Moog Inc.

Ladies and gentlemen, please stand by. Good day and welcome to the MoG fourth quarter and year end fiscal year 2020 earnings conference call. Today's conference is being recorded. And now at this time, I would like to hand the conference over to Ann Lohr. Please go ahead, ma'am.

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 via www.move.com. John?

Thanks, Anne. Good morning. Thanks for joining us. We hope all our listeners are staying safe and healthy. This morning, we'll report on the fourth quarter of fiscal 20 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 21 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, more specific topics. From a macroeconomic perspective, fiscal 20 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 MoG's 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 81 cents 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 and between dividends and share repurchases, we returned over $240 million to our shareholders in fiscal 20. 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 20 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'd like to express my gratitude and thanks for the dedication and commitment of our 13,000 employees around the world who made all this happen.

Now let me provide some more details on the quarter.

Q4 fiscal 20. Sales in the quarter of $707 million were 8% lower than last year. Sales were up in space and defense, but lower in aircraft and industrial. Taking a look at the P&L, our gross margin was down on lower sales and underutilized 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 gap earnings per share of minus $2.40. Excluding the pension charge, restructuring, and asset impairment impacts, adjusted earnings per share were positive 81 cents. Fiscal 20. Full year sales of $2.88 billion were 1% lower than last year. Sales were way up in space and 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 28 cents per share for the full year. Excluding these one-time charges, adjusted full year net earnings for $157 million and earnings per share for $4.81. Fiscal 21 outlook. As we look to fiscal 21, 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 perhaps soften slightly from the surge of demand we saw 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 hoping that the commercial OEM business will stabilize at the advertised rates from the OEMs 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 up 50% and OEM sales to Airbus were up 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 I think 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 were 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 20. 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 six-month periods. On the military side of the house, sales were up 16% relative to last year. We saw strength in every quarter in fiscal 20. with second half sales up 6% over the first half. OEM sales were up on strong F35 activity as well as higher funded development. Aftermarket sales were up across the portfolio with the largest contributor being the F35 that the active fleece grows. Commercial sales were down over 30% from last year. In the first six months of fiscal 20, 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% in 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 replanned their production and continued destocking. In the quarter, we incurred $4 million in restructuring charges as we continued to size our business with 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 20, R&D was down $10 million relative to last year, while funded development was up over $20 million over the same period. Aircraft fiscal 21. We cannot predict what will happen over the coming 12 months, but we can share our planning assumptions as we look to fiscal 21. 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, were assuming a modest pickup in demand in the second half of the year. Turning now to space and defense, sales in the fourth 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 onsite installations have ground to a halt. Space and defense fiscal 20. Full year sales of $770 million were up 13% from fiscal 19. Space was the major driver of the growth with sales up 34% year over year. 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 will up marginally year over year. Fire 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 19. 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 21. At the moment, we're assuming that fiscal 21 will be somewhat similar to fiscal 20, 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 20. 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 one of our four 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 offshore oil exploration, Industrial automation was down as the combined effects of the pandemic and the general slowing in capital investment hit, and simulation and test sales were down, primarily on depressed demand for flight simulators. Full-year sales in industrial systems of $909 million, or 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 20, and that slowdown accelerated in the second half as COVID hit. Finally, sales into simulation and test markets were down across all major sub-markets, 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 sub-market. In the quarter, we incurred $11 million of charges, 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 21. 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, our simulation and test products. We believe the world will continue to struggle with the effects of COVID and recovery in investment will only begin in fiscal 22. For our medical markets, we expect another good year, although we think demand will moderate from the highs we saw in fiscal 20 as the surge in demand for COVID-related equipment wanes. Summary guidance. Fiscal 20 was an extraordinary year by any measure. Our employees around the world roasted 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 21. 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 what's somewhat similar to the second half of fiscal 20. Over the last six months, we've resized our business to align with the future demands. 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 20. Fiscal 21 will be a year of renewed investments to prepare ourselves for the recovery we believe will come in fiscal 22 and to position us to take advantage of growth opportunities. Now let me pass it to Jennifer who will provide more color on our cash flow and balance sheet.

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 continue 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 in 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 dividends, 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 release measures, we also actively reduced expenses to mitigate the impact 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 dividends. 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. Networking 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 2.4 times the same as a quarter ago. The effects of trailing 12 months adjusted EBITDA and our share buyback activity was offset by strong pre-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 4.0 times on a net debt basis. Our leverage is based on trailing 12-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 US 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 Plan total $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 these 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.

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

Ladies and gentlemen, if you would like to ask a question today, please signal by pressing star 1 on your telephone keypad. Just keep in mind, if you're using your speakerphone, make sure your mute function is released to allow that signal to reach our equipment. Once again, star 1 for questions. We'll begin Q&A with Robert Spingarn with Credit Suisse. Hi, good morning.

And thank you both for so much detail. Actually, quickly, I want to start with you, Jennifer, just on the cash flow. And in the absence of 21 guidance, but based on the color you offered and John offered, how should cash flow trend next year, just from a high level?

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 had an incredible collections quarter from a receivable 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. However, as we move later into the year, we should see benefits from some of our operational efficiency platforms, such as the and 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 our 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.

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?

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's certainly maybe some smaller pockets of that, but nothing to drive it from a significant basis. I think our greatest opportunity is really some of the efficiencies that should overtake the current situation related to the pandemic and should be able to see some of those in the later parts of the year.

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 21, 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.

So you're right, Rob, the space business 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 years. So defense was kind of flat up a little bit in fiscal 20. It grew in 19 from 18 by almost 25%. From 18 to 19, space was kind of flat, and then space had this huge growth of 35% as we got into 20%. and one of the things I said is as we look to fiscal 21, we believe both markets will remain strong, but we're not anticipating space will continue to grow at anything like that pace. 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. They're actuators that control the steering of the rocket engines at the bottom of the missile the vehicle that allows us to go up straight, and then various avionics products. And then once you get to 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 of them. The vast majority of our space business, and I won't break it down into specifics, 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 Blue Origin or SpaceX, they're commercial, but a lot of the money is, again, 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 on top of 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 bus. At this stage, it's still relatively early. Although having said that, Rob, 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-up 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, space is an 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, well, why don't you just sell the space business? Maybe you should just get out of space because at the time space was kind of not going anywhere particularly fast and of course now it's a star in our portfolio. So space, we, you know, we re-looked at that strategy about six, seven years ago, redefined where we wanted to go, got out of, 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 it.

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.

I would definitely think so. Of course, now, as I say, because so much of it is government Thanks very much. My pleasure.

Now we will move to a question from Kai Von Rumar with Talon.

Thanks so much, and nice quarter, guys.

Thanks, Kai. Good morning.

John, good morning. So you had this write-off, 200 bps 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 does this thing have to go, you know, leaving us presumably with some residual risk?

Yeah, so as you know, Kai, you know, the way you do these estimates that completes the EHCs is 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 taking 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 in the types of things we do, as you get into qualification, you cannot plan for a qual failure. On the other hand, every now and again, failures happen in qual, and if that happens, you can end up taking an additional charge because the contract value is fixed and so it costs more to fix it. 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 a reserve on the if-come unfortunately. But we're feeling 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 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 put down to, well, you know, it's kind of like an internal R&D type of thing because we're investing in a program. 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 we do the best we possibly can to estimate costs, but sometimes stuff happens that you can't predict.

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 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 expect payables, receivables, and customer advances to kind of go as you go through the year to the extent you can comment on that?

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 quarter again, generating 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 stretching 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 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 piece all of the aspects together we're feeling like we're in really solid shape looking forward to have continued good, strong cash flow.

Terrific. And then John, you didn't talk, I mean, obviously you haven't provided guidance, but can you give us any kind of color You know, is 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 the rough pattern as you see it today of the year?

Well, let me do it by market, Kai. because I'm not sure I have a good answer for you. Let me start with defense and space. Our anticipation, our assumption is that they will both remain strong. 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 F-35, we had a super year. Some of that depends on timing, but it's pretty much at race. There could be some pressures in some programs here or there, so assume that they stay similar to the second half of 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'll 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. 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 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 down to a 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 19, but it may come off the boil a little bit from some of the kind of the bumps that we saw in fiscal 20. Industrial, I'm not optimistic about the industrial business, Kai, 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 21. 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 of 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 22. 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 for 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 dollars. 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 advertised rate from Boeing and Airbus was in the 8-7 was 10, was 14 down to 10 now and then maybe down to 6 next year. But if you look at our Boeing business, that would suggest it would be down about, you know, 35%. It's down over 50%. Airbus business on the A350 rate from 10 to 5 would be down 50%. It's down in the second half over 70%. and so our hope is that those rates will stabilize and what it is it's the stocking 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 at 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 we're describing it is the second half of 2020 through most of next year. Now, I would say we have, particularly in the aircraft business, quarter to quarter, sometimes we've got some unusual foreign military business. We've got some mixed 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. 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.

Thank you very much.

You're welcome.

And as a reminder, ladies and gentlemen, to ask a question, press star 1 on your telephone keypad. We are now moving to a question from Ken Herbert from Canaccord Genuity. Please go ahead.

Yes, hi. Good morning. Morning, Ken. 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 in 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 21, Can you quantify sort of what you've done on the cost front and can you give any more color 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 in the back half of the year.

Let me offer some thoughts on it, Ken. I'm doing the bobbin and weaving here despite all of the attempts to lock us down on fiscal 21. So I'll continue to give you the color. 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 close to 11%. Second half of the year, if I adjust for the charge associated with the military program, we're in that kind of four and a half. So no to mid single digits. We think next year that should do a bit better. I mean, we should see a little bit of a pickup. We've done a lot of restructuring. Assuming the commercial demand stabilizes, not gets better, but just stabilizes and we get out of this inventory destocking. We should see a bit of an improvement for that. And assuming that the military business continues strong, that should hold up. So I would hope that we would see aircraft margins improve from the second half of fiscal 20. Space and defense, we had blowout margins this quarter. And as the COVID restrictions continue, I think we're already starting to see a certain amount of fatigue that comes in and the you know the efficiencies with which you can get programs done. Keep in mind a lot of what we do in space and 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 in 20 maybe margins will come off the boil a little bit there. and then industrial, as I was describing to Pat, 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, at 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 21. I just don't see demand picking up. And so I could see pressure on the industrial margins. And so when I put it all together, maybe a little bit of upside in aircraft relative to the second half, a little bit of downside on space and defense, a little bit of downside on industrial and I put it all together and maybe there's some upside in margins as we get into next year but right now we're not betting on it. Hopefully that helps, Ken.

No, 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, as you've right-sized the business and taken costs out, 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?

Yeah, 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 it, Ken, was asset write-downs, inventory write-downs, asset impairments and stuff. So that kind of goes off the capital base, and so you might say, well, depreciation might come down a little bit in the future, and that's true, but it's not as if there's, of that 70 million, let's call it 60 is kind of stuff that's associated with write-downs. That's not just coming back. That's just write-downs of the values on machinery, inventory that we're not going to be able to sell, et cetera. 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 there's 70 million and then 70 million comes back next year. Unfortunately, that's not the match that we've got going. So there will be some gain from that. Stabilizing demand on the commercial side is really important because 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. So the advertised rates are 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.

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 21. 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?

Well, look, so let me – mentioned something on the inventory stuff. So if we look at the incoming inventory, we're down from the rate in the second quarter in aircraft to the rate that we anticipate in the first quarter, 40%. We're down from having kind of purchased materials of about $150 million in the second quarter of 19 when business is going normally. We're going to be down to $90 million. So we have done a ton of work. And the whole operations 2.0 and improving the supply chain met 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 points 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 demand. But that will change and the tide will turn on that sometime as we go through in the second, maybe third quarter of next year. In terms of rate, Ken, we always say that 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. Beyond that, I think the risk 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 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 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 22, 23, 24, we'll 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 21 rather than the risk is being to the upside that we won't be able to keep up with production.

Thank you very much.

Now moving to a question from Michael Ciaramolli with Tourist Securities.

Hey, good morning, guys. Nice results. 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 know, you've got 60% of the business based in defense, medical. You've got $1.7 billion backlog shippable. 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, it's 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 assessments. You usually give an EPS range that's, you know, plus or minus 25 cents. It seems like you could have done that with everything you've You've kind of given us here, so why didn't you guys give guidance on a specific level?

Well, I think, so we did 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 race or Airbus race or destocking based on what you see across the industry. What's your sense of where you see the industrial world going? 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 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 for us to pick a number, you know, pick any number, three, four, five, six, it doesn't matter, to say we think it's going to be that number, and then to be gauged off it, I feel would be counterproductive because 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 it 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 than if I were to give you a number today because maybe something comes up or something doesn't. We could see 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, and 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 for what has worked.

Got it. No, 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 were small, but they were up over 30% on a sequential basis. Can you give us any color, what you're seeing there? I know you've got sort of variety of sort of end market channels, whether it's provisioning or just Spares. But what are you seeing in the aftermarket? Or what happened in the quarter sequentially as well?

Well, let me give you another little data point. If you look at commercial, you know, when we did the investor day and actually even when we got into COVID, we tried to stress to the market. 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 of it on the business. So the commercial aftermarket was up. I mean, from the third to the fourth, it was up nicely. Our commercial aftermarket this year is $113, $112, $113 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 stuff you get back, stuff that was maybe already in the pipeline, stuff we 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 Michael I don't think that you know 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 forty million dollars so an eighty million dollar annualized run race that's down from a hundred and forty million dollars in 2019 we're hoping that we do a little bit better than that annualized race as we go through next year but I can't see any major pickup. I just can't see us all getting on airplanes anytime soon. So that's what we're thinking. The OE side, as I think I mentioned, it's the 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%. Everybody's advertised rate was down 50% and the second half on the on the 350 was down 80% from the first half. I mean, it's just an enormous shift. So I'm hoping those rates stabilize and we'd see better rates than we saw in the second half. But the risk, I think, is to the downside on those rates as we chat about. Got it.

And just the last one on inventory, up a little bit sequentially, and I know you gave all that detail. on 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 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?

Yes, it is substantially the commercial OE business that we're working on that. In the near term, we're going to be continuing to look at 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. So 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 our inventories and the buffers that we need in that. And so it does provide us some opportunity as we move forward.

Got it. Helpful. Thanks a lot guys.

Thanks Michael.

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.

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 20 was going to be the COVID year. We're now looking at another COVID year, I think. We're optimistic, of course, that vaccines, all these things 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.

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.