Moog Inc

NYSE:MOG.A

Earnings Call Transcript 2020-Q4

[Operator]

Good day, and welcome to the Moog Fourth Quarter and Year-End Fiscal Year 2020 Earnings Conference Call. Today’s conference is being recorded. At now at this time, I would like to hand the conference over to Ann Luhr. Please go ahead, ma’am.

[Ann Luhr, Investor Relations]

Good morning. Before we begin, we call your attention to the fact that we may make forward-looking statements during the course of this conference call. These forward-looking statements are not guarantees of our future performance and are subject to risks, uncertainties and other factors that could cause actual performance to differ materially from such statements. A description of these risks, uncertainties and other factors is contained in our news release of November 6, 2020 our most recent Form 8-K filed on November 6, 2020 and in certain of our other public filings with the SEC.

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

[John Scannell, Chief Executive Officer]

Thanks Ann. Good morning. Thanks for joining us. We hope all our listeners are listeners are staying safe and healthy. This morning we’ll report on the fourth quarter of fiscal 2020 and reflect on our performance for the full year. Given the continuing uncertainty we all face as a result of the pandemic, we’ll not be providing detailed guidance for fiscal 2021 today. Instead, we’ll provide color on what we’re seeing in our various end markets and our operating assumptions as we head into a new year.

I’ve organized my headlines into three broad categories: first macroeconomic, second microeconomic, and third Moog specific topics. From a macroeconomic perspective, fiscal 2020 was a tumultuous year. Early in the year, we worried about trade disputes with China and the potential impact of a hard Brexit on our business. Unrest in the Middle East was also on our radar. Then COVID hit, and the last six months have been dominated by the impact this pandemic is having across the globe and speculating about when we’ll see a recovery.

Looking to the microeconomic, our diversity across end-markets was a significant strength in a period of great uncertainty. Half of our business is in the defense and space markets and these markets were essentially unaffected by the pandemic. Our medical market was very strong all year, as demand for specialty equipment to help COVID patients buoyed our sales.

Our industrial markets slowed as we went through the year, although our geographical diversity of end customers helped alleviate the impact. Finally, our commercial aircraft business was hit very hard with both OEM and aftermarket customers feeling the brunt of global travel restrictions.

Turning to Moog specific comments, the fourth quarter was a good quarter overall, compared to the same quarter a year ago, particularly given the operating conditions this year. Sales were up in our defense, space and medical markets, but lower in industrial applications and down over 50% in our commercial aircraft market. Adjusted margins of 8.3% and earnings per share of $0.81 were respectable. We had another outstanding quarter for free cash flow, and we reinstated our dividend and bought back 600,000 shares.

We incurred impairment and restructuring charges totaling $15 million as we continued to align our operations with the demand predictions from our customers. We also completed a major transaction to de-risk our DB pension plan in the U.S., transferring half the assets and liabilities to an insurance carrier at a very favorable rate. We incurred a non-cash charge of $121 million or $2.85 per share for this transaction. Jennifer will describe this in more detail later on our call.

Looking back on the full-year the following headlines stand out. First, it was a year of records, divided into two halves. The first half was characterized by record sales, record net earnings, and record earnings per share. In the second half, we generated record free cash flow. Our response to the pandemic dominated our third and fourth quarters as we shifted our attention from sales and earnings to leverage and liquidity.

Our intense focus on expense reduction and cash flow generation resulted in lower leverage at the end of the year than six months ago when the pandemic hit. We incurred over $70 million in charges associated with restructuring, impairments and asset write downs.

Second, we refinanced our balance sheet in our first quarter – extending the term of our revolving credit facility and selling $500 million of high yield bonds at 4.25%. At the time, we were just following our usual strategy of getting the money before we needed it. In hindsight, it was brilliant timing.

Third, we followed our historical capital allocation policy. We completed one acquisition early in the year, and returned excess capital to our shareholders through our dividend and buyback programs. We paused these activities during the third quarter as we assessed the situation, but as cash flow improved, we returned to a balanced capital allocation in the fourth quarter. Over the course of the full-year, we repurchased almost 3 million shares. Between dividends and share repurchases, we returned over $240 million to our shareholders in fiscal 2020.

Fourth, as we’ve mentioned many times, our diversity across end markets provided stability and continued strong operating performance throughout the year. And finally, and most importantly, I believe you see the true strength of a company during times of adversity. On that measure, fiscal 2020 was a record year for our company in every way. The employees of the company across the globe did an outstanding job managing through an unprecedented crisis.

It was definitely not the year we planned for 12 months ago and to say it was a challenge would be an understatement. However, our long-term strategy of diversity across end markets and financial prudence served us well. As I do at this time each year, I would like to express my thanks for the dedication and commitment of our 13,000 employees around the world who made this all happen.

Now, let me provide some more details on the quarter. Q4 Fiscal 2020. Sales in the quarter of $707 million were 8% lower than last year. Sales were up in Space & Defense, but lower in Aircraft and Industrial. Taking a look at the P&L, our gross margin was down on lower sales and under-utilized facilities. R&D was down as our engineering teams moved to funded development projects. SG&A expenses were also down on cost containment measures.

Interest expense was lower, the net result of lower rates, but slightly higher debt levels. We incurred $6 million of restructuring in the quarter and incurred a non-cash charge of over $120 million associated with annuitizing half of our DB pension plan. Our effective tax rate in the quarter of 21.8% resulted in GAAP earnings per share of minus $2.40. Excluding the pension charge, restructuring and asset impairment impacts, adjusted earnings per share were positive $0.81.

Fiscal 2020. Full year sales of $2.88 billion were 1% lower than last year. Sales were way up in Space & Defense, about flat in Industrial Systems and lower in Aircraft. Similar to the fourth quarter, gross margin, R&D, SG&A, and interest expense were all lower as a result of the change in operating conditions in the second half. We incurred a total of $38 million in asset impairment charges, $23 million in inventory write downs and $11 million in restructuring charges, all in the second half.

Combined with the DB pension settlement charge, the net result was $0.28 per share for the full-year. Excluding these one-time charges, adjusted full-year net earnings were $157 million and earnings per share were $4.81.

Fiscal 2021 outlook. As we look to fiscal 2021, we’re planning that COVID will be with us through the full-year. In terms of our major markets, we believe defense and space will remain strong. We also think our medical market will be strong, but will perhaps soften slightly after the surge of demand in the initial stages of COVID. We’re not anticipating any recovery in our industrial markets from the level in the second half of 2020.

Finally, we’re hopeful that the commercial OEM business will stabilize at the advertised rates from the OEM’s and that the aftermarket may see a modest recovery towards the second half of the year. At this stage, we’re not making any assumptions about significant shifts in U.S. policy in terms of tax, trade or defense spending.

Now to the segments. I’d remind our listeners that we’ve provided a three-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 Q4. Sales in the quarter of $275 million were 19% lower than last year. It was a contrasting story between military and commercial. Military sales were up over 20% in both the OEM and aftermarket. Higher sales on the F-35 to Lockheed drove the OEM beat while strength across the entire portfolio of platforms drove the aftermarket beat.

On the commercial side, OEM sales to Boeing were off 50% and OEM sales to Airbus were off 70%. On a slightly more positive note, or perhaps less negative note, sales into the commercial aftermarket were “only” down by 34% this quarter. In the present environment, our usual comparisons with Q4 last year are not particularly relevant, while comparisons with last quarter are perhaps more insightful.

Compared with our third quarter, sales to commercial OEM customers in Q4 are up 6%, while sales to our commercial aftermarket customers are up over 30%. It’s definitely too early to tell if this is a trend, but perhaps they indicate that Q3 was a floor.

Aircraft fiscal 2020. Full-year sales of $1.21 billion were down 7% from last year. Similar to the quarter, it’s a story of two very different markets. It’s also a story of two very different 6-month periods.

On the military side of the house, sales were up 16% relative to last year. We saw strength in every quarter of fiscal 2020, with second half sales up 6% over the first half. OEM sales were up on strong F-35 activity, as well as higher funded development. Aftermarket sales were up across the portfolio, with the largest contributor being the F-35 as the active fleet grows.

Commercial sales were down over 30% from last year. In the first six months of the year, commercial sales actually grew marginally from the same period last year. However in the second six months, as the global travel industry collapsed, our commercial sales fell by almost 60% from the prior year. The drop was across all OEM and aftermarket customers.

Aircraft margins. Adjusted margins in the quarter of 2.7% include about 200 basis points of charges on fixed price development programs. Demand from our commercial customers remained volatile in the quarter as they re-plan their production and continue destocking. In the quarter, we incurred $4 million in restructuring charges as we continued to size our business for the latest projected demand from our customers.

Adjusted margins for the year were 7.6%. Adjusted margins dropped from close to 11% in the first half to only 3.6% in the second half. We incurred a total of almost $60 million in restructuring, asset impairments and various other write-offs in the second half – all attributable to the COVID impact on our commercial business.

On a more positive note, we continued to see the shift from internal R&D to funded development work throughout the year. For all of fiscal 2020, R&D was down $10 million relative to last year while funded development was up over $20 million over the same period.

Aircraft fiscal 2021. We cannot predict what will happen over the coming 12 months, but we can share our planning assumptions as we look to fiscal 2021. On the military side, we’re assuming the demand for our products will remain strong and that our operations, and suppliers, will continue to operate effectively. On the commercial OEM side, we’re working to the production schedules our major customers have published, while recognizing that there remains considerable risk in that outlook. For the commercial aftermarket, we’re assuming a modest pick-up in demand in the second half of the year.

Turning now to Space and Defense. Sales in the quarter of $207 million were 9% higher than last year. The strength was all on the Space side of the house, with sales up 40% from a year ago. We saw strength across the entire portfolio of space products including hypersonics, propulsion, avionics, and satellites.

Defense sales were down 5% as a result of a much softer security market and lower sales on missile programs. The security market has been particularly hard hit by the pandemic as on-site installations have ground to a halt.

Space and Defense fiscal 2020. Full-year sales of $770 million were up 13% from fiscal 2019. Space was the major driver of the growth, with sales up 34% year-over-year. We saw growth in every product line within space. We’re benefiting from increased government spending both on military applications, such as hypersonics, and civil missions at NASA to put humans back on the Moon.

There is also increasing commercial interest in space from tourism to launch vehicles for low-cost satellites. As the space market evolves, we’re gaining share in many of our product categories and increasing our scope of content on new platforms.

Defense sales were up marginally year-over-year. Higher sales on ground vehicles and into naval systems compensated for lower sales in security applications. Sales of components used in missile steering applications were in line with a very strong fiscal 2019.

Space and Defense Margins. Margins in the quarter of 14.2% were very strong. We’re particularly pleased with this margin performance in the face of a global pandemic and at a time when we’re experiencing elevated levels of lower-margin funded development work. Full-year adjusted margins of 13.3% were up from 13% last year. Again, this is an outstanding performance given the challenging conditions through the year.

Space and Defense fiscal 2021. At the moment, we’re assuming that fiscal 2021 will be somewhat similar to fiscal 2020 with continued strength in both the space and defense markets. We do not, however, anticipate we’ll see a continuation of the explosive growth in the space market we enjoyed in fiscal 2020.

Industrial Systems Q4. Sales in the quarter of $225 million were 4% lower than last year. Excluding the impact of foreign exchange and acquired sales, underlying organic sales were down almost 10% from the prior year. Sales were higher in 1 of our 4 markets. Sales into medical applications were up on strong demand for both our IV and enteral product offerings.

Energy was down on lower investment in off-shore oil exploration, industrial automation was down as the combined effects of the pandemic and a general slowing in capital investment hit, and simulation & test sales were down primarily on depressed demand for flight simulators.

Full year sales in Industrial Systems of $909 million were just 1% lower than last year. However, there was a significant shift in the mix through the year. Medical was the bright spot for the year, with sales up 20% on strong demand for our pump products and for various components used in breathing equipment.

Sales into our energy markets were up slightly, the result of the acquired sales from our GAT acquisition. Sales into industrial automation were already slowing as we entered fiscal 2020 and that slowdown accelerated in the second half as COVID hit. Finally, sales into simulation & test markets were down across all major submarkets including aero test, auto test, and flight simulation.

Industrial Systems Margins. Adjusted margins in the quarter were 9.7%, down from last year on a less favorable mix and factory inefficiencies across the footprint as a result of the big shifts in demand by submarket. In the quarter, we incurred $11 million of charges, a combination of restructuring and asset impairments as we look to resize the business and consolidate our activities.

Adjusted full-year margins were 10.3%, with the average margin in the second half down almost 200 basis points from the average margin in the first half.

Industrial Systems fiscal 2021. The industrial business is probably the most difficult to predict given the range of end markets we serve. As we look into the coming year, we’re assuming no recovery in demand for our energy, industrial automation or simulation & test products. We believe the world will continue to struggle with the effects of COVID and recovery in investment will only begin in fiscal 2022.

For our medical products, we expect another good year, although we think demand will moderate from the highs we saw in fiscal 2020 as the surge in demand for COVID-related equipment wanes.

Summary guidance. Fiscal 2020 was an extraordinary year by any measure. Our employees around the world rose to the occasion and delivered an outstanding performance. As we close up the year, our company is strong and well positioned to continue to weather the COVID storm through fiscal 2021. Over the coming 12 months, our planning reflects continued strength in the defense, space, and medical markets, continued weakness in the industrial markets and a stabilizing of demand in the commercial aircraft market. Overall, a year somewhat similar to the second half of fiscal 2020.

Over the last six months, we’ve resized our business to align with the future demand. Our liquidity is strong and our leverage is in our comfort zone. After one quarter of capital conservation in Q3, we’re back to a more balanced capital allocation strategy this coming year, including actively seeking acquisitions which complement our internal strategy and drive our growth. We’ll also invest in programs and innovations, which will fuel our long-term organic growth and continue to invest in improving our operations.

Despite the challenges around us, we remain very optimistic about our business and the future potential. Our long-term strategy of technology focus, market diversity and financial prudence paid off handsomely in fiscal 2020. Fiscal 2021 will be a year of renewed investment to prepare ourselves for the recovery we believe will come in fiscal 2022, and to position us to take advantage of growth opportunities.

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

[Jennifer Walter, Chief Financial Officer]

Thank you, John. Good morning, everyone. We had another incredibly strong cash flow quarter, making the back half of this year a record in free cash flow generation. We achieved these results during a time filled with uncertainty and pressures in some of our end markets. Our company-wide initiatives that are focused on cash conservation and liquidity continued to contribute to our strong cash performance.

Free cash flow in the fourth quarter was $73 million, bringing the total for the year to $191 million. Free cash flow conversion, adjusted for charges associated with the pension settlement and the pandemic, was nearly 300% in the fourth quarter and over 100% for the year.

At the outset of the pandemic in the March timeframe, we made significant adjustments to our major capital deployment activities. We paused our M&A pursuits; halted share repurchases, suspended our dividend and delayed certain capital expenditures. We also took measures to slow our incoming inventories to be in line with expected demand. In addition to these cash relief measures, we also actively reduced expenses to mitigate the impacts to our operating margins.

We continue to focus on cash preservation and cost management. However, we have resumed investments in a measured and balanced way, as our strong financial position affords us these opportunities. The $73 million of free cash flow for Q4 compares with a decrease in our net debt of $37 million. During the fourth quarter, we repurchased about 600,000 shares of our stock for $37 million and resumed paying our quarterly dividend.

For the full-year, free cash flow of $191 million compares with an increase in our net debt of $105 million. We repurchased 2.9 million of our shares for $215 million, paid $54 million for the acquisition of GAT and paid $25 million of dividends.

Net working capital, excluding cash and debt, as a percentage of sales at the end of Q4 was 28.4%, about the same level as a quarter ago. Robust collections, including on defense contracts, were offset by increasing inventories, continuing the trend we experienced earlier in the year.

Capital expenditures in the fourth quarter were $18 million, about the same level as in the third quarter and down from a $27 million quarterly run rate in the first half of the year. We actively managed and prioritized our spend, focusing on compliance and business critical projects. Depreciation and amortization totaled $21 million, continuing at a fairly constant level throughout the year.

At the end of Q4, our leverage ratio, which is net debt divided by EBITDA, was 2.4x, the same as a quarter ago. The effects of trailing 12-month adjusted EBITDA and our share buyback activity was offset by strong free cash flow generation.

At quarter-end, our net debt was $845 million, including $85 million of cash. The major components of our debt were $500 million of senior notes, $362 million of borrowings on our U.S. revolving credit facilities and $69 million outstanding on our securitization facility.

We have nearly $700 million of unused borrowing capacity on our U.S. revolving credit facility. Our ability to draw on the unused balance is limited by our leverage covenant, which is a maximum of 4.0x on a net debt basis. Our leverage is based on trailing-twelve month adjusted EBITDA and has been impacted by the decline in our business related to the pandemic. Based on our leverage, we could have incurred an additional $552 million of debt as of the end of our fourth quarter.

We are confident that our existing facilities provide us with adequate liquidity to successfully navigate through these uncertain times. This past quarter, we took a meaningful step out of being in the pension business, significantly reducing our exposure by settling about half of the liability for our largest defined benefit plan. That plan is in the U.S. and has been closed to new entrants for more than a decade.

We fully funded this plan in 2018 and adjusted our investment strategy accordingly to reduce our exposure. In the fourth quarter, we purchased an annuity for retirees who are receiving benefits in the plan, and we took advantage of favorable market conditions to obtain attractive pricing. Our retirees continue to receive their same benefits, and a reputable insurance company now carries the obligation.

With this transaction, we settled $486 million of the plan’s projected benefit obligation, which triggered settlement accounting. This resulted in a $121 million non-cash charge as we accelerated unrecognized losses held in equity into our earnings. We remain fully funded in this plan and are in the process of adjusting the plan’s investment portfolio to address the plan’s remaining participant base.

Cash contributions to our global retirement plans totaled $12 million in the quarter, compared to $10 million in the fourth quarter of 2019. Global retirement plan expense in the fourth quarter was $21 million, up from $18 million in the fourth quarter of 2019. For the full-year, cash contributions to these plans were $46 million and expense was $79 million. Expense for 2021 is expected to be $72 million. The decrease in expense next year includes a modest benefit resulting from shifting assets in the U.S. plan after settling a substantial portion of that obligation.

Our effective tax rate, excluding charges associated with the pension settlement and the pandemic, was 28.3% in the fourth quarter, compared to 21.2% in the same period a year ago. The higher adjusted rate in this year’s fourth quarter primarily reflects an earnings mix change this year and lower state tax accruals in the U.S. last year. For all of 2020, our adjusted tax rate was 20.9%, compared to 23.1% in 2019.

The lower tax rate in 2020 reflects an increase in foreign tax credit utilization associated with our 2019 tax return filing, a reduction in rate related to taxes accrued on accumulated earnings in one of our foreign jurisdictions, and legal entity restructuring that reduced withholding taxes previously accrued in another foreign jurisdiction.

As we look forward, we are well positioned to invest in our business. We expect free cash flow to be respectable in 2021. We may see shorter-term pressures on inventories as we continue to adjust to changing demand from our customers. However, the benefits associated with our efforts to create operational efficiencies in our business will outweigh these pressures later in 2021.

With respect to capital expenditures, we are beginning our ramp up from the constrained levels of the back half of 2020. After just a quarter or two of pausing some key capital deployment activities, we’ve returned to a well-balanced capital allocation.

With that, we’ll turn it back to John for any questions you may have.

[John Scannell, Chief Executive Officer]

Thank you, Jennifer. And I’ll hand it back to Jake, our operator to help us with questions.

[Operator]

[Operator Instructions] We’ll begin Q&A with Robert Spingarn with Credit Suisse.

[Robert Spingarn, Credit Suisse]

Hi, good morning. And thank you both for so much detail. Actually quickly want to start with you, Jennifer, just on the cash flow. In the absence of 2021 guidance, but based on the color you offered, and John offered, how should cash flow trend next year? Just from a high level?

[Jennifer Walter, Chief Financial Officer]

Yeah, so as I mentioned, we're feeling comfortable in our lookout for cash flow next year. So, historically, we've looked at cash flow generation in the 100% range from the free cash flow generation conversion ratio. We expect that that's a reasonable target. As we look forward, there's a few things going on that will be puts and takes as we move forward. We may see – we had an incredible collection quarter from receivables standpoint. We may see pressure on the opposite direction of that depending on how things go from government contractors.

From an inventory standpoint, we do have opportunities here. In the near term, we will be facing some continued pressures, possibly related to our customers continuing destocking. And however as we move later into the year, we should see benefits from of our operational efficiency platform such as the operations 2.0, that we've mentioned several times before. So, we certainly have a lot of opportunities, especially on the inventory side of the business in working capital.

As we look forward, we are positioned nicely from a financial position so that we can start investing more in our business. And that includes a ramp up on capital expenditures. So overall, we should see some increase as we move forward through the year. We'll continue to monitor the situation and adjust our plans accordingly, but we're feeling confident in where we'll come out for cash flow for next year.

[Robert Spingarn, Credit Suisse]

Just on the inventories, are there any areas where you might need to build inventory that's now been depleted during this past year and drawn down where we might be seeing some recovery in certain spots?

[Jennifer Walter, Chief Financial Officer]

I don't know that. I expect to see anything that would be meaningful. As far as a growth in inventory from a restocking level. There certainly may be some smaller pockets of that, but nothing to drive it from significant basis. I think our greatest opportunity is, is really some of the efficiencies that should overtake the current situation related to the pandemic and to be able to see some of those in the later parts of the year.

[Robert Spingarn, Credit Suisse]

Okay, okay. And then John, I had a high level sort of broad question on space, just because it's growing so well. And I think you already said, it won't grow quite as much in 2021, but it's clearly among the fastest growing businesses you have. And I wanted to see if you could dig in a little bit, perhaps, and talk about the relative sizes of the military, civil, and commercial space, pieces of that, and where your major positions are on big programs?

[John Scannell, Chief Executive Officer]

So you're right Rob that the space business, what has been going gangbusters over the last year. Ironically, if you look at the space and defense business it’s kind of a story of two markets that have gone up in sequential year. So defense was kind of flat up a little bit in fiscal 2020. It grew in 2019, from 2018, by almost 25%. From 2018 to 2019, space was kind of flat. And then space had this huge growth of 35% as we got into 2020. And one of the things they said is as we look to fiscal 2021, we believe we believe both markets will remain strong, but we're not anticipating space will continue to grow at anything like that pace.

We really – so we provide a whole range of components for space applications, kind of divided into launch vehicles. Most of the launch vehicle work is thrust vector control, there are actuators that control the steering of the rocket engines at the bottom of the missile on the vehicle that allows us to go up straight, and then various avionics products. And then once you get the satellites, we've got everything from fuel control systems, solar array drives, we've got small rocket engines, we've got avionics, a whole range of different components that go on satellites. And so we've just seen broad strength across both the vast majority of our spaces, and I won't break it down into specific, but the vast majority is government spending.

So, when I say government spending, I'm talking about military space. And then of course, the NASA work to put folks back on the moon. But in the end, almost all of it is government spending, plus actually, even on the commercial side, some of the commercial stuff. If you take a Blue Origin, or SpaceX space, they have commercials, but a lot of the money is against government related money for launch.

We've seen a lot of strength in this push that space is viewed as the next frontier in terms of from a military perspective. And so I think there's a lot of acceleration in military spending, and so all of our component businesses are seeing an uptick from that. But for that part of what we're also doing in the space business, is we're evolving to provide more scope of supply to some of our major customers.

And so instead of providing four or five different components, we're starting to see opportunities to put those components together into a small satellite box. At this stage, it's still relatively early, although having said that, we've been at this as a kind of a shift in strategy to be a more integrated provider for five or more years. So it's not as if this is a kind of a one year thing that we just discovered, but that's starting to pay dividends.

We're starting to be seen as an integrator of components. Not a full of satellite, not payloads, but an integrator of components. And so I believe we're gaining share through scope gain, as well as share through market gain plus, of course, just growth in the market. And so, I think, you know spaces and up and down business. It's something that you need a strong stomach for, because I think it was four or five years ago, I had quite a few conversations with investors where they said, ‘why didn't you just sell the space? Maybe you should just get out of space.’

Because at the time, space was kind of not going anywhere particularly fast. And then of course, now it's a star in our portfolio. So space, we, you know, we looked at that strategy about six, seven years ago, redefined where we wanted to go got out of it, you may remember we got into some operations in Europe, we sold those off, we saw a little bit of a shrinking in the business, we consolidated. And now we're blocking and tackling with great components, and the market is doing well. So, we're very pleased with this.

[Robert Spingarn, Credit Suisse]

So, it's fair to think that over time, it's bigger than 10% of the total. I understand today, you know, this year sales are depressed, but it sounds like it's got some endurance as a growth market.

[John Scannell, Chief Executive Officer]

I would definitely think so, of course now, as we say, because so much of it is government spending, whether directly or indirectly. What happens in the future there? If there was a shift that said, we don't see space as a future military frontier, then, you know, you wouldn't know, but we are engaging in the whole new space opportunities as well as small sub not building small satellites or providing Launch Services for small satellite. So, yes, we think the space business has nice growth opportunity and could be north of 10% in our business in a few years time.

[Robert Spingarn, Credit Suisse]

Thanks very much.

[John Scannell, Chief Executive Officer]

My pleasure.

[Operator]

Now, we will move to a question from Cai von Rumohr with Cowen.

[Cai von Rumohr, Cowen]

Thanks so much, and nice quarter, guys.

[John Scannell, Chief Executive Officer]

Hi Cai. Good morning.

[Cai von Rumohr, Cowen]

John. Good morning. So you have this, this write-off 200 bips in aircraft on the fixed price development contract, can you tell me is the contract work fixed so that we will know that this is truly behind us, or how much longer this thing has to go, you know, leaving us presumably with some residual risk?

[John Scannell, Chief Executive Officer]

Yeah, so as you know Cai, you know the way you do these estimated completes the EAC's as you take everything you know at the time, and you make your best possible estimates, and you look at the contract value, and then you take any adjustments through the P&L. And so as we sit here today, we believe that we have taken account of all future risks, and taken the necessary charge on the contract.

Having said that, the contract is probably going to go for another 18 months to two years, and so, there's always residual risk, and particularly, you know, the types of things we do, as you get into qualification, if you, you know, you cannot plan for a [clause failure]. On the other hand, every now and again, failures happen in [clause]. And if that happens, you can, you know, end up taking an additional charge, because the contract value is fixed. And so it costs more to fix.

So, as we sit here, today, we’ve taken all of the risks into account that we know of, but there are kind of events that can happen in the course of a development program that are, you know, cannot be planned for, and you cannot simply take the reserve on the [indiscernible] unfortunately. But we're pretty good. And, you know, when we take fixed price development programs, you know, we're taking some charges on it. The vast majority of it is paid for, and it's because we believe there's a, you know, a long-term future in it.

So, it's a little bit like an R&D investment. And as I mentioned, the R&D, the internal R&D has come down by $10 million, this year, funded development has gone up by $20 million. And so this 200 bits call it a $5 million charge I could have put down to well, you know, it's kind of like an internal R&D type of thing, because we're investing in a problem we just didn't anticipate it would play out this way. But you see all the primes.

I mean, this happens across the board as things unfold. What we do is not easy. And it's – we do the best we possibly can to estimate costs, but sometimes stuff happens that you know, you can't predict.

[Cai von Rumohr, Cowen]

Absolutely. So Jennifer, maybe could you give us a little color on the rest of the working capital items? I mean, it looks like you accelerated your payment of excuse me that your payables, you know, really came down a lot. So you're not stretching any of those. And although customer advances did a little better than expected, how should we, you know expect payables receivables and customer advances to kind of go – as you go through the year to the extent you can comment on that?

[Jennifer Walter, Chief Financial Officer]

Sure. Let me start with the quarter for the customer advances and payables since we didn't really cover that before. So customer advances, nice next quarter, again, generating a lot of a lot of activity advances. We're seeing a bunch of that predominantly on the U.S. Defense side of the business. So, our customer advances have come in strong. Our payables as you mentioned, we have not been structuring payables at all, so that's kind of neutral in the quarter.

As we look out next year, in these other areas, I would say that in customer advances we've got a really nice strong balance right now in our customer advances due to the increase that we had. We will be working some of those down as we go through the year. So that will be a pressure as we look forward into next year. On the payable side, we are looking to have that largely near the activity that we would have from a receivable perspective.

So, the level of activity in our business, we're going to see both on the receipt side and on the payable side. So, I wouldn't expect anything to be out of sync when we look at both of those areas together. So that's kind of how we're looking at it, but overall, when we keep all of the aspects together, we're feeling like we're in really solid shape looking forward to have continued good strong cash flow.

[Cai von Rumohr, Cowen]

Terrific. And then John, you didn't talk, I mean, obviously, you haven't provided guidance, but is it – can you give us any kind of color, you know, as to your rough sense, in terms of the pattern for the year, like it's going to be, I mean, what you're talking about is clearly maybe a little bit more difficult to start the year and then a little bit better toward the end of the year, but any color you could give us in terms of, you know, the rough pattern as you see it today, of the year.

[John Scannell, Chief Executive Officer]

Let me do it by market Cai, because I'm not sure I have a good answer for you. But if I – let me start with defense and space, so our anticipation, our assumption is that they will both remain strong. So, you know, this year was very strong. And so, we would hope that they would maintain the level of this year, maybe we'll see a pickup here or there. But at 35 is, you know, we had a super year, some of that depends on timing, and but it's pretty much at race, you know, there could be some pressures and some programs here or there. So, assume that they face similar to the second half of fiscal 20. That's kind of the assumption that we have there. And I don't think that will vary much as we go through the year. I think they are both very strong. And so maybe we'd have again, maybe you'd have some ups and downs, quarter to quarter, but if the average of next year was equivalent to the average of the second half, I think we'd be feeling pretty good.

Medical, super year, this year, some of the sales that were a little bit artificial, because we got some very large orders. Early on in the pandemic, we described some of that for ventilator motors. Actually, we've seen a reversal of some of those as we've gone through the third and fourth quarter. And the demand was one of those things where when you looked at it, you said, let's be really careful, we don't buy all of this inventory. Because you know, in two or three months time, they're going to be coming back saying no, we don't need that many.

To give you an example, we had a demand for ventilator motors, we had just been qualified before the pandemic hit to be a motor supplier for ventilators. Now these are small, these are sub $100 motors. So it's not a big number, but the demand was 800. And within about a month, it went to almost 800 per month, it went to almost 40,000 per month. And since then that’s kind of unwound [indiscernible] much more sensible level.

So, we saw some real pickups in the second half. And so that says, as we go into next year, we think the medical business will remain strong relative to [say a 2019]. But it may come off the boil a little bit from some of the kind of the bumps that we saw the fiscal 2020. Industrials, I'm not optimistic about the industrial business Cai in general. And when I say that, you know, we saw a slowdown, we were already seeing the economy slow before we hit the pandemic. And our assumption is that the pandemic will be with us through all of fiscal 2021.

So, we're not assuming it's going to get better in March or July, we're just going to say, let's assume it's there all year. And so, we're going to have to operate with a lot of people working remotely all with the challenges associated with that. And so, when we look at the industrial business, I just don't see a recovery coming. Our thought right now is, if there's going to be a recovery, it's going to be into fiscal 2022. And if anything, maybe we could see a softening as we go through the year, if we don't see some of the pandemic effects starting to wane.

So, you know, within industrial, industrial automation is a big contributor far us. The energy business, I mean, you can't, it's unimaginable that oil is going to take off again anytime soon. So that would be – would stay in the doldrums and then the simulation and test. You know, a year ago, we were optimistic – the thought was that there was going to be a lot more simulator training on the MAX. But you know, the MAX numbers better than we do. I mean, in terms of how many of them are going to get out there and how many pilots they're going to need. The demand for simulators just does not seem to be there. And so that's probably going to stay soft for the year.

So those are all kind of down and then commercial, commercial on the OE side we'd hope would stabilize. You know, the advertise rate from Boeing, and Airbus, it was – in the [indiscernible] and then maybe down to six next year. But if you look at our Boeing business, that would suggest it would be down at about, you know, 45%, it's down over 50%. Airbus business on the A350 raise from 10 to 5 would be down 50%. It's down in the second half over 70%.

So, our hope is that those rates will stabilize. And what it is, it's the destocking effect that we've talked about. So, we hope as we get into the year, by the second quarter, we will see that stability in those rates, and then we can – our factories are sized to that rate, but they're still oversized today, because they're not even taking those rates. So, we hope we'd see some stability there. And then the commercial aftermarket, maybe we'll see a little bit of a pickup in the back half of the year. But I mean, who the heck knows.

So. the way you know, the way we're describing it is, you know, the second half of 2020 through most of next year now, I would say we have particularly aircraft business, more to the quarter, sometimes we've got some unusual foreign military business, we got some, you know, mix shifts, that you can see some bumps up or down. And so, as we go through the year, we may see some bumps, which I would caution you to wait until we maybe talk our way through it before jumping to a conclusion that there's a big shift. And so that's the other thing that we might see. But again, that type of volatility, we'll see quarter-to-quarter in normal years.

[Cai von Rumohr, Cowen]

Thank you very much.

[John Scannell, Chief Executive Officer]

You’re welcome.

[Operator]

[Operator Instructions] We are now moving to a question from Ken Herbert from Canaccord Genuity. Please go ahead.

[Ken Herbert, Canaccord Genuity]

Yes, Hi, good morning.

[John Scannell, Chief Executive Officer]

Good morning, Ken.

[Ken Herbert, Canaccord Genuity]

Hey, John, and Jennifer, appreciate all the detail you provided. I wondered if you could just help John with thinking about margins in the next year, at least directionally, and how this could play out. I mean, it looks like third quarter was probably the trough and margins, but it sounds like you've clearly got some cost actions. And volume is probably the biggest single swing factor. So, as we think about 2021, can you quantify sort of what you've done on the cost front and can you give any more cover on how we should think about incremental volumes across the year, as we do get or incremental margins as we do get any improvement in volume sounds like more of the back half of the year.

[John Scannell, Chief Executive Officer]

Let me offer some thoughts on it. I'm doing the bubble and we've been here, despite all of the attempts to lock us down on fiscal 2021 for sure. So I'll continue to give you the color. My hope is or our hope is that what we're trying to do is explain how we're thinking, what we're seeing, and the assumptions we're making, and that you folks then can make the best guess because we don't know, I mean, we don't know any more than I think anybody knows what's going to happen over the next 12 months. But let me tell you what I think on the margin front.

Let me start with aircraft. So, aircraft in the first half of the year had margins, you know, in the close to 11%. Second half of the year, if I adjust for the charge associated with the military problem, we're in that kind of 4.5, so low-to-mid single digits. We think next year, that should do a bit better. I mean, we should see a little bit of pick up, we've done a lot of restructuring. As soon as the commercial demand stabilizes, not get better, but just stabilizes and we get out of this inventory restocking. We should see a bit of a an improvement for that. And assuming that the military business continues strong, you know that that should hold up.

So I would hope that we will see aircraft margins improve from the second half of fiscal 2020. Space and defense, we had blowout margins this quarter. And as the COVID restrictions continue, I think we're already starting to see you know, a certain amount of fatigue that comes in and the, you know, the efficiencies with which you can get problems done.

Keep in mind, a lot of what we do in space is defense, it's not production, it's a lot of folks getting together, coordination between development production supply chain, and when everybody's apart with all of the tools that we still have today, you miss some stuff. And so, I could worry that there might be some efficiencies that will creep in just by virtue of the fact that everybody is not together and talking the way we normally do. And so, we had a stellar year and 2020. Maybe margins will [come off the ball] a little bit there.

And then industrial as I've been describing in the past, I worry about our industrial business, because I think there's I just don't see any recoveries coming. We are in the process. We talked about that in our Investor Day and really looking at the portfolio taking steps to resize the business consolidate activity. So, we will be doing some of that and continue to do that through all of 2021. I just don't see demand picking up. And so, I can see pressure on the industrial margins.

And so when I put it all together, maybe a little bit of upside on the aircraft relative to the second half a little bit of downside on space and defense, little bit of downside and industrials. And I put it all together and I maybe there's some upside in margins as we get into next year, but I – right now we're not betting on it. Hopefully that helps Ken.

[Ken Herbert, Canaccord Genuity]

So John, that's very helpful. That's all I could ask for. Just maybe one other way to think about this, from my standpoint is, you're not talking much about sort of operations 2.0, but as you think about cost actions you did in the back half of the year, in particular, how much of that doesn't come back? Or can you maybe help with sort of how you've with as you’ve right sized, the business and taking cost out? You know, what are we looking at moving forward in terms of how much of that are you able to keep versus how much of that eventually comes back as volumes return?

[John Scannell, Chief Executive Officer]

Yeah, so. So we took about $70 million of restructuring in the second half of the year, most of that almost 60 of it was in aircraft, the remaining 10 or 11 was in industrial. The vast majority of a 10 was asset write downs, inventory write downs, asset impairments and so. So, that kind of goes off the capital base. And so you might say, well, you know, depreciation might come down a little bit in the future. And that's true. But it's not as if there's, it's about 70 million in all it's called a 60 is kind of stuff that's associated with write downs.

If that's not just coming back, that's just write downs of the values on machinery inventory that we have, we're not going to be able to sell etcetera. The other piece of it is restructuring its severance. And we should see a little bit of a pickup from that as we go into next year. So yes, we will see some gains from that as we go into next year. But it's not as if they're 70 million, and then 70 million comes back next year. Unfortunately, that's not the math that we've got going.

So, there will be some gains from that stabilizing demand on the commercial side is really important, because we did, we did a big restructuring in the third quarter in commercial. And thinking that that's it, we're just going to do it once and we're going to get it done. And then the fourth quarter demand continued to soften. And so we're looking for a floor on the OEM side. And the destocking has been enormous. I mean, it's so the advertised rates are not what we're producing, not what we're shipping to by any means.

So, we're going to have to see that stabilize, which would give us a floor and then we can start building from there. And of course, as production volumes come back, we should start to see a pickup there.

[Ken Herbert, Canaccord Genuity]

That's great. And just one final question, John. On the commercial aerospace side, on the OEM side, I mean, it sounds like the inventory issue could drag on for a couple more quarters or into the first half of 2021. As you think about announced rates from Boeing and Airbus, do you see risk that there's further downside or I guess, how would you – there's always risk, how would you characterize the risk around further rate reductions beyond what's been announced from either Airbus or Boeing?

[John Scannell, Chief Executive Officer]

Let me mention something on the inventory side. So, if we look at the incoming inventory, we're down from – we're down based on the rate in the second quarter in the aircraft to the rate that we anticipate in the first quarter 40%. We’re down from having kind of purchase materials of about $150 million in the second quarter of 2019. When this is going normally, we're going to be down to $19 million.

So, we have done a ton of work. And the whole operation is 2.0 and improving the supply chain meant that we had an organization in place that could respond quickly. But that's a 40% drop on a 60% drop in OEM production so far. And so, we're still in that catch up, and it may take another few quarters before we can get our supply chain to slow down to the point that we're seeing with our OEM.

So, we may continue to see inventory pressure, but it's not because we're not reducing what we're buying, it's just we cannot get down there as fast as the drop in the math. But that will change, and that, you know, the tide will turn on that sometime as we go through second, maybe third quarter of next year. In terms of rate, can – I'm you know, we always say, look we follow what our OEM customers say.

Not only is it the best information we've got, we are contractually obliged to make sure that we do what they tell us that they're going to do. And beyond that, I think the risk, you know, that I'm seeing is the same as what I read and you read Ken with all of the investment community, the analysts, you guys are spending, you know, an enormous amount of time following Boeing and Airbus and Passenger Miles and all those things and so what I'm going to give you would be secondhand, which would be probably coming from your colleagues in the market.

So, it seems like there's additional risk from what I read. I just read this morning, you know, something that said, if anything, it doesn't look like white bodies, you know white bodies do not seem to have the future that we that they had hoped for. When is international travel going to come back? When is the MAX going to get back in the air? The big ones for us are the [A7 and the 350].

So, it's the white body. Luckily, they're both very new airplanes. And I think they both have a tremendous long term future. And so, as we get out, hopefully into 2022, 2023, 2324, we see that pick up, but I you know, if you ask me, we'll be assuming that the risk is to the downside as we go through 2021 rather than the risk of being to the upside that we won't be able to keep up with production.

[Ken Herbert, Canaccord Genuity]

Thank you very much.

[Operator]

Now moving to a question from Michael Ciarmoli with Truist Securities.

[Michael Ciarmoli, Truist Securities]

Hey, good morning, guys. Nice results.

[John Scannell, Chief Executive Officer]

Good morning, Mike.

[Michael Ciarmoli, Truist Securities]

Thanks for taking my question here. Hey, John, just to be a pain, I mean, you've given us enough sort of pacing items and directional movement of revenues of margins, free cash flow conversion, you've got 60% of the business based on defense, medical, you've got 1.7 billion backlog shippable. What was what was the internal conversation like about not giving specific guidance? I mean, it seems like you could have put something conservative out there. And I appreciate you know, there's a, you know, as COVID, we don't know what's going to happen, but you've kind of given us enough here where, you know, we've got some, you know, data to make some good assessment, you usually give an EPS range that's plus or minus $0.25. It seems like you could have done that with everything you've kind of given us here. So, why didn't you guys give guidance on a specific level?

[John Scannell, Chief Executive Officer]

Well, I think – so we didn't have a lot of conversations. I think actually, what we've given is a lot more detail that allows you to make a series of judgments about what do you think about Boeing’s rates or Airbus rates, or destocking based on what you see across the industry. What's your sense of where you see the [industrial world goes]? And if anything, actually, I believe, we provided more details that allow you to make a better assessment, and therefore, come up with your version of what you think the future looks like, for us. We're managing the business to the, you know, to the set of assumptions that I've given you.

The thing that we don't know, and of course, you don't know, none of us know is, what else might happen over the coming year. You know, right now, who the heck knows what U.S. policy might look like in three months time. I mean, given the uncertainty that we're sitting with today. And so, it's the uncertainty in the environment that to – for us to pick a number of you know, pick any number 3, 4, 5, 6, it doesn't matter. To say, we think it's going to be that number. And then to be gauged off that I feel would be counterproductive, because it does, it can drive behavior to some extent to say, look, we said this to the street, so we want to make sure we do that.

What we want to make sure is, we are running the business as effectively and efficiently for long-term value creation as possible. And so for that reason, if an opportunity comes up to invest, we will invest in this, because we think it's the right thing to do long-term, even if it has a short-term impact. We may spend more on capital investments over the coming years, if we see the opportunities arise, then, you know, if I were to give you a number today, because maybe something comes up or something doesn't.

We could see, you know, efficiency changes that we talked about. We could see more efficiency challenges if we're going to spend another year working through COVID. And we may have a situation where we're explaining that to you. And so I feel like I've given you everything, or we've given you everything that we know. And I think you can put together models that you feel like are pretty good. And I guess to give you just a fixed number didn't feel right. So, that was the thinking and for what it's worth.

[Michael Ciarmoli, Truist Securities]

Got it. That’s helpful. And yeah, we certainly do have a lot of items. What about, can we just break down or maybe deconstruct the aftermarket a bit? I know the revenues, you know, were small, but you know, they were up over 30% on a sequential basis? Can you give us any color? You know, what you're seeing there? You know, I know you've got, you know, sort of variety of sort of end market channels, or whether it's provisioning or just spares, but what are you seeing in the aftermarket? Or what happened in the quarter sequentially as well?

[John Scannell, Chief Executive Officer]

Let me give you another little data point. If you look at commercial because you know, when we did the Investor Day, and actually even when we got into COVID, we tried to stress to the market in commercial aircraft is an important piece of our business. But it's not the whole business. And we're you know, we're a diversified company. So we're a real safe bet as we go through this crisis, we believe.

At that time commercial was back in March, April. Commercial was just over 20% of our business. In the fourth quarter, commercial was about 11% of our business between [OE and aftermarket combined]. And so just putting it into context as to the size of that and therefore the relative impact on the business. So the commercial aftermarket was up, I mean, in the – from the third to the fourth it was up, you know, it was up nicely. Our commercial aftermarket this year is [$112 million, $13 million] worth of business.

If I look at the second half, we ran at about $40 million for the second half. And that's compared with about $75 million in the first half. So we're significantly down. I think what happened between the third and the fourth was a little bit may have been just how much stock you get back, stock that was maybe already in the pipeline. Stock, we’ll managed to ship out as we came through the, you know, how do you keep making [stuff] in a COVID environment?

You know a bit of a pickup here and there. I don't think it's a trend, Mike. I don't think that the increase from the third to the fourth is anything to get excited about at this stage. If we do – what I said is, you know, the second half is $40 million. So an $80 million annualized run rate that's down from $140 million in 2019. We're hoping that we’ll do a little bit better than that annualized rate as we go through next year, but, you know, I can't see, I can't see any major pickup.

I just can't see us all getting on airplanes anytime soon. Yeah, so that's, that's what we're thinking. On the OE side, as I think I mentioned, it's a question of just stabilizing demand. Boeing in the second half was half of what it was in the first half, except the advertised rate was only down maybe 40%. Thereby, advertised rate was down 50%. And the second half on the 350 was, you know, down 80% from the first time, I mean, it's just an enormous shift. And so, I'm hoping those rates stabilize and we see a better rate than we saw in the second half, but it is the risk, I think, is to the downside on those rates as we talked about.

[Michael Ciarmoli, Truist Securities]

Got it. And just the last one on inventory, you know, up a little bit sequentially. And I know you gave all that detail on, you know, slowing your incoming purchases and dealing with the production drops, it sounds like the bulk of the inventory challenges. And what you're dealing with is commercial aerospace. I mean, is there anything, you know, kind of driving that from the industrial side as well, or as we look at you guys trying to manage that inventory down? Should we just be thinking it's entirely commercial Aero OEM?

[Jennifer Walter, Chief Financial Officer]

Yes, it's substantially the commercial OE business that we're working on that. You know, in the near-term, we're going to be continuing to look at, you know, destocking, what we're delivering to our customers. As we continue to work down, John referenced how we're slowing the incoming receipt. So, we've done a really strong job in that we're continuing to focus on that, but still making sure that we can satisfy the obligations we have to our customers.

And then obviously, taking advantage of opportunities that we have to streamline our processes so that we can reduce – reduce our inventories and the buffers that we need in that, and so it does provide us an opportunity as we as we move forward.

[Michael Ciarmoli, Truist Securities]

Got it. Helpful. Thanks a lot, guys.

[John Scannell, Chief Executive Officer]

Thanks, Michael.

[Operator]

And ladies and gentlemen, this does conclude your question-and-answer session. I'll turn the call back over to John for any additional or closing remarks.

[John Scannell, Chief Executive Officer]

Thank you, Jake for your help. Thank you all for listening. We hope that you all remain safe and healthy as we go through this coming fiscal year. You know, as we went into the pandemic, we thought fiscal 2020 was going to be the COVID year, we're now looking at another COVID year, I think. We're optimistic of course that vaccines obviously will come, but in the meantime, please stay safe and we look forward to reporting on our earnings at the end of our first quarter. Thank you.

[Operator]

With that, ladies and gentlemen, this will conclude your conference. As a reminder, the event replay is available at Moog’s website for the webcast page. You may now disconnect. Have a good day.