Moog Inc

NYSE:MOG.A

Earnings Call Analysis

Revenue Up, EPS Growth, Negative FCF

The company's fiscal year '23 guidance anticipates a sales increase of 7% to $3.3 billion, 9% when adjusted for divestitures and foreign currency movements. Strong sales growth across all sectors—particularly commercial aircraft and space and defense—are driving this performance. Adjusted earnings per share are expected to rise by 3% to $5.75. Operating margins are up, with Industrial Systems and Aircraft Controls seeing a 190 and 70 basis points increase respectively, driven by pricing initiatives. However, due to a third-quarter increase in physical inventories, the company now forecasts fiscal year '23 free cash flow at negative $60 million, a significant revision from the previous break-even expectation.

Conference Introduction

The Moog Third Quarter Fiscal Year 2023 Earnings Call, led by Executive Aaron Astrachan, was an opportunity to discuss Moog's financial results, which are available on the company's website. The call provided adjusted non-GAAP results.

Executive Overview

CEO Pat Roche commenced the conference with highlights of the quarter, including record sales, and strong operational performance despite cash demands and unexpected charges associated with space vehicle projects.

Strategic Goals

Moog set forth explicit business goals at their Investor Day, committing to a revenue compound annual growth rate (CAGR) of 5% to 7% up to fiscal year '26, based on the '22 baseline.

Operational Excellence and Customer Focus

Despite challenges in supply chain and labor availability, Moog achieved record sales, recognized by Boeing and Airbus for outstanding service. The company carried out organizational adjustments to better service their customers and meet financial targets. Notably, Moog's site in Baguio was acknowledged for its operational excellence and commitment to sustainability and ethics.

Pricing as a Margin Enhancer

A systematic approach to pricing across all markets and products, including significant margin improvements in the Aircraft Control segment, has enhanced profitability throughout Moog's businesses.

Macroeconomic Environment

The macroeconomic background, such as the Department of Defense budget, the ongoing war in Ukraine, and ongoing U.S.-China tensions, provide both opportunities and challenges for Moog. Notwithstanding these, the company reported a solid recovery in the commercial aircraft sector and a strong presence at the Paris Air Show, indicating potential growth for the company.

Financial Performance

For the second consecutive quarter, Moog posted record sales, with an increase of over 10% from the previous year and double-digit organic growth in every segment. Despite a decrease in adjusted operating margin, underlying performance, excluding space vehicle charges, showed improvement.

Cash Flow and Investment

Cash flow felt pressure from the growth of physical inventory; however, the company expected to turn strongly positive in Q4.

Space Vehicle Business and Cash Flow Guidance

Although space vehicles incurred charges of $25 million, Moog remained optimistic due to improvements in satellite bus system integration. Cash flow is projected to normalize by fiscal '25, '26, indicating management's efforts to strategically navigate current challenges.

CFO's Financial Recap and Guidance

CFO Jennifer Walter provided a recap of financials, indicating record sales levels, adjusted operating margins of 10.2%, and challenges with space vehicle programs. The company adjusted its free cash flow outlook for fiscal '23 but maintained its leverage within target ranges.

Anticipated Free Cash Flow and Inventory Trends

Despite substantial growth in physical inventory, Moog anticipates improvement in free cash flow to $40 million in Q4 and expects modest free cash flow generation in the upcoming year. This suggests that inventory growth will moderate, contributing to long-term financial health.

Full Year Fiscal '23 Sales and EPS Guidance

Jennifer Walter concluded the call projecting full-year fiscal '23 sales guidance and earnings per share expectations. There is also an anticipated improvement in the company's effective tax rate which will aid in offsetting increasing interest expenses.

Earnings Call Transcript 2023-Q3

[Operator]

Good morning, and welcome to the Moog Third Quarter Fiscal Year 2023 Conference Call. Today's conference is being recorded.

At this time, I would like to turn the conference over to Aaron Astrachan. Please go ahead, sir.

[Aaron Astrachan, Director of IR]

Good morning, and thank you for joining Moog's third quarter 2023 earnings release conference call. I'm Aaron Astrachan, Director of Investor Relations. With me today is Pat Roche, Chief Executive Officer; and Jennifer Walter, our Chief Financial Officer.

Earlier this morning, we released our results and our supplemental financial schedules, both of which are available on our website. Our earnings press release, our supplemental financial schedules and remarks made during our call today contain adjusted non-GAAP results. Reconciliations for these adjusted results to GAAP results are contained within the provided materials.

Lastly, our comments today may include statements related to expected future results and other forward-looking statements. These are not guarantees as our actual results may differ materially from those described in our forward-looking statements and are subject to a variety of risks and uncertainties that are described in our earnings press release and in our other SEC filings.

Now I'm pleased to turn the call over to Pat.

[Pat Roche, CEO]

Good morning, and welcome.

Today, we will share our update on a quarter notable for record sales, strong underlying operating performance improvement masked by a space vehicle charge and cash demands above expectation. We are also increasing our full year earnings per share guidance while reflecting this stronger demand on cash.

It's almost two months since our Investor Day conference in New York City. Our team was delighted to have the opportunity to make public our business plans. For the first time, we were explicit on our goals for the business, namely revenue CAGR of 5% to 7% to fiscal '26 from our '22 baseline, average annual adjusted operating margin expansion of 100 basis points to fiscal '26, adjusted earnings per share CAGR of 15% to 20% to 26% and free cash flow returning to the 75% to 100% conversion by '25, '26.

We took the time in New York City to explain how we are going to deliver on these significant improvements in performance and talked in detail about our simplification and pricing activities that deliver margin enhancement. During today's call, I will give several specific examples of such activity within the quarter.

Two months ago - two months on, I remain confident that we have a great business that is growing and becoming more profitable over the next few years. Let me start right away with an update on our operational performance, covering each of my three themes.

Starting with customer focus. We delivered record sales while managing the ongoing challenges of supply chain and labor availability. These challenges have an impact on inventory holding, product flow and overall efficiency. Our enhanced maintenance, repair and overhaul service was recognized by both Boeing and Airbus, achieving a top two ranking with Boeing.

We continue to simplify how we're organized. We have made internal reporting structure changes within our $330 million space business that empower business leaders to better meet operational needs of our customers and to achieve financial performance.

Secondly, people, community and planet, our Baguio site, which is core to our commercial aircraft operations was recognized by the employers confederation of the Philippines for our commitment to operational excellence, sustainability, employee relations and ethical behavior. We are thankful that our people are safe following this week's super typhoon.

And finally, let me return to financial strength. We are relentlessly driving simplification and pricing across our business. Let me share some examples. Within Industrial Systems, we continue to refine our portfolio with the launch of a sales process for our business in Luxembourg. For context, this is a $15 million revenue operation with 70 staff manufacturing cartridge valves and manifolds.

We are refining our footprint with several moves. For example, we've changed from a direct channel to market in South Africa to a distributor model exiting our leased facility. In aircraft controls, we have announced the closure of the Cincinnati-based operation of SureFly and its transfer to our Genesis Aerosystems facility in Texas.

While each change yields relatively small impact today, it is the accumulation of these changes over the next couple of years that delivers footprint benefit. We are seeing 80/20 gain further traction within our business. We have the data analytics on profitability complete for over two-thirds of our revenue base across the entire organization. We have trained well over 100 leaders on the 80/20 approach, and we are growing capability as pilot sites mature the process and expand scope from profitability analysis to include reduction of cash conversion cycle.

Ultimately, 80/20 is accelerating decisions that increase our profitability. For example, we have identified several product lines that we feel are at end of life, and we are either working with customers to close our production or finalizing agreements with other companies who will continue to support the products.

Now let me turn my attention to pricing. We are driving pricing activity across all markets that we serve. We have a systematic approach, pursuing high-impact opportunities early and using 80/20 to focus further margin enhancement. Our philosophy is to ensure that pricing reflects the value that we deliver.

Aircraft Control has made very significant margin improvements through pricing that are now reflected in our full year forecast. In addition, Industrial Systems has delivered substantial operating margin enhancement in this quarter with pricing being the most important contributor. Across all businesses, pricing is driving margin enhancement.

Now let me turn to the macro economy. The Department of Defense budget for fiscal '24 is still on its way through the House and Senate, the requested increase of 3.2% is looking to protect new platforms. Significantly, this includes maintaining the future vertical lift funding stream, moving next-generation air dominance aircraft and collaborative combat aircraft to programs of record in 2024 and increasing to $30 billion to funding for the space force.

Unfortunately, the war in Ukraine has now stretched beyond 500 days. Politically, the obstacles to Sweden's accession to NATO has been overcome and ratification by Turkish and Hungarian Parliament is anticipated. The significant demands of arming Ukraine is driving missile replenishment orders and increased equipment MRO activity.

According to Lockheed Martin, the fleet of F-35 fighters operating in Europe is expected to increase fourfold by 2030. U.S. China tensions continue with the trade dispute of our semiconductors now extending the cloud computing and precious minerals. It appears that important diplomatic efforts continue with Antony Blinken, Janet Yellen, Henry Kissinger and John Kerry all visiting China in recent weeks. Whilst the slowdown in Chinese economic activity is a minor concern, escalating trade embargoes would be a greater concern and potentially more disruptive. Our philosophy remains to be in China for China.

The recovery of commercial aircraft continues. Consequently, we are seeing real strength in aftermarket. And consistent with Investor Day, Boeing and Airbus continue to project a doubling of rates in wide-body production by fiscal '26. Industrial Automation remains a watch item. The June purchaser Managers Index for manufacturing shows contraction in the U.S. and for 12 straight months in the Eurozone. Our order intake for Industrial Automation is down about 4% in the last six months relative to the prior six months. However, we have a healthy backlog carrying us into fiscal 2024.

Now turning to what was notable in the quarter. We returned to the Paris Air Show after four years absence. It was a remarkable show in which the sentiment was extremely positive. Both commercial aerospace and defense markets are anticipating continued strong growth. In fact, record-breaking gross orders for 1,000 aircraft were placed with OEMs in the month of June.

There was quite a notable presence of EV tolls at the show, and we're pleased to supply hardware so far on two of these aircraft. In May, the C919 entered revenue service with China Eastern. This is a significant step for COMAC. We are planning a handful of shipments in calendar year '23 and a gradual increase through calendar year '24.

As noted at Investor Day, the engineering and manufacturing development phase of V-280 started in June. We are making good progress in ramping our engineering team. It was notable that Collins Aerospace was sold by RTX to Safran. Given no new commercial platform development over the next decade, the sale does not, in our opinion, change the competitive landscape for flight control systems.

Now turning attention to our financial performance. Our second consecutive quarter of record sales was a great achievement for our entire staff. We are starting to see the benefits of simplification and pricing feeding through in our operational performance. We delivered sales of $850 million, up over 10% on prior year, with every segment posting double-digit organic growth.

We are seeing the recovery of commercial aircraft, reconfigurable integrated weapons platform at full rate and high levels of activity in space components, industrial automation and simulation. Our bookings remained strong overall with 12-month backlog at $2.3 billion, up 2% over prior year. We do see some softening within Industrial Automation, as noted earlier. Our adjusted operating margin was down 30 basis points on prior year. Excluding space vehicle charges, our margin performance would have been up 120 basis points.

This margin enhancement is due to pricing and business growth. Our cash flow was clearly pressured in this quarter with a $19 million use of cash arising from growth of physical inventory.

Before I hand over to Jennifer, I'd like to expand on my view of the two key issues impacting performance in this quarter and for the full year, namely space vehicle charges and cash flow. Firstly, we incurred a $14 million charge on our space vehicle fixed price contracts. You may ask, since we were 90% complete on our last call, how further charge could arise.

The charge is driven by two factors, namely additional software development efforts required to resolve all remaining open issues necessary to achieve flight-ready software and additional integration and test effort required to rework issues arising at integration of the last couple of flight units. These are complex systems in which the final stages of integration can flush out on anticipated challenges.

Despite incurring year-to-date charges of $25 million in space vehicles, I remain very confident in that business. These charges represent additional investment in gaining a much deeper understanding of satellite bus system integration and building our capability to deliver. Our achievements to date include the development of two spacecraft bus platforms, namely Meteorite and Meteor, which weigh 120 kgs and 650 kgs, respectively.

These buses share many common components, in particular, the avionics unit and the software base. We have now fully built and tested six payload ready meteorite class satellites, and we have shipped all flight hardware required under two contracts as of last week.

We will deliver the final software release within the next two weeks. From my perspective, we have a great offering with two satellite bus platforms that can carry a variety of customer payloads. We are operating in a rapidly expanding market and see plenty of new opportunities ahead.

Our execution risk is reduced due to our improved capability and the commonality of hardware and software across both the Meteorite and Meteor platforms. Now turning my attention to our cash situation. We adjusted our free cash flow guidance from 0 to minus $60 million for FY '23. Let me describe what has changed. First, our sales have come in much stronger than anticipated.

We also believe 90 days ago that there would be less growth in physical inventory during the second half of the year. We now recognize that it will take longer for our actions to slow the growth of inventory as we work to strike the right balance between slowing material inflow and meeting growing customer requirements.

Our efforts have begun to reduce the underlying rate of increase of physical inventory, and we expect this improvement to continue. Given our leverage, the demand on cash is manageable with free cash flow turning strongly positive in Q4, reversing a three quarter use of cash.

We are actively managing the situation. First, we are working to reduce material inflow while dealing with material constraints and ensuring a healthy supply chain. We are unlocking production challenges to improve throughput and material flow whilst dealing with material availability and labor constraints. We reflected during Investor Day that cash flow would take until fiscal '25, '26 before it would normalize. We are confident that this is getting the necessary attention and oversight throughout the organization.

We have executed and will continue to drive many tactical changes that are slowing inventory. We are now focused on longer-term actions to drive improvement by fiscal '25, '26. On these two key issues, I believe we are making progress. We have significantly reduced risk on our space vehicle contracts, and we have made initial progress on physical inventory and will drive progressive improvement over the coming quarters. Overall, I remain very optimistic for our business.

We have a strong growth, which I see as a sign that we are creating value for our customers. In addition, we've made excellent progress on our journey to improve margins through simplification and pricing.

Now I'll hand over to Jennifer to review our financials in more detail.

[Jennifer Walter, CFO]

Thanks, Pat.

I'll begin with a review of our third quarter financial performance. I'll then provide an update on our guidance for all of fiscal year '23. It was another exceptional quarter from a sales perspective. For the second quarter in a row, we hit a record level of sales for the company.

Our adjusted operating margin was 10.2%, including $14 million of charges on space vehicle programs. Our underlying operational performance was strong this quarter. We achieved $1.37 of adjusted earnings per share, which was negatively impacted by $0.33 from the space vehicle charges and was positively impacted by $0.13 from tax adjustments associated with higher R&D tax credits. This suggests performance near the high end of our guidance when carving out these two factors. Sales in the third quarter were $850 million.

Total company sales increased 10% over the same quarter a year ago. Excluding the impact of divestitures, sales were up 11%. The largest increase in segment sales was in aircraft controls. Sales of $355 million increased 12% over the same quarter a year ago. Commercial OE sales in the quarter were especially strong, driven by the continued market recovery in wide-body platforms as well as growth on business jets.

Commercial aftermarket sales were at a record high with strong sales on the A350 program, which has been steadily ramping over the past several quarters. Military aircraft sales declined in the third quarter compared to the same quarter a year ago. The military sales decrease reflects lower funded development activity, including the delayed start on the flower program. In addition, military aftermarket sales were down slightly from the same quarter a year ago. Sales in Space and Defense Controls of $242 million increased 8% over the third quarter last year.

Adjusting for the divestiture of a security business last year, sales increased 11%. The ramp-up in production on the reconfigurable turret program, which hit full rate production levels in the first quarter this year, drove sales this quarter.

The sales growth was also driven by increased activity on avionics and components for satellites. Industrial Systems sales increased 9% to $253 million. Excluding the divestiture of our sonar business last year, sales were up 11%.

Within Industrial Systems, our Industrial Automation sales growth was driven by demand for capital equipment. This business has recovered nicely since the pandemic, but we're now seeing orders slowdown in line with global capital spend.

Our growing construction business is also contributing to the industrial automation sales strength. Simulation and test sales were also strong, driven by high demand on flight simulation systems. Sales and energy adjusting for the divestiture last year were up nicely compared to a year ago.

These sales increases were partially offset by lower sales in medical, which was impacted by supply chain issues. We'll now shift to operating margins. Adjusted operating margin of 10.2% in the third quarter decreased 30 basis points from the third quarter last year. The space vehicle charges pressured our total operating margin by 150 basis points. These pressures were mostly offset by strong operational performance on our underlying business and a marginal return on the sales increase.

Adjustments to operating profit this quarter and the same quarter a year ago were $2 million and $1 million, respectively. These adjustments reflect restructuring and other charges. I'll now describe the key drivers of our adjusted operating margins for each of our segments. Operating margin in Aircraft Controls was 10.9% in the third quarter compared to 11.0% in the same quarter a year ago. Operating margin in Space and Defense Controls was 7.8%, down 360 basis points from 11.4% a year ago.

As Pat described, we incurred significant charges on space vehicle programs again this quarter, over 500 basis points worth, masking the benefit associated with higher sales and improvements in the core business.

Operating margin in Industrial Systems was 11.5%, up nicely over the 8.7% of last year's third quarter. Benefits associated with our pricing initiatives accounted for three quarters of this improvement. In addition, last year's margin was pressured by supply chain disruptions and the pandemic impacting our operations in China. Interest expense is another area that's impacting our financial results.

In the third quarter, interest expense was $17 million, up $8 million over the third quarter last year. The increase in interest expense relates to higher interest rates and to a lesser extent, higher levels of debt. Our adjusted effective tax rate in the third quarter was 16.0%, about the same as in the third quarter of last year. We're benefiting from higher levels of R&D tax credits and have captured these benefits in our return to provision third quarter adjustments in both years. Putting it all together, adjusted earnings per share came in at $1.37 within the range we provided a quarter ago.

EPS is down 15% from the same quarter a year ago due to higher interest expense and corporate expense, partially offset by increased operating profit. Let's shift over to cash flow. In the third quarter, we had negative free cash flow of $19 million. Net earnings were solid, and capital expenditures were on plan. However, net working capital, in particular, physical inventories grew substantially.

Growth in physical inventories, both unbilled receivables for long-term contracts and inventory as shown on the balance sheet resulted from continuing to receive in materials at a faster rate than shipping product to customers. We've maintained material flow to ensure we're positioned well for customer deliveries.

However, a combination of staffing shortages, supply chain challenges and production inefficiencies have limited our ability to convert inventories to cash. In addition, this quarter, we took ownership of some inventory from a vendor to prevent a supply chain disruption. Capital expenditures were $35 million.

That's pretty much in line with our average spending last year and just over the average quarterly spend this year, excluding the facility we purchased last quarter. We're investing in facilities to accommodate our growth, focus our factories and enhance our capabilities through automation. Our leverage ratio, calculated on a net debt basis as of the end of the third quarter was 2.7x, within our target range of 2.25x to 2.75x. Our capital deployment priorities, both long term and near term are unchanged. Our current priority continues to be investing for organic growth.

We'll now shift over to guidance for the full year. Compared to a quarter ago, we're increasing sales, adjusted operating profit and adjusted earnings per share and modifying operating margin down slightly. Based on continuing pressures on cash, we are decreasing our free cash flow guidance for the year. Let's take a more detailed look at our guidance. We're projecting sales of $3.3 billion in fiscal year '23, which is up $60 million over our previous guidance.

That's a 7% sales increase compared to FY '22 and 9% when we adjust for divestitures over the past year and the impact of foreign currency movements. We expect high single-digit organic sales growth in each of our segments. Aircraft control sales are projected to increase 8% to $1.4 billion. The increase is all on the commercial side of the business. Commercial OE will be up across the board with growth on Airbus and Boeing platforms, business jets and the Genesis business we acquired a couple of years ago.

We'll also see growth in an already strong commercial aftermarket business. To account for the strong sales this quarter, we're increasing our commercial OE forecast by $35 million and our aftermarket sales forecast by $20 million. We expect a decline in military aircraft sales, driven by lower funded development and aftermarket sales. We're decreasing our military aircraft sales guidance by $30 million to reflect the results we're seeing, especially related to funded development activities. Space and Defense Controls sales are projected to increase 7% to $930 million.

Adjusting for the divestiture of a security business late last fiscal year, sales will be up 9%. When looking at our numbers within the segment, you may recall that we shifted a product line from defense into space at the beginning of our first quarter. We've now adjusted last year's numbers for that shift in our supplemental materials.

Space sales will increase for satellite components and space vehicles, and defense sales will increase on production ramps for the reconfigurable turret and tactical missile programs. Our sales forecast is up $10 million over our previous forecast, reflecting the strong sales levels we're achieving in both space and defense.

Industrial Systems sales are projected to increase 6% to $965 million. Adjusting for the sale of the sonar business and foreign currency movements, the increase is 10%. Most of the growth will come from industrial automation and simulation tests, both of which were particularly strong this quarter. Our sales forecast is up $25 million from our previous forecast on record sales this quarter. Let's shift over to operating margins.

We've updated our segment operating profit and margin guidance to reflect retroactive pricing benefits we'll get in the fourth quarter on aircraft programs. The higher level of sales we're now projecting and the charges we incurred this quarter on space vehicle programs. We're now projecting an adjusted operating margin of 10.9% in fiscal year '23, which is up from 10.2% in fiscal year '22. Industrial Systems will increase 190 basis points to 11.4%, largely due to progress on pricing initiatives. Aircraft Controls will increase 70 basis points to 10.8%, also reflecting the benefit we'll see from pricing initiatives.

Factory utilization will improve as sales in the commercial OE business increased. However, this benefit will be largely offset by an unfavorable mix with the relative increase in Commercial OE. Operating margin in Space and Defense Controls will decrease 40 basis points to 10.5%, reflecting $25 million of charges incurred on space vehicle programs this year, offset by incremental return on higher sales.

Higher interest expense will depress adjusted earnings per share by $0.62 relative to fiscal year '22. For fiscal year '23, we're now projecting adjusted earnings per share of $5.75 plus or minus $0.10, which is up 3% over fiscal year '22.

Adjusting for interest, EPS would be $6.37, an increase of 15%, reflecting strong operational performance. Next quarter, we're forecasting earnings per share to be $1.71 plus or minus $0.10. Finally, turning to cash. We're projecting free cash flow for fiscal year '23 to be negative $60 million, down from 0 that we were projecting 90 days ago. The change largely reflects our third quarter growth in physical inventories.

As we move into the fourth quarter, we expect working capital to be a source of cash, the first time in several quarters. Receivables will be the largest generator of cash within working capital. Accruals for compensation will normalize from a timing perspective in the fourth quarter, also contributing to free cash flow generation.

Those sources of cash will be partially offset by continued growth in physical inventories, though we're beginning to see the growth in physical inventories trend downward. Outside of working capital, we're projecting a strong earnings quarter and we're maintaining our forecast of $165 million in capital expenditures for the year.

Overall, we had a solid third quarter, and our outlook for the fourth quarter looks strong. We're positioned well from a liquidity and leverage standpoint, enabling us to invest for future growth in our business.

And now I'll turn it over to Pat.

[Pat Roche, CEO]

Thank you, Jennifer. As you've heard, we closed out a solid quarter, delivering record sales. And we're on a path to deliver a fiscal year with 9% organic sales growth and 70 basis points margin improvement.

We are now happy to take your questions.

[Operator]

[Operator Instructions] And our first question is going to come from Kristine Liwag from Morgan Stanley. Please go ahead.

[Kristine Liwag, Morgan Stanley]

Great. Hi, guys. Thanks for putting [on queue]. First, on pricing. You guys mentioned aircraft controls. You're getting the pricing increases rolling through. Can you quantify that? And are you seeing that in specific aircraft programs or all programs? And how much of a pricing increase is this?

[Pat Roche, CEO]

Hi Kristine, good morning. How are you?

[Kristine Liwag, Morgan Stanley]

Great. Great. Happy Friday.

[Pat Roche, CEO]

Thank you. So I think we've made really strong progress during the course of this year in pricing conversations with our customers. It's across all of our customers on the commercial aircraft side of the business. And in the other businesses, as I've emphasized in the Investor Day, in those conversations, we also said at Investor Day that some of them have been going on for an extended period of time. And we reached agreement with our customer that the negotiation would be retrospective to the 1st of January.

And so now that we've concluded those conversations with our customer, we're able to, in the fourth quarter, reflect an increased operating margin in our Aircraft group as those prices flow through.

The gain or step-up in performance of the aircraft group in Q4 is including that retrospective pricing element. And so it will be in our business going forward, but not at the same high level of operating margin as Q4 will show for Aircraft group.

So I would say, in answer to your question, Kristine, we don't want to be specific about which customer it is and it is across multiple customers within our Aircraft group business. And I don't think we want to share the increment of the increase at this point. Although in Q4, we will do a retrospective that shows how much gain has come through pricing in our business and how much has come through simplification.

Jennifer, do you have anything you'd like to add?

[Jennifer Walter, CFO]

No, I think that's fair, Pat. I think we've made a lot of progress. As Pat said, we've got a retro coming up in the fourth quarter. So when we look at it for the full year, pricing is a substantial contributor to the margin enhancement for all of fiscal year '23 compared to all of fiscal year '22 across our aircraft business.

[Kristine Liwag, Morgan Stanley]

Great. It's great to see you guys make progress there. And so when we think about this pricing reset, is this a onetime reset on all - on the programs that you have? Or is this something that we should expect to occur on an annual basis?

[Pat Roche, CEO]

I would describe it as a progressive program, Kristine. We have still more work to do on pricing with other customers, so it's ongoing. And in addition, the pricing that we have negotiated with our customers to date has included a provision in the contracts for escalation year-over-year. And so we have a framework and a mechanism for further increases over time, depending on certain indices that we're tracking.

[Kristine Liwag, Morgan Stanley]

Great. Thanks. And if I could squeeze one last one on free cash flow. I mean we've seen fairly dramatic cuts in free cash flow outlook now for two consecutive quarters. I mean, what would - is this - what makes you confident that negative $60 million is for the year? And is that a conservative enough number if revenue maybe picks up even more than you thought? And then also, at some point, we'll see an inventory unwind. At what pace do you think that unwinds that will be for 2024, could we see all of that come back and you get your normal course of positive free cash flow plus the inventory unwind?

[Pat Roche, CEO]

Yes. I'll start, and then I'll hand over to Jennifer as well for some comments on this. I think the difference where we sit today is that we know it's taking longer to slow the rate of growth. We took a lot of actions in the last 90 days, which have had an impact and have slowed down the growth of inventory, but it's striking that right balance between the inflow of materials and sufficient material on hand to meet our customers' requirements. So that's a little bit longer going and taking a little bit more time than we anticipated.

It will - to your point, it will unwind, Kristine. The inventory that we have is nonperishable, and it will get used in our programs. That unwind will begin to come through in future quarters. But you've got to bear in mind that our - especially our commercial aircraft programs are ramping. We are currently running at rate 5 on our Boeing production.

So that's up from the rate 4 we were previously running, and we are getting - we are ahead because of our lead times of Boeing's own rates. So the unwind is balanced in some way by a pickup in inventory required for those higher rates in the future. So that will play out during the course of fiscal '24.

Our cash used in '24 is the demand for next year. Our free cash conversion will be - I don't know if we gave the figure in Investor Day, it will be lower than it will be in '25, '26, but we get back to the normalized levels in '25, '26. So there are demands through the course of next year. So you see it as multiple quarters as we go through this transition now.

Jennifer, do you have anything to add to that?

[Jennifer Walter, CFO]

Yes. Maybe just to complement that. So for our forecast this year, for a $60 million use of cash, to your point, I would say it's balanced. To your point, if we have higher sales, we may be pressured from the receivable standpoint associated with that.

But I would say, overall, it's balanced. The area we give confidence to it when we're looking at how the fourth quarter is going to shape up is we do have - we have some customer advances that were built late in Q3. And just on the normal terms associated with that, we will get the collections of that advance in Q4.

With our high level of sales in Q3, we'll also collect on those sales as well. So there's definitely some things, especially on the receivables side, that will help us as we move into the fourth quarter.

We're also seeing a slowdown in the need for growth in physical inventory. So it's still growing. But over the past few quarters, it's been decreasing. So in the first quarter, it was about $71 million. In the second quarter, it was $67 million. Although in the third quarter, it was $65 million. That included about $10 million of a payment we made to prevent a supply chain disruption by taking some inventory from a vendor. And we're projecting that to improve to $40 million in Q4.

So we are seeing a slowdown in the growth of physical inventories, but we're not yet projecting that to turn. As we look into next year, we're expecting a modest level of free cash flow generation, which is consistent with what we said a month or two ago as well. So definitely physical inventories is an area that will take us a while to work through.

[Kristine Liwag, Morgan Stanley]

Great. Thank you for the color, guys.

[Pat Roche, CEO]

You're welcome.

[Operator]

And our next question is going to come from Michael Ciarmoli from Truist Securities. Please go ahead.

[Michael Ciarmoli, Truist Securities]

Hi. Good morning, guys. Thanks for taking the questions. Just Jennifer, I guess, to stay on the inventory and cash side of things. Can you kind of specify what end markets, from a material standpoint, I guess, that you're trying to reduce, is it more aerospace-related or industrial? And then any color on where you are with 787 inventories? I know you guys have been building ahead there. It sounds like Boeing is certainly pushing for five a month by year-end and kind of how that fits into kind of the equation?

[Jennifer Walter, CFO]

Yes. From a market perspective, we're seeing the supply chain pressures in many of our markets. Each of our markets is reacting a little bit different, but we're still seeing supply chain constraints in many areas for electronics. Some areas have eased up a little bit, but there's also some sourcing in other areas that continue to pop up as well on that. I would say in our industrial businesses, it's easing up from a standpoint of our matching of incoming materials to what is being able to be processed. However, there's different things that are happening in the aerospace business. And they still seem like there's changing associate with it.

So for instance, we're still keeping our incoming receipts for the most part, fairly level from our supply chain. We want to make sure, first, that we've got everything that we need so that we can meet customer requirements, and also to make sure that we've got a healthy supply chain.

Obviously, we want to balance that so that we're not carrying excess amounts of safety stock. So we're being very careful, but it's a very tedious process to go through and make these decisions, and then input them into our systems, and then wait for it to actually manifest through our numbers.

But in some of the A&D side of the business, and it's in different parts of it, some places we've got, we're short on staff a little bit. So when we've got the materials in, it still takes a while for us to push those products through based on our staffing. Some of the supply chain challenges are happening as well, and this throughput through our factories of making that all happen.

So if we get a huge slug of inventories in, even from our supply chain, the time that it still takes to process it through doesn't necessarily mean that we'll catch up right away. So there's second level challenges that we're facing even though that we are getting materials in the door. As it relates to 787 inventories, currently, it's not having a significant amount of impact on our free cash flow.

However, we are carrying inventory that we had built up in previous periods, especially in fiscal year '22. That's going to help us as we start going into this ramp, and we're at that five a month rate right now on that. So right now, it's stable, not causing any further pressure, but -- and we do have stock in hand so that we can manage as we move forward.

[Michael Ciarmoli, Truist Securities]

Got it. And then what about -- you called out the, I think, earlier the unbilled receivables. What sort of the line of sight in terms of driving that down? Do you - is it more milestone-based? Are they presumably more on the space and defense side? And should we expect that to be more of a tailwind out in '25 or '26? Or do you think you can start unwinding some of that in the shorter term?

[Jennifer Walter, CFO]

Yes. So the unbilled receivables, there's a number of things that are happening, first of all, with our level of activity. We've got continuing growth with our sales growth. A lot of our business on the A&D side is on long-term contracting. So it does happen to go through the unbilled receivables as we have progress on that.

Certain things have gotten delayed in the unbilled and converting that over into cash. For instance, the space vehicle charges that we described, the delays associated with that, the higher expenses has delayed our activity on that, such that the cash that we would have expected to get in this year, we're now projecting getting into next year instead. So there's different things on different programs.

[Michael Ciarmoli, Truist Securities]

Okay. And then, Pat, can I just try the pricing in aircraft one more time. I mean can you maybe even - I know you don't want to maybe give a lot of specifics, but are you having more success immediately in the aftermarket? Or are you getting some on the OE side? I figured that the conversations with Boeing and Airbus might be a bit more challenging there. And then are you getting some across the military as well? And then I, guess, with that price, you talked about some of the escalators, but are you trying to manage, I guess, future price step-downs with volumes? Are those components in the conversations as well?

[Pat Roche, CEO]

Well, thanks, Michael. The pricing activity is across all of the OEMs and all of the aftermarket. So it's not limited to OEM activity. And as you know, in some of our OEM contracts, aftermarket is an element of the contract, and that's part of the contract discussions. So, all those factors are rolling into the conversations that we're having.

But my position is that we've made great progress with those conversations with the customers. There's a recognition on both sides to have a sustainable business. There had to be an adjustment, and that has come through now.

[Michael Ciarmoli, Truist Securities]

Okay. Got it.

[Pat Roche, CEO]

I'm really pleased, Michael, where we got to with those conversations. And the impact then, as we say, will show through in Q4 and throughout next year.

[Michael Ciarmoli, Truist Securities]

Perfect. Perfect. Okay. Great. Also impacting the Q. Thanks guys.

[Pat Roche, CEO]

Thank you.

[Operator]

And our new question is going to come from Cai von Rumohr from TD Cowen.

[Cai Von Rumohr]

Yes. Thanks so much for taking my call. So maybe switching back for a second to space, another large charge. How close are we to the end of this? I mean what should we be looking for as a milestone to say, from here on out, we shouldn't expect more space vehicle charges?

[Pat Roche, CEO]

Hi Cai, welcome, and thank you for the question. I think we have really done a good job over the last two months in burning down the risk associated with that space vehicle program. There are two programs on which we have shipped units. The first six of our Meteorite class units. Those shipments completed two weeks ago - or last week was the last shipment out of our facility to our customers' facility.

So in terms of the integration and test activities, all of those have been completed for all six units. So that's one element that reduces the risk down. We know that the hardware is functional, and it is with our customers at this point. The software, we have a revision of software to be delivered to the customer on August 11. So that's within the next two weeks. So, we're in the final stages of working through that update to code.

And so again, because we're so close to the finish line now with the software, we have really high confidence that we have the issues addressed in terms of delivery there. And we don't expect to see a change in the cost of development of the software as a consequence of being so close to the finish line at this point.

We also sent in an expert team about two months ago to do an assessment on work left to be completed, and that was part of revising the estimate to complete. So 90 days ago, I would have said we were 90% complete. If I look at the estimates to complete, as of last week, we were 97% to 98% complete. So we are, most of the way, almost entirely through those two programs, Cai.

[Cai Von Rumohr]

So is that both Meteor and Meteorite the both the two vehicles, basically you've had shipments on? Are those six all Meteorites?

[Pat Roche, CEO]

So it is on the Meteorite class that we have shipped six satellites.

[Cai Von Rumohr]

And the Meteor?

[Pat Roche, CEO]

On the Meteor, we will ship the first of those in the latter part of this calendar year. What's my point around Meteor and Meteorite is that they have a common platform of avionics, which is the electronics that control the system and a common base of software. And so a lot of the complexity and the integration risk is actually associated with those parts of the system. Many of the hardware components are also similar.

What might vary from one to the next is the propulsion system and the size of the solar ray panels, but there's a high level of commonality. So, I would look at them as a modular platforms, Cai, which is another reason why we have confidence.

[Cai Von Rumohr]

Very good answer. Thank you very much. So getting back to the cash flow. So what about - as we think about next year or so, I guess, we can expect the inventory to continue to go up. But even with some improvement, it looks like your DSOs have really been going up a fair amount. Where do you see those going next year? Where do you see kind of your payables relative to sales? And also with the inventory uptick, it looks like you're close to 23% of sales, whereas if we go back to '22, you've gotten down to below 20%. So it looks like there's really quite a lot of excess inventory relative to your sales level. When do you see that sort of starting to cross?

[Jennifer Walter, CFO]

So I'll take that, Cai. We'll give further detailed guidance on fiscal year '24 when we do this in 90 days. But just on a general type of basis, what we can expect to see is, on physical inventories, as you mentioned, we're going to continue to see growth. We expect that to moderate at least in this fourth quarter, and we'll comment more on next year in next quarter's call. We will have a little bit of lumpiness associated with our customer advances.

Our customer advances level right now is strong, but it comes in lumps. And we do expect to see some, next year, probably in the later part of next year, and it's just due to program timing that we've got. We are still expecting to generate modest levels of free cash flow generation, which is what we shared in the Investor Day for fiscal year '24.

So some of the inventories that we're talking about now, the physical inventories, we would not see a significant turn in that until we're getting out in some out years when we'll return to more normal levels of free cash flow.

[Cai Von Rumohr]

Right. But so what about the receivables? I mean the DSOs look like they also are higher. I mean do you expect your collection rate to improve?

[Jennifer Walter, CFO]

There's a couple of forces. There's - they're offsetting forces. So let me describe that. Right now, our sales are high. There's a couple of - our receivables are high. So they're high to the level of sales that we have. If you look at our balance sheet right now, there is a gross up between some receivables and advances for advances that we have built, but not collected until the fourth quarter.

So that comes through, but that just shows up as a bad guy in our receivables in the third quarter, but that converts fully to cash in the fourth quarter. As our sales continue to grow, there is pressure on our receivables that continues to happen, especially on the ramp-up associated with our aircraft business where terms are less favorable than the average of the company. And that's the area of the business that we're growing.

So, there are pressures associated with that. But again, we do have the strong collections that we're expecting from the Q3 sales that we had as well as the advances that we are collecting, and that's the timing from Q3 to Q4.

[Cai Von Rumohr]

Got it. So Pat, you described lots of improvements, which all sound really very good and better pricing going forward on aircraft on a normalized basis. And space defense like we're out of, hopefully, we have less problems from the satellite vehicles. And industrial, you've got some price hikes. You're looking for, I think, 100 basis points on average for the next couple of years. I mean it would look like you would get sort of a proportional percent of that next year. I mean you could be close to up 100 basis points on the op margin. Am I reading that incorrectly?

[Pat Roche, CEO]

We are feeling really confident, Cai, that we are going to deliver on the 100 basis points a year on average, as we said in the Investor Day. Everything that we're doing is on track towards that at this point.

[Cai Von Rumohr]

Okay. Thank you very much.

[Pat Roche, CEO]

You're welcome.

[Operator]

[Operator Instructions] Michael Ciarmoli from Trust Securities. Please go ahead. [Operator Instructions] And Michael is back. Please go ahead.

[Michael Ciarmoli, Truist Securities]

Hi, can you guys hear me now.

[Pat Roche, CEO]

Perfectly Michael. Thank you.

[Michael Ciarmoli, Truist Securities]

Okay. Sorry about that. Pat, just can you give us maybe a little bit more insight into maybe within Space and Defense, do you have a lot of other development contracts or new start contracts? I mean we are seeing this mix shift across the defense sector of legacy programs winding down, new programs ramping up. And I mean just to try and get an assessment of maybe how much risk you see with some of the other contracts in there. For example, I don't know if you have any firm fixed development contracts, but just trying to maybe get a framework on what else could crop up in that sector?

[Pat Roche, CEO]

Thanks, Michael. I think we have, in general, reducing our exposure to - from fixed contracts in our military side of the business. We have some, for sure. We have some legacy programs that are still to close out. And there are a couple of pieces of business in space and defense that are still under fixed price contracts. So, I think that we feel comfortable with the profile that we have there, Michael. I wouldn't say it's degrading in answer to your question.

[Michael Ciarmoli, Truist Securities]

Okay. Okay. Perfect. Yes, that was the last one I had. Thanks guys.

[Pat Roche, CEO]

You're welcome. Thank you.

[Operator]

[Operator Instructions] And I have no further questions in the queue at this time, and I'll turn the call back over to Aaron Astrachan. Please go ahead.

[Aaron Astrachan, Director of IR]

So it's back to Pat, and I appreciate you taking the time to join the call, and I look forward to meeting you all again in 90 days' time. Thank you very much.

[Operator]

And this concludes today's call. We appreciate your participation. You may now disconnect.