Moog Inc. (NYSE: MOGA)Q2 2019 Earnings CallApril 26, 2019, 10:00 a.m. ET

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Operator

Good day, and welcome to the Moog Second Quarter Earnings Conference Call. Today's conference is being recorded. At this time I would like to turn 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 April 26, 2019, our most recent Form 8-K filed on April 26, 2019 and in certain of our other public filings with the SEC.

We provided some financial schedule to help our listeners better follow along with prepared comments. For those of you who did not already have the document, a copy of today's financial presentation is available on our Investor Relations home page and webcast page at www.moog.com. John?

John R. Scannell — Chairman and Chief Executive Officer

Thanks, Ann. Good morning, thanks for joining us. This morning we will report on the second quarter of fiscal '19 and update our guidance for the full year. Overall our underlying operations performed well this quarter and the year is shaping up nicely. Unfortunately, we had a supplier quality issue in the quarter which negatively impacted our results.

Let me start with the headlines. First, another good quarter for our operations. Sales were up 4% and adjusted earnings per share of $1.40 were up 21% from last year and above the high end of our guidance from 90 days ago. We took a $10 million charge for a supplier quality issue in the quarter which resulted in a $0.20 hit to earnings per share, yielding GAAP EPS of $1.20.

Second, free cash flow was relatively low in the quarter due to a build up of working capital and some accelerated CapEx spends. Third, the grounding of the 737 MAX has not had any direct impact on our Company to-date. Based on Boeing's outlook for production and return to service, we're not adjusting our forecasts for the year at this stage. Our (inaudible) value on the 737 MAX is about $15,000. And finally, the macroeconomic conditions remain positive across defense and commercial, and are stable in industrial. This supports our continued confidence in our revenue outlook for the full year.

Now let me move to the details starting with the second quarter results. Sales in the quarter of $719 million were 4% higher than last year. Underlying organic growth was 5%, offset by 1% in forex movement. Sales were way up in space and defense, modestly stronger in aircraft and about flat in industrial systems. This quarter our P&L was affected by the supplier quality issue while last year's numbers were affected by the decision to exit the wind pitch controls business.

Adjusting for both these affects, our underlying gross margin from operations this quarter was more or less in line with last year at 29%. Both R&D and SG&A were down as a percentage of sales about two-year ago. Our effective tax rate was 23.8% to yield GAAP net income of $42 million and earnings per share of $1.20.

Fiscal '19 outlook, at the half way mark of our fiscal year we're comfortable keeping our sales guidance of $2.9 million, unchanged from last quarter. After the charge in aircraft this quarter, we're also on track to meet our original EPS guidance of $5.25. However, including this charge, our new EPS forecast for the year is $5.05 per share, plus or minus $0.20.

Now to the segments, I'd remind our listeners that we provide a three-page supplement data package posted on our website which provides all the detailed numbers we've modeled. We suggest you follow in parallel with the text. Starting with aircraft, sales in the second quarter of $321 million were 3% higher than last year. Commercial OEM sales were up healthy 11% with growth on the 787, A350 as well as several Business Jet propels.

The commercial aftermarket was down from last year and the aftermarket story is almost the inverse of the OEM growth story with lower activity on the 787 and in our Business Jet product line. The A350 aftermarket was up slightly from a year ago. On the military side, sales were about flat with last year. Slightly higher F-35 sales were more than offset by lower sales on our helicopter product line.

In last year's Q2 we had an unusually strong quarter for Black Hawk sales and this year they returned to a more normal run rate. In the military aftermarket, we had higher activity on both the F-35 and B-22 platforms. Fiscal '19 aircraft, we're keeping our full year sales forecast unchanged from 90 days ago at $1.3 billion, up 6% from fiscal '18. We were adjusting the mix slightly, reducing the A350 sales by $8 million and increasing sales to Gulfstream by the same amount. At the halfway mark, sales are tracking nicely to plan.

For the second half, we expect a slight acceleration in the A350 sales with a slightly lower commercial aftermarket. On the military side, we should marginally higher OEM sales and aftermarket sales pretty much in line with the first half. Aircraft margins; margins in the quarter of 8.5% were adversely impacted by 300 basis points due to the supplier quality issue I mentioned in the headlines. This issue was caused by one of our suppliers changing one of their sub suppliers. This new sub supplier introduced a defect in their process which got through our supplier's manufacturing and in turn was passed onto us.

We discovered the software issues in our operations and over the last few months have worked to rectify the problem going forward and the charge we took this quarter is associated with the cost to correct that issue. Absence the charge, underlying margins from our operations were up 60 basis points from both the first quarter and from the same last year. Lower investment in R&D drove the improvement year-over-year. We expect an acceleration in R&D spend as we move into the second half of the year which will result in full year R&D at just over 5% of sales. Excluding the $10 million charge, we're keeping our margin forecast for the year unchanged, however, including the charge the revised margin for the year will be 10.6%.

Turning now to space and defense, sales in the quarter of $165 million was 15% higher than last year. Similar to the first quarter, the growth is all coming from the defense side. Sales into defense were up across all our major business lines. We saw growth in volumes on our (inaudible) fire and toll missile products as well as increased sales for funded missile development work.

Sales of our new turret system were also up nicely from a year ago and in general we're benefiting from the increased tempo of defense spending across the complete range of applications we serve. Sales in the space market were down from a strong quarter to a year ago. The drop was primarily in our satellite components and avionics product lines with sales into NASA applications flat year-over-year.

We are leaving our full year forecast for space and defense unchanged from 90 days ago at $681 million. We're adjusting the mix slightly within the defense portfolio. The ramp up of new programs for our turret system are moving a little slower than anticipated, so we are moderating that forecast for the year down to $40 million. However, we're forecasting increased sales of defense components and security products that will make up this shortfall. So, net-net, no change.

Our full year sales forecast assumes an acceleration in the second half for both our space and defense product lines. We're comfortable with this outlook as the macro picture for both space and defense remains bullish. Margins in the quarter of 12.4% were up 50 basis points from last year. For the full year, we're keeping our margin forecast unchanged at 11.8%.

Turning now to industrial systems, sales in the quarter of $233 million were in line with last year. Wheel sales were up about 3% in local currencies but the strengthening dollar offset this gain. Sales into the energy market were down as a result of last year's exit from the wind pitch control business, but sales into energy exploration applications continue to grow as the price of oil remains strong. Sales into industrial automation were higher on the acquired sales of our large motor facility in the Czech Republic and sales into the simulation and test end market were about flat with last year, while sales into medical devices applications were up on stronger enteral pump sales.

For the full year fiscal '19 we're keeping our sales outlook unchanged at $931 million. Sales into the industrial automation markets will be about flat in the second half with a slight acceleration in sales in our other three sub markets. Our book-to-bill in the second quarter remained slightly above 1, supporting this positive outlook. Margins in the quarter were strong at 13%. We enjoyed a particularly favorable mix this quarter and our expenses were slightly below flat. For the full year, we're keeping our margin forecast unchanged at 12%.

The summary guidance, Q2 was another good quarter for our operations with adjusted earnings per share at the high end of our guidance range. Through the first half, sales were up 6% and adjusted earnings per share of $2.65 are up 23% from an adjusted number last year. Our aircraft group is on track for 6% sales growth this year driven by strong growth across the military portfolio and a continued ramp up of production on our key commercial platforms.

In our space and defense group, we're anticipating modest growth in our space applications and very strong growth in our defense business spread across our complete range of applications. The overall macro picture for defense spending remains very positive, but the space community is anticipating strong growth in future years on the back of the GBSD program, hypersonic missile developments and NASA's plan to return to the moon in 2024.

As I said last quarter, we're pretty comfortable with our fiscal '19 outlook for our industrial systems, but the low growth in Europe and the risks of the slowdown in the US over the next 12 months are reason for caution as we look out beyond this year. We will keep a close eye on this macroeconomic trends and adjust our business accordingly.

As always there are upside opportunities and downside risks associated with our forecasts. I believe there continue to be opportunity for upside in our defense businesses although the (inaudible) remains a real challenge to realizing these opportunities. Similar to last quarter, I think the longer term downside risk is more in our industrial business and as usual, we try to provide the market with a forecast which balances these pluses and minuses.

Last quarter, I finished by saying that the optimist in me would hope best when we report out our second quarter results. The government shutdown would be long over. There would be a sensible Brexit strategy and the trade dispute with China would have been resolved. Well, we're one for three. So let's hope that when we report out in our third quarter we'll have a better score. Overall fiscal '19 is shaping up nicely. Our sales forecast of $2.9 billion is unchanged from 90 days ago and our underlying operating margin is on track, absent the supplier issue. For the third and fourth quarter, we expect earnings per share of $1.30, plus or minus $0.10.

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

Don Fishback — Chief Financial Officer

Thank you, John, and good morning, everybody. Free cash flow for the second quarter was $9 million, bringing our six month total to $49 million. This represents a year-to-date conversion of less than 60% reflecting growth in receivables, inventories and capital expenditures. Receivables and inventories have increased due to our top line growth and due to timing of shipments to our customers. Capital expenditure activity has been significant largely related to a building addition for our aircraft operations, which we need to do to accommodate the growth in our military aircraft business and the growth-related investments in machinery and test equipment.

Demographic turns and hiring challenges have resulted in us making a bigger investment in our automation sooner than we have been projecting. Looking ahead to all of 2019, we're moderating our forecast of free cash flow to $160 million, down from our previous forecast of $185 million. The previously described $10 million reduction in our projected operating profit in combination with $15 million increase in our forecasted capital expenditures accounts for the $25 million free cash flow reduction for all of 2019.

This update reflects a revised cash flow conversion of 90%. In recent years, we've enjoyed average free cash flow conversion well in excess of 100%. In this year, increases in working capital and capital expenditures to support our top line growth are offsetting the benefit of not making any contributions to our US Defined Benefit Pension Plan. We remain focused on generating a respectable long-term free cash flow conversion that will average at least 100%.

Net working capital, excluding cash and debt, was 26.8% of sales at the end of the second quarter compared with last year's 25.5%. The adoption of the new accounting standard for revenue recognition in 2019 completed this ratio in the second quarter of 2019 by about 70 basis points. After making that adjustment to get numbers comparable, the residual 60 basis points increase reflects the growth in the balance sheet elements that I've just described. We're expecting this ratio to decline to between 25% and 26% by the end of this fiscal year.

Net debt increased $7 million compared to free cash flow of $9 million. The difference relates primarily to the payment of our quarterly dividend. Capital expenditures in the quarter were $36 million while depreciation and amortization was $22 million. Year-to-date CapEx was $60 million while D&A was $43 million. For all of 2019, we're increasing our CapEx forecast from three months ago to $110 million for the reasons that I described earlier. Depreciation and amortization in 2019 will be about $87 million.

Cash contributions to our global pension plans totaled $10 million in the quarter compared to last year's second quarter of $80 million. Last year included incremental accelerated contributions to our US DB Pension Plan to take advantage of some tax benefits related to the Tax Act passed by Congress in December 2017. For all of 2019, we're planning to make contributions in our global retirement plans, totaling $36 million, nearly unchanged from our forecast three months ago.

Global retirement plan expense in the second quarter was $16 million compared to $15 million in 2018. Our expense for retirement plans for all of 2019 is projected to be $63 million, an increase over last year's $57 million and essentially unchanged from the forecast three months ago. Our second quarter effective tax rate of 23.8% compares with our forecast for all of 2019 of 26%. The lower rate this quarter is due to a residual impact related to last year's decision to exit from the wind pitch controls business.

Year-to-date, our tax rate is 24.1% compared with last year's 79.2% which was complicated by the significant effect of the Tax Cuts and Jobs Act enacted last year, and the wind business restructuring. We're still projecting our tax rate for all of 2019 to be 26%. Our leverage ratio, net debt divided by EBITDA, was 2.1 times at the end of the second quarter, unchanged from last quarter and from a year ago. The free cash flow that we've generated over the past 12 months has been consumed by acquisitions and share buybacks.

Net debt as a percentage of total capitalization at the end of the second quarter was 35% compared with 34% a year ago. At quarter end, we had $520 million of available unused borrowing capacity on our $1.1 billion revolver that terms out in 2021 and another $300 million of 5.25% high yield debt matures in 2022. Interest expense in the second quarter was $10 million compared with last year's $9 million, up due to higher borrowing rates of forecasted interest expense for all of 2019, it's $38 million, essentially unchanged from our forecast in the last quarter.

With respect to leverage, we previously shared that our target leverage is between 2 and 2.5 times, that's net debt dividend by EBITDA. We're within our target range of 2.1 times at the end of Q2 and with respectable free cash flow forecasted for the balance of 2019, we expect to be below our target range by the end of the year, everything else unchanged. We just announced today our fifth consecutive quarterly cash dividend to our shareholders. We continue to look for M&A targets strategically and share buybacks opportunistically.

We're off to a pretty solid first half of 2019 where sales up 6% and adjusted EPS up 23%. And our backlog's increased over 20% in the last 12 months. In summary, our businesses are growing, we're seeing improvement in margins and our longer-term free cash flow outlook remains encouraging.

So with that, I'd like to turn you to back to John, opening up for any questions you may have for us.

John R. Scannell — Chairman and Chief Executive Officer

Thanks, Don. April, we're happy to take questions now.

Questions and Answers:

Operator

(Operator Instructions) And we'll take our first question from Robert Spingarn from Credit Suisse. Please go ahead.

Robert Spingarn — Credit Suisse — Analyst

Hi, good morning.

John R. Scannell — Chairman and Chief Executive Officer

Good morning, Robert.

Robert Spingarn — Credit Suisse — Analyst

Just a few different things, but John I wanted to start, I know you opened mentioning the MAX and I think you essentially said there's been no major impact. But I just wanted to clarify

few things. You're at 52, now you stated rate?

John R. Scannell — Chairman and Chief Executive Officer

Yes.

Robert Spingarn — Credit Suisse — Analyst

And are they paying suppliers or they're paying you specifically for 52. It's been unclear I think from supplier to supplier. We've seen receivables build elsewhere and your receivables are up at tick and I think Don said that was timing of payments, any relationship with MAX here?

John R. Scannell — Chairman and Chief Executive Officer

No. keep in mind Rob as I said it's about $50,000 of content we have on the MAX. so even if you were talking about them dropping 10 shipsets a month, it's $500,000 to $1.5

million over the course of a quarter, so it's in the noise. But there's been no change to our supplier arrangement, payment arrangement except with Boeing to-date. It's depending on how long this all goes on, perhaps that will change in the coming quarter or two. But even if it does, as I say the numbers are relatively small.

Robert Spingarn — Credit Suisse — Analyst

Understood. I just want to get an idea of the behavior and what's actually happening here, so that's very helpful. You mentioned higher R&D spend and I was hoping you could talk a little bit about the future and what areas you're targeting, particularly the end markets.

John R. Scannell — Chairman and Chief Executive Officer

I think I said that we're anticipating some higher spend in the second half. Let me do kind of a general piece on R&D spend. So we spend about 4% per year on R&D across the whole Company. you know we've had times over the last decade of course where the aircraft spend was particularly high, it was getting up north of 10%, but that's now back in that kind of 4% to 5% range and across the Company, typically about 4%. Our forecast for this year is about $140 million of sales of $2.9 billion, so around that 4% mark.

Over a long period of time, we think it's very important to maintain pretty much that spend raise and so we're seeing a little bit of pick up in space and defense spending there particularly in the second half and that's driven by some of the big things I mentioned. There's the GBSD program where we're working on variety of — at this stage, it's still early stage so there's no real fund that's development of significant yet. Over the coming years that should change the fund, but right now we're spending our own money to try and make sure we're well positioned.

There's the hypersonics and again most of that is funded, but you really want to do in these circumstances is make sure that there are particular pieces of IP that you want to retain and so you fund that yourself, plus you want to be in a position because of the shift in the way defense contracts are being allocated. You really want to put some of own money in first to make sure you're available to take advantage of the faster pace of which they want turnaround.

And I've talked about our turrets in the past, that was very much our own development work where we spent our own money and then we — we're now in a position where we can move quickly and have a product already available as the programs comes — there's urgent needs. On the aircraft side, much less spending on the commercial clearly, but there's still some ongoing spending when you got major programs like the 87 to 350, E2 starting to ramp up. There's still some E2 work. And even on the other ones, there's a maintenance level of spend on those that you have to assume is going to continue year after year.

There's money that we're spending on the military aircraft side and again this is about positioning ourselves for new programs and also about positioning ourselves to retain IP on some of the programs where you got partial funding. And then there's — our industrial business continues at kind of what I call the normal run rates. But we're focusing also on trying to invest certain amount of money in what I call next generation technologies.

Additive manufacturing, we've talked about this in the past, we're spending money there. We're also spending money more now on autonomous systems. And when I say autonomous systems this is not competing with the Tesla's or the Google's. It's really looking at autonomy in the context of what we do, which is high reliability, well devised environment type applications and whether it's on the aircraft side, Uber taxi type stuff that folks are doing, in the industrial business where there's construction equipment or agricultural equipment or it's in space and defense and you can imagine lots of (inaudible) ground vehicles, submarines, lots of opportunities for autonomy in the future.

We're carefully spending in a couple of particular areas to develop our capabilities and components and systems in autonomy to position ourselves for the future. I would say that falls into the category of a little bit like the turrets that I think we described in the past, our turret is an overnight success that we invested in for 10 years and never talked much about it. I think the autonomy stuff I'm sure we're going to run down a bunch of blind alleys. But I hope in five or 10 years' time we'll be talking about, hey here's new applications that are building on the capabilities we have and the investments that we've made over the last decade. So they are early stage exploratory, but we're spending money, we're investing engineering time and we think that's important for the long-term.

Robert Spingarn — Credit Suisse — Analyst

Okay, couple of follow-ons. I was going to ask you couple of follow-ons on that because that was very interesting and then I'll step back in the queue. But on the defense side, should we think about your businesses tracking the budget or it sounds like it's more about your specific areas of expertise and what's happening in those specific veins. Particularly now space is well. So when I look at a defense budget, that is very strong in '18, slightly softer in '19 and then getting down to inflation levels in '20. Should I disregard that when I think about your next few years?

John R. Scannell — Chairman and Chief Executive Officer

So when we put together our outlook for next year and we do a five-year outlook every year, we're doing it program by program, Rob. It's not the defense top line. And so it very much depends. So the F-35 is big program for us, V-22 is a big program, the F-18 is a strong program, but the F-18 is winding down. We look at the military vehicle. So the new turret we have is brand new application. So it doesn't necessarily reflect the spending on military vehicles in total, it reflects the opportunities around that turret. Missiles were big on health fire and (inaudible) but we're not (inaudible).

Hypersonics, we're spending, — we're on a lot of new program opportunities there. It's all early stage funded development and who knows which of them are going to be a real success. And so, yes, for us it's definitely a program by program make up and sometimes that might line up with the defense budget, other times it may not. Generally speaking, positive defense spending or strong defense spending is a good thing and there's no doubt we saw through the sequestration period a slowdown in our business and in the last year or two, we've seen a significant uptick. And so that definitely does reflects the macro picture, but it's more the micro level individual program I think. So if the F-35 took a huge cost, you missed the defense budget stay strong, we'd see a drop on. So I think it's more program by program.

Robert Spingarn — Credit Suisse — Analyst

Okay and then just to close this and I'll step out. The 17% growth you're looking for this year, can we stay double-digit for a while beyond that?

John R. Scannell — Chairman and Chief Executive Officer

I would love to say double-digit, but I don't know whether Mr. Biden or Mr. Trump or somebody else is going to be in Office in the years' time. So, I honestly don't know. You know the defense world's — I remember being the aerospace industry's association meetings few years back and this whole sequestration thing was being talked about and even Obama at the time said well, that's never going to happen, we're never going to do that. And so forecasting the future I think is a tough thing to do.

We would definitely hope so, we think we're well positioned F-35, we're working on next generation helicopter stuff. The hypersonic seems like there's a real push to do that. There's an announcement that says we got to get back to the moon. We've got prospector control, we're all over those type of product. So the macro picture looks good, but I just don't know what the future could hold, I wish I did.

Robert Spingarn — Credit Suisse — Analyst

That's a fairy answer. Thank you so much for the color, John.

You're welcome.

Operator

And we'll take our next question from Kristine Liwag from Bank of America Merrill Lynch. Please go ahead.

Kristine Liwag — Bank of America Merrill Lynch — Analyst

Hi, good morning guys.

John R. Scannell — Chairman and Chief Executive Officer

Good morning, Kristine.

Robert Spingarn — Credit Suisse — Analyst

John, in the past few years you've implemented many processes to improve the quality of your supply chain. Can you provide us an update on where you are today and what's left to do? And broadly speaking, what are the new risks that have been introduced to your business as you're starting to look at sub-contractor risk of your suppliers?

John R. Scannell — Chairman and Chief Executive Officer

So you're right, Kristine. As we ramp production we have been developing the supply chain over the last, I'm going to say, decade. I would say that's a never-ending journey, it's a bit like lean or any of these process improvements and you keeping going, you keep putting one step in front of the other, you never get to the point where you're at an end. And of course it's a changing environment and so overtime some suppliers — you'll have to change out suppliers because of performance issues, because of pricing issues, because they've decided that they want to do something different, because a supplier just bought by another supplier or just bought by a competitor. And so it's a dynamic system that you can't just say, well, now we fixed it and now it's done.

So we put in an enormous effort over the last decade and we will continue to do that this year and next year and for the decades to come. And actually we're spending money as well on outside experts to continue that journey with us, people that are — that's what they do for a living, to continue to build our learning as we go through that. And so in terms of what's left to be done, I don't know that I have a good answer for that. Is there ongoing potential to continue to see improvement? The answer is absolutely, yes.

We're still, I would say, if you look at ramp in our production over the last five to six years, which is really when this has happened, the 87 really only started ramping five or six years ago, the 350 has been ramping over the last two to three and the E2 is coming behind that. We doubled our aircraft business through that periods of times in terms of these major programs, also the F-35. And so that's an enormous step-up in terms of our operational capabilities and that's not done without pains and struggles and challenges and setbacks along the way. And so we're in that process, we're seeing our aircraft business perform nicely, but it will continue to be an ongoing process.

So I don't have a specific that I'd say, oh yes, we can substitute this or do that. I would just say it's a continuing process of improvement. I don't know if that answers your questions, Kristine.

Kristine Liwag — Bank of America Merrill Lynch — Analyst

That's very helpful. And just circling back on that $10 million charge that you took in the quarter, if the issue you've identified is a supplier switched out their supplier, is a fix as simplistic as going back to their old supplier therefore their problem is finished. Is that a way to think about that?

John R. Scannell — Chairman and Chief Executive Officer

No, they don't even have to do that. Once you identify the problem that sub supplier can fix this. It was just that it wasn't. They didn't understand and we didn't understand that they

introduced that non-conformance at the sub supplier. So it's not a — if the problem has been fixed. Once it was identified, the problem has been fixed. The cost is just associated with

reworking itself that's already in the supply chain.

Kristine Liwag — Bank of America Merrill Lynch — Analyst

That's very helpful. And switching gears to space, you put together your usually report space and defense, but is there a way for you to give us an idea of how much pure space is for you as a percent of total revenue and how much of that work is military versus commercial?

John R. Scannell — Chairman and Chief Executive Officer

Yeah. So if you look on our supplemental, Kristine, we have a space forecast for this year of $220 million. And so $220 million, that's our sales forecast for space out of $2.9 billion, it's 7%, 8%. So our space business is kind of $200 million plus, $200 million to $250 million business. And the split out between military and non-military is tough because it's really a split out between what's government funded and not government funded, and most of space in the end is government funded, whether it's — some of it is commercial satellite that's true, but all of the NASA work, we have a lot of, what's the word I'm looking for that, secret work at this stage for our — classified work for military satellites that we can't obviously talk about. But even a lot of the launch vehicle stuff is — in the end it's the government is paying for that because they launch military satellites as well.

So it's — I would say well over half of it is governments related funding, but it's about $200 million to $250 million business and I'll just say this year we're forecasting about $222 million. And that's off — I said in the quarter space was down from a year ago and that's true in the quarter. If you went back to last quarter, 2018 second quarter, we actually had a blowout quarter in space. Ironically, defense was about flat and space was way up a year ago. This year the space is down a little bit, but that's off a very strong Q2 and for the year, we're actually anticipating space will be up 3% relative to last year.

When I attended the Space Symposium in Colorado Springs a couple of weeks back and there's an enormous amount of activity and as I say, it's really been driven by three things. The GBSD program, hypersonics which is getting an enormous amount of attention and we — for us hypersonics is — a lot of that is in the space because hypersonics are launch vehicles and so we put that under our space category and then there's announcement to return to the moon in 2024. Everybody was going around scratching their head saying, oh my gosh, Vice President just announced we're going back to the moon by the end of 2024 and nobody knows how we're going to do that, so they're scrambling to let contracts get work out there. So, the space outlook looks pretty bullish at the moment.

Kristine Liwag — Bank of America Merrill Lynch — Analyst

Great. And as launch costs come down, there seems to be more interest in space for commercial entities. Is there more opportunity for you in the next few years to pursue commercial business in space?

John R. Scannell — Chairman and Chief Executive Officer

Absolutely. I mean, that's not new. We've been pursuing — we've been working with Blue Origin, SpaceX has been more difficulty (Technical Difficulty) integrated, but we work very closely with Blue Origin and (inaudible) commercial space and so they — the reduction in the cost of launch I think that's putting pressure on the whole supply chain and we worked hard with our customers, we're traditionally very strong with the ULAs of the world, but we've also worked hard to get our cost down and so we're working with Blue Origin as well.

And so that brings pressure on the cost side. On the other hand it potentially drives volume which of course is an interesting word in space, instead of two year, it's five year, eight or 10-year, but it is driving that. And the more launch capacity you have, the more satellites get put up. And when satellites get put up, we've got lot of products that go on satellites and then we have — one of our areas of investments that we've not talked a lot about is what we're calling the OMV, which is the Orbital Maneuvering Vehicle and essentially what that is, it's a space tug. It's a ring that goes on the top of a launch vehicle and you bolt on 10, 15 small sats onto that. There's various configurations out.

And the idea is right now if you put up small sats on a regular rocket, the rocket — the fearing opens and the small satellites are deposited where they're deposited because small sats don't have any kind propulsion. And the idea of an Orbital Maneuvering Vehicle, which is a vehicle essentially it's a ring, holds all of the satellites but has propulsion baked into it, is that you can then move to chose an orbit and release individual small sats at the orbit that you want to do. So instead of having a propulsion system on each little satellite, you have a single propulsion system that then can place, 10, 15, 20 small sats in a particular orbit.

That's also an area — the space business moves very slowly. We've got our first contract that we're hoping to fly that in the next year or so, so again it's not something that's going to be huge number in the next year or two, but again it's indicative of the opportunities that we see when you get into commercial space and we have all of the components to build something like that in-house. So it's like a mini satellite in its own ways delivering small satellites, particular orbits.

Kristine Liwag — Bank of America Merrill Lynch — Analyst

This is great color, John. Thank you very much.

John R. Scannell — Chairman and Chief Executive Officer

You're welcome.

Operator

And we'll take our next question from Cai von Rumohr with Cowen & Company. Please go ahead.

Cai Von Rumohr — Cowen & Company — Analyst

Yes, thanks so much. So to go back to the quality issue, was it that you didn't specify what you should have specified because if your specs were correct and they didn't meet those specs, theoretically it's on your supplier or on your sub supplier?

John R. Scannell — Chairman and Chief Executive Officer

Good morning, Cai. So there's always a discussion around what — so it was a non-conformance that was introduced when our supplier changed their supplier. And so, there is some opportunity for a discussion with our supplier and potentially for them with their sub supplier in terms of if there's some recourse, some recovery. However, if you think of it the way our industry works, Cai, if I invest sub supplier I'm providing a part to our supplier and I'm going to pick a number that costs $100. Our supplier puts that into their product that costs $500. We're getting that product and we're putting into actuators that costs $5,000 and eventually we'd sent actuators to customers and they're seeing airplanes that costs $50 million or more.

And so as hiccups happen through the supply chain, typically what happens is that each level in the supply chain tries to contain their liability to some reasonable number that reflects the risk and the profits, the gain that they can make through that supply chain. And so it's — there are opportunities to obviously talk and work with your supplier, find some — sharing the cost. But we've not anticipated a significant recovery of that. And we'll have those conversations, but that is — we also supply, we're a component supplier into other customers as well and so we're — we've been on both sides of this over the years. And so typically sub suppliers and suppliers will try to each tier has to — by virtue of the nature of their business, has to try and limit their exposure. Plus sometimes as you get down through their tiers, you end up with very small companies and they literally don't have the resources to cover the types of costs these things could generate.

Cai Von Rumohr — Cowen & Company — Analyst

Got it. And then, so was this issue — so of the cash on this issue, when does it get spent? And — get spent, what, to rework the problem.

John R. Scannell — Chairman and Chief Executive Officer

Yeah, we spent — some of it would have been spent in Q2 and probably it'd be mostly Q3 and maybe a little bit into Q4.

Cai Von Rumohr — Cowen & Company — Analyst

Got it OK. And then your R&D, you're still at $140 million which is quite a large number given you've only been going at $31 million rate. So the big uptick you mentioned to space and defense, where is aircraft for the year? Is that still $65 million or is that down to $60 million?

John R. Scannell — Chairman and Chief Executive Officer

No, we have that at $65 million. So through the half aircraft is about $30 million, second half I think it's about $35 million. Part of what's happening Cai is, I mentioned a few times that one of the challenges for us on the defense side is just having the staff to take the opportunities that are there. And so we've been working very hard to ramp up staffing over the last six to 12 months. And as we've been ramping that up, we become more successful in our ability to do that. And so we're seeing an increase in our staffing. And as I mentioned some of those staffing will end up going to expense because we will choose to spend it, it's not it's going to be all funded.

So we're anticipating that we will spend more in the second half. The ramp up on the space and defense side is particularly strong, that goes from about less than $10 million in the first half to about $15 million in the second half. Whether that's possible or not, we don't know. I mean when we get an — engineering talent that we need to make that or not, I don't know, plus there continue to be opportunities to work on funded programs and so that typically is drawing away from it. But we are cautious about not neglecting that Company funded R&D even in what I call the really good times when there's a lot of funded work out there as well, so that we don't wake up in two, three, four years' time and say, boy, we missed some opportunities by not investing in our own staff.

So maybe we come into the year a little bit below what we're anticipating right now. But as we say, we've been staffing up to try and make sure we can spend the money prudently to invest in the long term.

Cai Von Rumohr — Cowen & Company — Analyst

Got it. And then, so it sounds like aircraft also is higher in the second half, is that commercial work or is that military and perhaps classified work?

John R. Scannell — Chairman and Chief Executive Officer

Yes it's more — I mean it's not — as I mentioned before, when you've got an H7450 north of $100 million sales program. there's just ongoing activities around that, that you're going to spend. But those are fairly fixed at this stage. For E2 we spent some money on that, but again that's kind of winding down. The Chinese airplane is there, some of the Business Jets. It's more really around — it's a plethora of smaller programs, Cai. Everything from the V280, there's a bunch of classified work in there and then there's this new technology that I've talked about. We're spending a little money on looking at autonomous systems, additive manufacturing capabilities, digital — various digitalization of some of these things, new materials, new actualization technologies. So it's a long range of stuff and so we're moved past this. Here's the three big programs that they pick up 80% of that spend.

The major programs I would say at this stage are making up less about half of the spend and the rest of it is a very long list of things that we — and to some extent we have, I don't know the word, neglected, but in the investment in the major programs of the last decade we've not spent as much on those as we would have perhaps later. And so there's a little bit of catch up there in terms of making sure we're current and leading in terms of technology.

Cai Von Rumohr — Cowen & Company — Analyst

Got it. And if we go to industrial, I think you mentioned the book-to-bill was over 1 in the quarter.

John R. Scannell — Chairman and Chief Executive Officer

Yes, I said it's slightly over 1.

Cai Von Rumohr — Cowen & Company — Analyst

But was the book-to-bill in automation over 1?

John R. Scannell — Chairman and Chief Executive Officer

Actually no, that was — it was a little bit under 1 for the industrial automation.

Cai Von Rumohr — Cowen & Company — Analyst

Got it, OK and then last…

John R. Scannell — Chairman and Chief Executive Officer

I think that's where we're — I think, as you know Cai, that's the kind of the — the backbone of that is the German machine builders and there's no doubt that those guys are slowing down.

Cai Von Rumohr — Cowen & Company — Analyst

Got it, OK. And then, so the aftermarket, it looks like your projections, we get a declaration in the commercial aftermarket in the second half and we don't get any real pick up. We actually got a lower level, actually we don't get much change in the military aftermarket. Do those two numbers have opportunity?

John R. Scannell — Chairman and Chief Executive Officer

I think the military aftermarket has opportunity. I think the commercial side, again, I mean you're doing the run rate through the first half, it is about 140, we're forecasting about 130 for the year. We have seen the slowdown, there's no question about that. The 87 IP stuff, we're seeing that slowdown from the last couple of years. So is there opportunity? Perhaps fleets continue to grow, there continues to be a lot of activity. But at this stage this is our best estimate as to what we think the outlook looks like.

Cai Von Rumohr — Cowen & Company — Analyst

Thank you very much.

John R. Scannell — Chairman and Chief Executive Officer

You're welcome.

Operator

(Operator Instructions) We'll move onto our next question from Michael Ciarmoli from SunTrust. Please go ahead.

John R. Scannell — Chairman and Chief Executive Officer

Good morning, Michael.

Michael Ciarmoli — SunTrust — Analyst

Good morning, guys. Thanks for taking my question. Maybe just to kind of tie in some of Rob's and Cai's initial questioning, I mean you put up a great margin quarter adding back the supplier charge. You've got a very good demand backdrop on defense. The R&D portion of the defense budget was up significantly. You're talking about a lot of spending on new programs.

How do we think about mix shift and what that may do to margins on a go forward basis? I know you wanted to get specifically aircraft back into low to mid-teens. I mean, do you envision as some of these programs really start to ramp up whether it's GBSD or you get on some of the hypersonic opportunities that you're going to be dealing with some of this legacy verse new margin mix that, that might have a little bit of a headwind on you going forward?

John R. Scannell — Chairman and Chief Executive Officer

Yeah, I mean, the funded developments, so I think we described — if you go back, '16, '17 funded developments in aircraft was $20 million, $25 million. We're up to $60 million to $70 million now. So that's a real positive. On the other hand, that typically comes with very low margin and then when I add the fact that the R&D is going to, we're supplementing that with our own R&D in particular areas, it is a margin headwind in that respect. And on the space and defense side, there's a — the mix as you shift to (inaudible) developments tends to bring down the margin. But it's a portfolio thing. The hypersonic stuff, I think we're a few years out before that gets to production and the GBSD, that is a long ways out Michael. That is a decade before that turns into real production.

There's a lot of development work, initial production work, a variety of things that could provide sales, but with relatively little margin over the next, depending on what we ran and when the program itself. But that won't be a margin enhancer I would say in the next decade. Beyond that, when it gets into production, we think that could be — for the space business, that's the GSF (ph) for the space business, that could be over a 10, 15, 20-year period, that could be a $1 billion plus program for us, so that's a big potential program that's worth investing in now, but it's not going to be a margin driver until it gets into production and as I say that, I think it's 2028 before you reach out to see that ticking in.

So yes, there's that mix but there's also nice mature missile programs that are doing well. The turret is developing now, but it's quickly switching into production of units there. So there's a-its' a balance I don't know that I would draw any broad conclusion at this stage, but it's for sure that higher defense spending right now, a lot of that is going into new technologies and that is typically lower margin contribution.

Michael Ciarmoli — SunTrust — Analyst

Okay and then the pricing environment on the military. I know you talked about that, maybe mid last year, anything changing on the pricing environment. I mean it just seems like you're getting good trajectories here on the margins and I know you wanted to keep driving them higher and it sounds like you're managing all of these if there are potential headwinds, but any color on defense pricing?

John R. Scannell — Chairman and Chief Executive Officer

I would say the environment I described last year and the environment they have the better buying, the defense department continues as does every one of our customers to want to get the best possible value from their suppliers and so that continues. I think what's changing a little bit, is that, there's this various new contract mechanisms that they're introducing which will reward if you can move very quickly and perhaps have already expensed some of your own R&D. and so they're trying to move away from the that's been five years trying to check out what this new military vehicle is or this new hypersonic weapon should be and then another five years developing it. And maybe in a decade's time we've got something to-we want something in the next year or two and if you've already got some of your own R&D investment, we're going to move quickly on that.

And so I think there's-the traditional pricing pressure on the big programs that's going to continue, there's no question about that I think, the Lockheed's of the world are seeing that. Even the President comes out and says everything is too expensive. So I think that environment is just there, it's there in the commercial side, it's there in the military side. But there are, I think there are opportunity to be rewarded for those, who are willing to spend their own money. So take the margin in your own size and are able and willing to move quickly and that's an area that we're looking to try and make sure that we're well positioned for.

Michael Ciarmoli — SunTrust — Analyst

Got it. And then just last one on the 737, you're at 52, who are you shipping your product to? Who's holding the inventory?

John R. Scannell — Chairman and Chief Executive Officer

Well we ship to Boeing.

Michael Ciarmoli — SunTrust — Analyst

Okay.

John R. Scannell — Chairman and Chief Executive Officer

But we also typically in a situation like this, there's safety stock that you would hold at our own location as well and so, keep in mind that the 37 most of this (inaudible) they've been ramping up over the last few years. And so I think Boeing even made the point that, if they slow their production, it's a chance for their suppliers perhaps to catch up with their acceleration and gives us a chance to build some of that safety stock, build a little bit more stock. But right now we're continuing to shift to Boeing and I think there's plenty of, we have-relatively small-so this is not like wings or bodies they're going to be stacking at –.

Michael Ciarmoli — SunTrust — Analyst

Right.

John R. Scannell — Chairman and Chief Executive Officer

Who's holding it and where it is-it's not a big space issue. (inaudible) 737 if you have (inaudible) smaller the room, so it's not a big deal.

Michael Ciarmoli — SunTrust — Analyst

Okay and then maybe the other side of it, just last one for me. The bigger opportunity I mean, it sounds like some of the US carriers might not take delivery of trainers. But you've got a lot of content on the aircraft trainers. If we see more demand for 737 MAX Trainers globally, is that something that can move the needle for you guys?

John R. Scannell — Chairman and Chief Executive Officer

I think you're talking about the flight simulators?

Michael Ciarmoli — SunTrust — Analyst

Flight simulators, yes.

John R. Scannell — Chairman and Chief Executive Officer

Yes. We're hoping that's the case although maybe more current Michael than I am, but it would seem that Boeing at least in the FAA are trying to avoid a wholesale retraining of pilots on the new MAX software versus the old 737. I think that was one of the big positive aspects of the 37 MAX. And I know some of the international guys maybe that will change. The time to build a simulator and get it out into the field, if that's not something that-our customers are seeing, the flight safeties are going to do over nice. So yes I would say over a longer cycle, if this drives more training that's a real positive and we would end up selling more simulation basis to-because we got a dominant share of that market and so that would be a positive for us.

And we actually have talked about customers to says, can we sit down with you folks because if that's coming, if you think there's going to be a big surge in your demand. Let's get-head it out right now and make sure we're prepared to meet your demands and so far there really hasn't been a strong reaction to that, so I'm hoping that's coming, but it's not moving the needle at the state.

Don Fishback — Chief Financial Officer

I just want to add perspective in that too, Michael. The total volume of activity we've got on flight simulation in our company for all of 2019 is in the $70 million range and that's not too different from the last couple of years. I'm talking to some of our guys recently, they are talking about CAE (ph) business, it sounds like it's pretty robust and we would certainly benefit from whatever uptick CAE's (ph) going to see, but it's only 70 and not to diminish it, it's a really important product line and it's great success story. But it's not going to drive a needle at a macro level for our business.

John R. Scannell — Chairman and Chief Executive Officer

And actually adding to that, ironically Michael in 2016 it was about 80, in 2017 it was about 80, in 2018 it is about 80 and this year we're forecasting it will be down to around 70. I think

there was an enormous build up as the 87350, E2 are ramping. But they got ahead of that and so that's what-talk there.

Michael Ciarmoli — SunTrust — Analyst

Perfect. Thanks a lot guys.

John R. Scannell — Chairman and Chief Executive Officer

April, is there any more question with you?

Operator

There are none.

John R. Scannell — Chairman and Chief Executive Officer

Thank you very much indeed. Thank you for joining us and we look forward to reporting out again in 90 days' time. thank you. Thanks April.

Operator

Ladies and gentlemen, this does conclude today's presentation. We thank you for your participation. You may now disconnect.

Duration: 54 minutes

Call participants:

Ann Luhr — Investor Relations

John R. Scannell — Chairman and Chief Executive Officer

Don Fishback — Chief Financial Officer

Robert Spingarn — Credit Suisse — Analyst

Kristine Liwag — Bank of America Merrill Lynch — Analyst

Cai Von Rumohr — Cowen & Company — Analyst

Michael Ciarmoli — SunTrust — Analyst

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