Moog Inc

NYSE:MOG.A

Earnings Call Transcript 2019-Q3

[Operator]

Good day, and welcome to the Moog Third Quarter Earnings Conference Call. Today's conference is being recorded.

At this time, I'd like to turn over to Ms. Ann Luhr. Please go ahead, ma'am.

[Ann Luhr, IR]

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 July 26, 2019, our more recent Form 8-K filed on July 26, 2019, and in certain of our other public filings with the SEC.

We've provided some financial schedules to help our listeners better follow along with 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 homepage and webcast page at www.moog.com. John?

[John Scannell, Chairman and CEO]

Thanks, Ann. Good morning. Thanks for joining us. This morning, we report on the third quarter of fiscal '19 and update our guidance for the full year.

Our business continues to perform well, and we remain on track to meet our full year EPS targets. As usual, I'll start with the headlines. First, this month, we celebrated the 50-year anniversary of the Apollo 11 moon landing. Moog provided the Thrust Vector Control actuation on all 3 stages of the Saturn rocket on that historic flight back in 1969. This was one occasion when performance really mattered. And thanks to the ingenuity and dedication of the Moog's staff at the time, everything worked perfectly.

As I said before, at Moog, we play for the very long term. And, today, 50 years after the Apollo landing, we continue to work with NASA to develop the next generation of technology, which will take humans back to the moon in 2024. Second, coming back to today, our Q3 was a record quarter for both sales and earnings per share. Sales were up 7% from a year ago and earnings per share of $1.35 were up 19% over last year. Third, relative to our forecast, we had a shift in the mix of earnings in the quarter, with Space and Defense group very strong, while the Aircraft group was behind plan. Fourth, free cash flow in the quarter was soft as investments in working capital and fixed assets accelerated in support of our growth.

And finally, despite the ongoing uncertainty around global trade and Brexit, the outlook for our major markets remains healthy, giving us confidence to affirm our guidance for this year and an optimistic outlook for the next year.

Now let me move to the details, starting with the third quarter results. Sales in the quarter of $741 million were 7% higher than last year. Sales were up double digits in both Aircraft and Space and Defense while Industrial sales were up 5% as a result of our exit from the wind pitch control business.

Taking a look at the P&L. Our gross margin was about in line with last quarter while our operating expenses were about 70 basis points lower. Our R&D spend was the same as last year, at $31 million, resulting in operating margins of 11.4%, up 50 basis points from Q3 '18.

Earnings before taxes were up 12%. We had a lower tax rate this quarter, resulting in net earnings of $47 million, up 17% and earnings per share of $1.35, up 19% over a year ago. Overall, a nice quarter for the company.

With one quarter to go, we're keeping our sales and EPS forecast unchanged for -- from 90 days ago while adjusting the mix slightly between the groups. We think sales in Aircraft will be slightly ahead of our forecast from that quarter while sales in both Space and Defense and Industrial will be marginally lower. We're also lowering our EPS range to plus or minus $0.10. In summary, we're forecasting full year sales of $2.9 billion and full year EPS of $5.05, plus or minus $0.10.

Now to the segments. And I'd remind our listeners that we provided a 3-page supplemental data package posted on our website, which provides all the detailed numbers for your models. We suggest you follow this in parallel with the text. Starting with Aircraft. Sales in the third quarter of $337 million were 12% higher than last year. We saw a double-digit sales growth in both our Military and Commercial books. On the Military side, higher sales across the OEM book of business compensated for lower sales on the F-35 program.

In particular, we had stronger shipments on some foreign platforms and various helicopter programs. And Military aftermarket was up nicely in the quarter, led by our 2 biggest programs, the F-35 and the V-22. On the Commercial side, OEM sales were up across most of the portfolio. Sales to Boeing were 11%, led by the 787, and sales to Airbus were up almost 30%, all driven by the A350 program. Business jet sales were also higher on strengths across the Gulfstream portfolio. Commercial aftermarket was down from a very strong Q3 last year on slowing IP sales, particularly on the A350.

Aircraft fiscal '19. We're increasing our full year sales forecast by $24 million to reflect the strength we're seeing in the back half of the year. On the Military side, we're keeping our full year sales unchanged, but adjusting the mix by lowering the OEM sales by $10 million, while increasing the aftermarket sales by the same amount. The net increase is all on the Commercial side. We're increasing our commercial OEM sales by $16 million, balanced across the portfolio.

In addition, although the commercial aftermarket was down this quarter relative to a year ago, it's running ahead of our forecast for this year. So we're adding $8 million to our projected aftermarket sales in fiscal '19. Overall, we now anticipate full year sales of $1.29 billion, split 48% Military and 58, 52% commercial. Aircraft margins in the quarter of 10.2% were below expectations. Through 2017 to 2019, we've seen Aircraft R&D dropped by about 300 basis points while other operating expenses remained more or less flat as a percentage of sales.

We had anticipated we will see much of gain drop to the bottom line, we haven't. The challenge has been on the gross margin line where our expected productivity gains have not materialized. Over the last 2 years, as we've experienced various challenges of certain vendors and with our in-house manufacturing process, we've addressed each of one on an individual basis. We believed each challenge was an isolated incident. And as we addressed each one in turn, the margins would improve.

Given the margin and cash flow results this quarter, we concluded that our operational challenges require a new approach. Therefore, we've decided to engage in a more structured program of work and make additional investments in our factories and supply-chain processes to deliver longer-term operational excellence. As such, we've reorganized the management of our Aircraft operations and engaged outside consultants to work with our internal teams to lay out the plan that will deliver sustainable improvements.

Our Aircraft business remains very strong and has excellent long-term prospects. However, the investments we're making to build a world-class operating model will constrain the pace of margin expansion that we had plans to deliver. In the short term, we're moderating our full year fiscal '19 margin forecast of 10%, down 60 basis points from our forecast 90 days ago. We believe our fiscal '19 margin is a reset and looking ahead, our additional investment in operations will deliver gradual and sustainable margin improvements over the coming years.

Moving now to Space and Defense. Sales in the third quarter of $173 million were up 16% from last year. Similar to recent quarters, the Defense side of the business continues to be the powerhouse. Defense sales were up 23% over the same quarter last year, with strength across the portfolio, particularly in missiles, vehicles and slip ring components for a variety of end applications. Sales of our new turret products doubled from the same quarter last year to $9 million.

On the Space side, sales were up marginally, a combination of slightly higher launch vehicle and NASA work, compensating for lower satellite avionics sales.

Fiscal '19 Space and Defense. With 1 quarter remaining, we're moderating our sales forecast in both our Space market and our Defense market by $6 million each, resulting in full year sales of $669 million. On the Space side, our avionics product line is coming in a little softer for the year than we had anticipated. While on the Defense side, the ramp-up on our new turret program, the RIwP is lower than we had planned as a result of delays in locking down the final product design.

For the year, we now anticipate RIwP sales of $31 million, up from $15 million in '18 and only $3 million in fiscal '17. Despite the slower ramp, we continue to be very excited about the prospects for this new product.

Space and Defense margins. Our Space and Defense Group is delivering excellent margin performance this year. In the third quarter, margins of 14% were up almost 300 basis points from the same quarter a year ago. This quarter, we had a very favorable mix which, helps with the strong results. For the full year fiscal '19, we're increasing our margin outlook by 90 basis points to 12.7%.

Turning now to Industrial Systems. Sales in the third quarter of $231 million were down 5% from last year. The loss of sales for our winds pitch controls business drove the decrease. Looking across our 4 major markets, Medical was up 5% on higher sales of enteral pumps. Industrial automation and simulation and test were more or less in line with last year with some minor changes in the mix. Energy was down almost 40% from a year ago. Sales in energy exploration applications were about flat from last year, but in addition to the loss of the wind pitch business, we also had lower sales in energy generation applications.

Fiscal '19 Industrial Systems. We're moderating our full year forecast by $12 million to $919 million. We anticipate sales into energy generation applications will be down from our forecast and the sales of components into medical applications will also be slightly lower.

Margins in the quarter of 11 % were up 70 basis points from last year. For the full year, we're keeping our margins unchanged at 12%. This is up 110 basis points from an adjusted operating margin last year, excluding the wind exit charges of 10.9%.

Summary guidance. Overall, Q3 was a good quarter for the company but with some swings in margins from what had anticipated. Growth in both sales and margins in our Space and Defense group compensated for operational challenges in our Aircraft Group. Our Industrial group is more or less on plan. Overall, our major markets remain strong, and we continue to look optimistically to the next few years.

Defense makes up almost 40% of our business in total and continues to be very vibrant. The F-35 program continues to ramp, we're seeing increasing orders in the military aftermarket and our missile and vehicle businesses are growing nicely. We have over $70 million of funded R&D for next generation military aircraft this year and next, and we're investing in new growth platforms for remote turrets and counter drone systems. We believe as we look out to the fiscal '20, this Defense business will continue to grow and deliver strong results.

Our commercial book of business is healthy, although the growth is slowing from a few years back. The 787 is more or less at rate and the A350 ramp is leveling out. Our business jet applications with Gulfstream are doing well, and the aftermarket is gradually increasing as the 787 and A350 platforms come out of warranty. Looking out to next year, we'll see the legacy book of business decline on 777 rates in particular, but we'll see the E2 ramp-up, so that net-net, we think our sales in the Commercial Aircraft market should be more or less in line with this year.

In the industrial markets, GDP growth is slowing in both Europe and Asia, but the U.S. remains strong. Given this picture, we believe the diversity of our end markets is a real plus. Year-to-date, for fiscal '19, our book-to-bill remains positive. We deliver products into energy exploration and power generation markets, industrial automation applications ranging from steel production to plastic molding machines, flight simulation systems and products that are driven by the global spending on medical technologies. Each of these submarkets within our industrial group has a different economic cycle, giving us optimism that fiscal '20 will the another solid year for our Industrial business.

Global events, of course, are hard to predict, and we cannot foresee the impact of a hard Brexit or escalating trade wars. Therefore, notwithstanding our optimism, we're very vigilant for any material changes in the outlook for our Industrial markets. We plan for what we know and remain flexible to adjust our business plans as events unfold.

For the full year fiscal '19, we're keeping our forecast unchanged from 90 days ago, while adjusting the sales and margin mix slightly between the groups. Full year sales should be $2.9 billion, with earnings per share of $5.05, plus or minus $0.10. This results in earnings per share in the fourth quarter of $1.25, plus or minus $0.10. We'll provide a detailed forecast for next year on our Q4 earnings call in November. But we anticipate that fiscal '20 should be another year of good growth in both sales and earnings per share.

Now let me pass you to Don who will provide more details on our cash flow and balance sheet.

[Don Fishback, CFO]

Thank you, John, and good morning. Third quarter free cash flow was a use of funds, totaling $11 million, coming in below what we had been expecting. Year-to-date, free cash flow stood at $38 million or a 28% conversion ratio, behind the pace of our previous 90% conversion forecast for all of 2019 and short of our recent average historical free cash flow success that's been in excess of 100% conversion.

Growth-related challenges are putting more pressure on our free cash flow than we had anticipated, driven by CapEx and working capital demands. At the end of Q3, working capital as a percentage of sales was 28.4%, up from 24.9% at the end of FY '18. The working capital increase is mostly related to growth in physical inventories where we've procured and build safety stock, partly in response to the strains on the global Aerospace and Defense supply chain. As we focus on improving our operational processes, we expect that we'll our physical inventories, and more generally our working capital, drop back down to the levels that we had been realizing until recently.

For all of FY '19, we're reducing our free cash flow forecast to $90 million or a conversion ratio of 50%. Mostly, the decrease in our forecast from three months ago is the result of working capital demands. In addition, we've increased our CapEx forecast for FY '19 by $10 million from three months ago. Increased demand from machinery and test equipment is significant in support of our growing business. Our updated free cash flow forecast for all of FY '19 suggests that our Q4 free cash flow will be in excess of 100%.

Looking ahead to future years, we remain focused on free cash flow as an important metric and believe that 100% conversion, while challenging during a strong organic growth cycle, is an appropriate and realistic target to average over a number of years. Net debt increased $23 million compared to a free cash outflow of $11 million. The difference relates primarily to the payment of our quarterly dividend. Capital expenditures in the quarter were $31 million while depreciation and amortization was $21 million. Year-to-date, CapEx was $91 million while D&A was $64 million.

For all of 2019, our updated CapEx forecast of $120 million compares with projected depreciation and amortization for all of 2019 of $86 million. Our normal sustaining level of CapEx is between 3% and 4% of sales and in 2019, our spend rate will be at the higher end of that range. Cash contributions to our global pension plans totaled $9 million in the quarter compared to last year's third quarter of $75 million. Last year, included incremental accelerated contributions to our U.S. DB plan to take advantage of some tax benefits related to the Tax Act passed by Congress in December of 2017.

For all of 2019, we're planning to make contributions to our global retirement plans totaling $37 million, essentially unchanged from our forecast 3 months ago. Global retirement plan expense in Q3 was $17 million compared with $15 million in 2018. Our expense for retirement plans for all of 2019 is projected to be $64 million, an increase over last year's $57 million and unchanged from our forecast 3 months ago. Our Q3 effective tax rate of 23.1% compares with last year's Q3 rate of 25.8% and with our previous forecast for all of 2019 of 26.0%.

The lower rate this quarter is due to a refinement of estimates associated with the filing of our fiscal 2018 tax return and to changes in our projected mix of global earnings. Year-to-date, our tax rate is 23.7% compared with last year's 56.4%, which was complicated by the significant effect of the Tax Cuts and Jobs Act and the restructuring of the wind pitch controls business. We're now projecting our tax rate for all of 2019 to be down to 24.2% compared with our forecast 90 days ago of 26.0%, driven by the same factors as in our Q3.

Our leverage ratio, that's net debt divided by EBITDA, was 2.1x at the end of Q3, unchanged from last quarter and down from 2.2x a year ago. Net debt as a percentage of total cap at the end of Q3 was 35% compared with 36% a year ago. At quarter end, we had $507 million of available unused borrowing capacity on our $1.1 billion revolver that terms out in mid-2021. And our $300 million of 5.25% high-yield debt matures in late 2022. Interest expense in Q3 was $10 million compared with last year's $9 million, up due to higher borrowing rates. Our forecasted interest expense for all of 2019 is $39 million, nearly unchanged from our forecast last quarter.

With respect to leverage, we've previously shared that our target leverage is between 2 and 2.5x. We're within that target range at 2.1x levered at the end of Q3, and we expect to be slightly below our target range by the end of the fiscal year.

Regarding capital deployment, today, we announced our quarterly cash dividend of $0.25 per share payable to our shareholders. And we continue to look at M&A targets physically and share buybacks opportunistically. M&A tends to ebb and flow and it feels like we've got a lot of things going on right now. We'll continue to exercise patience and discipline throughout our processes, looking for targets that fit well strategically, culturally and, of course, financially.

FY '19 will show respectable sales and EPS growth and operating margin improvement. Business, particularly in Defense, is good, giving us a reason to be optimistic as we look beyond FY '19. Our backlog is strong. Since the end of FY '17, 7 quarters ago, our 12-month backlog is up over 30%. That's a nice tailwind to have as we look ahead to continued growth. Lastly, with respect to free cash flow, our increased focus on strengthening our operational performance should serve us well.

So with that, I'd like to turn you back to John and open it up for any questions that you may have. Chantel?

[Operator]

[Operator Instructions] We will now take our first question from Kristine Liwag from Bank of America Merrill Lynch. Please go ahead.

[Kristine Liwag, Bank of America Merrill Lynch]

John, can you provide more details on the structural changes you're making in Aircraft operations. How long do you anticipate the reorganization will occur? Is there downside risk to the margins from here? And lastly, when do you expect margins to go up?

[John Scannell, Chairman and CEO]

So let me take them in turn, Kristine. So the, we've done a shuffle at the management, we brought in some additional talent from other parts of the company to strengthen the Aircraft operational team. So that's done, those folks are already in place We've done that over the last 3 months or so. And again what, it is, is we really brought in some additional talent from operational folks from elsewhere in the company that can help bolster the team over there. We've also engaged with outside consultants, just one of the large operational, aerospace expert consultants. Their name is [indiscernible], they're, a German operation, but they're a big consulting operation, done a lot of work in the aerospace industry. And we decided that we need additional outside expertise to strengthen our internal knowledge around building a world-class supply chain. So they're onboard, had been onboard for the last several months and we're working through a program there, identifying the structural things that we now need to improve and then start to roll that out. So that program of work is already underway. The changes that, that will push through will probably take the next 6, 9, 12 months, Kristine. So we should see --

and we said this, we think, as we look into next year, we'll see some margin improvement from this year. This year is a reset. And it's a real disappointment. There is no -- let's be clear, this is not what we were either anticipating or looking for. But what happened in this quarter, and I think I described it in the text, but we've been looking at, we've seen margin, we've seen kind of productivity gains over the last couple of years, we've seen some margin improvement. But the rate of improvement has been slower than we anticipated. And as we look to this year, the impact that brought strains across the supply chain. I mean a lot of this is strains as well as our major suppliers.

The processes we have built internally are not robust enough to give the type of results that we need. And so we need to say we need to build more robust processes as we go forward. And that's what we're starting to do now again, taking a response to that. So I think we saw a nice margin expansion this quarter. I think we saw a couple of things come together. That said, these are individual things that are going to just get better when each -- this is -- we got to be a little bit more structural. And so we've taken the immediate response of strengthening the management team and bringing in additional experts. So...

Your question of, is there downside risk to operating margins? There's always risk, Kristine, that's one of the challenges I think with any of the businesses that we run. But we're anticipating that the reset that we're doing this year and actions that we're taking, we should start to see that flow through in the course of next year.

[Kristine Liwag, Bank of America Merrill Lynch]

And as you roll out these changes this year and presuming that next year -- or I guess presuming that all the changes that you're making this year come to plan and bear fruit, should we expect to see a bigger step-up in margin next year, then what we would, otherwise, anticipate it, if this is all organic?

[John Scannell, Chairman and CEO]

We'll provide guidance at -- in the November call, Kristine. And given the news I'm telling you today, I'm very cautious about telling you what next year is going to look like today. I can't - as I said, I think, directionally I gave you sense. But we'll provide a much more detailed forecast when we get together again in 90 days' time. So I'd ask you to hold off until then before we make more detailed commitments and what we're seeing as a result of the investments.

[Kristine Liwag, Bank of America Merrill Lynch]

Great. And if I could ask a follow-up question on F-35. I mean Lockheed's production rate seems to be going up. Is there some sort of timing thing here that's occurring, that's causing F-35 OU revenues to be down or lower than what you had anticipated?

[John Scannell, Chairman and CEO]

Yes. There's always anomalies between -- so the program, in total, is absolutely going up, Kristine. If we look at our forecast for the year versus last year, we're up 12%. My guess is if you look at Lockheed's forecast and then you did all mix and the fact we're pulled forward six to nine months, that would all lineup. Quarter-to-quarter what tends to happen is, a lot of it, because it's long-term contracting, depends on receipt of inventories, it depends on the orders that we receive from Lockheed, et cetera. And so it's the quarter-to-quarter movements. I wouldn't put any -- read anything into that. I look at kind of a rolling four quarter or year-over-year. And as I say year-on-year, we're looking at 12% growth, which I think will probably align pretty well with what Lockheed is looking at.

[Operator]

[Operator instructions] We'll now take our next question from Michael Ciarmoli with SunTrust.

[Michael Ciarmoli, SunTrust]

Just, maybe, John, just a little bit more on the -- that gross margin issue. I mean was there -- as you look and try to identify, maybe why you weren't getting the efficiencies? I mean were there -- I guess what I'm trying to figure out, is this pretty broad-based across Aircraft? Is it stemming from -- I know a couple quarters ago, you talked about Military pricing. Are there certain military programs where you're seeing mix shift or is this more commercially driven where you're just not getting that leverage and sort of learning curve acceleration on some of the newer platforms? Can you just give a little bit more detail of it? I guess what we're looking for, is it broad-based across all programs, is it isolated to Commercial or Military?

[John Scannell, Chairman and CEO]

So it's operational challenges, Michael. And our Aircraft business, we have about 5 large facilities around the world, but they're all highly interconnected. There's a lot of movement of parts, et cetera, between our facilities. And so it's kind of a large operational structure that we've got put in place. They're not individual kind of smaller facilities. And so it is broad-based. And that's, I think that's one of the things that in this quarter that became clearly obvious, which is why we've reacted as quickly as we have, which is historically, you have a challenge with supplier A.

You say, okay, well, that challenge is, we're going to have to do some additional work, take on some additional inventory, we're going to see some productivity impact from that, but we'll work our way through and then it will get better. And then it's supplier B and supplier C. And I think, this quarter, what, we eventually recognized the pattern of inefficiency and you say, no, it's not just one idiosyncratic issue or another one, it seems like it's more structural. And therefore, it does seem to affect the base of business because most of our suppliers and most of our in-house production is, what I call, somewhat common across the base.

So there are suppliers of LVDTs, or check valves or other types of things, those products typically go into all of our end products. And so it's not isolated to an individual program, it's not isolated to an individual vendor. It's a systemic thing that you say while our processes are not sufficiently robust given the growth that we're seeing new programs and the stresses that we're seeing across the supply chain to make sure that we can deliver at the type of operational excellence and productivity gains that we had been planning. And again, we've seen some margin expansion over the last couple of years.

The pace of it was not what we had hoped or would've liked. And as we've been going through that, we've set some of the R&D gains, that you'd see on the bottom line has actually shifted up into the gross margin line as we put more of our engineering talent into making sure we can be efficient. I'd say, this quarter, it's, well, it continues to be a challenge and now we go to take a step back and do it more structurally to make sure we got the long-term gains that we're expecting.

[Michael Ciarmoli, SunTrust]

Got it. I mean you could talk and use that analogy there of supplier A challenges. Did the supplier charge and that issue that cropped up last quarter, did that help bring this to light? Or did that create any more analysis of your processes that led you to this conclusion?

[John Scannell, Chairman and CEO]

It did. No, that issue, we put that behind us in the sense that we have to work our way through, but we took the expense last quarter, and that's not changed. So I don't want to give that impression. And, of course, the issue that came up, as we looked at that, that was a wake-up call to say, this one is big and let's take a step back and look at what else we're seeing happening going around. No, we've got a team of folks in our Aircraft business who'd been working very hard for the last few years, tackling each of the different things that they come up along the way.

But that did beat, well, I'll say, trigger to say, we go to take a step back and take a broader look at this and said, we need to bring in some additional outside expertise to take a fresh look at our operational processes and say, how can we build on what we've already got to make sure that we're delivering the type of operational excellence in the face of both the growth and the strains in the supply chain that we're seeing as we look out to the future. So yes, I would say that kind of was a, an additional trigger or perhaps the straw that we got to take another step and look at this in a more structural way.

[Michael Ciarmoli, SunTrust]

Got it. And then just, I mean it would seem the outlook for the year I guess assumes that the margins in Aircraft pick a bit higher to get to that 10%. Should we think then that the pressures you've seen, I mean, are these the bottom for the margins? And it sounds like the initiatives you're taking should get some lift next year. But do you anticipate maybe margins taking a step backwards before they take a step forward?

[John Scannell, Chairman and CEO]

Well, the fourth quarter, actually, the margins to get to the year are flat essentially with the third, they're about 10.2%, Michael. Our anticipation is the activities that we're taking that when you engage in supply chain process redefinition itself. This isn't something that happens in a week or a month or even a quarter. It's something that over a period of time it has an impact. And so we're anticipating that we'll start to see improvements as we move into next year. But as I said to Kristine, on low, in the context of giving you a revised, revising our margin down today, to say, I'm promising you that this is what we're going to get next year. We'll continue over the next quarter to refine the work packages that we're doing, understand the benefit that they'll recruit us and over what period of time will see that. But we're optimistic about the business in total. And so I don't want to give you a promise right now. And I would also say, what we saw last quarter, which was a supplier issue that had a big impact, I can't be absolutely certain that we won't encounter some other issue as we move forward. And again, that's just based on history, every now and again you see one of these things. So I can't promise you that, that won't happen and we'll take a margin hit from it. But structurally, the work we're doing should give us a structural gain over time that we should start to see some benefits next year and into the out years. The disappointment, Michael, is that we set from where we are at this year now at 10%, which is not where we had started the year and not where we were anticipating that we would be. And so the margin expansion that we had anticipated has taken a bit of a step back. And that is as I say a disappointment.

[Michael Ciarmoli, SunTrust]

Got it. And then last one and I'll get out of the way here. How do we think about, where is this cost going to flow through, whether it's the consultant cost that you have, any IT-related cost? I mean will these, are you plan on flowing them through the segment? Will they be adjusted out? Just how should we think about the costs related with this initiative?

[John Scannell, Chairman and CEO]

No. They'll all flow through the segment. They'll essentially in the gross margin line, and we won't be trying to make an adjustment for them. Because to suggest that, I mean are there one-off, I think everything we've discovered is a one-off. It's just that when a one-off repeats often and often, it's no longer a one-off. And to adjust them out I think would be disingenuous. So no, we will recapture them in the operating margin of the segment as we go forward. And we should, that's where we'll be looking to see that improvement.

[Operator]

We will now take our next question from Julia Corsetti with Cowen and Company.

[Cai von Rumohr, Cowen and Company]

It's actually, it's Cai. Let's turn to the balance sheet. I mean the receivables were up $25 million, sort of an all-time high, 114 days. The inventories were up $25 million sequentially. The customer advances were down $20 million. What's happening there? I mean it looks like all of the trends were substantially negative, you reduced your cash flow guide for the year. What's the problem there?

[John Scannell, Chairman and CEO]

So let me start and Don can join in. It's the, so I think first of all, Cai, the receivables are unbilled receivables. So as Don said, it's essentially growth in inventories. It's not bills receivables. They moved around a little bit but it's more on bills receivable. So essentially, it's growth in inventory. And as we've seen some of these inefficiencies run through our processes, part of the response to that is to make -- continue to acquire inventory in order to make sure we can meet the delivery commitments that we've made. And so this is all good inventory. So it'll all turn into cash, it'll turn into shipments and cash in time. But that has been the response of our system, that's part of the reason, as I said that our processes are not as efficient and as effective as they need to be in response to the growth and the strains in the supply chain. So our processes continue to drive inventory to make sure that we have safety stock in place to meet our commitments. But as a result, you see this growth in working capital. And that's what actually happened in the quarter. Don?

[Don Fishback, CFO]

Yes. I was just going to complement, I guess, what you said, John. The -- just to clarify, the comment that I made with respect to physical inventories, captures both the -- an inventory that's on the inventory line and what is part of the receivables number, which is the unbilled receivables. Unbilled is another way of looking at physical inventory that's been charged or accounted for the sale to our customer, but the cash earned for that unbilled inventory or unbilled receivable has not been clocked yet because we haven't shipped the product to our customer. When you combine those two elements, the inventories and the unbilled piece, that's really the driver for the most of the growth in our working capital over the last 90 days.

[John Scannell, Chairman and CEO]

I'd also say, Cai, in a scenario where cash flow is very important to us, and I think you've seen that over the last several years we've been very focused on it. But what we want to make absolutely sure of is that we have everything that we need to meet our commitments to our customer. And so given -- even in the situation that we find ourselves in where some of our productivity gains and processes aren't that efficient that we want them to be, we will make sure that we put the inventory in place, make sure that we can make all deliveries on-time. And so I think, as I said, it's all good inventory. Our inventory doesn't age out. This is not like cellphone processors. And so it will turn back into cash, and we'll start to see that come down.

[Cai von Rumohr, Cowen and Company]

So if you look at your receivables, they're up $165 million year-over-year. How much of that is the unbilled because -- I mean the receivables have just been going up absolutely every single quarter. So you would think you would've kind of recognized earlier that you had a problem.

[Don Fishback, CFO]

So Cai, so this gets into the confusion of changing to the new rev-rec accounting standard. And the receivable line that you highlight you're absolutely right, that's the way it looks on the face of the balance sheet with the way the accounting gods provided some guidance on how to adopt a new standard. The 930 number is from last year presented in the old way, and the numbers starting up in the first quarter are presented in the new way. And what has happened is under the new rev-rec standard, we have increased accounts receivable to take product that was not under a long-term contract accounting, now they call it over-timed accounting. That was not on long-term contract accounting before, it is now under the new standard. And that number is about $90 million, $90 million. So the part of the inflation on the receivables line is simply a reclassification to conform to the new accounting standard.

[Cai von Rumohr, Cowen and Company]

Got it. And just so the last one. Your customer advances were down $22 million. When is that going to bottom out and start moving up?

[Don Fishback, CFO]

Yes. I think looking at that number, and what's behind it gets ebbs and flows, it's the timing of uncertain elements. And some of the drop in the quarter related to some of our missiles activity and some of it related to some of our Aircraft activity. And it does ebb and flow. And we've been fortunate in years past, or quarters past to have done a pretty good job of working on customer advances. We continue to work on that on new orders that come in. And we're certainly interested in negotiating favorable cash terms as best we can. From a year ago, if we look at, I'm sorry, from the end of fiscal '18, our cash advances are down just modestly. So it does pick up, it comes down with the timing of when orders received, when we negotiate terms. So it's been hovering in the $150 million range on and off over the past 5 or 6 quarters.

[Operator]

We will now take our next question from Robert Spingarn from Credit Suisse.

[Robert Spingarn, Credit Suisse]

I'm here with Audrey as well who may have a question. John, and Don, I don't want to beat a dead horse here, but can you walk through, first of all, are the gross margin and cash flow and buying ahead, some of your inventory problems. Are these all related? And if so, can you just walk us through the mechanics, give us an example of what's going on because I'm finding this a little bit tough to follow.

[John Scannell, Chairman and CEO]

So the inventory growth and cash flow is 2 different, it's 2 things, 2 effects. One is, just growth. There's growth, if you look at our Space and Defense business, the Defense side of that is up 23%, and it's been growing like crazy over the last several quarters. So there's a growth element to the growth in inventories that is independent of some of the operational inefficiencies that we're seeing at Aircraft. And then, there's the operational inefficiencies that we've cited in our Aircraft business.

So let me give you an example of the process. So we have, we run a sales and operations planning process. And that's a process where the folks that they forecast the sales of the business, you run it through a master plan and you plan your production schedule based on that. So certain assumptions that are always made in any of these process around stability of the supply of various parts, around the lead time on the supply of various parts. And when I talk about stresses in the supply chain, it means stresses that your vendor is not getting you the right products at exactly the right time.

And so let's assume that you've assumed you're going to get a series of products from vendors on a particular date, the first of the month, you then have a month's worth of work to put that all together, test it and ship it out. Well, if there are, as I said, the stresses that we're seeing with the growth across the aerospace supply chain, if that stuff doesn't come in on the first of the month, or perhaps it comes in on the last day of the month, it's now 3 or 4 weeks late. Now you've put a lot of work in, now you have to do perhaps rework. And of course, lost capacity in terms of people, assembly, test, test equipment, is not something that you can recover. You can't recover lost time.

And so you end up putting a lot of additional energy into overtime, more work, adding to capital equipment to make sure that you've got slack in your supply chain additional capacity in order to take, to compensate for those inefficiencies. So that's a simple example of it. And the rest of the product that you would have, the other 99 pieces to make that product, we still acquire those on time. But if you've got one part that's late, of course, you can't get your product out. So you end up doing a lot of additional work and driving a lot of inefficiency in order to make sure that you still meet your delivery commitments. And that ...

[Robert Spingarn, Credit Suisse]

Okay. So that's your gross margin hit?

[John Scannell, Chairman and CEO]

That's where you start, yes, that outflows through the gross margin. And so you stop working with the vendor, looking at alternatives, all of those things, Rob, and that's kind of a micro version of the broader set of activities. And when it's one supplier or one particular part, you put a lot of energy and then you can fix this. As I said, this quarter, the number of ones turned out to be more than you can say that's just an idiosyncratic thing. We got to take a more structural approach to make sure we're building systems and processes that can help our suppliers and account for some of those instabilities.

[Robert Spingarn, Credit Suisse]

Okay. So that brings the next question which is, is it really Moog or is there something odd just happening at numerous suppliers at the same time just because of something industry-wide?

[John Scannell, Chairman and CEO]

Well, that's a tough question to answer in the sense that each company that you follow, Rob, is going to have a different perspective on it. We, I think there are stresses in the supply chain, I think that's a known effect. I think one of the conversations around the slowdown on the 737 is that it got some, various vendors trying to catch up and to make sure that they are on top of it. The growth in rates, the production, and for us, we've seen, while we've not, the top line in Aircraft is going 7% to 8% organically this year.

But when you look at the big programs, F-35, 87, 350, those new programs are compensating for losses of all form. So you're seeing significant growth. And I think across the supply chain, both Defense and Commercial, people are seeing significant growth. And that inevitably I think leads to stresses and strains. Now depending on how much you in-source versus how much you outsource, who your supply base is, all those things, I think everybody is going to have a different perspective on it.

But I think you and the other folks on the phone probably have a good view of the entire industry and across the supply chain as anybody. We, this is the set of activities I think that we're seeing at the moment and we're trying to respond to it by making some additional investment. So I loathe to say, but everybody else is saying, I can't say though that our supply base is not, many of our suppliers are the industry suppliers.

And so they're not, it's not as if they are just unique suppliers to us. And so I think we are seeing and I think what others are seeing as well challenges, just to make sure we're keeping up with the rest. But a return, result is, productivity not being what we'd hoped.

[Robert Spingarn, Credit Suisse]

Right, right. And you mentioned the MAX and I wanted to just ask you quickly. I know that you've said you're pretty small on Max, we talked about this last quarter. But given what was said by Boeing a couple of days ago, is it preferred, if they have to make a tough choice between another drop in rate or simply turning the program off for a period of time, what's better for you from a supplier perspective?

[John Scannell, Chairman and CEO]

Let me offer you my thoughts, but, it's a small program for us, relatively speaking. And so we prefer to continue keeping the line going, I think every suppler would want to do that. But it's not like an 87 or a 350 for us which would be a very big challenge if everybody says just turn it off.

So our preference would be keep it going, if it's 42 a month or 35 a month or 32 a month, I think all the suppliers would say, it's easier to ramp down gradually and then ramp back up because, of course, it's easy to stop making stuff. It's, the challenge I think and the one that I think Boeing, I am sure, recognizes and their supply base will recognize is it's turning it back on. You furlough people or you stop the machines, get them up and going again and getting the rhythm going is always a big challenge.

And I think, even if Boeing were to say, let's go to 0, I think, again, companies, like us, would probably continue to have an internal production and put some stuff on the shelf, continue to buy inventory to make sure that we've got a process running so that when Boeing turns it back on, we're ready to respond to that and not because of MAX crumble there. And I think a lot of the supply chain will try to protect the key resources, the machines, the people, the skilled workers to make sure that they don't just have a shutoff and that try to restart. But I think Boeing has a broader set of considerations, of course, as to how they like to do it. But that's my thought.

[Don Fishback, CFO]

Maybe I'll add to that and just say, it's not just things the internally that we'll be able to control, it's all of our suppliers as well. And so we have a network obviously that we're talking about suppliers. So if we're turned in -- if we're being turned off or shutting down the line at our place, what do we do with our supply chain. So we've got to take that in consideration. I think we want to keep it warm as opposed to shut it down.

[John Scannell, Chairman and CEO]

But again, as you said, Rob, it's -- this is not a huge program for us and so we're -- luckily we're not as susceptible to those changes I think as perhaps some of the other aerospace suppliers might be.

[Audrey Preston, Credit Suisse]

This is Audrey, also c. And I had a couple of questions here. I just wanted to switch tags little bit. So while you're seeing some particular strength in space activity across the industry with some of your key customers over the past few quarters and this quarter, particular. So with some of more positive rhetoric that we've been hearing, both on the Commercial side and out of Congress on the space funding, could you talk a little bit more about your opportunities out there over the long term? And particularly how the emergence of a more robust commercial space ecosystem could potentially provide some upside here?

[John Scannell, Chairman and CEO]

Yes, Audrey. So, we -- if you look back at '17, our Space business was about short of $190 million. And in '18, that it went up to $215 million. So we saw a nice growth from '17 to '18. I think if we went before that -- so we saw a very nice growth up to '18. We're about flat '18 to '19, and we think that there is growth opportunities. I think you're right, there's funding opportunities, there's a lot of going on. One element of our space business that we talked about in the past is being the GBSD program. That's obviously in a little bit of flops, given some of the announcements over the last day or two, so we're not sure how that might play out next year. In any event, it's not a big -- for next year, it's probably more some development working with that. So that's not a big thing, of course, long-term that is a big opportunity for us.

But the hypersonics which we classed into space, they'll get back to the moon in 2024, the Commercial space growth, all of that has positive outcomes for us. And this year we're seeing this space is about flat. We've a very nice avionics business, but we pushed a little bit of that out. It turns out that some of the contracts we were expecting have not happened the way we thought, but it's been in the noise and so we're optimistic about space, good growth over the last few years. Flat this year. But we think that there is growth opportunities as we look out to the future.

[Operator]

[Operator instructions] We'll now take our next question from Michael Ciarmoli.

[Michael Ciarmoli, SunTrust]

We've been kind of talking margins and cash here, but just on the end markets real quick. I think you said simulator and test within Industrial seem to the holding up. Can you maybe just give us a little bit of a deeper analysis there, specifically some of the sales you have into auto markets versus what you're seeing on the aircraft simulator side is do you expect or are you seeing any positive developments from the MAX situation creating extra simulator demand for you guys?

[John Scannell, Chairman and CEO]

So we, the test business is a combination of aero and auto and we don't break that out, Mike. But if I look back to '17, that was about high 40s business, '18, it was a little bit, $1 million or $2 million higher. This year, actually it's a little bit higher than that again, it's kind of a mid-50s business. So that's, it's doing pretty solid. As I said, it's both aero and auto. The simulation business which is primarily flight simulation had a couple of gangbusters years in '17 and '18, it's actually off a little bit this year. But some of this have to do with, again, the way our customer orders, long-term contracting and the mix of business that they have. I think if we look out, we think the simulation business, it's grown dramatic from where it was a couple of years back. We have a very strong position.

We believe we have, perhaps 80% to 90% of the available market there because of the technology that we have. And I think our business will go with the number of simulators up or down that the major guys actually supply. We're not seeing anything directly from a 37. I don't know, maybe you do, that there's been a confusion that says all the pilots have to go back into simulator training. I think that one of the big objectives was to avoid to have that significant additional expense. And even if that were to happen, that's the kind of an instantaneous, everybody knows how to get flight training simulation time before getting back to MAX.

And that's going to be something that people want to do in the next quarter. And to build and ship simulators is not something that you do in that period of time. So I could see that having a structural positive impact over the next year, perhaps. If that's emerged, therefore the demand for simulator and simulation time were to increase, but at the moment, I don't think we have enough clarity around that. And we've not seen anything from our customers that said, hey, let's start ramping up production to get ahead of that potential increased demand.

[Operator]

And we'll take our next question from Julia Corsetti with Cowen and Company.

[Cai von Rumohr, Cowen and Company]

This is Cai, again. So next year, this, last couple of years you've been fighting big ramp in terms of your bigger programs, but 787 is now basically stable at 14. A350 is at 10. So as we look forward, what have been the big drivers of growth commercial OE should start to flatten out. And I would think that you would get better growth in the aftermarket and in Military programs. To what extent can mix help the margins next year? I mean if you have less commercial OE growth, should that make it easier to address the supply problems you've been having?

[John Scannell, Chairman and CEO]

From an underlying, so yes, Chi. The mix should be a tailwind. And, of course, we've talked about that over the last few years. We've seen R&D come down. This quarter, we're running just north of 4%, so we've seen that come down. And that's a positive in terms of the overall P&L from top to bottom. But as I mentioned, tented up and a lot of that additional effort has gone into the gross margin line. So the mix should be a positive, I said in the call. I think if we look at the total for Commercial next year, we think probably around flat with this year. So you'll have a drop off because you'll have 777 dropping off, A350 and 87 are kind of pretty stable, but you'll may be a little bit of E2 coming in.

And then we should hopefully start to see some aftermarket pickup. That definitely structurally will pick up. But we're a little bit, we've been cautious about the IP and we've talked about this year Commercial aftermarket is down from last year and that's A350 IP that you got a big shot last year. So let that wind your way through and then you start to see the things come out of warranty. But mix should not be happen in next year I would say from a margin perspective. Having said that, the operational inefficiencies that I've talked about, we need to make sure that we've got our arms around how that will play out and how we'll start to see the margin impact of that play-out over the next year. We'll report on that in the next quarter.

Chantel, if you got any more questions?

[Operator]

We do not. It appears there are no further questions. At this time, I would like to turn the conference back to you for any additional or closing remarks.

[John Scannell, Chairman and CEO]

Thank you, Chantel. Thanks, everybody, for your time this morning and your questions. And we look forward to reporting out again in 90 days' time, and at that stage, we will give you a detailed look at what we think fiscal '20 looks like. Thank you very much.

[Operator]

This concludes today's call. Thank you for your participation. You may now disconnect.