications that are being developed. And it's not quite clear which ones will be most successful, which ones will have production problems behind them. What we do feel like is that we're on a portfolio with multiple customers and multiple programs. And so by betting on lots of them, hopefully, you end up being on the winners when the time comes.

If you go back a long time, the JDAM, there were dozens and dozens of military missile programs, and it turned out that the JDAM was the golden goose. And somebody -- it was Woodward, I think, who won the JDAM at the time. Nobody knew it and of course, that was the huge one. And I think with the hypersonics, it will be similar. There'll be some real winners and probably some losers.

As I say, our focus is on let's get on as many of them as we possibly can to make sure that we end up with some of the winning programs. But at this stage, it's way too early, I think. I think partially because many of them, we don't -- they're still in the test phase as well, and I don't think the military folks know yet which ones they think will be most successful.

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Operator [16]

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Our next question comes from Robert Spingarn with Credit Suisse.

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Robert Michael Spingarn, Crédit Suisse AG, Research Division - Aerospace and Defense Analyst [17]

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I wanted to ask you about the Defense margin guidance, just it's flat, but still double-digit growth. If we could just talk about that a little bit.

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John R. Scannell, Moog Inc. - Chairman & CEO [18]

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So I think, Rob, you're asking about the margin in the Space and Defense group. Is that correct?

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Robert Michael Spingarn, Crédit Suisse AG, Research Division - Aerospace and Defense Analyst [19]

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Yes. In the Space and Defense group, you're calling for a 13%, sort of flat year-over-year 13% margin. Now your growth is coming down a little bit, but it's still pretty good, so I thought maybe you have some leverage there.

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John R. Scannell, Moog Inc. - Chairman & CEO [20]

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Yes. So that is a good question. So the sales grow by about $90 million. But about 1/3 of it is actually funded development activity. And typically, that's very low-margin business. 1/3 of the growth is about funded development.

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Robert Michael Spingarn, Crédit Suisse AG, Research Division - Aerospace and Defense Analyst [21]

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So $30 million?

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John R. Scannell, Moog Inc. - Chairman & CEO [22]

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And it's a very low-margin business, and so that's what tempers your volume leverage that you might otherwise hope for or expect.

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Robert Michael Spingarn, Crédit Suisse AG, Research Division - Aerospace and Defense Analyst [23]

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Okay. Very high-level question then, changing gears. But with all of this strength that we see in Space and Defense, and I suppose, eventually, Industrial will get working, but just the dynamics that you've seen in Commercial aviation, do you think that Commercial aviation over time will shrink as a percentage of the business? I'm talking like on a 5- to 10-year basis.

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John R. Scannell, Moog Inc. - Chairman & CEO [24]

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Well, so let's take a step back and look at the programs we've got. So we've got a range of legacy programs. We mentioned the A380, it was never really a big program, but that's gone away. The 777 is reducing. We're -- we've got a stable position on the 37, so that looks like it's got long-term legs.

And of course, we're on the 87 and the 350, the E2. The 919, I mean eventually that will probably become a program. So I think we've got some very nice programs that will keep us going for the next 10, 15 years. However, right now, there is no major new development program.

Maybe the NMA is coming. It seems hard to imagine that they're going to do anything with the 320 or the 37 in the next 5 to 10 years. And so I can't tell you what that next program might be. And there's also, of course, the dynamics that Boeing has said, that they would like to do more actuation internally. And so we can't put a figure around that.

But I think we have a nice -- a very nice book of business. Our focus is on continuing to improve the operational performance and watching the aftermarket growth. And we have lots of other opportunities for growth with our technologies. Given the diverse range of things that we do, we can refocus on some other areas and new innovations. And we are looking within the Aircraft business beyond just the flight controls business, at other possible areas of future growth.

So I don't know that if I -- if we're sitting here in a decade's time, would our Commercial OE business be as much as it is now? I'm not sure. I think the aftermarket will be a lot stronger. But it all depends on when those new programs come up and if we win some of them. We have very strong relationships, I think, with our customers.

On the Military side, where there have been new programs, we are -- we believe we are the de facto company to do almost all of the military programs. And so we think we're in a very strong position. And the more we can get better on the operational side, the better positioned we will be for the future potential programs that are coming along.

I do think that whole industry has changed. Of course, Rob, as you know, we've gone from what I might call, 4 OEMs and the Chinese as a fifth, down to 2. I mean it's an Airbus, Boeing duopoly at this stage. So that's an interesting shift. And then the consolidation in that industry. And it's hard to see how that all plays out.

Our focus is simple, we want to be very deep in flight controls and that's what we're really good at. And then look at how we gradually expand beyond that core. And I think we've got the time to do that now, while there's a lull in the major aircraft programs.

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Robert Michael Spingarn, Crédit Suisse AG, Research Division - Aerospace and Defense Analyst [25]

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And just on that, and you may have touched on this earlier, and I might've missed it. But when I look at the decline in Boeing OE sales in your forecast, I imagine that's 787-driven, but to what -- how -- given the advanced, the lead times you have, is that a fully baked-in 12 in that number? Or do we have more headwind in the subsequent year? And then how does the MAX factor into that number? So in other words, what's happening with those 2 programs between '19 and '20?

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John R. Scannell, Moog Inc. - Chairman & CEO [26]

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Yes, so '19 and '20, the 87 is about flat, up just a tiny bit, but it's pretty much flat. And given the way inventory moves, the way ours, I mean it's up, we'll probably see that reduction in the 787 top line from Boeing. That will be more in the 2021 time period. So the drop is essentially all the 777. I mean that's essentially what it is. We model the 37 in '20 at pretty much the same rate as in '19.

So you can do 87 about flat, 37 about flat and the drop that we're showing on the top line is essentially all the drop in the 777 rates.

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Robert Michael Spingarn, Crédit Suisse AG, Research Division - Aerospace and Defense Analyst [27]

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Is the 777, given the delays, the pushout of the 777X, I mean is it possible you will outperform that number if they keep selling freighters and essentially, extending the classic?

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John R. Scannell, Moog Inc. - Chairman & CEO [28]

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If they ship more of them and build more of them, then yes, I think there may be some upside. But I -- again, it drops from mid-30s to mid-teens -- '19, mid-30s, mid-teens next year. They make a couple of more airplanes, maybe that gets up a couple of million dollars, but I don't think it will move the needle.

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Operator [29]

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Our next question comes from Mike Ciarmoli with SunTrust.

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Michael Frank Ciarmoli, SunTrust Robinson Humphrey, Inc., Research Division - Research Analyst [30]

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John or Don, maybe just one housekeeping, maybe I missed it. Did you talk about how the year would start, first quarter, from an earnings perspective? Or sort of give the earnings cadence for the year?

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John R. Scannell, Moog Inc. - Chairman & CEO [31]

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Yes. We said, the year would be $5.55, and the first quarter would be $1.30, plus or minus $0.10.

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Michael Frank Ciarmoli, SunTrust Robinson Humphrey, Inc., Research Division - Research Analyst [32]

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$1.30. Okay, I missed that. And then just back to the margins. I mean I'm trying to get I guess more of an apples-to-apples on this Aircraft. You closed the year at 9.4%. You're guiding to 10.5%. There was $7 million roughly in the quarter, and then you had the supplier charge of $10 million in 2Q. That would -- just losing those charges would kind of put you at a 10.7% margin.

So is there any other -- I would imagine these implementation costs are lingering throughout next year, but am I thinking about the math correctly? Is there any other headwind next year from maybe the implementation of these processes? It just seems like the core margins aren't really expanding much.

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John R. Scannell, Moog Inc. - Chairman & CEO [33]

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Your math is right, Mike. And so what we are seeing is that we're starting out with what we think is maybe a conservative view of what we think Aircraft will do next year. So there's always mix shifts, so there's always movement in the mix that move one way or the other. But our anticipation is if we avoid some of the challenges that we've had this year, there is ongoing -- you're right, there's ongoing investments that will continue.

So we will continue to be spending more in terms of consultants, in terms of process upgrades, in terms of those types of investments than what we might do when you get to a steady state. But that's why I said that the margin expansion, when I answered Kristine's thing, from the 9.4% to the 10.5%, is not an unreasonable step to go with next year.

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Michael Frank Ciarmoli, SunTrust Robinson Humphrey, Inc., Research Division - Research Analyst [34]

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Okay, okay. Got it. And then just on -- I guess on the capital deployment side and you guys were saying you're really busy looking at M&A, nothing came across the finish line. What's been the biggest obstacle? Has it really just been valuation preventing you from closing these deals? Or maybe could you give a little bit more color as to maybe why you have not gotten anything across the finish line?

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John R. Scannell, Moog Inc. - Chairman & CEO [35]

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Yes. I would say it's primarily valuation, Mike. So if people -- I mean if folks are paying 12, 14, 15, 16x EBITDA, and we -- and the assumption is that cost of capital has fundamentally and structurally gone down and it's never going to go back up. And I think we're -- if it's something that we feel is absolutely core to what we do, we will pay up. If it's something that's adjacent, that's kind of a growth vector, we're cautious about being able to make the numbers work when you're paying well into the double digits on EBITDA. And we just have backed away from some things where when we run the numbers, it just doesn't seem to make sense for us.

My own belief, for what it's worth is -- and the other thing I think that's happening is the PE guys have money to invest. And they're paid to invest money, not paid to sit on it. And we can be patient. We've got other uses for the capital. And my belief is that in a couple of years' time, some of those deals that have been incredibly highly levered may come unglued. And there may be assets to pick up at a more reasonable price.

And so we're patient. If it's something that we absolutely feel is core to what we do, we'll pay up, because there is a strategic element to it that we believe is worth it. But otherwise, we're cautious and we'll find -- we look, we're patient and we've got lots of things we can do with the capital to make sure that our shareholders will get the type of return they need.

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Operator [36]

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(Operator Instructions) Our next question comes from Tony Bancroft with Gabelli Funds.

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George Anthony Bancroft, Morgan Group Holding Co. - Research Analyst [37]

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On the GBSD program, could you remind us again how you participate there? What the potential opportunity is? As well as your thoughts on the recent bid dynamics regarding -- with Boeing? And how that could play out? And what would it mean for you, depending upon how it does play out?

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John R. Scannell, Moog Inc. - Chairman & CEO [38]

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So I can tell you a little bit, Tony. But the irony is that the GBSD program is, in theory, not something we're supposed to talk a lot about. It seems to be always [suppressed]. So within that context, I think what we've said in the past is that we are participating with both teams. We think we've got offerings for both teams, always you favor one team over an another because of the content that you might have. But right now, it seems like it's getting down to 1 team, although what seems to be in the news is maybe there'd be a unified team, a kind of a national team.

So at this stage, we don't know the answer. I mean we -- we're reading the same things that you guys are reading. And I don't think we have a better read on it. We do still think that there is significant opportunity for us. It's a very long-term play. And so it would be the next, call it, decade of investments, funded development work, a couple of million dollars here, a couple of million dollars there. It's really, as you get out towards the end of the decade, that it would turn into production.

So we're still optimistic that we've got the type of products, capabilities and technologies. We're talking to both potential OEMs. We don't know how it's going to play out, the latest FTC investigation, who knows. But we're -- we'll continue to be part of it and to supply our customers with everything and anything that they think that they would like to get from us. And we do think it has long-term potential. But as I say, it's out a ways.

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Operator [39]

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(Operator Instructions)

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John R. Scannell, Moog Inc. - Chairman & CEO [40]

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Sounds like we have -- we're -- we're done, Stephanie?

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Operator [41]

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There are currently no additional questions at this time. I'll go ahead and turn it back over for closing remarks.

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John R. Scannell, Moog Inc. - Chairman & CEO [42]

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Thank you all for listening in this morning. Thank you for taking the time. We look forward to reporting out again in 90 days' time. Thank you.

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Operator [43]

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Thank you, ladies and gentlemen. This concludes today's presentation. You may now disconnect.