Curtiss Wright Corp Q3 FY2021 Earnings Call

Good day, and thank you for standing by. Welcome to the Curtiss-Wright Third Quarter 2021 Financial Results Conference Call. At this time, all participants are in a listen-only mode. After the speaker presentation, there will be a question-and-answer session. I would now like to hand the conference over to your speaker today, Jim Ryan, Senior Director, Investor Relations. Please go ahead.

Thank you, Laurie, and good morning, everyone. Welcome to Curtiss-Wright's Third Quarter 2021 Earnings Conference Call. Joining me on the call today are President and Chief Executive Officer, Lynn Bamford; and Vice President and Chief Financial Officer, Chris Farkas. Our call today is being webcast, and the press release as well as a copy of today's financial presentation is available for download through the Investor Relations section of our company website at www.curtisswright.com. A replay of this webcast also can be found on the website. Please note today's discussion will include certain projections and statements that are forward-looking as defined in the Private Securities Litigation Reform Act of 1995. These statements are based on management's current expectations and are not guarantees of future performance. We detail those risks and uncertainties associated with our forward-looking statements in our public filings with the SEC. As a reminder, the Company's results include an adjusted non-GAAP view that excludes certain costs in order to provide greater transparency into Curtiss-Wright's ongoing operating and financial performance. Also note that both our adjusted results and full year guidance exclude our build-to-print actuation product line that supported the 737 MAX program as well as our German valves business, which was classified as held for sale in the fourth quarter of 2020. GAAP to non-GAAP reconciliations for current and prior year periods are available in the earnings release at the end of this presentation and on our website. Any references to organic growth exclude the effects of restructuring, impairment of assets held for sale, foreign currency translation, acquisitions and divestitures, unless otherwise noted. Now I'd like to turn the call over to Lynn to get things started. Lynn?

Thank you, Jim, and good morning, everyone. I'll begin with the key highlights of our third quarter performance and an overview of our full year 2021 outlook. Then I'll turn the call over to Chris to provide a more detailed review of our financial results and updates to our full year guidance. Finally, I'll wrap up our prepared remarks before we move to Q&A. Starting with the third quarter highlights. We experienced a strong 12% increase in overall sales, of which 4% was organic. Our A&D markets improved 15%, reflecting solid growth in commercial aerospace, naval defense and yet another quarter of strong performance from our PacStar acquisition. Having just completed its first year under Curtiss-Wright's ownership, I'm pleased to report that PacStar is executing very well, and its integration remains on track. The business is well positioned for continued strong top line growth and is closely aligned with the Army's top modernization priorities. Turning to our commercial markets. We experienced strong year-over-year growth, which was led by both our industrial vehicle and process markets as these industries continued to sharply rebound. Looking at our profitability, adjusted operating income improved 12% with adjusted operating margins strong at 17.5%, reflecting higher sales and operating income across all our segments as well as the benefits of our operational excellence initiatives. It's important to note that this strong performance was achieved while we continued to invest strategically with a $4 million incremental investment in research and development compared to the prior year. As a result, we are on track to invest $12 million in incremental R&D this year to support our future organic growth initiatives. Adjusted diluted EPS was $1.88 in the third quarter, which was slightly above our expectations due to the strong operational performance and the benefits of our consistent share repurchase activity. Free cash flow was similarly strong, up 76% compared with the prior year, with strong free cash flow conversion that exceeded 125% and keeps us on track to achieve our long-term objectives. Turning to our third quarter orders. We achieved 13% growth, and book-to-bill exceeded onetime sales, driven by increases within each of our three segments. Digging a little deeper, we experienced solid growth of 7% in our A&D market orders as well as robust growth of 25% in our commercial market, providing continued support to our strong backlog. Next, I wanted to address the global supply chain disruption on our business. Overall, I am really proud of the team's strong execution in light of this challenging supply chain environment. As we expected and as we indicated last quarter, our operations continued to face some supply chain disruptions caused by both delays in container shipments and shortages in electronic components, principally impacting sales within our A&I and Defense Electronics segment. Thus far, these disruptions have been immaterial to our full year 2021 results, essentially limited to timing rather than lost revenues based upon the team's untiring efforts to mitigate these impacts on sales and to preserve our profitability. We continue to aggressively manage the timing of product within our supply chain and remain encouraged by our strong backlog. As we move forward, this remains a watch item for us. And should we encounter further revenue pushout, we anticipate offsetting any delays through the strength of our combined portfolio. I'd also like to address our press release from mid-September, where we announced the Board's support for a substantial increase in our share repurchase authorization from $150 million up to $550 million. We immediately and opportunistically began to repurchase $200 million of our stock in mid-September. I'm pleased to report that we recently completed this program and bought back more than 1.5 million shares. We are on track to complete at least $250 million of share repurchases in 2021, and we remain well positioned for the continued return of capital to our shareholders going forward with $350 million of remaining authorization. Finally, turning to our full year 2021 adjusted guidance. While we maintained our outlook for sales, operating income, margin and free cash flow, we tightened and raised the bottom end of our adjusted EPS guidance range. We now expect to achieve between $7.20 and $7.35, essentially double-digit growth compared with the prior year based on our strong year-to-date performance and the benefit of our repurchase activity. We remain very much on track to deliver strong results in 2021. Now I'd like to turn the call over to Chris to provide a more thorough review of our third quarter performance and our outlook for 2021. Chris?

Thank you, Lynn, and good morning, everyone. I'll begin with the key drivers of our third quarter results where we again delivered another strong financial performance with higher sales and operating income in all three segments. Starting in the Aerospace & Industrial segment. Sales increased 14% in the third quarter, led by strong increases in demand for our products and services in both commercial aerospace and general industrial markets. Within the segment's commercial aerospace market, sales increased more than 20% year-over-year as we experienced improved OEM demand on Narrowbody aircraft as well as a solid increase in aftermarket sales. We also experienced higher sales for our industrial vehicle products, including both on- and off-highway, which continue to benefit from improved demand and strong order activity. Turning to the segment's profitability. Adjusted operating income increased 34% while adjusted operating margin increased 240 basis points to 15.7%. Our results reflect favorable absorption on strong sales and the savings generated by our prior year restructuring actions. In the Defense Electronics segment, revenues increased 22% in the third quarter, principally reflecting the contribution from our PacStar acquisition. Lower organic sales reflect the timing on various C5ISR programs in aerospace defense as we experienced a shift of about $10 million to $15 million in lower-margin system sales into the fourth quarter, which was mainly due to the global shortage of electronic components. This segment's third quarter operating margin reflected favorable mix for our higher margin embedded computing revenues, which was more than offset by $4 million in incremental R&D investments and about $1 million in unfavorable foreign exchange. And absent these two unfavorable impacts, this segment's third quarter 2021 operating margin would have been in line with the prior year's strong performance. Next, in the Naval & Power segment, revenues increased 3% in the third quarter, led by higher sales of naval nuclear propulsion equipment and higher valve sales to process markets where we continue to experience strong demand. This segment's adjusted operating income increased 4% while adjusted operating margin increased 20 basis points to 18.6%, reflecting favorable absorption on sales and approximately $2 million in restructuring savings. It's also worth noting that we achieved higher profitability in this segment despite the wind down on the CAP1000 program in our commercial power market. To sum up the third quarter results, overall, both sales and adjusted operating income increased 12%. And across Curtiss-Wright, we drove 10 basis points of year-over-year margin expansion while adding $4 million in incremental R&D investments, which represents a 70 basis point headwind on our overall profitability. Turning to our full year 2021 guidance. I'll begin with our end market sales outlook, where we continue to expect total Curtiss-Wright sales growth of 7% to 9%, of which 2% to 4% is organic. And while our sales guidance remains unchanged, I wanted to briefly highlight some specific dynamics within a few markets. Starting with naval defense, our guidance remains unchanged at flat to up 2%, and we continue to see strong order activity for our nuclear propulsion equipment on critical naval platforms. For example, as noted in our September press release, Curtiss-Wright was awarded contracts valued at approximately $100 million to provide pumps for the U.S. Navy's Virginia-class submarine and Columbia-class submarine as well as Ford-class aircraft carrier programs. These awards not only support our outlook for overall aerospace and defense market sales growth in 2021, but also provide long-term visibility and stability for our naval defense market revenues. Next, a few comments about our commercial markets where overall sales growth remains unchanged at 6% to 8%. In the process market, we continue to see a solid rebound in MRO activity for our industrial valve businesses, principally to oil and gas customers. In the general industrial market, based upon strong year-to-date growth in orders for industrial vehicle products, we are now on track to return to 2019 levels in this market by the end of 2021. This is one year ahead of what we communicated at our May Investor Day where we previously expected to reach those levels in 2022. Continuing with our full year outlook, we are reaffirming our sales, operating income and operating margin guidance. We expect adjusted operating income growth of 9% to 12% and adjusted operating margin growth of 40 to 50 basis points to a range of 16.7% to 16.8%. Diving deeper, I'd like to share a few specific reminders about our segment guidance. I'll begin in the Aerospace & Industrial segment where we're expecting operating income to grow 17% to 21% while operating margin is projected to increase 180 to 200 basis points, keeping us on track to exceed 2019 profitability levels this year. Next, in the Defense Electronics segment, we're maintaining our outlook for solid growth in sales and operating income despite the challenges that we've encountered in the supply chain. As we noted earlier, we experienced a $10 million to $15 million shift in revenue from the third into the fourth quarter based upon the timing and receipt of electronic components. We expect these delays to continue, and now expect to finish the year closer to the lower end of this segment's guidance range for sales. It is, however, a very dynamic issue, and we're working aggressively to mitigate the impact on our business as we look to close out the year. Regarding the segment's profitability, it's important to note that we are maintaining our outlook for operating income despite the revenue timing issues and our $8 million year-over-year increase in strategic investments in R&D. Lastly, in the Naval & Power segment, our guidance remains unchanged, and we continue to expect 20 to 30 basis points of margin expansion on solid sales growth despite the wind down of the CAP1000 program. Continuing with our financial outlook, we increased the bottom end of our full year 2021 adjusted diluted EPS guidance to a new range of $7.20 to $7.35, which reflects growth of 9% to 12%, in line with our growth in operating income. Our updated guidance reflects both the lower share count stemming from our ongoing share repurchase activity as well as a slightly lower interest expense where we continue to maintain sufficient capacity under our revolver for continued share repurchase, acquisitions and operational investments. And lastly, based on strong year-to-date free cash flow generation of $128 million, we remain on track to achieve our full year free cash flow guidance of $330 million to $360 million. And now I'd like to turn the call back over to Lynn for some closing remarks. Lynn?

Thank you, Chris. I'd like to recap some of the key takeaways of our 2021 guidance where despite some caution as it pertains to the ongoing supply chain issues, we are well positioned to drive strong results for this year. Led by high single-digit revenue growth, including the contribution from last year's PacStar acquisition, we expect to generate 9% to 12% growth in both operating income and diluted EPS this year. Our 2021 operating margin guidance of 16.7% to 16.8% reflects our solid execution and ongoing focus on operational excellence. We expect to achieve those results while investing an additional $12 million, or 40 basis points, in strategic R&D to facilitate future organic growth. In addition, our adjusted free cash flow remains strong, and we are on track to achieve our ninth consecutive year of greater than 100% free cash flow conversion. We also continue to maintain a strong and healthy balance sheet and remain committed to deploying disciplined and balanced capital allocation to support our pivot to growth. We are focused on investing our capital for the best possible return to drive long-term shareholder value. And in the case of our recent share repurchase announcement, we took advantage of opportunities to ramp up our activities in this area. Meanwhile, acquisitions have been and will continue to remain the highest priority for Curtiss-Wright. With a full pipeline of opportunities, I remain ever confident that we will effectively deploy our capital to strategically and profitably grow our business for the long term. In summary, Curtiss-Wright is performing well, and we remain on track to deliver strong profitable growth in 2021, driven by our diversification and the strength of our combined portfolio. Our defense backlog remains strong, particularly in naval defense. And our commercial orders have been very resilient, reflecting book-to-bill of 1.1x sales year-to-date. We continue to demonstrate the highest levels of agility in response to the dynamic changes taking place in our end markets. Altogether, this affords us the opportunity to remain on track to achieve our long-term guidance communicated at our May Investor Day. At this time, I would like to open up today's conference call for questions.

Our first question is from Peter Arment of Baird.

Lynn and Chris, everyone, nice results.

Thank you.

Lynn, maybe you could just talk a little bit about the supply chain risk. I mean you guys have done a very good job, I think, of mitigating it. Is it just your dual sourcing or some of the DPAS ratings that you've talked about in the past? Maybe talk about some of the bigger levers and then how you're kind of working that going forward.

Yes, it's definitely a significant issue that we're focusing on. Thank you for the question. It is very real and continues to pose challenges that we are actively trying to address. We mentioned that we had approximately $10 million to $15 million in revenue shifted from Q3 to Q4 in our Defense Electronics segment due to supply chain pressures. This is a key focus area for our team, and we are doing everything possible to manage it. This is the most notable impact we are experiencing, along with challenges related to container shipments, where we are dealing with high freight costs and longer transit times. We're also starting to manage some allocation issues concerning chips, as we were promised a certain supply but have received fewer chips than expected. This area is quite dynamic. We are implementing dual sourcing where possible and exploring new processor chips to alleviate supply chain stress. I'm proud of the team's creativity in tackling these challenges. Additionally, we are prioritizing our DPAS ratings and strengthening executive relationships to highlight the importance of receiving products critical to national security and mobility. The team's efforts have been impressive, and I mentioned this in my opening remarks. We hope to see an improvement in this situation over the next calendar year and return to more normal operations. Furthermore, we are actively addressing Q4 challenges while planning effectively for 2022 and managing our supply chain needs well into the future, adapting our practices to maintain our position.

As a follow-up, another area of concern that many are inquiring about is the effects of a continuing resolution. This resolution has persisted for several years, and we have had to manage it. Could you remind us how this affects you and share your high-level thoughts on the growth of your defense portfolio for next year?

Thank you, Peter. It's disappointing to see us continue with this pattern of a continuing resolution. This situation isn't healthy for the country or our national defenses, and it hinders the initiation of new programs. The global environment is dynamic, and we should not manage our country this way. We're somewhat insulated from the effects of a continuing resolution since we're primarily selling to prime contractors rather than directly to the government, and they are working to keep things progressing. We can handle a certain level of continuing resolution without feeling immediate effects, but ultimately, it affects us through the supply chain. We recognize that we align with the key priorities in the defense budget, and we're pleased with the proposed positive funding from the President's budget. The markups that went through the House showed good potential for Curtiss-Wright, and I believe they will pass it; it's just a matter of time. This will be beneficial for us. We are optimistic about the strong bipartisan support for the Navy and the ongoing belief in shipbuilding. We feel confident that we have aligned ourselves with the top priorities that have bipartisan backing. Once the budget passes, I believe we will be in a good position.

And our next question is from Michael Ciarmoli of Truist Securities.

Nice results. Maybe can we just stay on defense. I guess organic growth down two quarters in a row and I guess some of that organic pressure due to the slide outs. But maybe can you speak to the performance of some of the acquisitions? I mean are they seeing some of the same challenges? And I guess you were touching on the continuing resolution that's going to create some pressure here, but most of your customers have tempered their growth expectations next year. Should we kind of calibrate ourselves for a little bit more of a challenged defense environment here over the next couple of quarters?

We remain confident in the guidance we provided at Investor Day. There is some uncertainty in the market, primarily related to supply chain issues and delays. What we are experiencing is mostly delays in revenue rather than a loss of business. For instance, Lockheed Martin has adjusted its F-35 outlook, which does impact us since we have involvement with the F-35 program. This could present a minor challenge moving forward, but it represents only 2% to 3% of our overall revenues. Aside from the F-35, we have stronger positive factors, particularly from our naval and Defense Electronics sectors, as well as our investments in MOSA and our growing business there. Additionally, the feedback from our recent PacStar acquisition has been very positive, with strong support from its end customers within the budget. So other than the F-35, we don't see any significant headwinds, and we feel good about our guidance. Regarding our acquisitions, we're pleased with their performance, and while they are influenced by overall defense budgets, they are all performing well. We recently reported to our Board on these acquisitions, and the feedback was overwhelmingly positive.

Got it. And now shifting to power, you mentioned the CAP1000 in your prepared remarks. I'm trying to understand what to expect moving forward. I know there are no forecasts from your end, but there's been speculation about Ukraine's interest in the AP1000 and other countries as well. What else are you observing or preparing for? Additionally, how should we consider the situation if no orders are placed for the capacity at your facilities outside of Pittsburgh? Can they be easily repurposed if there isn't much activity with the AP1000?

We are actively addressing a dynamic issue and believe we are effectively managing capacity and workload as we transition away from the AP1000 program. We are balancing our resources with no immediate expectation of new orders. However, if an order does come in, we have preparations in place to scale up efficiently. The labor requirements typically follow material orders, giving us time to adjust our workforce. We are confident in our ability to achieve this, and there are skilled individuals available in the area. This is an exciting time, even though new orders are not currently anticipated. Recent developments, such as the agreement between NuScale and Bulgaria on next-generation reactors, are encouraging. The discussions surrounding the COP26 Summit highlight the growing acknowledgment that nuclear energy will play a crucial role in carbon-free solutions. After years of limited support, public sentiment is shifting, and I believe funding will increase throughout this decade. While I can’t say exactly when it will happen—whether in 2022, 2023, or 2024—I feel it is closer than we had anticipated for many years.

And our next question is from Nathan Jones of Stifel.

Start with a question on the share repurchase executed a couple of hundred million here in the second half of 2021. Is the plan to go back to more just offsetting dilution? Or do you have designs on utilizing some more of that authorization here in the short term?

We have consistently stated our commitment to deploying our capital to create value for our shareholders, and we have not pursued any acquisitions yet. Currently, we have available capital and have chosen to move forward. We have $350 million in open authorization, and we will make decisions regarding it as acquisition opportunities become clearer. This remains our top priority, but we are focused on ensuring our capital generates value for our shareholders. With that, I will let Chris share some insights on the current landscape.

Yes. I would only add, Lynn, we have a very strong balance sheet, and we're excited about what we can do with that to support our capital allocation strategy. And we think that the share buyback is the most effective way to return capital to shareholders. Over the last five years, it's been $130 million. Last year during the pandemic, it was $200 million. And we also did the PacStar acquisition. And this year, we're on track to $250 million. I think we like where we're positioned. I think that we feel we have opportunity. And the only other thing I might add is that at the recent Investor Day when we set those minimum financial targets out there. You'll notice that we said 5% minimum sales CAGR, and that we said that there would be a 10% EPS CAGR. So absent any further acquisitions, you can kind of quickly do the math and see that you need to return capital to shareholders through share repurchase to hit that 10% EPS CAGR. So we're excited about it. We feel that it's a great time to buy Curtiss-Wright stock given the position of our multiple and where we are relative to our peers and our pivot to growth strategy. So we remain committed.

Does the repurchase say anything about the actionability of the M&A pipeline in the short term? Or are they kind of separate issues?

No, it really does not signal anything about where we sit with M&A that Chris and I work very closely to model scenarios and our ability to drive acquisitions. And we still very much have a lot of dry powder and are able to move on acquisitions as they become available. We planned for that to be in coincidence with the purchase buyback that we have done so far.

And then just one follow-up on a comment you made about the budget markups being positive for Curtiss-Wright. Can you give us a little more detail on what some of those budget markups were that you believe are a positive for Curtiss-Wright?

Sure. I think the two that are the most notable is a potential for a third Virginia-class and another DDG-51 are both part of the markups. And then additional support within the Army for network modernization, which already had really great support in the primary budget that was put forth by the President, but even some further potential increases from it.

We have a question from Myles Walton of UBS.

You've got Lou Raffetto on for Myles. As we consider the $12 million increase in R&D spending this year, how do we approach that for 2022? Do we maintain this higher spending level, or do we reduce it to some extent?

Yes, we get that question frequently, and we haven't provided guidance on R&D spending for the upcoming years. There are a couple of reasons for this. First, about half of our total engineering spending is for internal research and development, while the other half is funded by customers. We constantly assess where to allocate our engineers—between customer-funded programs that offer the best return for Curtiss-Wright and investing in our own ideas. It's a balancing act between these two areas. We aim to make investments based on the most effective use of our resources to promote long-term growth. Instead of setting a fixed amount for spending, we evaluate the return on investment for each opportunity, considering both short-term and long-term gains, as well as incremental investments to expand product lines. Some projects may represent a larger risk or opportunity, and we make decisions as new projects arise. I firmly believe in the importance of R&D spending and expect us to continue investing in it to foster long-term growth for the Company. While I anticipate this approach will persist, we are not specifying any concrete spending levels.

And I would only add that we are committed to achieving 17% operating margin this next year. So that is a big focus of ours. But we are also working our operational excellence initiatives across the organization to continue to free up money for investments. So we'll be able to provide more color on that in February.

Okay. Great. And just a couple of other quick follow-ups. Is there any update on the assets held for sale for the one business. I guess, they've been out there now for about a year. Does that indicate any lack of interest or anything like that we need to be mindful of?

No, I think we're making good progress in that process. While I won't go into specifics about the sale or our current status, I believe we're positioned well to proceed with that property in the near term.

Okay. Great. And then just last one. Page or Slide 11 in the deck, I think it's third quarter lays out the end market sales growth and has 4% organic growth for A&D and then 5% organic growth for commercial markets, but I thought organic growth was only up 1% for the quarter. So what am I missing?

Well, I think as you take a look at our sales growth, Q3 year-over-year, the biggest contributor to the growth was obviously within Aerospace & Industrial. And the strength of that market was really driven by what we're seeing in industrial vehicles and then also commercial aerospace for the quarter. The second biggest, I would say, organic mover was within Naval & Power. And that was really based upon the strength in what we saw year-over-year naval defense, particularly the Virginia-class submarine. Looking at Defense Electronics, while we were up substantially year-over-year, the majority of that contribution was from PacStar. We were slightly down organically, roughly $5 million year-over-year. But that was really related to the timing of the pushout into the fourth quarter due to the availability of electronic components.

All right. So the 4% organic growth isn't really organic growth then for the aerospace defense market as sort of indicated on that slide?

No, I think for the full year, we're maintaining all of our assumptions in our guidance range. While we anticipate being at 4% to 6% for the full year, it will likely be closer to the lower end of the range due to some timing issues we've mentioned within Defense Electronics. However, we expect to stay within all those ranges.

And we have a question from Peter Arment of Baird.

Yes. Just a quick question, Lynn. In the power and process area, you mentioned strong growth in valves for the process market. What level of visibility do you have there? And could you remind us about the general outlook and its sustainability?

Okay. Yes. Thank you. It's an area of the business we don't usually get as many questions about, so it's nice to talk about it. So we definitely continue to see growth opportunities for our severe service applications. And the forecast is that the process markets will grow mid- to high-single digits with full recovery in 2023. So our visibility, it's a fairly short-term business. So we really look to market trends to anticipate where we're going. And we've tracked well with where the market outlook is. So we feel good about tracking that with full recovery in 2023. We've definitely seen favorable trends in 2021 as the industry increases MRO work, which is the largest portion of our sales and is generally tied to GDP. We did have one CapEx project back in the last quarter push into 2022, so there are some mixed bags. But we do see full recovery from the pandemic.

And we have a question from Michael Ciarmoli of Truist Securities.

Just another end market I wanted to ask about. Within industrial, what are the trends you're seeing in the surface treatment side of the business? And maybe any color on where that is in relation to prepandemic, and kind of what you're seeing with your various customers in different geographies there?

Yes. Regarding the surface technologies business, which is primarily a short-cycle business, we've previously described it as an indicator of economic health. It tends to be the first to decline during economic downturns but will also be among the last to recover when conditions improve, as orders from long-cycle businesses need to follow. Since the low points in the second quarter of last year, we've observed consistent quarter-over-quarter improvements in that sector. The ongoing orders reinforce our expectations for steady growth. Initially, this recovery was largely driven by the industrial segment, including industrial vehicles, automation, and services, which have shown good growth rates. We did start this year with a slight decline in commercial aerospace, primarily due to widebody aircraft, but we are seeing signs of recovery there as well. Orders in commercial aerospace continue to rise, although not as rapidly as in our long-cycle sectors, yet it gives us confidence that we're moving in the right direction in the short cycles.

And there are no further questions at this time. I will now turn the call over back to Lynn Bamford, President and Chief Executive Officer, for closing remarks.

Thank you. Thank you all for joining us today. We look forward to speaking with you again during our fourth quarter earnings conference call, and have a great day.

And this concludes today's conference call. Thank you for participating. You may now disconnect.