Earnings Call Transcript - HXL Q3 2021

Operator, Operator

Good morning. My name is Brent, and I will be your conference operator today. At this time, I would like to welcome everyone to the Hexcel Third Quarter 2021 Earnings Call. At this time, all lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. It’s now my pleasure to turn the call over to Patrick Winterlich, Chief Financial Officer. Sir, please go ahead.

Patrick Winterlich, CFO

Thank you. Good morning, everyone. Welcome to Hexcel Corporation’s third quarter 2021 earnings conference call. Before beginning, let me cover the formalities. I want to remind everyone about the Safe Harbor provisions related to any forward-looking statements we may make during the course of this call. Certain statements contained in this call may constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. They involve estimates, assumptions, judgments and uncertainties caused by a variety of factors that could cause future actual results or outcomes to differ materially from our forward-looking statements today. Such factors are detailed in the Company’s SEC filings and last night’s news release. A replay of this call will be available on the Investor Relations page of our website. Lastly, this call is being recorded by Hexcel Corporation and is copyrighted material. It cannot be recorded or rebroadcast without our express permission. Your participation on this call constitutes your consent to that request. With me today are Nick Stanage, our Chairman, CEO and President; and Kurt Goddard, our Vice President of Investor Relations. The purpose of the call is to review our third quarter 2021 results, detailed in our news release, issued yesterday. Now, let me turn the call over to Nick.

Nick Stanage, Chairman, CEO and President

Thanks, Patrick. Good morning, everyone. And thank you for joining us today as we share our third quarter results and look ahead to year end. The results we shared in our news release last night reflected strong earnings performance as sales recover and our margin expands as a direct result of the decisive actions we took to realign our cost base early in the pandemic, along with our continued focus on improving productivity through operational excellence. With our restructuring now behind us, we have never been leaner, more focused, or better aligned to take advantage of the demand for lightweight advanced composite products than we are today. With customer destocking essentially complete, we remain confident that build rates will steadily increase to meet pent-up demand for air travel as well as the need to replace aging aircraft with more fuel-efficient, lower emissions aircraft made possible by the advanced material solutions that Hexcel has to offer. We’re closely monitoring the continued effects of the pandemic on our business, including supply chain constraints, inflationary pressures and a competitive market for talent. Our supply chain is experiencing some tightness, and our team is focused and working hard to ensure the continued availability of raw materials to meet our customers’ growing demand. We are not immune to inflationary pressures, such as the rising cost of energy and freight. However, at this point in time, we have not experienced any meaningful impacts to our costs, in part, thanks to our long-term supply contracts and commodity hedging. Yet, we must remain vigilant. Historically, we’ve offset inflation through productivity initiatives to improve efficiency, and I can assure you, all our plants will have robust productivity goals built into their plans for 2022 and beyond, no different than years past. After reducing our headcount by approximately 35% over the past 18 months, we are now rehiring as we bring idled assets back online to meet new and increasing demand, especially for carbon fiber. Like many others, we are finding the talent pools to be tighter than they were pre-pandemic, yet still, we have made exciting new additions to our team over the past quarter. I am confident that we will continue attracting the best, the brightest, the most diverse and talented workforce available. There are many encouraging signs that lead us to believe that a sustained return to growth is now taking place. For example, the U.S. is expected to lift its international travel ban in November, and that is great news since international travel has been muted for so many months. We’re seeing strong improvement in aircraft orders around the globe. Airlines are recovering, with many receiving new planes and, more importantly, refreshing their fleets with the most fuel and emissions-efficient aircraft, which means composite-rich platforms. Now, let me highlight some of the results from this quarter. Overall, sales in the third quarter of 2021 were $334 million compared to $287 million in the third quarter of 2020. Aerospace sales of $167 million represents an increase of almost 30% compared to the third quarter of last year due to stronger narrowbody demand. We believe the A350 destocking generally concluded during the third quarter, and after three successive quarters of increasing business jet sales, we think that business jet destocking is also now largely behind us. In July, Airbus launched the A350 freighter with a scheduled entry into service in 2025. It will be the first composite-rich freighter in the market, and because of its fuel-efficient profile, it will comply with the tightening aircraft emission standards that take effect later this decade. Lightweight composites helped enable the value proposition, and additional A350 production volume will obviously be beneficial for Hexcel, whether passenger or freighter configurations. Sales to other commercial aerospace, such as regional and business aircraft were up over 9% compared to the third quarter of 2020. The business jet market, where we have great positions, particularly on new composite-rich large cabin aircraft, continues to demonstrate a positive trend. Turning to Space & Defense, sales were more than $110 million, which represents a 1.5% increase over 2020. We have content on hundreds of programs in Space & Defense, including significant advanced composite content on both the Lockheed Martin F-35 and Sikorsky CH-53K, and we anticipate winning additional incremental work to help boost future sales. Industrial sales were about $56 million during the quarter, which was roughly a 12% increase in constant currency. We’re seeing strength return to several industrial submarkets, including winter sports and recreation equipment. Our automotive business remains strong, even considering the chip shortage impacting that industry. Hexcel has also benefited from new sales as we allocate carbon fiber capacity to other industrial markets. Wind energy sales, which is the largest submarket in Industrial, declined more than 31% in constant currency compared to the third quarter of 2020, which reflects ongoing softer demand as well as the closure of our wind blade material plant in the U.S. about a year ago. Before I turn it over to Patrick, let me share some highlights from the quarter. In September, we announced an expansion at our engineered core facility in Morocco. We expect to double the size of the plant by early 2023 to meet continued and increasing demand for lightweight honeycomb materials for engineered core parts for aircraft, engine nacelles and helicopter blades. You’ll recall that we celebrated the grand opening of our plant in Casablanca in 2018. So, in just three years, with at least half of that time spent navigating the effects of a global pandemic, we are realizing strong demand growth for our composites in the region. Just last week, we were joined by several of our customers and local government officials in Salt Lake City for a groundbreaking at what will become our newest center of research and technology excellence. We announced plans to build the center back in May, and we remain on track for completion in late 2022. It will be our largest center for innovation and product development in North America and a flagship for our advanced composites technology, with space for future growth and expansions in the years ahead. Our additive thermal plastic manufacturing capabilities are now certified by both Airbus and Boeing for commercial aircraft applications. In September, we announced that we have been awarded a multiyear contract to produce aerospace structures using this technology for the Boeing 777X. And finally, we had a couple of terrific recognitions from customers. We were awarded the Success Partner award for our efforts to deliver outstanding product quality on time to Spirit AeroSystems. And our Salt Lake City operations were recognized by Blue Origin for our contributions towards helping them achieve their first human flight aboard the New Shepard.

Patrick Winterlich, CFO

Thank you, Nick. As a reminder, the year-over-year comparisons are in constant currency. The majority of our sales are denominated in dollars. However, our cost base is a mix of dollars, euros and British pounds as we have a significant manufacturing presence in Europe. As a result, when the dollar strengthens against the euro and the pound, our sales translate lower, while our costs also translate lower, leading to a net benefit to our margins. Conversely, a weak dollar is a headwind to our financial results. We hedge this currency exposure over a 10-quarter horizon to protect our operating income. Turning to our three markets, Commercial Aerospace represented approximately 50% of third quarter sales. Third quarter Commercial Aerospace sales of $167.2 million increased 29.8% compared to the third quarter of 2020, led by narrowbody sales, as narrowbody destocking concluded last quarter, and Airbus is increasing the production rate on the A320 family. For widebodies, the A350 destocking was generally finished by the end of the third quarter, consistent with our communications during our last earnings call. Destocking for the 787 will be extended, though we are not in a position to estimate the time frame. Space & Defense represented 33% of third quarter sales and totaled $110.4 million, increasing 1.4% from the same period in 2020. We witnessed strength in fixed-wing aircraft, including the F-35 and unmanned aerial vehicles as well as commercial helicopters in the CH-53K. Regionally, Europe was strong, partially offset by some softness in Asia Pacific. Industrial comprised 17% of third quarter 2021 sales. Industrial sales totaled $56.2 million, increasing 11.7% compared to the third quarter of 2020. We are continuing to experience subdued wind demand, with wind energy representing approximately 40% of third quarter Industrial sales. Recall that our Industrial business uses both carbon and glass fibers. We purchase glass fiber from third parties for applications such as wind turbine blades, and our aerospace-grade carbon fiber is sold for technology-driven industrial applications. Our Industrials team is now selling carbon fiber to several new customers, utilizing available capacity for high-performance applications. On a consolidated basis, gross margin for the third quarter was 19.8% compared to 4.7% in the third quarter of 2020. The strengthening gross margin benefited in the quarter from a strong fiber-rich sales mix, leveraged against our reduced overhead cost base. To share some perspective on mix, our manufacturing processes obviously differ, whether we are producing honeycomb, carbon fiber or engineered products. For carbon fiber, our manufacturing value chain begins with the production of precursor, which is then carbonized. We then weave the carbon fiber or arrange the fibers in a unidirectional orientation and apply one of our many proprietary resin formulations in a process called prepregging. As we begin to grow again, the impact of ramping and producing the carbon fiber is more pronounced as that is the highest margin portion of our product line. We expect relatively more weaving and prepregging activity going forward compared to the last two quarters, which is why our margin recovery will not always be a perfectly smooth quarterly progression. As Nick commented, we did not experience any meaningful inflationary cost pressures during the third quarter. However, we are not immune to cost challenges and supply chain pressures. Our team is focused and working hard to ensure the availability and delivery of raw materials on time for our production requirements. Our largest raw material purchases, including resins and fibers, are typically under long-term contracts, and industrial resins typically have pass-through mechanisms. We hedge our acrylonitrile purchases, which layers in cost changes over time. We have long-term contracts for power and natural gas at many of our sites. And specifically, our European natural gas needs are locked in for a period of time, a lot of which was done before the recent price spike. There will likely be additional cost pressures over time with certain raw materials, including aluminum, though at this point in time, I would characterize the anticipated impact as being modest relative to our total cost base. And as a reminder, the flip side to higher oil prices is that it drives the aircraft fleet replacement, which supports our top-line growth over time. As a percentage of sales, selling, general and administrative expenses and R&D expenses increased to 12.7% in the current quarter compared to 12.3% in the third quarter of 2020. Recall that last year, we had implemented temporary compensation and benefit reductions as part of our cost control actions. Adjusted operating income in the third quarter was $23.6 million, reflecting strong variable margin performance and robust cost control. The year-over-year impact of exchange rates in the third quarter was favorable by approximately 100 basis points. Now turning to our two segments. The composite materials segment represented 76% of total sales and generated an 11.1% operating margin, strengthening on sales mix and top-line growth. The operating margin in the comparable prior year period was negative. The Engineered Products segment, which is comprised of our structures and engineered core businesses, represented 24% of total sales and generated an 8.1% operating margin. Again, the operating margin in the comparable prior year period was negative. The effective tax rate for the third quarter of 2021 was 38.3%. The pandemic and consequent mix of results across the countries in which we operate is expected to continue to impact the Company’s overall effective tax rate throughout 2021. Net cash generated by operating activities was $64.2 million year-to-date. Working capital was a use of $46 million year-to-date. We believe this level of working capital growth is appropriate to support our forecasted sales growth. We managed our working capital by considering number of days. The quarterly days sales and days payable outstanding have been consistent each quarter in 2021. Inventory has seen some growth as we prepare for increasing OEM aircraft production rates in 2022. Capital expenditures on an accrual basis were $6.5 million in the third quarter of 2021 and $14.3 million year-to-date. This compares to $39.4 million through the nine months ended September 30, 2020. Capital expenditures continue to be tightly managed with a focus on improving existing asset efficiency and new technology advancements. Free cash flow for the third quarter of 2021 was $19.5 million and is $49.2 million year-to-date through the end of the third quarter. This compares to $109.2 million generated through the first nine months of 2020, which was supported by large reductions in working capital. In summary, expanding profitability and tightly controlled capital expenditures are supporting free cash flow generation in 2021, despite some modest working capital increases to support growing sales. Our liquidity remains well above the bank covenant minimum of $250 million, and we have no near-term debt maturities. I am confident that we will continue to meet this minimum liquidity covenant and confident that we are well positioned to meet the pre-pandemic leverage coverage ratio when the revolver covenants revert back to the original facility agreement terms in mid-2022. Our share repurchase program is restricted through March 31, 2022, by the revolver amendment executed in January 21. Dividends also remain suspended at this current time. Our Board continues to regularly evaluate capital allocation priorities. As our earnings release states, we are not providing financial guidance at this time. However, I have previously provided some framework around 2021 financial expectations which I will briefly reconfirm. Market consensus revenue is generally reasonable, though be mindful of specific program pressures. The year-to-date adjusted operating margin percentage is now a reasonable proxy of our expectations for the full year. Capital expenditures in 2021 will continue to be tightly managed and are expected to be at a similar level to 2020 or just below. We expect to continue to generate positive free cash flow during the remainder of 2021 and further reduce debt levels. We expect the effective tax rate to be approximately 23%. With that, let me turn the call back to Nick.

Nick Stanage, Chairman, CEO and President

Thanks, Patrick. Over the past several months, we have been adjusting and making tough business decisions to position ourselves for growth as the effects from the pandemic begin to lessen. While it is going to take a number of years before we return to pre-pandemic revenue levels, our fundamentals remain unchanged. We have leading positions on the world’s largest programs with our advanced composite technology and the broadest portfolio in our industry. We continue to generate cash flow and further strengthen our balance sheet. The great job our team has done to strengthen our foundation over the past decade put us in a strong position that has allowed us, not only to weather the storm but to come through it stronger than ever. It goes without saying, our markets remain uncertain. Even though we’re seeing positive signs, we need to be cautious and stay extremely focused on cost control and cash management. Our team is also laser-focused on staying on top of our raw material supply chain to minimize any potential production impacts. We closely monitor on-time delivery and quality, and our customer ratings regarding these two key performance metrics remain very high, despite the challenges imposed by the pandemic. Most importantly, we are staying close to our customers to ensure that we are aligned with changing demand. We remain confident in a continued aerospace recovery, which is supported by growing OEM backlogs and production rate increase announcements that should support strong growth in 2022, 2023 and thereafter. We have refocused, restructured and drawn on our resiliency to ensure that we continue to deliver exceptional value to our customers and this is only going to continue. Global demand for lighter weight, stronger and more durable materials in all of our markets will grow, and our broad and expanding technology portfolio remains unrivaled in our industry. In addition, we have an exceptionally talented, diversified and experienced advanced composite material science workforce. We anticipate strong pull for our entire portfolio for many years to come. Our team remains energized and focused on our priorities, including innovation, generating and tightly managing cash and further strengthening our already strong balance sheet, and controlling costs while at the same time positioning ourselves for the demand recovery ahead. We’re aligned and positioned to deliver strong incremental margins and long-term shareholder value. With that, Brent, we’re now ready to take questions.

Operator, Operator

Your first question comes from the line of Sheila Kahyaoglu with Jefferies. Your line is open.

Sheila Kahyaoglu, Analyst

Good morning, Nick and Patrick. And thank you. I guess, Nick and Patrick, you both talked about inflationary pressures in the industry. Can you give us a split of raw materials and labor, and what percentage of your raw materials you’ve hedged? And just a follow-up to that, Patrick, I want to clarify what you said. I think you said operating margins in the quarter could be a proxy for the full year, but I might have misheard it. So, if you could just clarify that.

Patrick Winterlich, CFO

So just to clarify that firstly, I’m really saying the year-to-date 4.6% adjusted operating income is sort of roughly a proxy. I mean, it’s not an exact science, and I’m not giving you an exact number, but there or thereabouts for the full year, not the quarterly number, the year-to-date number. In terms of raw materials, I mean, I’m not going to be exact and specific. Acrylonitrile is the one commodity we hedge. We hedge it over eight quarters. We actually buy propylene as a proxy because that through a formula drives what we pay for acrylonitrile. And what that does over time is it takes away the peaks and troughs of any price movement. It will go up, it will go down, but it has a good smoothing effect for us. Our key aerospace resins are perhaps the most obvious thing, and that is our largest single third-party purchase. We have long-term contracts to buy those. And so, we do get protection. What we’re really talking about is freight, energy costs and some of our smaller raw materials, where we don’t have the same long-term contracts. We are going to see some inflationary pressure. And undoubtedly, around labor, at some point, there will also be pressures. But within the total cost base, we’re confident to keep it under control. And as Nick talked about, through efficiencies and productivity drives that we put in place every year, we will do our best to mitigate it as much as we can. But, we’re not immune. We don’t want anyone to sort of accuse us of saying we’re not going to feel any effect, but we are going to do our very best to minimize that effect, and we’re confident to do that.

Operator, Operator

Your next question comes from the line of David Strauss with Barclays. Your line is open.

David Strauss, Analyst

Nick, you touched on the growth that you’re expecting next year. I wanted to see if you want to comment at all on what you’re thinking relative to where the 2022 revenue consensus is, which looks like it implies about 35% to 40% growth in your Commercial Aero business?

Nick Stanage, Chairman, CEO and President

Yes, David. So, we’re in the process of rolling up the plan. We are optimistic. Looking at narrowbodies, what our customers have stated, they’re growing their rates too, over the course of 2022 and beyond. The fact that destocking is behind us on the A350, the narrowbody, the business jet, that’s going to be a tailwind for us going into 2022. So, I don’t want to get ahead. I think consensus 2022 estimate isn’t wildly out of line. So, I look forward to providing guidance when we report in Q4, report our full year results, which is our intent in January. But we’re excited with the strong growth that we’re seeing as of today.

David Strauss, Analyst

Thank you for that. Patrick, you mentioned a bit of a working capital challenge. I would assume that as revenue begins to increase, your capital expenditures will also rise. You’ve provided some preliminary guidance on the progression of EBIT margins from here. Looking ahead to an EBITDA figure over the next couple of years, at what level do you believe you can convert EBITDA into free cash flow, considering the working capital challenge and increased capital expenditures?

Patrick Winterlich, CFO

Yes. I mean, our CapEx is going to remain subdued for some time, I mean, multiple years. We’re probably going to creep up back towards what we saw historically at the maintenance level, but our need for large-scale capacity spend is some years away. I mean, we’re really going to grow back into the existing plant and equipment we have. So, based on that, I mean, we need top line growth that will pull up, obviously, our bottom line. That will drive our EBITDA. And for a period of time, we should see very good cash conversion. I don’t want to get into forecast and specifics today, but with that ongoing reduced level of capital expenditure, we’re going to have a period of, yes, very good cash conversion, which I think is your underlying point, which I would agree with.

David Strauss, Analyst

And can you just remind us the maintenance level of CapEx?

Patrick Winterlich, CFO

We’ve always historically talked about $60 million to $70 million. And so, it’s not an exact science, but it’s in that range.

Nick Stanage, Chairman, CEO and President

And that’s when we’re running near full capacity.

Operator, Operator

Your next question comes from the line of Paretosh Misra with Berenberg. Your line is open.

Paretosh Misra, Analyst

Can you just remind me what your sales mix is typically in terms of carbon fiber versus honeycomb? And I think you mentioned that mix has been different in recent quarters. So, just any sense as to what it has been more recently?

Patrick Winterlich, CFO

Yes. Paretosh, we don’t disclose sort of our individual product line sales. Obviously, the sales we disclose are by market and we sort of build rates and ship sets give you some of the key programs. I mean, carbon fiber is either sold directly to third parties or we use more of it, we use two-thirds or more of what we produce internally, and it gets pulled through woven fabrics or prepregs. What I’ll say and what we’ve been trying to say the last couple of quarters is that that’s at the beginning of the supply chain process that we have, and it’s been sort of perhaps disproportionately weighted towards more carbon fiber over time now in front of us, and it will be a bit lumpy. We’re going to see the woven products, the prepreg products grow. And so, there’ll be a small dilution. It’s still all aerospace. It’s still good quality margin but that’s sort of almost exceptional weighting towards carbon fiber will dilute a little bit. But carbon fiber is growing. We’ve seen two or three really nice quarters of growth. It’s come back probably a little bit faster than we had expected, and we hope to see that continue, especially as our team are also doing a good job allocating some of the capacity to industrial sales for personal electronics, recreation, oil and gas applications, which is also great for covering overhead.

Paretosh Misra, Analyst

And then, just to follow up on your share buyback program, when is the earliest that you can restart your share buyback? Is it the second quarter next year, or could that be sooner?

Patrick Winterlich, CFO

Yes. Well, unless we were to sort of renegotiate our way out of the agreement, which I don’t expect us to do, we will come out on the first of April next year. Now, that doesn’t mean we will jump straight back into it, but the option is technically open to us, and we will be reviewing our capital allocation as we are now going through next year.

Operator, Operator

Your next question comes from the line of Pete Skibitski with Alembic. Your line is open.

Pete Skibitski, Analyst

Hey. Good morning, guys. Nice quarter. It’s good to see the return to growth.

Nick Stanage, Chairman, CEO and President

Thanks, Pete.

Pete Skibitski, Analyst

I was particularly surprised by the growth in the industrial markets, especially considering what Patrick and Nick mentioned about the Colorado shutdown not annualizing yet and the ongoing issues in the automotive sector. Can you provide more insights? Is recreation significant enough now to drive growth on its own? As we approach the middle of 2022, once Colorado is annualized and we hopefully move past the semiconductor and automotive challenges, is it reasonable to expect that the Industrial sector can grow strongly in double digits when conditions stabilize?

Patrick Winterlich, CFO

I would say that wind has been somewhat weaker and has deteriorated recently. The market for wind is softer, and we have closed the U.S. plant, which affects our overall performance as reflected in the headline numbers. However, we are optimistic about our automotive and recreation sales, which have been strong. New industrial markets are also beginning to emerge, though they are currently not as large as wind, they are growing. We are focusing on value-added applications and opportunities in the industrial sector, utilizing our capacity, and we aim to push this forward. Looking ahead, we see potential in electric vehicles, battery technologies, and possibly storage tanks. While these opportunities won't materialize overnight, we are excited about pursuing them in the coming years.

Pete Skibitski, Analyst

Okay. You’re expecting a little more headwind in like Europe wind and China wind next year? Is that a good assumption?

Patrick Winterlich, CFO

Well, I don’t want to get into specifics. I mean, we’ve called China wind out as a watched item, and I think that’s how I would term it today. I think Europe wind will be reasonably steady, perhaps with some small headwind there as well.

Operator, Operator

Your next question comes from the line of Richard Safran with Seaport Partners. Your line is open.

Richard Safran, Analyst

So, Nick, you clearly had some real success here with the $150 million cost takeout this year. I was just wondering how you think you might top that? How much runway you have left for additional cost reduction next year, or is it that you’re just thinking now you have an optimal cost structure based on the volumes you see ahead?

Nick Stanage, Chairman, CEO and President

Yes. So, anybody in ops is always driving for productivity improvements, and we’re no different. I was excited during my U.S. tour and visiting all the sites and looking at the automation initiatives, looking at the plant throughput initiatives. And again, just a reminder, when we have so many common lines across the business, when we develop an improvement, it’s very easy to replicate and translate that into further productivity. So, I’m very proud of what the team has done. We responded very quickly. We attacked the challenge and rightsized our cost structure. We’re going to be very careful as we grow to take advantage of the processes, the systems, and the automation that we put in place. And I along with Patrick and the team are excited about the leverage we’re going to yield and how we’re going to get back well into double-digit operating income earnings as we’ve seen in the past and even higher.

Richard Safran, Analyst

Now, just as a quick follow-up, in your remarks about the A350 freighter, since that was an incremental opportunity for Hexcel, I was just wondering if the 777X freighter that Boeing is now talking about also represents an incremental opportunity for you?

Nick Stanage, Chairman, CEO and President

We don’t anticipate significant differences in the shipset content between the freighter and passenger versions. As you know, the A350 has a lot more content, but the 777 may not utilize composites to the same extent, yet it does offer efficiency improvements that are likely to be favorable in the market. All widebody rate drivers are beneficial for Hexcel.

Operator, Operator

Your next question comes from the line of John McNulty with BMO Capital Markets. Your line is open.

John McNulty, Analyst

I guess the first question would be about the industrial applications you have identified or the newer applications. Do you see these as long-term opportunities where the market has finally opened up for you, or do you view them more as temporary placeholders while you wait for some recovery in the aerospace sector?

Nick Stanage, Chairman, CEO and President

So, I’ll take this and Patrick can add too. But, one of the positives coming out of the pandemic is we had time to take a step back, reevaluate certain markets, certain areas that we may want to pursue. And with available capacity, it allowed our teams to go in and go after niche performance-related industrial applications. So, when we go into this, we went in with the thinking that these are sustainable areas of the industrial market that we intend to continue to serve and grow.

John McNulty, Analyst

Got it. Fair enough. And then, I guess, maybe to that angle, just given the increased push that we’re seeing kind of daily from an ESG perspective, are there new opportunities that are opening up from that angle, whether it’s for more lightweighting or for different energy storage uses, et cetera, that maybe you can speak to where, whatever, three, five years ago, they weren’t even on the radar screen and where they now are really opening up? Are there opportunities that we should be thinking about from that angle?

Nick Stanage, Chairman, CEO and President

It’s a huge topic, and there are tremendous opportunities. If you really look, it will be an evolution to get to a carbon-zero footprint, which people are talking about in 2050. We’re talking about more efficient fuels. But, if you really think of what the short-term and medium-term enabler is, it’s lightweighting. Lightweighting, composite structures, aircraft, more efficient engines, that’s step number one. So, we’re seeing significant opportunities on the sustainability front. I would just be remiss if I didn’t mention, we work on sustainability every day; we have going back for many, many years. We reissued our sustainability roadmap in 2017. So, we recognize that this was a real opportunity. It’s being adopted at different levels, based on the region, but it is going to be here and continue to gain traction, visibility and priority going forward. It’s a great enabler and opportunity for Hexcel and lightweight materials.

Operator, Operator

Your next question comes from the line of Gautam Khanna with Cowen. Your line is open.

Gautam Khanna, Analyst

Patrick, I just wanted to follow up on your directional guidance on margins next year. With that type of sales increase, why shouldn’t margins improve off the year-to-date level? It just seems like you’ll have the leverage, you’ll have...

Patrick Winterlich, CFO

I may have been unclear, but I want to clarify that my comments were solely about 2021. I did not make any statements regarding 2022. My focus was on how we expect to conclude 2021, particularly regarding our year-to-date operating income and adjusted operating income percentage. I made no mention of 2022. We will discuss that in January. However, with strong sales growth, we anticipate and hope to achieve significant growth in our bottom line as well.

Gautam Khanna, Analyst

Okay. That helps. Maybe I misheard that. And then just as we talk about next year, are there any remaining programmatic headwinds? I mean, destocking is over or hopefully, 787 is a risk, I don’t know, F-35, is there anything from where you sit today where you see would actually be declining?

Nick Stanage, Chairman, CEO and President

There’s always the unknown, but based on what we see today, based on if you look at the Space & Defense segment with projections from Lockheed on the F-35, with the growth rate we’re seeing on CH-53K, when you look at the diversity of the product offerings and the new platforms we’re winning on, there’s no surprise in that segment. I’m encouraged with what our team has done in industrial, especially given the softness in wind and the ability to offset with nice margin business in the subsegments in the industrial. Then I think you hit the nail on the head with the commercial aerospace. It’s really around China certification for the MAX and what will MAX rates do over the course of 2022. What will happen with the 787, with respect to some of the recent issues and the idling of the production build, which I do have to point out the 787 was a large headwind for our top line in the third quarter. If you remember, Boeing really slowed down their line; they adjusted the supply chain, and the demand to the supply chain significantly dropped, and that’s a function of them working on the issues to retrofit and get those corrected to get back up to their rate 5 and then beyond. So, other than that, I think we’re well positioned and very excited about the opportunities we’re seeing and the pull on our products.

Operator, Operator

Your next question comes from the line of Myles Walton with UBS. Your line is open.

Myles Walton, Analyst

Maybe a follow-up to David and Gautam’s question a little bit, does engineered products as a segment face more material headwinds because of the Kent relocation of work, or maybe I have that note incorrect, but thought it was a 2022 clip over. And I don’t really have the size of that headwind, if at all.

Patrick Winterlich, CFO

So, if you like, it’s a revenue adjustment, which we flagged up some time ago with those sales transferring out of our Kent facility into the joint venture that we own 50% with Boeing today based in Malaysia. So, that work will transfer. You are correct. That transfer essentially takes place at the end of this year, and then those sales move into the JV, from which we derive 50% of the earnings. In terms of a material headwind, I mean, I wasn’t quite sure. I mean, it’s a revenue adjustment. It obviously reduces the material that we sell on those programs that are transferred, we’ve worked through it. I think with the pandemic, in some ways, it’s kind of going to smooth, soften that adjustment, but there is a specific. Even though we’re going to grow strongly into 2022 within that, there will be a step down out of that Kent, Washington facility.

Myles Walton, Analyst

Okay. And then, maybe a clarification, in the Q, you mentioned a $20 million grant from the American Jobs Act. I think half of that comes through the fourth quarter. Would that just be a one-time exclusion and no impact to the margin trajectory you were talking about, Patrick?

Patrick Winterlich, CFO

Exactly, Myles. It will come through the first half; roughly will come through in the fourth quarter this year, and we probably will see the second half, maybe in the second quarter next year, I would expect at the end of the six-month period. It is tax-deductible. But, you’re right, it will go through non-operating income, and we will adjust it out. Obviously, it will be a cash benefit.

Operator, Operator

Your next question comes from the line of Pete Osterland with Truist Securities. Your line is open.

Pete Osterland, Analyst

This is Pete on for Mike Ciarmoli this morning. Thanks for taking our question this morning. Firstly, just a question on raw materials, how much ability do you have to pass through increased raw material costs in your pricing? And how does this vary across your different end markets?

Patrick Winterlich, CFO

It varies quite a lot, I guess, in truth. In our industrial markets, if I start there, some of our larger contracts, we have a pretty good pass-through mechanism, the base chemical, base industrial chemicals, there may be a quarterly lag, but we can pass those through. In aerospace, our protection, our mitigation is really through our own long-term sourcing contracts and our hedging on the acrylonitrile. We do have some of our commercial contracts with sort of escalators around oil price and some other commodities, which do kick in, but they tend to be fairly wide sort of corridors, ceilings and floors. So industrial, pretty readily pass through. On the aerospace side, it’s more about the protection that we put in place through our long-term sourcing and hedging contracts.

Pete Osterland, Analyst

Okay. Thanks. That’s helpful. And then, just a follow-up on margins. Are there any significant price or margin differences that you’re expecting as a result of repurposing your capacity for industrial products, or do you expect that the margins you’re able to realize are consistent with the aerospace applications that you repurpose over some?

Patrick Winterlich, CFO

Well, I think the reality is the industrial markets are not as strong or margin-intensive as the aerospace markets, but it’s still good. It’s not commodity carbon fiber or industrial-grade carbon fiber margins. There stood good solid margins that justify us using the capacity in that direction. But I would have to say, it’s not as strong as aerospace, simply because the qualifications, the specification, and cost to serve is different.

Operator, Operator

Your next question comes from the line of Noah Poponak with Goldman Sachs. Your line is open.

Noah Poponak, Analyst

I was wondering if we might go back to 787 and the MAX, and if you could spend a little more time on your take on what’s happening there? What’s your take on the latest quality revelations on the 787, and how long until you’re delivering back to Boeing’s stated rate there? And then, on the MAX, what’s your take on why the delivery rate there is slower than we would have thought, based on their production rate targets and inventory unwind?

Nick Stanage, Chairman, CEO and President

So, I’ll start with narrowbodies in general and just reflect on the huge backlogs and the ability for airlines to get aircraft that they want and they need. So, obviously, you see what Airbus is doing with the 320. I think there’s significant demand for the 737 MAX. I think, if you look at the flights that have been taken and the slope of the curve on how it’s being brought back into service is fantastic and a signal of the product. I think, the big question on the MAX again is around certification in China because it drives a pretty meaningful portion of the backlog. I don’t have a crystal ball that can give you anything more than you can read. So, again, I think if you look at where Boeing is today and where they’re planning to go, it’s going to be a nice step-up on rates. Without China, with China, it will accelerate. Switching to the 787, unfortunately, there’s been a couple of issues. There’s one that just recently came about. We’re keeping abreast of that. We’re staying close to Boeing to make sure we’re aligned with them on the demand and the volume adjustments. So, again, it’s too early for us to make any predictions. I would recommend you listen to Boeing’s call on I think next week and see what they have to say on their plan to get back to 5-plus.

Noah Poponak, Analyst

Okay. So, I hear all your points there, Nick, on the narrowbody market and the MAX in terms of where the backlog is. We see the new orders coming in. It doesn’t seem like there’s any major challenge with the airplane, but the delivery rate just doesn’t add up to that. It sounds like you don’t see any showstopper, and it’s more of a logistical issue at the moment.

Nick Stanage, Chairman, CEO and President

I think it’s making sure the supply chain is fully prepared. As you know, these supply chains are quite complex, and it only takes one sole-source component or supplier to hold it up. So, I think both the big OEs are being sensitive and practical on how they’re going to grow their rates on narrowbodies and/or widebodies. So, we’ve seen that. And that’s what we expect to see going forward. But we don’t see an issue. And certainly, Hexcel is ready and prepared.

Noah Poponak, Analyst

Just one other one, Patrick. In order to have the full year 2021 adjusted operating margin equal the first nine months, it would need to be down in the fourth quarter on your projection of higher revenue. So, why would that be the case?

Patrick Winterlich, CFO

I didn't provide an exact figure, but I think it's a reasonable estimate. We might exceed that figure, and we could possibly reach mid-single digits. I'm not stating anything specific. I understand the calculations, and your observation is valid.

Operator, Operator

Your next question comes from the line of Mike Sison with Wells Fargo. Your line is open.

Richard Garchitorena, Analyst

Hi. This is Richard on for Mike. First question is on the comment that the consensus for 2022 revenues is in line with what you’re thinking. Can you give us some color in terms of breakdown? Obviously, commercial is going to drive the bulk of that. But, do you see anything on the Space & Defense side that could lead to higher growth or conversely on the industrial side where you have some new applications, new customers that you’ve signed? Anything there that should drive higher than expected growth in those segments?

Patrick Winterlich, CFO

I mean, I don’t think so. I mean, I think the world is basically spelled out. I mean, Nick just talked to now about the narrowbody strengths. I think A320 family is going to be the foundational driver into next year. I think we are excited about the MAX and where that’s going to go because it is going to accelerate at some point. The 350 just getting back to a steady state rate of 5 beyond the destocking obviously makes a significant difference to us, given the shipset. Boeing will work through the 787. So, Commercial Aerospace is the big driver year-over-year. No surprise there. I think the F-35 is going to end up a little bit softer than this year than we would have expected back in January. We know about 10 or so were pushed out into 2022. So, that growth should solid out. The CH-53K continues to grow, so, Space & Defense, low single-digit growth that we’ve talked to for some time. And we’re going to push industrial as hard as we can. We’ve alluded to some new customer opportunities. So, too early to give guidance or commentary. I mean, directionally, we recognize where Street consensus is. And as Nick said, it’s not crazy.

Richard Garchitorena, Analyst

Okay, I understand. As a follow-up, regarding your capacity, you mentioned that you are beginning to hire some people to restore production. What is your current capacity utilization? Additionally, how do you foresee that aligning with growth over the next few years?

Patrick Winterlich, CFO

Yes. I mean, we’re going to still be growing back into existing capacity over the next couple of years. It’s going to be beyond that timeframe that we’ll need to put in new plant and equipment. If you think we were at $2.3 billion, $2.4 billion coming into the pandemic, we’re obviously going to be driving sales up $1.6 billion, $1.8 billion, $2 billion over the next two to three years or so. We’ve got capacity to grow back into by and large. It varies across our plants. Fibers are coming back fast as we’ve talked to, but we still have capacity there for a period of time. We’ve got weaving and prepregging and honeycomb capacity to grow into. The engineered products is perhaps more direct labor-driven. But across the board, we will increase direct labor pro-rata essentially with our sales growth, building in as much efficiency and productivity as we can. So, I think the simple answer is growing back into capacity over the next couple of years is by and large what you’re going to see.

Operator, Operator

Due to time constraints, your final question comes from the line of Hunter Keay with Wolfe Research. Your line is open.

Hunter Keay, Analyst

I have two questions. First, regarding the 787, are you experiencing any production issues, or are your suppliers facing any? Also, can you quantify how significant the impact was in the third quarter? You noted it was a significant headwind, if I remember correctly, Nick.

Nick Stanage, Chairman, CEO and President

So, to answer your first question, we’re having no issues with our material, our supplier’s inability to supply 787 or any program. I would tell you, directionally, the 787 headwind was close to the gap we saw between consensus and our actual number.

Hunter Keay, Analyst

You mentioned some fluctuations in the margin for the upcoming year regarding the weaving and prepreg mix. I apologize, I wasn't following that part of the conversation. Could you explain to me what is fundamentally happening with that? Thank you, please go ahead.

Patrick Winterlich, CFO

Not really choppiness, but as the business grows, different product lines are going to grow at slightly different rates. We’ve seen the carbon fiber product line grow first, which is expected. Then we move to weaving and prepreg. Essentially, the product lines will progress in a large vertical integration, starting with carbon fiber. Therefore, that component is the fastest to start and generate returns. We’ve seen some advances in weaving and prepregging as we move forward, and these aspects are likely to accelerate as carbon fiber may slow down at some point, which is a natural expectation. Ultimately, we’re aiming to return to our pre-pandemic production mix across different lines. It’s important to note that we won’t immediately revert to the pre-pandemic production mix after the pandemic; it will take about a year or two to achieve that.

Operator, Operator

Ladies and gentlemen, thank you for your participation. This concludes today’s conference call. You may now disconnect.