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Edited Transcript of SNR.L earnings conference call or presentation 5-Aug-19 10:00am GMT

Half Year 2019 Senior PLC Earnings Presentation

Hertfordshire Aug 12, 2019 (Thomson StreetEvents) -- Edited Transcript of Senior PLC earnings conference call or presentation Monday, August 5, 2019 at 10:00:00am GMT

TEXT version of Transcript

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Corporate Participants

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* Bindi Foyle

Senior plc - Group Finance Director & Executive Director

* David Squires

Senior plc - Group Chief Executive & Executive Director

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Conference Call Participants

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* Andrew Douglas

Jefferies LLC, Research Division - Equity Analyst

* Charlotte Anne Keyworth

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

* Charlotte Anne Keyworth

Barclays Bank PLC, Research Division - Analyst

* Dominic Convey

Peel Hunt LLP, Research Division - Analyst

* Harry William Freeman Breach

MainFirst Bank AG, Research Division - Research Analyst

* Malini Chauhan

Redburn (Europe) Limited, Research Division - Analyst

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Presentation

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David Squires, Senior plc - Group Chief Executive & Executive Director [1]

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Okay. I think everyone is here. So good morning, everyone. Welcome to Senior plc's 2019 Interim Results Presentation. And as always, we really appreciate you making the effort to get here.

In terms of our agenda this morning, I'll briefly cover the H1 highlights, then Bindi Foyle will run through and comment on the results for the first half of 2019. I will then focus on markets and outlook. And as ever, we're providing lots of information and detail that I trust you will find useful. And do feel free to ask us any questions at the end of the presentation.

So overall, the first half of 2019 annual trading at group level was in line with our expectations despite the challenges our industry sector has been dealing with. And of course, we'll discuss that later in the presentation. We've worked very hard to mitigate the impact on our H1 earnings of the 737 MAX rate production. And there's been some real highlights, too, already this year. We've made good progress with our technology and product investments, particularly with additive capability and electric vehicle battery cooling solutions.

In June, we opened our new factory in Kuala Lumpur in Malaysia, and it's already producing many parts for various aerospace programs, including the A320neo. And we made progress with our prune to go strategy with the sale of our Blois automotive business in France.

For the full year, the Board expects to meet current expectations. So that juncture, I hand over to Bindi, who will take us through the financial results.

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Bindi Foyle, Senior plc - Group Finance Director & Executive Director [2]

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Thank you, David. Good morning, everyone. Let me take you through Senior's interim financial results for 2019.

Revenue in the first half of 2019 increased by 11% to GBP 580 million. And on a constant currency basis was up 6% with growth in Aerospace, partly offset by a decrease in Flexonics.

Adjusted operating profit increased by 6% to GBP 46.2 million. And on a constant currency basis, profit growth in Flexonics and lower central costs were partly offset by lower profits in Aerospace. The group's adjusted operating margin was 8%. This decreased by 30 basis points compared to last year. The benefits achieved from cost management, operational efficiencies and our prune to grow activity were offset by the 737 MAX rate reduction, the mix effect of transitioning from mature to newer programs, new product introduction and industrialization costs, and the start-up of our Malaysia facility.

Adjusted profit before tax was GBP 40.7 million, 4% higher than prior year, and on an IFRS 16 like-for-like basis, increased by 7%. With the group's adjusted tax rate at 20%, adjusted earnings per share increased by 7% to 7.84p per share. The interim dividend has increased by 4% to 2.28p per share with dividend cover maintained at 2.2x.

Senior generated free cash flow of GBP 13.2 million. This is after reinvesting GBP 35 million in capital expenditure. The key investments in capital expenditure were to support new product introductions, including our facility expansions and our investment in additive manufacturing technology. After payment of dividends, purchase of shares by the employee benefit trust and the disposal of Blois, net debt on a post IFRS 16 basis increased by GBP 19 million to GBP 268.3 million at the end of June.

As a reminder, the implementation of IFRS 16, the lease accounting standard, led to our opening net debt increasing by GBP 96 million on the 1st of January this year. Our lending covenants are currently based on frozen GAAP and about full calculated on a pre-IFRS 16 basis. So at the end of June, the group's net debt-to-EBITDA ratio was 1.2x.

Return on capital employed increased by 20 basis points to 11.7% at the end of June, and was in excess of our group cost of capital. The year-on-year increase was achieved through delivering profitable growth at a faster rate than the increase in capital employed that reflects our investments for growth.

Here I'll summarize the key elements of the group's trading performance in the first half. The chart at the top bridges the increase in revenue from GBP 523 million to GBP 580 million. The chart at the bottom bridges adjusted operating profit from GBP 43.4 million in 2018 to GBP 46.2 million in the first half of 2019.

With a stronger U.S. dollar compared to the first half of 2018, the group recorded favorable exchange rate translation of GBP 22.4 million in revenue and GBP 2.3 million in profit.

Looking at performance by division on a constant currency basis. Aerospace revenue grew by GBP 49.8 million, up 13% with growth from both civil and military sectors. The most significant growth came from civil aerospace, which increased GBP 40.7 million, up 14.5%. The group benefited from increased production of the A320, A350, 787, A220 and the Embraer E2-Jet, partly offset by decreases in build rates of the 777, A330, A380 and the legacy single-aisle platforms.

Military and defense sales increased by GBP 13.9 million, up 23%, primarily due to the ramp-up of the Joint Strike Fighter and higher demand from other defense products.

Revenue from other smaller markets decreased by GBP 4.8 million due to lower revenue from space and lower demand from the semiconductor equipment market.

Profit in the Aerospace division decreased by GBP 1 million, down 2.5%, and the margin decreased by 150 basis points to 9%. This was due to the 737 MAX rate reduction, the mixture of mature programs declining and newer programs ramping up and the cost of new product introduction and industrialization, including the start-up cost commencing from our operations in our second Malaysia facility. These headwinds were partly offset by the benefits from increases in operational efficiencies and learning curve improvements.

We continue to see improving returns in those businesses with new product introduction and industrialization is near completion.

On 737 MAX, we were geared up to increase to rate 57 per month this year, and have invested in capacity for this increase. In some businesses where we had strong order cover on other programs, we were able to mitigate the revenue impact. However, as we noted in our April trading update, our AMT business in the Seattle area is unable to mitigate the impact of the rate cut to 42 per month.

AMT has won high level of content on the 777X and is already absorbing high new product introduction and industrialization costs. As a consequence, AMT was less able to absorb the impact of the 737 MAX rate reduction.

Flexonics revenue decreased by GBP 15.5 million, down 9.4%. GBP 8.4 million of the revenue reduction was attributed to the sale of Senior Flexonics Blois, our French automotive business in February this year.

Flexonics revenue excluding Blois, decreased by 4.6%. Revenue from land vehicle markets decreased by GBP 7.1 million, down 9%. Senior sales to the North American truck and off-highway market decreased by 9% with higher sales of EGR coolers for trucks, offset by lower off-highway sales as market demand decreased.

Sales to the rest of the world truck and off-highway markets decreased by 6%, as growth from now ramp up of new programs in India was offset by lower market led sales in China. Excluding Blois, the group's passenger vehicle sales decreased by 12.5%, reflecting lower end market demand.

Revenue from power and energy markets was flat as drilling activity in upstream oil and gas-related markets decreased, and was offset by strong aftermarket sales from our Pathway businesses to petrochem and power gen markets.

Profits in the Flexonics division increased by GBP 1.1 million, up 8.3%. Flexonics margin increased by 150 basis points to 9.6%. This was from increased revenue from the downstream oil and gas repair and overhaul activity together with the benefits from our focus on cost management, efficiency initiatives and our prune to grow activity with the disposal of Blois. Central costs decreased by GBP 0.6 million from actions taken to mitigate the impact of the 737 MAX rate reduction on the group's overall performance.

This slide reconciles adjusted operating profit to the statutory reported profit for the period. It also highlights our interest and tax charges. Net interest payable of GBP 5.5 million increased by GBP 1.1 million. There was an underlying reduction in interest cost, but this was offset by the GBP 1.8 million increase from the adoption of IFRS 16 from the beginning of this year.

The group's adjusted tax rate for the first half of 2019 was 20% compared to 21% last year and currently, we anticipate the group's tax rate for the full year to remain at 20%.

In terms of reconciling adjusted profit to statutory reported profit, the following items are excluded from the adjusted profit measures for 2019: amortization of intangible assets from acquisitions of GBP 7 million, this was slightly lower than 2018 as intangibles of some prior acquisitions were fully amortized; the loss on disposal of Blois of GBP 7.2 million; and the related tax credit on both these items of GBP 1.6 million.

Now on to cash. The group converted 53% of its adjusted operating profit into operating cash flow of GBP 24.5 million. The depreciation figure on this chart includes GBP 4.8 million of additional depreciation related to the adoption of IFRS 16.

Working capital increased this year in support of revenue growth, new product introductions and partly as a consequence of the 737 MAX rate reduction. In the first half of 2019, we saw a net GBP 10 million outflow from change in working capital and provisions.

Capital expenditure of GBP 35 million was 1.6x depreciation, excluding IFRS 16. The callout box on the slide highlights some of the key CapEx investments made in the first half, supporting growth programs in the Aerospace division, including our second facility in Malaysia, the expansion of our metal bellows facility in Massachusetts and our technology investment in our Advanced Additive Manufacturing Centre in California.

For the full year, in line with previous guidance, total CapEx is expected to be between GBP 70 million to GBP 75 million as further investments are planned in support of these facility expansions and new programs.

Pension cash contributions in excess of service costs were GBP 5 million, and after allowing for interest and tax payments of GBP 11.3 million, the group generated free cash inflow of GBP 13.2 million.

Dividends paid were GBP 21.7 million and other net cash outflows of GBP 7.6 million included GBP 6.3 million for the purchase of shares by the employee benefit trust. Net cash outflow in the first half was therefore GBP 16.1 million. After taking into account adverse currency translation, the disposal of Blois and lease movements, net debt increased by GBP 19.2 million from GBP 249 million at the start of the year on a post-IFRS 16 basis to GBP 268.3 million at the end of June.

Senior's balance sheet remains healthy. As a reminder, the group balance sheet is consolidated at the spot rate on the respective reporting date and the box in the top right shows the main currency translation effects since December 2018.

As you can see from the box on the bottom right, the net retirement benefit surplus increased from GBP 18.5 million at the end of 2018 to GBP 20.6 million at the end of June 2019. The increase of GBP 2.1 million was primarily as a result of net actuarial losses being offset by the group's cash contributions to the plan and the disposal of Blois. The GBP 20.6 million surplus is comprised of GBP 30 million surplus in respect of the group's U.K. plan, which appears as an asset on the balance sheet, and a GBP 9.4 million net deficit for the rest of the world and U.S. plans, which is a liability on the balance sheet. Although the U.K. plan has an accounting surplus, in actuarial terms, this plan had a deficit of GBP 37 million at its last valuation in 2016.

And therefore, the company is continuing to make deficit reduction contributions of just over GBP 8 million per annum. We're in the process of conducting the U.K. plans biannual actuarial valuation, and we will update you on the outcome of this at the time of the full year results.

Other notable movements on the balance sheet relate to the adoption of IFRS 16. Taking into account lease additions and modifications during the first half of the year, as of 30th of June, 2019, property, plant and equipment includes GBP 94 million right-of-use assets, and net debt includes GBP 94 million of lease liabilities.

At the last results presentation, I went through the details of how IFRS 16 affects the group's financial results. So I will not repeat it here. But further details can be found in Slide 27 and note 19 of the interim results.

In terms of financing arrangements, our lending covenants are on frozen GAAP and are therefore calculated on a pre-IFRS 16 basis. Net debt before lease liabilities was GBP 174 million at the end of June, giving us headroom of GBP 138 million under the group's committed borrowing facilities. And the net debt-to-EBITDA ratio was 1.2x. Senior has strong liquidity and healthy financing arrangements.

Working capital as a percentage of sales remained under our ceiling of 15% and was 14.9% at the end of June. The increase of 50 basis points from the end of 2018 was principally due to increase in receivables. This was partly due to system logistics issues at one of our larger customers resulting in delayed receipts. Pleasingly, notwithstanding some upward pressure in support of new product introductions and as a consequence of the 737 MAX rate reduction, inventory as a percentage of sales remained flat as we continue to focus on inventory efficiency. I expect the group's working capital as a percentage of sales to be around 15% for the full year, which includes taking account of planning for Brexit.

Here I summarize Senior's first half financial performance according to the 5 financial metrics we use to measure the group's strategic progress and value add. These incorporate P&L, cash flow and balance sheet measures.

In summary, trading at the group level in the first half of 2019 was in line with expectations. Revenue on a constant currency basis grew by 6% percent and on an organic basis, excluding Blois, increased 8%. The group's adjusted operating margin was 8%, decreasing by 30 basis points compared to last year. However, adjusted profit before tax increased by 4% to GBP 40.7 million and with the slightly lower tax rate, resulted in 7% growth in adjusted earnings per share.

The group generated GBP 48 million of cash from operating activities, allowing us to invest GBP 35 million in capital expenditure for future growth and deliver free cash inflow of GBP 13.2 million. This delivered an improvement in our return on capital employed, which increased by 20 basis points to 11.7%. The year-on-year increase was achieved through delivering profitable growth at a faster rate than the increase in capital employed that reflects our investments for growth.

Thank you. And I'll now hand back to David to cover markets and the outlook.

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David Squires, Senior plc - Group Chief Executive & Executive Director [3]

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Thank you, Bindi. So let's turn our attention to markets. So I'll run through an overview of our markets then comment in more detail on the key sectors that Senior operates in.

Our exposure to civil aircraft has increased to 55% from 52% of group revenue, while military aerospace has increased to 13% from 11% of group revenue. Other full year results we reported, we have divested our Blois operation, which was our French automotive business, and that's the main reason why land vehicle has reduced to 12% of sales from 16%. Power and energy sales were actually flat overall, but it's down slightly as a percentage of overall sales because of Aerospace growth.

As I will explain later, upstream oil and gas activity was a little softer compared to prior year although our important power and energy aftermarket business held up well.

Overall, Aerospace represented 74% of the group in the first half of 2019, while Flexonics was 26%.

At the Capital Markets Day in May, we talked about the 2 technology themes across Senior: fluid conveyance and structures. The fluid conveyance products and systems, which we design and build in both Aerospace and Flexonics, benefit from shared underlying technology and intellectual property. More than half of our business is derived from these capabilities. Whilst we don't have design IP in our Structures businesses, as our customers own these designs, we do have significant manufacturing know-how and process intellectual property.

Equally important and providing a competitive advantage for these Structures businesses is our presence in cost competitive countries such as Malaysia, Thailand, Mexico and China. We encourage and enable collaboration across the group to ensure that we're making the most of our world-class engineering and manufacturing capabilities.

We'll now go through each of our key market segments in more detail, starting with our aerospace markets. And just before I talk about the civil aerospace sector more generally, I thought it would be helpful to give a factual recap on the 737 MAX situation given that has been the pressing issue for most businesses active in the Aerospace industry, including Senior.

So on the 13th of March 2019, the Federal Aviation Authority suspended operations of the 737 MAX following the Lion Air and Ethiopian Air tragic air accidents. Since then, all 737 MAX aircraft around the world have been grounded.

In early April, Boeing advised that they would be reducing production to rate 42 aircraft per month at the point at which the whole supply chain was poised to move to rate 57. Senior advised our assumptions for production rates in our trading update on the 25th of April. And then in June, the FAA identified an additional requirement, which Boeing advised would be addressed through updated software changes. In an announcement on the 18th of July, Boeing's senior leadership advised that they were currently assuming certification of the software changes to take place early in quarter 4 of this year, albeit this is subject to change depending on the FAA. They further indicated the rate 42 production will continue with a gradual ramp up to rate 57 in 2020, again, subject to change.

Our current assumption is know that we will be at rate 42 for shipments to Boeing at least until the end of 2019. And we're also assuming that deliveries to engine customers will be aligned to Boeing deliveries. For deliveries to Spirit, we're following their leads on maintaining production at rate 52, which will continue for some time after Boeing returned to rate 57 to burn off inventory.

Moving on to talk about the civil aerospace sector more generally, and of course, it is the most important market for the group. I showed this graph at our 2018 full year results presentation in March and at our Capital Markets Day in May. It gives a great visual representation of the momentous changes that have been taking place in the Aerospace industry over recent years as new, more fuel-efficient aircraft and aero engines have been introduced

And remember the bars in this chart represent annual production estimates with green being legacy aircraft and blue being the newer models. Modern single aisle and wide-body jets are way more efficient than the previous generations. They have lower cost per seat, generate more revenue per passenger kilometer and have less of an environmental impact than their predecessors. To be competitive therefore, airlines need to invest in these more efficient aircraft and engines.

And as I've said previously, just look at the pace of change. 2018 was the first year that more of the new models were built and delivered than mature models. The huge change, however, comes this year in 2019 with a massive ramp up in new model production and a very large decrease in mature aircraft and engine production.

We have adjusted this graph for the expected changes to production rates, in particular the Boeing 737 MAX. It doesn't change the overall shape of the chart. 2019 is still the biggest ramp up in new aircraft, though there is now a bigger step from 2019 -- from 2019 to '20 and '20 to 2021.

Aerospace is a long-cycle business, the need and desire to fly is not going to abate anytime soon. Air traffic growth is a constant and has been for 40-plus years. To satisfy that demand, the fleet is going to grow tremendously over the next 15 years. These aircraft will be in production and service for decades. And the installed base is now so large, the replacement of aging aircraft is a very important element of future growth.

As you can tell from this chart, if a company is not involved in these new programs, then it's not going to survive in the Aerospace industry, and that is why we at Senior have been so focused on maximizing our content on these new aircraft.

In recent years, we have introduced many, many thousands of new products into production. In 2018 alone, we introduced approximately 3,000 top level products, and many of those had lower-level assemblies, which, in themselves, go through the same introduction processes as a top-level assembly.

Safety is always the #1 priority. And therefore, the process to design, develop, inspect, qualify, certify and then industrialize is necessarily methodical. It costs money. Many companies capitalize this effort, but you would recall that in Senior, we take a different approach and expense these development cost to our P&L as and when they are incurred. NPI is expensive, therefore, and affects our P&L, but without it there is no future. NPI is fundamental to delivering profitable growth.

This year is another intensive year of NPI and industrialization activity, and there were a number of new aircraft programs still in the development cycle, for example, the 777X and Mitsubishi's new developments. But we can't expect that to start slowing over the next few years as entry into service is achieved and peak rates are hit on the new programs.

As I mentioned, a key aim for Senior Aerospace has been to maximize content on new platforms. We have more content on the key single aisle and wide-body programs than their older-generation predecessors. However, we're not chasing volumes at all cost. On the contrary, new bids need to meet our return on capital expectations, and we keep a pricing discipline when it comes to renewing contracts. In fact, we would rather forgo sales than take business at low or no margin.

In the last 6 months, we've added content on 777X, 787 and Embraer's E2-190, 195 aircraft. The smaller fluctuations are mainly due to currency effects. The reduction on A350 was a result of sharing material cost savings with our customer, which has been beneficial in opening up further opportunities. The reduction on 767 was due to the customer in-sourcing build to print parts to their Chinese operation. You will see that we have added the COMAC 919 and MC-21 to this chart as those aircraft draw closer to their production phases and entry into service dates.

Our good shipset content on the latest civil aircraft and engines will lead to profitable growth as markets grow and production rates ramp up.

Switching now to military aerospace markets. It's been a successful period for our businesses serving the sector. The platforms shown on this slide are, of course, not the only military aircraft, but they are the most important ones to Senior. Senior sales increased by 23% as a consequence of the continuing ramp-up in F-35 production and strong demand for other defense products. The F-35 continues to be the single most important platform when looking at future growth, and we have a very strong focus on trying to secure more content. So you may be a little bit surprised to see our shipset content decrease. In fact, this was as a consequence of good work in reducing material cost on parts made at our STEICO operating business, which we then shared with the customer as is common in U.S. Department of Defense programs.

We will continue to try and secure more content on this most important of U.S. military programs. CH-53K is the new U.S. transport helicopter being made by Sikorsky and will be an important platform for us in the future. So it's good to see customer securing low rate initial production orders. When this enters series production in a few years' time, it will generate significant sales for Senior Aerospace.

And back in March, we included T-X as a placeholder in this chart. So we're pleased to secure our first fluid systems content on the aircraft. T-X, you will recall, is the new trainer being developed by Boeing and Saab initially for the U.S. Air Force but with multiple other opportunities for follow-on orders.

Overall, our focus for military aerospace is very much in the U.S. market, where defense spending is as high as the next 7 countries combined, and series production volumes reach meaningful levels for sustained periods, which, in due course, will also generate good aftermarket sales for our fluid conveyance products. We are actively pursuing work in the sector -- further work in the sector therefore.

Turning now to Flexonics, we will firstly look at land vehicles, which covers truck, off-highway and passenger vehicles. On the passenger vehicle side, we completed the sale of our Flexonics Blois business in France, whose focus has historically been on diesel passenger vehicles. Excluding the effect of this disposal, sales to passenger vehicle markets reduced by 13% year-over-year, reflecting lower automotive market demand.

The more strategically significant part of our land vehicle business is truck and off-highway. We sell a range of proprietary products to the major OEMs, in particular, our exhaust gas recirculation coolers, or EGR coolers, as they are commonly known, which protect the environment by reducing emissions.

As expected, we saw some growth for Class 8 heavy-duty product for new production in North America and also Europe. However, that was more than offset by lower off-highway sales as production slowed in line with market demand on relatively high dealer inventory levels.

The forward trade forecast for later in 2019 and in 2020 are for slowing demand, and so we're maintaining the somewhat cautious view for truck and off-highway that we outlined at the start of the year. And accordingly, we'll take the appropriate operational measures to align capacity to demand.

Looking further forward, we are positioning ourselves to capture new business by developing solutions for new higher-efficiency internal combustion engines as well as electric vehicle applications. And this year, we've made good progress in this field with specific applications for a number of customers.

Our other most important Flexonics market is power and energy. Overall, our sales in this sector were flat in H1. At the start of the year, we highlighted the infrastructure issues in the Permian Basin affecting upstream oil and gas markets. However, lower sales there were offset by relatively strong aftermarket activity with our petrochem and power generation customers.

Taking everything into consideration, our Flexonics top line in the first half of 2019 was very much as expected, and we continued with our emphasis of growing margins faster than sales. Given that markets will continue to be less certain in the second half of 2019 and into 2020, that will be a continuing theme in this division. At the same time, the investments we are making in technology and products for vehicle electrification will be beneficial in the medium and long-term.

Just before I finish with the outlook, I wanted to talk a little bit about an area that we know from direct feedback from our largest investors is increasingly important to them and their clients. We take ESG, or environmental, social and governance, very seriously in Senior. I won't go through our whole ESG program here but will pick out some highlights that may be of particular interest. And for Senior, this all starts with our values. We place safety and ethics above all else in the company not because we're trying to tick boxes but because from the Board onwards, we believe it's right thing to do.

The universally acknowledged key performance indicator for safety is LTIR, lost time injury rate. Back in 2015, our Board agreed a target of reducing Senior's LTIR by 50% by 2020. By driving this from the top and implementing our advanced behavioral safety program, we have achieved our goal 2 years early in 2018. We've set a new target, which will move Senior from world-class performance levels to best-in-class performance over the next 5 years.

From an environmental perspective, we focused on a number of KPIs, including carbon footprint and waste recycling. Our 2020 goal was to recycle 90% of all waste we generate, and this was achieved 2 years early in 2018 when we recycled 92%. In 2018, we reduced our carbon footprint from 65 tonnes per million pounds of revenue to 60 tonnes. We're going one step further now and setting new science-based targets, which will be aligned with the Paris Agreement on climate change.

As a global company, Senior has a diverse workforce. There's always room for improvement, especially on gender diversity. Senior was an early adopter of the Hampton-Alexander Review targets for gender diversity on Boards and executive teams. And in last year's report, we ranked 14th in the FTSE 250 and amongst the top 3 from manufacturing companies. And we are enthusiastic members of the 30% Club with the aim of supporting the development and pipeline of talented women.

There are many other aspects of our ESG program such as the work that we do to support our local communities around the world and our responsible sourcing policy. We will continue to drive this forward for the benefit of all our stakeholders.

So let me finish by talking about the outlook for Senior. Trading in the first half of 2019 at group level has been in line with expectations, although we have had to work hard to minimize the very real impact of the 737 MAX rate reduction. The Board expects to meet current expectations for 2019 with Aerospace performing at a similar level in H2 as H1 and Flexonics continuing to offset the full year sales decline with margin progression in 2019 compared to 2018. We need to and are working to minimize the impact of the risk associated with current challenges, namely the 737 MAX rate reduction and the impact on industrial markets of geopolitical and macroeconomic uncertainty. We always work hard to control costs and improve efficiencies, and that will remain our strong focus throughout this year and into 2020.

Looking ahead, the group is well positioned. We're operating in attractive end markets, and we are financially robust. The Board remains confident of delivering improving performance and returns for our shareholders.

So with that, we'll open the floor for any questions, which Bindi and I will be delighted to answer. Charlotte, stay in there.

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Questions and Answers

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Charlotte Anne Keyworth, Joh. Berenberg, Gossler & Co. KG, Research Division - Former Analyst [1]

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Bindi and David, I'm Charlotte Keyworth from Barclays. I like your diversity stats, by the way. So 3 questions, first on I guess the outlook. So you're reducing the Aerospace margin from the original Q1 downgrades by about 100 basis points. I wondered if you could just -- I mean obviously, you've held guidance for the year. Perhaps you could just step through the components of how you're going to offset that through revenue-driven profit growth, execution and then obviously the margin that we've seen in Flexonics?

And then I guess looking forward into 2020 on the MAX, what cost-reduction steps are you going to be taking? And if we're not to believe Boeing's commentary that we get back to rate 57 next year, I mean what needs to happen to offset that?

And then finally, on the Pathway business, I think it has been part of the margin improvement in Flexonics. If from memory that's a -- put a high margin, emergency spares and repairs type business, and I think we've been waiting quite a long time to see some volume from that. Is this the -- is this just a sort of seasonal improvement? Or are we actually at the cusp of a CapEx refresh and things like petrochem and we can start to see some better EBIT coming through there?

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David Squires, Senior plc - Group Chief Executive & Executive Director [2]

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Okay. Maybe I'll go in reverse order, if I may, Charlotte. So firstly on Pathway, now as I mentioned in power and energy, so upstream oil and gas was a bit softer. But we talked about that at the start of the year because of those infrastructure restrictions in the Permian Basin, which are dragging on a bit longer than perhaps some people thought. And -- but we've had good aftermarket in Pathway. That's our petrochem and power and energy business.

So a couple of things there. A number of our competitors have disappeared in North America. They weren't be able to survive the downturn. But because Pathway has got this big installed base, they've been able to do that with a particularly strong spring outage season. So there's a couple of shutdowns of these plants each year, one in the spring, one in the autumn or the fall, as it's called in America. So spring was particularly strong. We wouldn't expect autumn to be quite as strong. But nonetheless, we've got decent order book coming to the second half of the year. So we expect Pathway to continue to perform well. Most of that is aftermarket. There are some new work coming through for smaller projects, but we'd be getting increasingly active on some of the larger capital projects. So there are some now approved. I think the last time we said sales probably not until the end of 2021 because it's about an 18-month gestation period from orders to sales. So we'd hope to be booking some orders next year for maybe sales starting at the end of '21, maybe into '22, that sort of time frame.

And then on the MAX, firstly, the reason I'm putting the factual comments from Boeing is really I'm not going to speculate more than what our customers are seeing or everybody else is seeing. So what the senior leadership, Dennis Muilenburg, at Boeing have said is their current assumption is early Q4 for FAA approval and then a gradual return to rate 57 June 2020, which of course implies rate 42 for the rest of this year. So that's what we are planning to do, and by implication, therefore, at the start of the year, still going to be at rate 42. We're going to wait and see. We'll plan for all sorts of scenarios, I won't to run through them all of here, but you can rest assured that we'll plan for every scenario you could possibly think of on the 737 MAX. But hopefully, it's as how Boeing have described.

And the sort of thing -- we always align capacity demand where we'd look at any capital investment requirements out there. We were tooled up for rate 57. So we'd already made a lot of capital investments. So that's one of the things we'd be having to mitigate. Wherever possible, we'll fill those machines with other work if we're not dedicated to 737. So in quite a lot of our businesses, that's exactly what we've done. That's why you've seen higher sales perhaps some people might have been thinking.

But the one business that we just struggle without is AMT. And we went to AMT with a dedicated 737 wing ribs blend, and you can't really put other work down that. So you -- straight away, you run some issues there. And also, they are just so busy with 20 new work packages on 777X. They haven't really got time to taking a lot of other new work to compensate. So -- and that's our biggest structure as a business, AMT. So the vast bulk of the 737 issue we've been -- that we've been trying to mitigate is in that particular business. The other guys have done pretty well, in fact.

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Bindi Foyle, Senior plc - Group Finance Director & Executive Director [3]

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Yes. And that links on to your first question around Aerospace margins. So the thing we really highlighted in the April trading update was we were working very, very hard to mitigate the bottom line earnings impact, which you can see in our half 1 results. So we have gone for more sales in other operations where we've had the ability to do that. Yes, margin is lower than our previous expectations, but we've absolutely delivered on the profit and the bottom line. And that's what we see going forward into the rest of the year. Also, we've now taken quarter 4 down to rate 42 for Boeing but also the engine as well.

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Charlotte Anne Keyworth, Joh. Berenberg, Gossler & Co. KG, Research Division - Former Analyst [4]

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So a combination of sales where we can get them in our business and of course just really managing those costs very carefully in the most affected businesses.

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Bindi Foyle, Senior plc - Group Finance Director & Executive Director [5]

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Andy?

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Andrew Douglas, Jefferies LLC, Research Division - Equity Analyst [6]

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Andrew Douglas from Jefferies. Four questions, please, if I may. Things that you can control, unlike the 737, with -- is the learning curve improvement, which you've talked over the last couple of quarters. Can you just give us an indication on how you guys are doing there from an operational perspective? I think last time you spoke, you're kind of hitting your numbers every month, which I know is dear to your heart. I guess also on NPI costs, just making sure that we're kind of progressing as you largely thought.

Secondly, I'm interested in your comment in the statement with regards to return on capital employed and capital deployment on existing work but also kind of new piece of work. Can you just expand upon that a little bit for us? That will be helpful.

Third, it might be a short one, but electric batteries, I know we talked about that at the Capital Market Day. But can you give us any kind of update there, if you're making any progress in that field?

And then last but by no means least, MC-21 and the C919, where exactly are you making those parts, just with interest?

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David Squires, Senior plc - Group Chief Executive & Executive Director [7]

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Okay. So again, I'll take the last one first because that's the easiest. Actually, a lot of that's in the U.K. So for example, MC-21, we're doing a low-pressure ducting system. So that's in Macclesfield. And COMAC, it's quite a variety of businesses we have there, so some from Europe...

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Bindi Foyle, Senior plc - Group Finance Director & Executive Director [8]

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Some from U.S. as well, actually.

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David Squires, Senior plc - Group Chief Executive & Executive Director [9]

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And some from the U.S. as well.

On the learning curve improvement, yes. So this whole 737 MAX is something that masks the improvements we're making elsewhere. So as you rightly point out, Andy, our divisional leadership teams review progress on our cost-out programs and learning curve improvements every month. And then Bindi and I review those every quarter on our very intensive quarterly business reviews. And each one of those plans is very granular, laborer hours reduction and material cost-down plans against it. So happy to confirm we're still bang in line where we expect it to be on those big programs.

And I think I said at the Capital Markets Day, the other check and balance we do is we look at -- if you like, the margin for the businesses are quite weak through their new product introduction journey, and they're good. We're very satisfied with quite a number of our businesses in Aerospace, and you can see the direction of travel over the last few years. They've gone from dealing with a lot of NPI industrialization to coming into production phase. I didn't see the margins come up accordingly. So those are things that give us confidence that we'll see that continuing over the next few years. Of course, in a number of businesses, there's still huge amounts of new products introduction happening, particularly in our Structures business where we have an ability to win work mid-cycle, if you like. On Fluid Systems, it's not impossible to get product on once the system's been qualified. In fact, we're displacing a couple of customers -- competitors, I beg your pardon, on certain aircraft. It's much harder and takes a few years. Whereas in structures because we don't do the design, the customer can approve people to make it. So that's how we're filling the lease in Thailand by taking market share from other people. So that means there's a lot more new product introduction, industrialization that's going on in those businesses. Probably fair to say the mix of NPI and industrialization is slightly moving from NPI to the industrialization phase. And what do we mean by industrialization? We mean growing from a really low rate initial production to be peak rate. So that's an expensive process as -- and it really helps you go up the learning curve, so -- whereas NPI, where we talk about the specific development costs associated with getting it to the point, which you can actually start production. So still a lot of NPI but even more industrialization at the moment. So you can see us drive and moving through there. And...

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Bindi Foyle, Senior plc - Group Finance Director & Executive Director [10]

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Capital deployment.

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David Squires, Senior plc - Group Chief Executive & Executive Director [11]

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Capital deployment. Bindi, do you want to comment on that?

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Bindi Foyle, Senior plc - Group Finance Director & Executive Director [12]

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Yes. So this -- we talked about our focus on improving returns on capital employed. So we're looking at when we do come to make investments, whether it's for new contracts or renewal of existing contracts, they have to meet our strict criteria on generating sufficient return on investment. So where the plans are not generating that, we will not take on that new work or the renewal. So we're making sure that where we are investing, it's in high-quality return-generating areas.

So this -- as David said in his speech, it may mean that sometimes we will forgo topline growth but to make sure that we get that return up.

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David Squires, Senior plc - Group Chief Executive & Executive Director [13]

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So we're still running some decent business but in other areas. A good example is I talked about the Tyco product. If we'd -- we want to attempt to match the in-sourced Chinese price for that particular customer, it wouldn't have made any sense. I think they've been quite up to live as if we had, but it just wouldn't make sense. So we'd rather not have that particular piece of business. And as I've said, every time I meet people, we win some, we lose some. But overall, we think we're making the right decisions.

Did I answer -- oh electrification, yes, my favorite subject. So no, good progress actually. So you might have seen in the Cummins announcement, they said that Cummins and GILLIG are now selling the buses -- the transport buses in North America. That's the vehicle. That's the first application for that 70-kilowatt battery pack that we've got that cooling plate on, that we've got the 2 patents that we've filed. So that was tremendous news. We hope quickly the volume picks up. We will see. We're not expecting massive sales next year or anything. But as we can see as that share of the market grows from 1% to over 50% by 2040, it's on a big curve there. But we've also got very pleasant not surprise but update from our business development guy in Flexonics, Shaz Malik, who is somebody you would have seen at the Capital Markets Day. He just gives all the other customers we're working on with similar products, and it's really quite extensive. So in the last few months, we've been very active and I think piqued a lot of interest with what we've been doing there, yes, on the truck side and off-highway and actually some on the automotive side as well on the passenger e-vehicle side. So good progress there.

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Malini Chauhan, Redburn (Europe) Limited, Research Division - Analyst [14]

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Bindi and David, Malini from Redburn. Three questions, if I may, 2, sorry, are MAX-related. And firstly, assuming Boeing's expectations are correct, how easy will it be for you to rate -- ramp up production from 42 back up to rate 57? And will there be any kind of cost associated with the ramp-up?

And two, you mentioned that you've taken your engine assumptions in terms of delivering to the engine manufacturers down also to 42 a month. Apologies if I missed it, but is this something that CFM had -- have announced to you?

And then thirdly, not on 737 MAX, but just on CapEx. We're still in an elevated year of CapEx spend. How many more years of elevated CapEx do you see going forward?

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David Squires, Senior plc - Group Chief Executive & Executive Director [15]

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Yes. So let me take the middle one for me. That's probably the simplest one. No apologies for 737 MAX questions. I was going to take a sweepstake on how and when we'd get over next week. We runs in the hundreds of (inaudible). But really, it's such an important subject we've got to talk about.

So firstly, on the -- yes, CFM and Safran/GE said they were going to -- they've caught up on their overdue deliveries. So now their manufacturing is going to be aligned to Boeing's, which in some ways is quite neat and symmetrical. So -- however, they stayed at the higher rate for longer because there were some overdue deliveries there not just from them but from some of their suppliers. Now they're caught up. So now that's in alignment. Spirit's a little bit different because they have this special agreement with Boeing out to next May as they continue to run at rate 52, which they confirmed on their earnings call last week. And I spoke to their senior leadership, and they confirmed that as well. So that means they're going to continue to build up inventory and then run it down again over -- it will be into 2021 before that's burned off. So in a sense, that's quite good as well because it means we're level-loaded on those products. So that's how we see. So our assumptions out to the end of this year, rate 52 for Spirit, rate 42 for Boeing and the other aircraft guys.

In terms of ramping back up when that hopefully happens, yes, there is quite a lot to do there. We have to go our whole supply chain aligned as well. And we know that that's a concern of Boeing's, and we talk to them almost daily about it, just making sure that raw material component parts, et cetera, that we can ramp up quickly when it needs to happen. We let -- we've let some labor go through natural attrition in a couple of our businesses, particularly AMT as we talked about. So we have gone from hiring machinists and assembly guys like crazy to not replacing them with attrition. So we'll be back into trying to hire those people when we need to.

And just moving up 15 shipsets a month over whatever period of time, it just take quite a lot more just to level our organization. So yes, we can do it. It's what we do in the business. But yes, there's some impact and there's some costs associated with doing that over a period of time.

And Boeing -- so we're heartened to see here Boeing say that they expected a gradual increase back up to rate 57. I think it's really the supply chain they have in mind there.

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Bindi Foyle, Senior plc - Group Finance Director & Executive Director [16]

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On CapEx, so I said it's -- first half was 1.6x depreciation, excluding the IFRS 16 piece of depreciation. So the second half, it's a similar level. And this is where the bulk of the spend on the metal bellows facility expansion comes through, also our additive manufacturing investments and then continuing to build out the capacity in our Malaysia facility. So then looking forward, and I always caveat this subject to winning more new work, it will come down sort of 1.4x eventually, 1.1x depreciation. We want to keep growing the business. So that is a sign of trying to maintain it eventually around 1.1x, but it will take a few years to get down.

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David Squires, Senior plc - Group Chief Executive & Executive Director [17]

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And of course, now we're in discussions with individual businesses. Bindi and I are very clear. If you're not growing, I would expect you to be at or below depreciation in terms of CapEx. For those businesses that are growing, show us a business case and we'll talk about it. So again, very disappointed in their approach there. David had a question.

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Unidentified Analyst, [18]

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First of all, on guidance going forward, what dollar rate are you looking in there? Presumably, you've got a -- quite a tailwind from where we were. Secondly, can you just -- you're very excited about this battery stuff. But we've got passenger vehicles down to, I think, 3% of group sales. Can we keep it at that level? We're not going to become an auto components company again, are we? And then finally, just what you're seeing pricing-wise, in particular the old C series? Airbus obviously needs to get the price of that down or the cost of that down.

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David Squires, Senior plc - Group Chief Executive & Executive Director [19]

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Yes.

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Bindi Foyle, Senior plc - Group Finance Director & Executive Director [20]

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In terms of currency, so for the first half of the year, we averaged $1.29. If you take the sort of average rate at the moment, for the full year, that equates to about $1.25. And a $0.10 movement in the dollar-pound rate is a GBP 4 million impact on profit.

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David Squires, Senior plc - Group Chief Executive & Executive Director [21]

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And yes, so I can assure you we're not choosing mass volume pass e-vehicle work. So mainly, it's our niche applications into truck, off-highway. There are some niche passenger vehicle applications, particularly the larger end of the cars where our technology would make more sense. We've mapped out with Cummins, for example -- they've shared their technology road map with us and what they think is going to happen in electrification. I think I showed some of that in the Capital Markets Day. So we've had a much more in-depth discussion with them and with other people about what size of vehicle they expect to become all-electric or hybrid and then what time frame. So we've kind of aligned our technology road maps and our product development road maps to those and to other customers. But typically, that's going to be into the commercial market rather than the domestic, so the passenger e-vehicle for sure. And I know it's a long play here as well. But I just said to the guys, "We can't ignore the fact that market's growing from 1% to 50% over the next 20, 25 years." So we want to be part of that but on a commitment at it.

And then the other question was on C Series, yes. C Series, so yes, your -- no doubt, part of Boeing's business case for the JV would have been...

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Bindi Foyle, Senior plc - Group Finance Director & Executive Director [22]

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Embraer.

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David Squires, Senior plc - Group Chief Executive & Executive Director [23]

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Well, did I say Boeing? But that's Boeing, Embraer. Yes, part of Airbus' business case for buying into C Series from Bombardier would have been -- we can help you get your material costs down. Good to see a bit of volumes coming through as we thought they would. So yes, we're engaged in pricing discussion with Airbus, as you would expect. But it's what can we do together to design cost out, share the benefits on our Fluid Systems work. And we don't do any structures work on C Series. So we're -- Airbus are very familiar now with our Malaysia and Thailand facilities. They've already been across and approved our new factory in Kuala Lumpur and the special treatments and processing line for using their programs. So for me, that's a natural way to help them get their costs down, and that program is by looking on Structures as well. So yes, ongoing discussions about ones that we're comfortable with. So Harry?

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Harry William Freeman Breach, MainFirst Bank AG, Research Division - Research Analyst [24]

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Harry Breach from MainFirst. Just maybe sort of 3 or 4. First, Flexonics margin improvement was, I think, impressive in the first half. Can you give us a feeling about whether the cost cuts that you've made and efficiency improvements still have some tailwind into 2020?

The next question, 777X maybe has been another industry theme over the last couple of months with the GE9X delays and Boeing talking about first flight moving out. If we do see delivery delays, is that going to be something material in terms of your outlook in 2020? Or frankly is it more of a sort of a minor issue?

And then maybe just finally, are you still feeling confident about the returns of the historic margin levels in 2021?

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Bindi Foyle, Senior plc - Group Finance Director & Executive Director [25]

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If I cover the Flexonics margin point, we grew by 150 basis points to 9.6% in the first half, and that was sort of the elements of taking costs out and our operational efficiencies because remember, revenues actually decreased organically. So that's one element. Our prune to grow with selling Blois also helped the Flexonics margin. And then the other element, which is the upstream -- the downstream oil and gas with Pathway, having that good spring outage season also helped first half margins. So if I look forward to the full year, I wouldn't necessarily expect to have the same level of fall outage season as the spring outage in Pathway. So you couldn't necessarily see the same thing there. But all the other elements around taking costs out and the prune to grow helps the overall year-on-year 2018 to 2019. We expect Flexonics margin to increase. And then -- so the bit about the Pathway won't necessary repeat in half 2.

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David Squires, Senior plc - Group Chief Executive & Executive Director [26]

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And then on 777X, yes, so what Boeing announced was that their engine was running a bit late. And therefore, there was some risk to the first flight. They said it was still in next year, but there is some risk to that. So we will see what Boeing say about that moving forward.

Now there is not a whole lot of production there next year. There was supposed to be some at the back end of the year. But really, ramping up from 2021, it's possible that they may substitute some 777 work instead of 777X. We shall see. We don't really yet know, but there wasn't a huge amount of volume in the next year in any event.

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Bindi Foyle, Senior plc - Group Finance Director & Executive Director [27]

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Yes. But our AMT business, which is working on a lot of work packages on that, the more design development, test phase extends, there will naturally, therefore, be some continuing NPI activity in that business.

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David Squires, Senior plc - Group Chief Executive & Executive Director [28]

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By the way, for those who haven't seen the folding wing tip on the 777X, have a look at it on YouTube. This is where the last 4 meters of the wings fold up. It's truly impressive for a commercial aircraft. This is how Boeing are going to fit the 777X into more airports. Remember for A380, they had to build a lot of infrastructure in airports. So Boeing's solution is to fold the wing tips so they can get into much more -- many more airports as it's one of the key selling features. So we're doing the folding wing tip assembly as one of the many packages that we have from AMT so -- at the heart of that. So we'll watch this space, I think, Harry, and we'll take a leaf from Boeing again.

I think on -- I'm confident that we're going to get to at least the levels of ROCE that Bindi has described in the Capital Markets Day, which was 13.5% post-IFRS 16 as a minimum in the medium term. That's where our whole focus is on, and margin expansion is part of that. But at a time when Boeing can't even give guidance for the rest of 2019, I'll probably save my -- keep my powder dry on what's going to happen in 2021. We'll see, as a lot more businesses are through that. As I said to Andy, a lot of the businesses are through their NPI journey. They're already at target margins. So we're making very good progress but clearly more to do, and there's some extraneous factors here we need to cope with as well.

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Bindi Foyle, Senior plc - Group Finance Director & Executive Director [29]

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We've got time for one more question. Yes, Dom?

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Dominic Convey, Peel Hunt LLP, Research Division - Analyst [30]

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Just one more, if I may, on that point about the Aerospace margins longer term, however we might define the time frame. But is it simply a question of seeing hopefully the 737 MAX come back, seeing the new business win run rate level, also the NPI and industrialization costs normalize? Or do you envisage actually having to take a different approach or more perhaps integration of those, I think, 19 sites and more fixed costs to come out of that business to get back up to the -- those margin targets and deliver those returns?

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David Squires, Senior plc - Group Chief Executive & Executive Director [31]

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Well, I think just your number of key elements to improving returns on capital employed, and therefore margin, and you've hit some of them there, Dom. Certainly, volume, of course, is an important one. It can be pricing discipline as another, as I -- as we've alluded to in the announcement, and again today and as I always said, it's very competitive and particularly built the pretty world, it's very competitive. So just keeping our pricing discipline there and not chasing volume for volume's sake. There's some hungry people out there. We'd rather not chase that type of work. So that's -- but there's always a fine balance there. So we'll watch that carefully.

Our underlying investments in our intellectual property in that business are important as well. So if you look at something like additive, we don't talk much about it. But I'm absolutely clear in the medium term that some of the parts we'd be supplying that we supply today as non-additive will be additive. And we've got a large customer with the Airbus. And it's going very well. That's going to help us to sustain and improve margins, I believe.

And yes, portfolio, as always, really important. So we're constantly reviewing our portfolio. We've sold one business, Blois. We've made no secret of the fact that our prune to grow strategy is important. It applies to the Aerospace as well as Flexonics. So yes, that's going to be ongoing part of our business model.

Okay. Unfortunately, we're timed out, and that's because we have meetings with investors to get to. So thank you, everybody, very much indeed for coming along. We truly appreciate it.

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Bindi Foyle, Senior plc - Group Finance Director & Executive Director [32]

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Thank you.