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Edited Transcript of MOG.A earnings conference call or presentation 3-Nov-17 2:00pm GMT

Q4 2017 Moog Inc Earnings Call

EAST AURORA Nov 6, 2017 (Thomson StreetEvents) -- Edited Transcript of Moog Inc earnings conference call or presentation Friday, November 3, 2017 at 2:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Ann Marie Luhr

* Donald R. Fishback

Moog Inc. - CEO, VP & 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 and Senior 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 Fiscal Year-End 2017 Earnings Conference Call. Today's conference is being recorded.

At this time, I'd like to turn our conference over to Ann Luhr. Please go ahead.

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Ann Marie Luhr, [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. These 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 3, 2017 and our most recent Form 8-K filed on November 3, 2017 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 Investor Relations Communications and 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 '17 and reflect on our performance for the full year. We'll also provide our initial guidance for fiscal '18.

Before I dive in, I wanted to explain the change in our organizational structure and the associated reporting going into fiscal '18. At the end of September, Larry Ball retired. Larry was the President in charge of our Components segment as Moog acquired this business from Northrop Grumman in 2003. Over his 14-year tenure, Larry grew the business from $130 million to over $500 million and delivered excellent financial results year after year. We'll miss Larry and we wish him well in retirement.

Going forward, we've decided to reorganize the Components segment into its 2 major markets, A&D and Industrial, and to align these markets with the other segments which serve similar customers and applications. Therefore, from the start of fiscal '18, we're integrating the A&D markets into our Space and Defense segment and the Industrial markets into our Industrial Systems segment. There is no change to our Aircraft segment.

In our remarks today and our supporting data pack, we describe the fiscal '17 results in each of the 4 operating segments as in the past. However, when we describe our outlook for fiscal '18, we provide guidance for only 3 segments next year. Over time, we believe this change will improve our service to our customers, leverage our capabilities more fully and simplify our reporting.

Now, let me start with the headline numbers and then offer some thoughts on the year. First, it was a good quarter financially. Sales were up 5%; operating margins were 10.7%, the highest of the year; and we enjoyed a lower than projected tax rate to yield earnings per share of $1.07. This brings our full year results to $3.90 per share, $0.15 ahead of what we projected 90 days ago.

Second, it was another quarter of positive free cash flow to end the year at just over 100% conversion ratio.

Finally, we're providing a first look at fiscal '18 today. We're projecting sales of $2.62 billion, up 5%, and 100 basis points of operating margin expansion with a higher tax rate. The net result will be a 5% increase in earnings per share to $4.10, plus or minus $0.20.

As we reflect back on fiscal '17, the following highlights stand out. It was another year of first flights with Moog hardware. This year, we watched the first flights of the Airbus A350-1000, the Embraer E195-E2, the Boeing 787-10 and the COMAC C919. And in September, the 787 celebrated its 1 millionth flight, all safety completed with Moog flight controls. Our long-term investments in R&D to become the premier flight control supplier continues to come to fruition.

Second, fiscal '17 was a better year for most of our markets after a tough fiscal '16. We enjoyed organic growth in most of our businesses. Our commercial aircraft business continued to grow, our defense business has improved and our oil-related businesses stabilized. We experienced some continued challenges in our Industrial businesses outside the U.S., but as the year closed, we started to see the order book form in this market.

Third, we continue to shape our portfolio for the future, divesting our European space facilities and selling off a product line we acquired as part of our additive manufacturing acquisition. In parallel, we acquired Rotary Transfer Systems, an investment that strengthened our industrial slip ring business in Europe.

Finally, to reiterate, our overall results came in stronger than we had projected at the start of the year. Sales were up 4%, earnings per share of $3.90 were up 12% than last -- higher than last year and we had another year of healthy cash flow. This year's results included write-offs associated with our portfolio refinement as well as the associated tax benefits. All told, the net impact of both of these effects on earnings per share for the year was negligible.

After several years of restructuring and cost cutting, fiscal '17 was the year our businesses started to turn around and our focus shifted to growth. We're optimistic as we look to fiscal '18 for continued growth. As always, it was the dedication and commitment of our 11,000 plus employees around the world that made this all happen and I'd like to thank them for their hard work.

Now, let me provide some more details in the quarter and the full year. Sales in the quarter of $649 million were up 5% from last year. Sales were up in Aircraft, Space and Defense and Components, but was slightly lighter in Industrial Systems.

Taking a look at the P&L. Our gross margin was up 80 basis points from last year on a negative shift in the mix in our Aircraft segment.

R&D was about flat with last year, a combination of lower Aircraft R&D with higher spend in our Space and Defense and Components segments.

SG&A was up in the quarter, but in line for the year. Last year, we incurred about $12 million of restructuring and impairment expenses in the quarter that did not repeat this year.

Interest expense was level with last year. Our effective tax rate was low again this quarter at 20.8%. And the overall result was net earnings of $39 million and earnings per share of $1.07.

Full year fiscal '17 sales of $2.5 billion were up 4% from last year. Sales were up in Aircraft, Space and Defense and Components, but lower in Industrial Systems. Full year operating margins of 10% were up marginally from last year. We saw margin expansion in Aircraft and Industrial, with Components margins about even with last year. Margins in Space and Defense were negatively impacted by the continued portfolio cleanup in that segment. Earnings per share were up 12% year-over-year. Free cash flow for the year of $142 million was just over 100% of net earnings, the fifth year in a row where free cash flow conversion exceeded 100%.

On fiscal '18, we're projecting sales of $2.62 billion, up 5%. We anticipate single-digit organic growth in each of our segments. Operating margins of 11% will be up 100 basis points over fiscal '17. Our tax rate in fiscal '18 will normalize to 31% after an unusually low raise in fiscal '17. The net result would be earnings per share of $4.10, plus or minus $0.20. Free cash flow next year is projected to be $135 million or about 90% of net income.

Now to the segments. I'd remind our listeners that we provided a 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.

Starting with Aircraft. Sales in the fourth quarter of $284 million were up 7% from last year. The strength was on the commercial side of the house where sales were up across all product categories. OEM sales to Boeing and Airbus were higher on the 787 and A350 programs, respectively. We also saw sales increases in our business jet product lines across the Gulfstream and Bombardier platforms. The commercial aftermarket was up nicely, driven by strength in some legacy platforms.

On the military side, higher sales of the F-35 and other fighter programs, coupled with increased funding on this development work, compensated for lower OEM sales in our helicopter programs. The military aftermarket was also down from a year ago as a result of a general softness across multiple programs combined with the temporary parts availability issue on the V-22 program.

Aircraft fiscal '17. Fiscal '17 was a strong year for our Aircraft business. Sales were up 6% organically to $1.12 billion with increases in both the military and commercial books. As expected, the growth continues to be fueled by the volume ramp-up on our major programs, the F-35 and the A350. We saw increases in our business jet product lines and in the commercial aftermarket, driven by higher 787 activity.

On the military side, growth in funded development programs more than offset lower sales on several foreign platforms. The military aftermarket was lower across a range of programs as several onetime initiatives we enjoyed in fiscal '16 wound down this year.

Aircraft margins. Margins in the quarter of 10.8% were up 50 basis points from last year despite an adverse shift in the sales mix. Higher sales of the A350 program, low-margin funded military development and lower military aftermarket resulted in a lower gross margin than last year. However, significantly lower R&D in the quarter more than offset the adverse sales mix.

For the full year, Aircraft margins of 10.1% are up 80 basis points from last year. It's a similar story to the fourth quarter with higher sales and lower-margin programs resulting in an overall lower gross margin. However, $13 million of lower R&D expenses and the absence of $7 million in restructuring charges from fiscal '16 resulted in an overall improvement over the operating margin from last year.

Turning now to Space and Defense. Sales in the fourth quarter of $101 million were up 4% from last year. Sales on the defense side were up nicely on higher sales into military vehicle applications. Space sales were down compared to a year ago as a result of the divestitures we completed during fiscal '17. Including the effect of the divestitures, organic sales in the space market were up 4% on robust satellite avionics business.

Full year sales in Space and Defense were up 8% from last year. Story for the year mirrors the story for the quarter. Defense sales were up sharply as a result of record shipments of components for military vehicles. Base sales were about flat with last year, but up 4% organically on strong sales in satellite avionics.

Space and Defense margins. Margins in the quarter were 9.9%. We recently decided to transfer our additive manufacturing capability from Detroit to our campus at East Aurora and we took a charge of $2 million in the quarter as we disposed of some assets we've decided not to move.

Full year fiscal '17 margins were 9.5%. These margins include $13 million in charges associated with the portfolio cleanup we performed this year, including selling our European space facilities and divesting a product line we acquired as part of our additive manufacturing acquisition. Excluding these effects, the underlying operating margins in our Space and Defense business continue to be very healthy.

Turning now to Industrial Systems. Sales in the fourth quarter of $127 million were 3% lower than last year. Sales were lower in energy and industrial automation, but up slightly in simulation and test. In the energy market, we continued to see an erosion of our wind market in Brazil as a result of the GE takeover of Alstom and in Europe. Sales to wind customers in China were up marginally based on the introduction of our new product. In the industrial automation markets, sales were generally lower across the various markets we serve. Finally, simulation and test sales were up with strength in both submarkets.

Full year sales in Industrial Systems of $477 million were 7% lower than last year. The energy and the industrial automation markets drove the lower sales. In energy, we had significantly lower sales of pitch control systems in both Brazil and Europe, while sales to our industrial automation customers were lower across the broad range of markets we serve. On a positive note, we're seeing an improving order trend in the industrial automation market, which we believe bodes well for the coming year. Test and simulation sales were up marginally over last year.

Margins in the quarter were 8.3% and for the full year were 9.7%. We're seeing gradual improvements in the margins in this segment, although our ongoing investment in the Wind Energy business continues to put downward pressure on our results. As we move into fiscal '18, our strategy in wind will shift from driving growth to improving profitability as our new products gain traction in the marketplace.

Turning now to our Components segment. This is the last quarter we'll report on the Components segment as a standalone entity. Sales in the fourth quarter of $137 million were up 10% from last year. We saw growth across each of our 3 major markets. Sales were up modestly in aerospace and defense markets with stronger defense vehicle sales more than compensating for slightly lower sales of components for aircraft. Sales in our industrial markets were up strongly with over 70% of the growth coming from the recent acquisition of Rotary Transfer Systems in Germany. Within our industrial markets, sales into the energy business were modestly higher than last year, another encouraging sign that this market has stabilized after several years of decline. Finally, sales into the medical markets were up nicely on stronger pump and set sales.

Full year sales for the Components group of $501 million were up 7% from last year. About 40% of the growth was due to higher sales of our medical pumps and sets. 35% of the growth was acquired growth and the remaining 25% was across the broad range of both A&D and non-A&D markets. Given the significant challenges this space -- business faced in fiscal '16, we're very pleased that fiscal '17 has been a return to growth across most of the portfolio.

Performance margins. We had a strong finish to the year with margins in the quarter of -- at 13.2%, attributing full year margins to 10.5%.

Now let me turn to fiscal '18. For fiscal '18, I'd remind our listeners that we have 3 operating segments going forward as we reorganize our Components segment into Space and Defense and our Industrial segments. There's no change to our Aircraft segment going forward.

Aircraft fiscal '18 sales. We're projecting fiscal '18 sales of $1.18 billion, an increase of $50 million over fiscal '17. In recent years, our growth has been fueled by the new commercial programs. However, the projected growth next year is primarily on the military side as the F-35 program continues to ramp up and the military aftermarket improves.

On the commercial side, despite higher 787 sales, we anticipate our Boeing book of business would be down on lower production rates on our legacy programs, particularly the 777. The A350 program will continue to ramp up nicely and we anticipate our business jets would be about flat with fiscal '17. We're planning for a softer commercial aftermarket as we believe many of our airline customers fulfills their long-term 787 spares needs in fiscal '17.

Aircraft fiscal '18 margins. We're projecting a continued steady increase in Aircraft margins in fiscal '18. Fiscal '18 margins of 10.6% will be up 50 basis points over fiscal '17. The margin improvement is a result of lower R&D spending and continued cost improvements on our new commercial OEM programs, offset by a negative shift in the mix as sales on our mature commercial programs are replaced by growth on the A350 program.

We believe that fiscal '17 was the turning point in our Aircraft margin story. R&D came down significantly and production costs on our new OEM programs improved nicely. This story will continue in fiscal '18 and for several more years to come. We're projecting R&D at 6.8% of sales in fiscal '18 with a longer-term target of 5% of sales. We continue to make progress on bringing the cost of production on our new commercial programs down and, as we look out a couple of years, the aftermarket in these new programs will build. We believe that defense spending is poised to turn up and anticipate that several of our foreign military platforms should recover. In addition, longer-term, our funded military development market today would turn into new production programs. Balancing these positives will be an erosion of our commercial legacy book of business, but the net result should be a steady multiyear expansion of our Aircraft margins.

Space and Defense fiscal '18. As I mentioned at the start of the call, we're combining the A&D activities from our Components segment into the Space and Defense segment going forward. We're forecasting sales of this combined entity in fiscal '18 of $547 million. It is approximately $200 million in space and $350 million in defense. Throughout the equivalent markets in fiscal '17, base sales will be 6% higher on strength of launch vehicles and satellite avionics. Defense sales will be 2% higher with higher missile sales and security sales compensating for lower vehicle sales.

Space and Defense fiscal '18 margins. Fiscal '18, we're forecasting margins of 11.5%. These margins are up over 130 basis points from the equivalent business in fiscal '17. However, if we remove the adverse impact of our divestitures from the Space and Defense operating profit for fiscal '17, then operating margins are more or less in line as we move from fiscal '17 into fiscal '18.

Industrial Systems fiscal '18. Similar to Space and Defense, our forecast for Industrial Systems in fiscal '18 includes the industrial activities of our former Components segment. We're forecasting sales of the combined businesses in fiscal '18 up $894 million, related to 4 major markets: energy, industrial automation, simulation and test, and medical. We're anticipating organic sales growth of 6% in total with growth ranging from 4% to 8% in each of the 4 major markets.

Industrial Systems margins for fiscal '18. We're forecasting margins of 11.2%. This represents an improvement of 80 basis points over fiscal '17 on the back of higher sales and an improving performance in our Wind Energy business.

So let me summarize our guidance. Our initial guidance for fiscal '18 builds on a strong fiscal '17. We're optimistic that we'd see organic growth in each of our major markets next year. We also believe that we continue to see that momentum build over the following years as the Aircraft book continues to mature and the portfolio focus in our Space and Defense and Industrial Systems segments play out. Our focus on top line growth, operating margin expansion and strong free cash flow remains unchanged.

I finish my year-end comments as I've done in previous years by looking at our business through the lens of the end markets we serve. Those markets are defense, industrial, commercial aerospace, energy space and medical.

Defense remains our largest single market with about 1/3 of our sales. Defense spending has gone through a multiyear down cycle, but the signs are now encouraging that the cycle is turning up and there will be increased budgets in the future. Our flagship F-35 program continues to ramp up and, over the last 2 years, we've won enviable positions on new aircraft programs, most of which we cannot discuss. Our foreign military aircraft programs have been relatively quiet for several years, but there are signs of renewed activity. Our missile business remains strong and we're investing to expand our scope on military vehicles by providing complete [tire] systems. Despite the signs that future defense spending will increase, we're taking a cautious approach and have not factored any significant increase in defense budgets into our FY '18 plan.

Commercial aerospace is our second largest market with about 1/4 of our sales. This business has grown dramatically over the last decade from less than $300 million in 2008 to over $600 million in 2017. Our focus in this business continues to be on execution, completing the development of our major platforms and optimizing the costs on our new production programs. In fiscal '17, we saw the R&D expense come down significantly and that trend will continue in fiscal '18, albeit at a slower pace. Fiscal '18 will see a continued ramp of the A350 program and the initial production on the E2 jets. We're now on a steady path to improve margins in this business, a trend that will be further helped by the pickup in the aftermarkets towards the end of the decade.

Industrial is our next largest market with just over 1/5 of our sales. This business has improved in the U.S. over the last year or so, but our European and Asian businesses have continued to be slow. On a positive note, over the last few quarters, we've seen the strengthening of our order book outside the U.S. and, therefore, optimistic that fiscal '18 will be a return to growth. Our focus in this business is on expanding our scope of supply in industrial hydraulics and developing new actuation technologies in our electromechanical products.

Our other 3 markets, energy, space and medical, each represent less than 10% of our sales. Our energy market will continue to be a challenge in fiscal '18. On a positive note, our oil and gas businesses have stabilized and our investment in Wind Energy has resulted in new products we're introducing to the market. Over the next year or so, we'll learn if our wind investment strategy will pay off.

In our space market, we're primarily focused on future U.S. opportunities. We're seeing growing interest in our satellite avionics products and are continuing to invest in propulsion systems which can benefit from the growth in the small satellite market. In addition, we remain committed to investing in the Ground Based Strategic Deterrent program. This is a long-term play which could be a significant business for Moog in a decade or so.

Finally, within our medical market, our medical pumps line performed very well again in fiscal '17. We're investing in next-generation pump products which we believe will further strengthen our position in this market over the long-term.

Our underlying strategy continues unchanged. We're a motion and controls technology company that looks to create value for our customers by adapting our core products to their specific needs. Customer intimacy is our strength where our engineers work with our customers' engineers to solve their most difficult technical challenges. We apply our products and applications where performance really matters, where the cost of failure is high and reliability is a must. We serve a wide range of diversified markets which provides for financial stability and significant opportunities for long-term growth. We invest heavily in technology and take a long-term view of these investments. We take adjacent acquisitions which complement this strategy. Our internal initiatives to deliver on our goals have not changed. They are innovation, lean and talent development. Finally, we're focused on deploying our capital to maximize our shareholder returns over the long-term.

For fiscal '18, we're anticipating sales of $2.62 billion and earnings per share of $4.10, plus or minus $0.20. And similar to previous years, we anticipate a slow start to the year with earnings per share in the first quarter of between $0.80 and $0.90.

Now, let me pass it to Don who'll provide some color on our cash flow and balance sheet.

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

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Thank you, John, and good morning, everybody.

We finished the year with $18 million of free cash flow in the fourth quarter, resulting in free cash flow for all of 2017 of 141 -- or $142 million and a conversion ratio of 101%. This follows strong results with an average better than 140% conversion over the previous 4 years.

The $142 million of free cash flow for the year compares with a decrease in our net debt of $92 million and the difference is primarily related to the April 2 acquisition this year of the Rotary Transfer Systems business from Morgan Advanced Materials with operations based in Europe. Rotary Transfer Systems designs and manufactures industrial slip rings and opens up the opportunity for us to expand our slip ring business internationally. The business has been managed as part of our Components segment with second half sales in 2017 of $12 million, in line with our projections.

Net working capital, excluding cash and debt as a percentage of sales, was 25.2% compared with 25.5% a year ago. Over the last 8 years, we reported a rather steady decline in this working capital metric since we peaked at almost 34% of sales in 2009.

For 2018, we're forecasting free cash flow of $135 million, reflecting a cash conversion ratio of about 90%.

As we've shared previously, over the next year or so, we expect to see a higher CapEx for growth-related investments in facilities for engine propulsion testing and for the production ramp of the F-35 program. We're also forecasting that customer advances will begin declining after reaching their current elevated levels.

Capital expenditures in the fourth quarter were $30 million, including $4 million for the purchase of a previously leased facility. Depreciation and amortization totaled $23 million in Q4. And for all of 2017, CapEx was $76 million while depreciation and amortization was $90 million. For 2018, we're forecasting CapEx of $95 million, while D&A will be about $90 million.

Cash contributions to our global retirement plans totaled $19 million in the quarter, resulting in $92 million of contributions for the full year. This compares with $95 million for all of 2016. For 2008 -- sorry, for all of 2017.

For 2018, we're planning to make contributions into our global retirement plans totaling $92 million, the same as in 2017. Global retirement plan expense in 2017 was $63 million compared with $65 million in 2016. And in 2018, our expense for retirement plans is projected to be at $58 million.

Our effective tax rate in the fourth quarter was 20.8% compared with the last year's 31.3%. This year's Q4 rate included a benefit related to the utilization of a net operating loss for business restructuring that took place earlier in the year. We had not factored this NOL benefit into our full year tax rate projections last quarter. We were able to recognize this benefit only after all tax uncertainties were addressed, which happened this quarter. The magnitude of this tax benefit in the quarter was $3 million or the equivalent of $0.08 per share. In addition, the mix of our taxable earnings for Q4 came in more favorable than we had forecasted 3 months ago, helping to lower our final year-end tax rate for all of '17 relative to expectations.

We reported quite a bit of quarterly volatility in our effective tax rate this year. In the first quarter of '17, our tax rate was 17.6%, second quarter was 34%, third quarter was 17% and now our fourth quarter is close to 21%. The fluctuations quarter-to-quarter are mostly the result of tax benefits that are associated with divestitures whose related losses are included in our operating results. When we consider the divestiture-related pretax operating losses and the associated tax benefits that we reported throughout '17, the net impact on our 2017 EPS was negligible.

For all of 2017, the effective tax rate was 22.7% compared with 28.5% in '16 with the decrease mostly related to the tax benefits associated with our dispositions. Removing the effects of divestitures and the NOL benefit previously mentioned, our effective tax rate for '17 would have been 20 -- just under 28%.

For 2018, we're forecasting an effective tax rate of 31%, reflecting a more normal base rate as we look ahead.

Our leverage ratio, net debt divided by EBITDA, decreased to 1.8x compared with 2.2x a year ago. Net debt as a percentage of total cap was 33%, down from 41% last year. At quarter-end, we have $535 million of available unused borrowing capacity on our $1.1 billion revolver that terms out in 2021.

And lastly, before I pass you back to John, I'd like to highlight that we're forecasting a very slow start in 2018 for free cash flow. Despite our forecasted conversion ratio of about 90% for all of 2018, our modeling tells us that our Q1 free cash flow could be rather soft. This would be a timing phenomenon driven by both receipts and disbursements and the latter quarters in 2018 will make up for this anticipated slow start to the year.

So with that, I'd like to turn it back to John for any questions that you may have. And, Evan, can we ask for your help?

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from Rob Spingarn from Crédit Suisse.

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Robert Michael Spingarn, Crédit Suisse AG, Research Division - Aerospace and Defense Analyst [2]

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John, as usual, and Don, a wealth of information. Of course, when that happens, sometimes we miss a few things. I wanted to highlight a couple of things you said. So let's start with the $0.20 plus or minus in the guidance around the $4.10. That's a 10% range, roughly. So what are the major swing factors here? What would point you to lower end and what would get you to the higher end?

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

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Well, we started out fiscal '17 with $3.50, plus or minus $0.20. And what happened through the course of the year was all of our businesses came in stronger than we had been anticipating, Rob, and so the plus or minus $0.20 is the margin that we are starting out because we feel like it's -- there's a lot of moving parts.

I'd say what we'd get -- if you ask me, so where's the upside and maybe the downside? Maybe that's also part of the question. I think military, the defense spending. There's a lot of talk in Congress about pushing up those budgets next year. I think that could be a positive for us. I think where we would see the impact of that most immediately might be in the military aftermarket if there was a push to increase maintenance on some of the platforms around V-22, F-18, more of a push to get the depots spending up on the F-35, so that might be a -- that could be a plus. There may be some additional units on some of those programs, so typically that would take a little bit longer to play through. Some of the foreign military platforms that we're on have been on a very slow pace for the last few years. There's -- they could pick up and that might be a little bit stronger. So that, I'd say, would be where I would see the potential upside.

I'd say our Industrial business is also turning up. We've had a tough couple of years, but we're starting to see the order book improve there for what I'd call the traditional hydraulic automation products. If that continues to be strong, that could also been an upside.

On the downside, I'd say mostly on our energy businesses. We've invested in wind for the last few years. We said that this is the year that we'd start to see that really improve. I would not -- we'd see how that plays out. I can tell you at the moment that it continues to be a challenging market for us. We have new products. We've got new technologies. Whether the market will adopt them as fast as we had anticipated and whether they'd be willing to pay the price that we believe corresponds to the value that we've created will be the other thing. So I'd say that probably on the energy side, I'd have more concern. And then, on the upside, I'd say defense would be the upside.

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Robert Michael Spingarn, Crédit Suisse AG, Research Division - Aerospace and Defense Analyst [4]

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Okay. So the way you answered the question, John, was mostly on the revenue side, volume-driven, if I heard you correctly. Is there -- can we apply the same thing to margins and/or execution? Or is this really about revenues?

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

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Yes. There is not a specific execution-related issue that I can say that -- depending on how that plays out, that we should be a lot better or a lot worse. So it's really a margin-driven story and we are in a period where we're forecasting nice organic growth for next year, anywhere between 4% and 8% across all of the various markets that we serve. And so the growth will help drive the margin. And there's continued focus on costs. There'd be -- we've got a couple of other little small portfolio things that we might do throughout the year, nothing of any real significance. So it's really -- it's a sales, margin story associated with sales growth, I would say.

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Robert Michael Spingarn, Crédit Suisse AG, Research Division - Aerospace and Defense Analyst [6]

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Okay. And then, on the margins, looking at some of the improvement that you're forecasting for next year, you were clear that R&D comes down and so that's part of it...

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John R. Scannell, Moog Inc. - Chairman & CEO [7]

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Aircraft R&D, Rob.

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Robert Michael Spingarn, Crédit Suisse AG, Research Division - Aerospace and Defense Analyst [8]

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Aircraft R&D comes down, so in the Aircraft segment. I wanted to just clarify what you're calling for from a gross margin perspective given the mix shift. I think you said it, but I don't know that I caught it in Aircraft.

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John R. Scannell, Moog Inc. - Chairman & CEO [9]

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Yes. We don't go into gross margin by segment, Rob. So I didn't say it and you didn't miss it.

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Robert Michael Spingarn, Crédit Suisse AG, Research Division - Aerospace and Defense Analyst [10]

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Oh, okay. All right. Well, what are the general gross margin trends then across the businesses, if you can talk to that? Or is a lot -- because I don't think all the margin improvement that you're forecasting here is just R&D dropping because, again, that's just the one segment. So Space and Defense, you're looking for a margin that's a bit above what you did in this last quarter here. I assume that has to do with the cleanup in the portfolio, but maybe you can elaborately a little bit.

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

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Yes. So you can do gross margin for the company in total if you look at that because we -- obviously we provide that level of detail. And I think if you do that, the gross margin for the company in total does not change that much. Actually, year-to-year, it's kind of in that 29% to 30%, but it pretty much stays in that range.

If I do it by segment though, over the -- if I look '16 to '17 to '18, the gross margin in our Aircraft business has actually come down a little bit. And the reason for that is it's the mix. So if you look at the mix in '17 versus '16, it's got lower military aftermarket, higher military funded development and lower military OEM sales. So you've got this lower aftermarket, lower kind of mature production, higher funding and so that's a negative mix shift.

And then, on the commercial side, aftermarket is up a little bit in '17, although we're projecting it to kind of come down again in '18 because we think there's a lot of IP stuff, initial provisioning in '17 that won't repeat. And then, you have the commercial book growing, but it's the 350 that's causing the growth. And what we're seeing in, as we move into '18, is some of the legacy Boeing stuff, particularly 777, is starting to tail off. So you've got legacy stuff tailing off replaced by growth in brand new programs and a slightly lower aftermarket in '18. So gross margin in the Aircraft business has come down a little bit. No, we're not talking about big moves, but it's come down a little bit from '16 to '17 to '18.

Now, after you look out, we start to see that improve again. As we talked about, military aftermarket starting to pick up a little bit, some of the foreign military stuff might pick up a little bit. We continue to come down the cost curves. And then, of course, under that, you've got the expense side and the R&D is coming down.

So that's what's happening in Aircraft in '18. It's really a negative mix shift because of this shift in the military side and on the commercial side away from legacy and lower R&D, lower expenses would still give you margin improvement.

In our Industrial businesses and the Space and Defense business, we'd probably see gross margins improve a little bit. We think the Industrial business should improve because the wind business is going to start getting better. And in the Space and Defense, just slightly higher sales should start to give us a little bit of a better margin.

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

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Did I hear you say somewhere that commercial aftermarket should tick up toward the end of the decade?

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

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Yes. And the logical thing if -- just the 87 continuing to come out of -- keep in mind, Rob, it's a 5-year warranty period that you have on this stuff. So we're not -- there's no A350 -- there's initial provisioning, but there's no A350 aftermarket yet and there won't be for another couple of years. 87 is just starting that, but if you said the fleet is, I'm going to pick a number, 600 or 700 of them are flying, there's probably 100 or 200 that are out of actual warranty. So it's a slow grind upwards, but it's starting to happen and we continue to see that as we get to the end of the decade and into next decade.

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Operator [14]

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Our next question comes from Kristine Liwag from Bank of America Merrill Lynch.

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Kristine Tan Liwag, BofA Merrill Lynch, Research Division - VP [15]

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John, how do you think consolidation in commercial -- in the commercial aerospace supply chain would mean for you? There's been a clear shift in Boeing supplier strategy with how they've structured the 777X program. What do you need to do to keep your competitive advantage for the next set of commercial aerospace programs?

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John R. Scannell, Moog Inc. - Chairman & CEO [16]

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So I think you asked 2 questions. One I think was the consolidation in the industry and then the other one was long-term competitiveness.

So I think there are -- obviously there are major shifts going on in the industry. My predecessor, Bob, told me that probably 30 or 35 years ago, somebody said to me, you guys -- with all the shifts in the industry, you guys are going to be too small to survive. And I think over those period of time, we've continued to focus on what we do really, really well and we've continued to grow the business. And so I think there will always be -- I think the aerospace business is a complex ecosystem which is based on a set of large clients and then a set of suppliers, an entire supplier network that's important in order to maintain the competition within that overall ecosystem. And I think there is room -- I think there will always be room for smaller -- and they're going to classify us as smaller now given some of the big guys that we've got out there -- suppliers with a real specialty who bring competition to some of the bigger guys who may want to bundle their products. And I think if you're one of the OEMs, you actually want that competition. You actually want to have multiple guys out there that can fly -- can be real credible flight control suppliers and not just have a situation where you've got one or 2 major suppliers who can leverage across the entire airplane. So I think that ecosystem is necessary for the long-term health of the industry and I think we can play a part in that. We continue as we probably do, which is focusing on being really good at the niche we're in.

But I'd remind you that, that niche, that flight control is only about 40% of our business. We really are a technology company diversified across multiple markets. It's not that we are just a flight controls company. We're a -- we've got a lot of different businesses. So that's the -- my view of the industry and the ecosystem that, I think, is necessary over the long-term to maintain the stability of the overall industry.

And then, in terms of competitiveness, Kristine, I think it's the same things that we've been doing for many years up until now. It's focusing on really great technology, focusing on working very closely with our customers to provide value in their application and focusing on lean and talent developments that these are -- making sure that our operations are as effective as they can possibly be as we've -- as there has been continued pressure, I would say, on costs across the industry and we've continued to find our way through that while working with our customers. So I believe it's always about value, not just about cost. And I think we can bring real value to our customers and continue to do that in the future.

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Kristine Tan Liwag, BofA Merrill Lynch, Research Division - VP [17]

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That's helpful. And maybe following up on your comments, right, too small to survive, and you're saying that you're not too small.

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

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Yes. I didn't say that, Kristine. It's quite the opposite. That was a suggestion a long time ago.

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Kristine Tan Liwag, BofA Merrill Lynch, Research Division - VP [19]

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Okay. But in this world where in the consolidating industry, you're smaller on a relative basis compared to your peers and some customers, in order to be competitive, does that mean that you're -- you'd have to have a higher R&D profile through a cycle than you previously would have had to do? And how should that affect margins longer term?

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

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Well, I think we've gone through that, Kristine. If you look at our R&D -- again, I'm going to pick the Aircraft business -- it peaked at -- I think we were over 10% of...

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Donald R. Fishback, Moog Inc. - CEO, VP & Director [21]

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It's close to 10%.

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

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Close to 10% of sales. So -- and the sales back then, our total Aircraft business, if you go back a decade, was I think around $600 million. So we've doubled over the last decade and I would say that we, in the specialty niche that we're in, we've essentially made that major investment. So even if there's another major program, we're anticipating long-term R&D in our Aircraft business running about 5% of sales. Let's assume that sales are in the $1.2 billion to $1.5 billion as they build over the next few years, so you're still talking $60 million to $75 million a year and I think that's sufficient to do the next generation of programs.

On the military side, typically they fund the programs. So that's in pretty good shape there. And on the commercial side, there's very few major programs that are out there on the horizon right now. So I think we have sufficient funding. Maybe it will -- maybe it will go up a little bit from 5%. You'll have an up cycle and a down cycle. So it might oscillate between 3% and 7%, I'm not sure, but I think the level of spending, what we've done is we've caught up with the sales over the last decade to get big enough to be able to afford the types of programs that we do.

Keep in mind, again, we're doing the flight control system. We're not doing bigger parts of the airplane. So I think we can fund that within the budgets that we have forecasted.

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Operator [23]

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Our next question comes from Cai Von Rumohr from Cowen and Company.

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Cai Von Rumohr, Cowen and Company, LLC, Research Division - MD and Senior Research Analyst [24]

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So, John, your contract loss reserve went up by $6 million in the final quarter. You mentioned the $2 million hit at Space and Defense. Maybe you could walk us through any additional adjustments, positive or negative, you had in the fourth quarter?

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John R. Scannell, Moog Inc. - Chairman & CEO [25]

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So I'll give you a general answer to that, Cai, and I know Don wants to add some stuff, but we don't walk through individual contracts, Cai, and do that. There are so many contracts that we have that have puts and takes on them and, in the end, you put them all together and that's what ends up with that number. And if you look at that number over time quarter-to-quarter, it'll go up or down by a few million dollars quarter-to-quarter. And so I think walking our way through that, first of all, we don't provide that level of detail. And secondly, I don't think it would help because I think all it would do is would add a level of complexity that will be difficult for you to follow in your models over a long period of time.

I would say that if we look at contract loss reserves, the biggest components often typically are new planes as we introduce them into production. And there's -- there are -- typically, there are small issues items that are associated with the new planes as we introduce them that have to be worked through and those get caught up in the contract loss reserves.

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Donald R. Fishback, Moog Inc. - CEO, VP & Director [26]

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The only thing I would add is kind of a below the line perspective that's highlighted in that number you've already talked through, and that's the tax rate. But above the line in the quarter, there really wasn't anything of specific significance that I would single out that would say the numbers are unusual. So I would say it was a pretty normal operating result in the quarter. It was only the tax rate in the quarter that was unusually low.

If we turn to the full year, the comments that we made tried to convey that some of the noise throughout the year as it related to the divestitures and some of the -- I guess, that was primarily related to the divestitures of the businesses that we manage throughout the year -- was essentially offset almost to the penny, earnings per share-wise, by the tax benefits that we recorded throughout the year. They didn't sync up quarter-to-quarter, but when you step back and look at what happened throughout the year and total it up, it's like kind of a wash. So the divestitures, which were specials during the year that we've reported throughout, and the tax rate that we've reported or highlighted throughout the year, that was kind of a wash in the end of the story.

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Cai Von Rumohr, Cowen and Company, LLC, Research Division - MD and Senior Research Analyst [27]

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And John, you mentioned the Aircraft R&D down to 6.8%. That kind of implies that your margin before R&D would be down some 70, 80 bps. You, I guess, alluded to the mix negative in commercial. But really when we look at the growth, most of it is coming on military and on the F-35, which is going from development into more production. So why isn't the margin a bit better before R&D?

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

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It's because on -- it's on the commercial side, on the gross margin side, Cai. It's lower aftermarket on the commercial side. And it's -- commercial looks flat, but it's A350 growth compensating for loss on legacy programs that are really end-of-life programs, 777 in particular, as I mentioned, and that puts gross margin pressure on there. And you put the whole thing together and the mix comes out with a slightly lower gross margin than what we've seen in fiscal '17. So you're right. There is gross margin pressure that's more than compensated for by lower R&D.

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Cai Von Rumohr, Cowen and Company, LLC, Research Division - MD and Senior Research Analyst [29]

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Got it. And then, CapEx, $95 million, seems like a big number. And you don't have any brand new programs. What are you spending all that money on?

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John R. Scannell, Moog Inc. - Chairman & CEO [30]

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It's really 2 -- there's 2 unusual items as we look into '18 and they're both building-related, Cai. Don has alluded to these. One is the F-35 is going from kind of 75, 80 up to 120 at the production rate next year. And we've been squeezing that in. Of course, this is all domestic stuff. We've been squeezing that into the operations that we've got and we just can't fit it in. So we're building an extension for the F-35, essentially for the growth of the F-35 program, so that's a big piece of it.

And then, the other piece is we're modernizing the test facilities that we have for engine propulsion. This is a business that we bought from AMPAC about 6 or 7 years ago, I think. A lot of old equipment we held up, putting much money into it as we were kind of working our way through some other stuff and it's just gotten to the point where it's strategically important. We believe, long-term, small engine propulsion is a business that we want to be in. It's also set the pace for being on the GBSD program in years to come. And so we're spending some money on those facilities. And so those 2 facility-related things are the difference between what I'd say is a normal year and the year that we're looking into next year, which is why it's up.

The other thing I'd say though, Cai, is if you look at our CapEx spend, it typically runs 3% to 4% of sales. That's kind of the ratio. And over the last, I don't know, 5, 6, 7 years, we've been significantly at the low end of that and we've been running CapEx below D&A. And over time, if you continue to do that, you start to erode your capital base. And for a company like ours where it's extremely high precision, it's trying to make sure we're using the most modern production techniques, the most modern equipments, then I think that, over time, that erodes your base. And so it should not be unexpected that at times we will flex up a little bit in CapEx to try to make sure that we got -- everything is as modern as it needs to be to meet our requirement and it will breathe up and down.

So it's 2 major things, but I would say, broadly speaking, one in CapEx, that the 3% to 4% range is something we should expect and we've been at the lower end of that for several years despite the big investments in programs so we squeezed in other places, and we're just seeing a little bit of a return to a more normal level, I'd say.

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Cai Von Rumohr, Cowen and Company, LLC, Research Division - MD and Senior Research Analyst [31]

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And the last one. Your net debt-to-cap, 1.8x. It looks like it goes down to about 1.3 by the end of the year. You haven't talked about where any of that money is going to go. What are your priorities for cash deployment?

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John R. Scannell, Moog Inc. - Chairman & CEO [32]

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So right now, we talked about this, I think, about a year or so ago. Our focus is on growth, Cai. It's looking -- we've talked about looking for adjacent acquisitions. We've done a lot of portfolio cleanup over the last 4 or 5 years. We've slowed our acquisition activity partially because of availability of interesting opportunities and partially because we wanted to just make sure that the acquisitions -- that we learned from some of the positives and negatives from history. And we've, over the last year, we've really strengthened our focus on trying to rebuild that pipeline. We only converted one deal in the last year, but we are starting to see more opportunities. I say these are adjacent bolt-ons. These are not transformational acquisitions. They're supportive of the broad strategy that we have to grow the business as a high-end performance company. And right now, we see that as -- the bigger opportunity is to reinvest in growth rather than continue to return cash to shareholders.

Now, if over the next year or 2, it turns out that there's nothing there and we find ourselves in the enviable position that we have a significant balance sheet capability, we will try to make sure that we're allocating capital in the best way possible for our shareholders.

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Operator [33]

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Our next question comes from Michael Ciarmoli from SunTrust.

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

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Maybe, John or Don, just to follow-up on what Cai's line of questioning was on there on the CapEx. So should we think about your conversion -- your free cash conversion rate on a go-forward basis trending? I mean, it sounds like it's clearly going to trend lower from where we it's been from the prior years, but should we be thinking about a more normalized level here in and around that 100% given that you've been under-investing in CapEx?

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Donald R. Fishback, Moog Inc. - CEO, VP & Director [35]

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I'll try to take that one. We're certainly targeting to do a little bit better, but yes, I think, over the long term, if we look at 100% conversion, that probably is a fair set of expectations.

We do have further room in the balance sheet to continue to manage that down to get to levels that we like to get to and we continue to focus on that, but I think, over the long term, 100% conversion is probably a fair target.

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Michael Frank Ciarmoli, SunTrust Robinson Humphrey, Inc., Research Division - Research Analyst [36]

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Okay. And then, John, I just wanted to go back. The Industrial segment margins were very weak in the quarter, weakest of the year, and, I guess, some of that had to do with wind. But as we look into '18, the Industrial Systems segment is going to be 11.2%. Can you maybe parse out what's going to be -- you're obviously combining the higher-margin Components in there, but what is that legacy Industrial margin from the product mix in '17 that's in that segment? What's that going to look like in '18? It sounded like you had the order book was firming up a little bit. Do you see any difference in the margin profile there? I'm just trying to get a sense of what the margin expansion, kind of that core Industrial margin is going to look like not with the added benefit of the Components group?

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John R. Scannell, Moog Inc. - Chairman & CEO [37]

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Yes. So let me do the 3 major markets that we divide that into, Mike. So you've got industrial automation, you've got energy and you've got test and sim. So that's the historical Industrial business.

The margin was, in '17, was pressured by the fact that just the sales were lower in the business. So you had lower sales that were primarily coming out of the wind business, but you had lower sales across the various markets and so that puts some margin pressure on the business.

As we look into '18, we're seeing the industrial automation, as I mentioned, the book of business is starting to firm. We've seen that over the last quarter or 2 that the book-to-bill has gone north of 1. So we're feeling like there's a lot of positive energy around that. I think I've described in the past that our industrial automation business, the way to predict it is to kind of look at the headlines in Wall Street or the Financial Times. And if global GDP starts to pick up or if regional GDP starts to pick up about 18 months to 2 years later, we start to see that improvement in the capital investment cycle, which is what we benefit from. So the U.S. would be doing well for quite a while. We've seen that in our Components business, which is mostly U.S. business. But Europe is, only in the last couple years, really stabilized and started to improve. And China has kind of gone through some ups and downs, but seems to have stabilized as well. And that's what we're starting, I think, to see through now in the Industrial business.

We anticipate the industrial margin, the industrial sales -- automation sales will be up and that will bring margin improvement with us. We're anticipating that simulation and test is going to be around the same as it's been over the last couple of years. That's not as big a shift for us over the -- I would say that's running at a nice -- very nice clip. So that's a nice business. It's up a little bit next year. It was down a little bit this year, but more or less in the noise. And then, the energy business, that's really -- that's the one, I think -- and particularly the wind energy side because that's the vast majority of it -- that's the one that, in '17, put more pressure on the business than we had anticipated. So ex-wind, the business did actually nicely. You include wind, the wind was bringing it down. And as we go into '18, that, as I mentioned in my comments, the focus there is shifting from sales growth to margin improvements and to trying to make sure that, that business is contributing the way we expect it to. So that's the one, I think, that we are -- have most upside in, but also I feel has -- is the one that we probably spend most time focused on.

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Michael Frank Ciarmoli, SunTrust Robinson Humphrey, Inc., Research Division - Research Analyst [38]

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Okay. Got it. And are there -- just the segment reporting change, I think you called out you can better service customers, leverage some capabilities. Should we expect any potential synergies or cost savings? Or is this really just for reporting purposes?

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John R. Scannell, Moog Inc. - Chairman & CEO [39]

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It's primarily for reporting purposes, Michael. I think you're aware, our Components segment, the guy who runs it is Larry Ball, runs a very tight ship. So it's not as if he had a lot of excess capacity. And it was mostly a business that was organized by individual sites. So most of the costs in the businesses were site-centric. They were what was necessary to run the site, whether it was the finance people, the HR, et cetera. So as we integrate them with the other 2 segments, what we will do is essentially reallocate those sites -- the sites are predominately either A&D or Industrial and make sure that we don't -- there may be some cost synergies over time as we take advantage of just scaling, but that's not -- there's not any big numbers for that in '18, that's not the primary focus. Really, it's more about leveraging the channels to the market. We have had -- because Components serves, I'd take an example, missiles and our Space and Defense service missiles, you'd have 2 more folks going into the same customer. And so we want to make sure that we streamline that and take more advantage of all the complete product offering.

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Operator [40]

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We'll take a follow-up question from Rob Spingarn from Credit Suisse.

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Robert Michael Spingarn, Crédit Suisse AG, Research Division - Aerospace and Defense Analyst [41]

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Just a really quick one, John. On GBSD, are you weighted more toward one team or the other?

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

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We're trying to. At this early stage, Rob, we're trying to be involved with all of the teams in as far as that's possible. So there's -- we're trying to play as many horses as we can because who the heck knows. So I would say, at this stage, it's too early to say.

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Operator [43]

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And there appears to be no other questions at this time.

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John R. Scannell, Moog Inc. - Chairman & CEO [44]

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Thank you very much to everybody for listening in. I would summarize by saying '17 turned out better than we had anticipated and we're optimistic that '18 looks like it's got some nice growth and continued improvement. So we look forward to come back to you in 90 days' time and continue that trend. Thank you.

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Operator [45]

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This does conclude our conference for today. Thank you for your participation. You may disconnect.