Earnings Call Transcript - WWD Q2 2026

Operator, Operator

Ladies and gentlemen, thank you for standing by. Welcome to the Woodward, Inc. Second Quarter Fiscal Year 2026 Earnings Call. At this time I would like to inform you that this call is being recorded for rebroadcast. Operator provided instructions. Joining us today from the company are Chip Blankenship, Chairman and Chief Executive Officer; Bill Lacy, Chief Financial Officer; and Dan Provaznik, Director of Investor Relations. I would now like to turn the call over to Dan Provaznik.

Dan Provaznik, Director of Investor Relations

Thank you, operator. We'd like to welcome all of you to Woodward's Second Quarter Fiscal Year 2026 Earnings Call. In today's call, Chip will comment on our strategies and related markets, Bill will then discuss our financial results as outlined in our earnings release. At the end of our presentation, we will take questions. For those who have not seen today's earnings release, you can find it on our website at woodward.com. We have included some presentation materials to go along with today's call that are also accessible on our website, and a webcast of this call will be available on our website for 1 year. All references to years in this call are references to the company's fiscal year, unless otherwise stated. I would like to highlight our cautionary statement as shown on Slide 2 of the presentation materials. As always, elements of this presentation are forward looking, including our guidance and are based on our current outlook and assumptions for the global economy and our businesses more specifically. These elements can and do frequently change. Our forward-looking statements are subject to a number of risks and uncertainties surrounding those elements, including the risks we identify in our filings with the SEC. These statements are made as of today, and we do not intend to update them except as required by law. In addition, we are providing certain non-U.S. GAAP financial measures. We direct your attention to the reconciliations of non-U.S. GAAP financial measures, which are included in today's slide presentation and our earnings release. We believe this additional financial information will help in understanding our results. Now I'll turn the call over to Chip.

Chip Blankenship, Chairman and Chief Executive Officer

Thank you, Dan, and good afternoon to all who are joining our Second Quarter 2026 Earnings Call. I'm pleased to report that Woodward delivered an exceptionally strong second quarter. Our team continues to execute with focus and discipline to meet ongoing robust demand across both our Aerospace and Industrial segments. Before we get into the results, I want to take a moment to acknowledge the complex global environment we're operating in. I'd like to thank our Woodward security professionals, our leaders and members in the region for their vigilance in keeping our team members operating in the Middle East safe. I also greatly appreciate our customers in the region for their collaboration on safety and coordination as we adjust projects that are underway there. While the safety of our team is our first priority, we're also closely monitoring broader geopolitical developments and how those might impact defense spending or airline traffic. If those impacts do occur, we expect them to be felt in fiscal 2027. Let me turn to a few financial highlights for the quarter. The second quarter marked a significant milestone for Woodward as we surpassed $1 billion in quarterly sales for the first time in our history. Sales increased 23% year-over-year reaching all-time highs in both Aerospace and Industrial. We also delivered margin expansion, including record quarterly adjusted earnings per share, up 34% from the prior year. These results reflect the strength of our end markets, the benefits of our strategic focus and the steady progress we're making in our operations. Our members' tremendous efforts and dedication to continuous improvement not only enabled us to deliver another quarter of outperformance, but also positioned us well for the second half of the year. While we are monitoring uncertainties in the geopolitical environment, we're raising our full year sales and earnings guidance based on our second quarter results and confidence in the remainder of 2026. Turning to our markets. Here's a breakdown of what's driving the robust demand in Aerospace and Industrial and what it means to Woodward. In Aerospace, commercial aircraft build rate increases are coupled with overlapping maintenance cycles of legacy and current generation fleets. In Industrial, we see power generation demand expressed in both power gen and oil and gas end markets. These market drivers create durable growth opportunities for Woodward. Our challenge in this environment is to continue to expand our capacity and that of our supply chain in ways that are well managed and resilient. We are doing the right work to achieve these outcomes. At times, however, we've seen demand outstrip our activities like dual sourcing projects or our additional test and procurement, installation and calibration, which are two real examples of what constrained output for us last quarter. In Aerospace, we saw expected growth in both commercial and defense OEM along with continued strength in commercial services. Legacy services activity remains solid, and we're seeing steady increases in volume for our control systems on LEAP and GTF engines. Shop inputs remained steady and we haven't seen any decreases as a result of airlines' recently announced capacity and utilization reductions. In Industrial, momentum continued across all our major markets, including oil and gas, transportation and power generation. Our ability to deliver on this robust demand reflects strong execution across the company. Moreover, our team is managing order growth, while simultaneously undertaking numerous critical projects to optimize our portfolio, strengthen our competitiveness and position Woodward for long-term growth. We remain focused on our value drivers: growth; operational excellence; and innovation. Our profitable growth pillar contains both organic and inorganic lines of effort along with selective divestitures and investments in capability, efficiency and capacity. These projects are changing the game in how we operate. They're also allowing us to focus on areas with the greatest potential to strengthen value creation. Our recent announcements reflect purposeful portfolio management decisions that our team has been working to activate over the last one to two years. In March, we closed the acquisition of Valve Research & Manufacturing, adding the premier designer and manufacturer of solenoids to the Woodward portfolio of control systems. These are critical enabling technologies for current and future aircraft with next-generation single-aisle platforms clearly in our sights. We also see opportunities related to Industrial Gas Turbine control systems; integration is progressing well as we welcome our new team members in Southeastern Florida. We also announced the sale of our Niles-based pilot controls product line to Ontic, a mutually beneficial transaction that will enable us to refocus resources. In addition, we communicated the relocation of servo valve production lines from our facility in Santa Clarita to Rockford. Rockford is our world-class servo technology design and manufacturing center where we intend to achieve the necessary quality and delivery improvements required for our customers and shareholders. In Industrial, our actions to wind down the China On-Highway product line remain on track and last-time buy volumes are reflected in our second quarter results. All of these actions streamline and strengthen our portfolio and sharpen our focus on our most attractive near- and long-term growth opportunities. These decisions allow us to serve customers better on our current book of business. By trimming product lines that don't have a path for us to be best-in-class and by moving work to where we can be more effective and efficient, we can focus on partnering with our customers to tackle their biggest challenges with their next generation of products. Our two biggest construction projects, Spartanburg and Glatten, are both on track. Our new facility in Spartanburg, which will be the location for Airbus A350 spoiler actuation systems, is on schedule. Walls are erected and floors are being poured as we speak. We are on target to be operational in 2027 and begin deliveries the following year. Our Glatten expansion to deliver more diesel fuel injectors for data center backup power is almost complete. We have moved over 100 machines within the new hall and legacy areas to perfect flow. Our teams have demonstrated the major achievement of small batch flow and customers will see substantial capacity increases with reduced lead times. This will translate into cost productivity and better inventory turns. While I've been vocal with many analysts and investors that Woodward has the facilities and capacity to support the ongoing power generation demand and data center accelerator to that demand growth, multiple customers have recently shared potential increases to their forecasts. We are working with our customers to evaluate the opportunities and capacity options. Shifting to growth in Aero MRO, the volume on LEAP and GTF is growing quickly. We continue to increase capacity at our Rockford and Prestwick sites with Kaizen activities focused on flow and turn time. We have added test and capacity at Rockford, and we are progressing with the expansion plans for Prestwick. As we've indicated in prior earnings calls, we have a strategy to perform repair and overhaul service in-house as well as through license providers that will deliver to OEM standards. This approach allows us to optimize our capital and internal resources and support our airline customers in the way they prefer to contract for maintenance and repair. It is a well-respected open maintenance model that we have refined to suit Woodward's strategy on LEAP controls components. Last week, we announced new partnerships at MRO Americas, including new licensed repair service facility agreements with Lufthansa Technik and Air France KLM as well as a new distribution agreement with AAR. We are thrilled to be partnering with industry leaders in MRO and material support. These partnerships expand our global service network, increase capacity and give airlines flexibility in how they contract for service. Moving to our operational excellence pillar. Investments in automation continue as we execute projects as simple as increasing the closed-door machining time as a total percent of the job and as complex as full assembly and test automation with vision systems and integrated inspection. We're also introducing repeat automation projects to additional sites, leveraging the automation lab in our Rock Cut facility. This lab was recently recognized by the Manufacturing Leadership Council as leading the way in manufacturing excellence. I see firsthand the results of continuous improvement nearly every day. I was recently visiting the industrial SOGAV value stream in our Fort Collins site and was impressed with an automated cell that allows one operator to manage three machines and turn a production bottleneck and staffing challenge into a high-speed machining cell that can outrun our current demand forecast. We need both capacity and productivity to achieve our goals in the long term. To us, it's equally exciting to create value for customers and for shareholders. As indicated by the list of projects I described above, our team is managing a high level of activity across the company, while at the same time, improving delivery to our customers and our financial results. We continue to invest in our people and our talent pipeline to make sure we have the engineering, manufacturing, business support and leadership needed to enable our growth trajectory. For example, we recently launched a rotational program to develop the next generation of Woodward leaders with the first cohort starting in June, yet another step to build a high-performing organization designed for the future. Turning to innovation. Innovation has always been and will continue to be a major competitive differentiator for Woodward. As I said last quarter, we're turning from pure technology development to more technology demonstration activities with our Aerospace customers. We have entered into collaborative agreements with many of our current customers to work together on trade studies and demonstration programs. This is an exciting time to be an innovator with a track record of industrialization. We will speak more about this trend at Investor Day late this calendar year, but you will see Aerospace R&D expenses beginning to tick up this year and more so in the years that follow as future aircraft timelines firm up. In Industrial, one focus is on a new actuation platform to provide precise fuel and error control on reciprocating engines that will deliver more customer value and is designed for a more efficient automated production system. It is more compact in size and produces a broader torque range than prior models, which allows us to simplify the product portfolio and use this platform in many applications. The product will enter service in 2027. Our priorities remain clear as we head into the second half of the year: meet OEM demand growth, deliver world-class service across our installed base, including legacy Aerospace, LEAP, GTF and Industrial Gas Turbine Systems and demonstrate customer value on key technologies to position Woodward for increased content on next-generation single-aisle aircraft. We are entering the second half of the year from a position of strength, and we'll continue to invest with discipline and focus to deliver long-term shareholder value. With that, I'll turn it over to Bill to take you through the financials in more detail. Over to you, Bill.

Bill Lacy, Chief Financial Officer

Thank you, Chip, and good evening, everyone. As Chip mentioned, Q2 was a strong quarter. Quarterly net sales exceeded $1 billion for the first time in Woodward's history coming in at $1.1 billion in the second quarter of 2026, an increase of 23%. The significant growth reflects strong demand and increased output in both Aerospace and Industrial. We achieved earnings per share in the second quarter of 2026 of $2.19 compared to $1.78. Adjusted earnings per share were $2.27 compared to $1.69. We generated $38 million of free cash flow in the second quarter. At the segment level, Aerospace segment sales for the second quarter of 2026 were $703 million, an increase of 25%. The strong growth was primarily driven by Commercial Aerospace. Commercial Services increased 36%, reflecting higher repair volume to support the continued high utilization of legacy aircraft as well as increased LEAP and GTF activity. In addition, spare LRU sales growth was strong in the quarter, with volume consistent with the previous two quarters. Commercial OEM sales were up 30% and we believe destocking is largely behind us as their output is now more aligned with current airframers' build rates. Defense OEM sales grew 9%, primarily due to increased JDAM pricing that took effect in the fourth quarter of 2025, and Defense Services grew 8%. Second quarter Aerospace segment earnings were $158 million or 22.5% of segment sales compared to $125 million or 22.2% of segment sales. While the strength in Commercial Services, higher commercial OEM volumes and solid price realization drove meaningful margin expansion, this was largely offset by planned strategic investments to support future growth and inflationary pressures. This reduced the Aerospace flow-through in the quarter, resulting in a net margin increase of 30 basis points. These strategic investments included enhancements to our manufacturing capabilities to deliver the content on current platforms, incremental R&D tied to early-stage efforts to compete for the next single-aisle aircraft platform and an enterprise-wide ERP upgrade. While these initiatives are impacting margins, they are critical to positioning the company for sustained long-term growth, and we expect these investments to continue. The flow-through in the full year 2026 Aerospace guide is expected to be at a targeted rate of approximately 30% to 35%. Turning to Industrial. Industrial segment sales for the second quarter were $387 million, an increase of 20%. Core Industrial sales, which exclude the impact of China On-Highway, increased 19% in the quarter, driven by higher volume, price and favorable foreign currency impacts. Marine Transportation sales were strong, increasing 34%, reflecting higher shipyard output and services activity. Oil and gas sales grew 18%, driven by higher volume, primarily related to greater midstream and downstream gas investment. Power Generation sales increased 7%. Excluding the impact of the prior year combustion business divestiture, Power Generation sales grew in the high teens on a percentage basis. This was driven by increasing data center demand for both base and backup power generation. Outside of our core Industrial business, China On-Highway sales were $29 million in the quarter. We expect approximately $30 million of sales in the third quarter and minimal sales in the fourth quarter. Industrial segment earnings for the second quarter of 2026 were $66 million or 17% of segment sales compared to $46 million or 14.3% of segment sales. Within our core Industrial business, margins were approximately flat at 14.7% of core Industrial sales, as strong price realization and higher sales volume were partially offset by inflation. In addition, margins were negatively impacted in the quarter due to a reserve for a product performance claim. Excluding the reserve, core Industrial margins would have been in line with Q1. The China On-Highway business added an additional 230 basis points of margin growth in the quarter. Nonsegment expenses were $45 million for the second quarter of 2026 compared to $27 million. Adjusted nonsegment expenses in the second quarter of 2026 were $38 million compared to $34 million. At the consolidated Woodward level, net cash provided by operating activities for the first half of 2026 was $205 million compared to $112 million, largely driven by higher earnings. Capital expenditures totaled $97 million for the first half of 2026. We continue to expect a meaningful increase in capital expenditures over the next two quarters consistent with our guidance for the full year. As Chip mentioned, construction of the Spartanburg facility to support future A350 production is progressing as planned. We remain on track to finish the building over the next few quarters and are beginning to purchase production equipment with the site expected to become operational in 2027. In addition, we continue to make strategic investments to support growth related to current platforms, including automation, preparing for increased LEAP and GTF service activity, our ERP upgrade and product line moves. We generated $109 million of free cash flow in the first half of 2026 compared to $60 million, driven primarily by higher earnings, partially offset by higher capital expenditures. As of March 31, 2026, debt leverage was 1.4x EBITDA. We continue to allocate capital according to our priorities, supporting organic growth, selectively pursuing strategic M&A opportunities and returning capital to shareholders through dividends and share repurchases. Regarding strategic M&A, we recently completed the acquisition of Valve Research & Manufacturing, consistent with our strategy of pursuing targeted, high return opportunities that enhance our capabilities and improve our position to compete for the next single-aisle aircraft. In addition, in line with our portfolio optimization efforts, we recently announced the divestiture of our pilot controls product line, which we expect to close by the end of the year. We are building a stronger, more focused Woodward as we invest in high-growth opportunities and expand in the right areas to position Woodward to create additional value for shareholders. In the first half of 2026, we returned over $355 million to stockholders through share repurchases and $36 million in dividends. Our strong balance sheet provides flexibility to move decisively as compelling opportunities emerge. Lastly, our fiscal 2026 guidance still assumes the return of between $650 million and $700 million through dividends and share repurchases. Turning to our 2026 guidance. Based on our strong second quarter performance and confidence in the second half outlook, we are raising our 2026 sales and earnings guidance. For 2026, we now expect the following: Aerospace sales growth between 21% and 24% with margins increasing to be between 23% and 23.5%; Industrial sales growth between 18% and 20%, with margins increasing to be between 18% and 18.5%. We now expect total Woodward sales growth between 20% and 23%, and adjusted EPS between $9.15 and $9.45. Free cash flow is still expected to be between $300 million and $350 million, and capital expenditures are still expected to be approximately $290 million. We expect to continue to maintain higher levels of inventory than previously anticipated as we prioritize to meet customer demand, while we strive for better alignment for the end-to-end supply chain. We have a number of inventory initiatives underway, which should drive improved free cash flow generation in 2027. We now expect our average diluted shares outstanding to be approximately 61.5 million. Adjusted effective tax rate guidance is unchanged. This concludes our prepared remarks on the business and results for the second quarter of fiscal year 2026. Operator, we are now ready to open the call to questions.

Operator, Operator

Operator provided instructions. And our first question comes from the line of Scott Mikus with Melius Research.

Scott Mikus, Analyst

On a sequential basis, your commercial aftermarket sales were up 12%. In the opening remarks, I think it was mentioned that the LRU volumes were roughly consistent with the prior two quarters. Since the quarter has ended, have you seen a drop-off in orders for spare LRUs? And are you concerned that if there is a broader slowdown in the aftermarket the amount of LRUs in the field could result in destocking pressures in the back half of this year or early in '27?

Bill Lacy, Chief Financial Officer

Yes, Scott. Let me jump on the front part of that and then Chip, maybe the second part. But as we head into third quarter, and as we've mentioned, these orders for these spare LRUs are rather short cycle, so we don't have a ton of visibility. But we're comfortable that sequentially, Q3 spare LRUs are in line with what we've seen in the first two quarters. And again, from a financial forecasting standpoint, tough to say what Q4 looks like currently. Chip, I don't know if you want to add?

Chip Blankenship, Chairman and Chief Executive Officer

Yes, we've certainly seen some airline signaling that they're removing a little bit of capacity. They're parking some planes. But none of the parking activity exceeds any of the forecasts that were already in play. And we haven't seen any drop-off in inputs to our shop for LRUs for repair. And we haven't seen any slowdown in the order rate for spare LRUs. There's always assumptions in the forecast, but we haven't seen any indications in our direct connections with customers to indicate that we're going to see a slowdown inside our fiscal year. That being said, we are obviously monitoring the situation at the higher level—geopolitical and macroeconomic. As far as what that means for FY '27, we'll all have to ride a little further along to see where that goes.

Scott Mikus, Analyst

Okay. And then a lot of energy infrastructure in the Middle East has been damaged in the ongoing conflict and it will need to be rebuilt. Just curious how you're thinking about that opportunity for your Industrial business. Are you receiving RFPs from your customers to support that reconstruction, fully understanding that that probably won't hit the P&L for next year, though?

Chip Blankenship, Chairman and Chief Executive Officer

I think we're a little bit further down in the supply chain to be seeing initial outreach on that for anything except service activity. So we have some ongoing projects, and a number of them are back up and running as far as service for our customers, be it on the valve-type equipment or on the electronic control systems for gas turbines and power plants. That activity is ongoing. Some of the things that need to be rebuilt as the customers and operators reach out to EPC-type companies will flow down to us and we haven't seen anything along those lines yet. But there'll probably be some opportunity.

Operator, Operator

And our next question comes from the line of Sheila Kahyaoglu with Jefferies.

Sheila Kahyaoglu, Analyst

We could focus on margins for both Aerospace and Industrial. So first on Aerospace, first half margins just under 23% with fiscal Q2 at 22.5%, yet you raised the full year to 23.5% at the high end. Can you just talk about what drives that second half margin expansion? What are the puts and takes?

Chip Blankenship, Chairman and Chief Executive Officer

Yes, I'll let Bill start there, and I'll jump in at the end.

Bill Lacy, Chief Financial Officer

So Sheila, we do continue to see good growth on the services side of the business. That helps our margin rates, while we continue to see the volume growth, which creates leverage. And then as we've been talking about, we've been investing and working hard on our lean activity and that work is paying off as we see the shipments increase. So those are some of the key things: continued good pricing in Aerospace and managing our inflation well. We're seeing that positive flow through to our bottom line as well.

Sheila Kahyaoglu, Analyst

Okay. And then maybe on Industrial core margins, they stepped down almost 300 basis points.

Bill Lacy, Chief Financial Officer

Yes, in Q2, we did have a reserve that we put up and that impacted Q2 margins for core Industrial. If you back that out, the margin rates are on the bottom line with what we saw in Q1, and we expect the second half to be more aligned to that—what we saw in Q1. Operationally, what we saw in Q2 we expect that to continue in the second half.

Sheila Kahyaoglu, Analyst

Yes. Maybe just—sorry, can you expand on what that product reserve was? What drove that? How big was it?

Chip Blankenship, Chairman and Chief Executive Officer

So it's simply a matter of a long-standing product development program with results that we see a little bit differently than our customer sees it. That's about all we'll be able to share at this time; it's a matter that's being undertaken through the legal process. So we're not going to comment much more on it.

Operator, Operator

And our next question comes from the line of Noah Poponak with Goldman Sachs.

Noah Poponak, Analyst

Chip, everyone is trying to figure out what's going to happen with Aerospace aftermarket. I guess as you described not really seeing much yet. I'd be curious to hear, given your experience in the market over a long time, why do you think you haven't seen anything yet? Why do you think the airlines are not responding that much yet? And when you talk about the possibility of there eventually being a response and seeing that in your fiscal '27—if it were to happen, what would make it happen? What's the threshold? Is it a higher fuel price? Is it the duration of fuel price, just what are your customers telling you? And then is there any way to frame or think about Woodward relative to the market because you have so much more content on newer products versus older product: if capacity is trimmed or things are retired out of the back end of the fleet, is it safe to assume you see much less of that than the average player in the space?

Chip Blankenship, Chairman and Chief Executive Officer

Okay, Noah, I may ask you for a repeat of the second half of the questioning, but I'll jump on the first half. I think you used the word duration, and I think that's the main question that is unanswered at this time in terms of what happens to fuel prices. My experience in situations like this is the reason things haven't happened very quickly from a negative standpoint is that there's still a strong traffic demand out there. And then the airlines that have decided to try to pass along price to the airline customer, that has not resulted in destruction of demand. I think everyone is kind of a little bit walking on eggshells, trying to see how much of this cost impact that airlines are seeing from oil prices can be passed on from passengers without reducing load factors on flights. They've taken some very smart decisions to take out some lower load factor mid-day, mid-week city pairs, and put some higher fuel-burning aircraft to the site. All those are prudent actions to look at what's going to happen next from a traffic standpoint. Demand is still strong. So I think people are continuing as they were with their maintenance programs. If the duration and the price of fuel continue to climb, then load factor breakeven points between city pairs is going to cause more planes to be parked and maybe there'll be some destruction of demand if prices go up too much. None of those ifs that I mentioned have happened yet. So I think it's business as usual, a little bit on the maintenance side. Some of our peers may seem like they're being a little more cautious with their quarterly results announcements. But if I remind everybody, we're halfway through our year. So we've got a little bit more in the rearview mirror already accomplished on the books, we've got a little less in front of us to ride on this duration question than our peers do. Second question, I think you asked was about what's specific for Woodward having higher content on the current generation of narrow-body, the higher technology fleet with better fuel consumption performance. I think from our standpoint, legacy narrow-body repair business continues to grow—much to my surprise—and we didn't forecast it growing quite as much year-over-year or quarter-to-quarter as it did in Q2. So things are still looking good on the legacy utilization front. But if we come to an oil shock that's even more severe and longer duration than we see right now, and if the newer technology fleet gets utilized much more than the older technology fleet, that happens to be good math for us. It's not good for the whole industry; we don't wish that on the industry. But if that does happen, we have a little bit of a hedge because we have a faster-growing, higher content position on that fleet.

Noah Poponak, Analyst

Okay. That is super helpful. I appreciate all that. And then just a follow-up on the Aerospace margin. Would it be possible to quantify the incremental investments you made in the quarter, just so we can all sort of keep tracking the underlying trend you've been experiencing there? And then on the pricing front, you guys have been providing kind of total company and then directional within the aftermarket pricing—any update you could provide on what happened there in the quarter?

Bill Lacy, Chief Financial Officer

On the first piece, Noah, we're focused on making sure that we've got the systems and the processes in place for us to continue to execute on our key imperatives. We are going to be diligent and thoughtful about how we increase that investment, not getting too ahead of the volume growth, but not being so far back that we can't execute on it. As you can see, there's still margin expansion that we're looking for in the results based off of our guide. I think we're being responsible and reasonable with how we are increasing the spend as it relates to those strategic projects.

Chip Blankenship, Chairman and Chief Executive Officer

I'll add that we have increased our R&D spend a little bit in Aerospace. Much of that is aimed at the preparation, the technology demonstration projects. We're working with our customers. We've invested in manufacturing engineering to accelerate our automation journey, which also feeds how we will industrialize for the next single-aisle aircraft components that we win. And we've been building that plant in South Carolina and are starting to staff up there some of our very key positions like plant leader and value stream leaders and some advanced manufacturing engineers. Some of these are longer-term investments; some of the automation investments will provide returns sooner, but some of the staffing up we're doing and the R&D expenses are really aimed towards the next generation.

Bill Lacy, Chief Financial Officer

And on price, Noah, price in the quarter was around 6.5% to 7% and that's roughly what we projected for the total year, with Aerospace being a little bit stronger on the price side than Industrial.

Operator, Operator

And our next question comes from the line of Gavin Parsons with UBS.

Gavin Parsons, Analyst

What drove the Aero revenue guidance raise between the subsegments? And then within aftermarket, how much of that is the spares provisioning drop-in versus repair and overhaul work?

Chip Blankenship, Chairman and Chief Executive Officer

Without getting quantitative about it, I'd say that Commercial Services is really the largest piece of the increased revenue gain. We had forecast OEM to be growing substantially and maybe hedged it back a little bit in terms of how we were thinking about it based on what the aircraft and engine OEMs would actually come through with orders and sort of meter us to. But it's been a little bit more on the demand side from the OEM. So it's driven a bit of the gain in the forecast guide, but Commercial Services, looking in the rearview mirror, we think that will sustain at least through Q3, as Bill said, with the higher LRU orders. Repair is strong across the board in commercial services—wide-body, legacy narrow-body, regional and the LEAP, GTF all contributing to revenue and earnings growth.

Bill Lacy, Chief Financial Officer

Gavin, the raise in the guide was partly recognized in the strong Q2 performance, but also in expected second half performance. Commercial OEM and defense OEM on the Industrial side—much of that OEM growth, especially in Q4, is expected to grow nicely, and that's a big part of the raise for the second half. That has a different flow-through pattern than the services we saw in Q1 and Q2.

Gavin Parsons, Analyst

Okay. That's very helpful. And then, Chip, you pointed out that airlines are maybe sidelining some of the least fuel-efficient aircraft. I think over the long run, you guys have talked about flight hours as being the key metric driving your aftermarket growth. But if it's those older, less fuel-efficient aircraft being sidelined, is the risk going forward more about accelerated permanent retirements, delayed shop visits or maybe cut shop visit scope?

Chip Blankenship, Chairman and Chief Executive Officer

If you're talking about the legacy fleet, certainly the risk is about retirement and part-out and not getting another shop visit on our LRU, whether it's a V2500 fuel control or CFM56-5 HMU. That risk is the end-of-life risk for the oldest part of that fleet. Many airplanes are still quite capable assets. Airlines are going to continue to fly, so flight hours will still correlate with how that equipment comes off and comes in for shop visits with us. The end of life for the oldest A320s will be driven by a combination of traffic demand, price of fuel and OEM delivery rates, and we'll monitor that closely.

Operator, Operator

And our next question comes from the line of Peter Skibitski with Alembic Global.

Peter Skibitski, Analyst

Great quarter. I just want to circle back to Sheila's question on Industrial margin. I want to think about the right way to think about it going forward. If we exclude the provision in Q2, it sounds like you're maybe a tad over 17% on Core Industrial margin in the first half. With the new guide, you get a boost in Q3 from China On-Highway, but then nothing in Q4. It seems like you'd still be exiting around 18% or so in Q4. So is the right way to think about it that 18% to 18.5% is a reasonable range for 2027, or maybe 17.5% at the low end? Or is there any logic wrong there?

Bill Lacy, Chief Financial Officer

I'm really happy about 2026 and where that stands, Pete, and I think how you laid it out is reasonable. We continue to work hard on margin and productivity initiatives. We'll be talking more about that soon. If we consider ourselves in the middle innings on this, there's still work to do on productivity and growing the service franchise; we'll see how it plays out for 2027.

Peter Skibitski, Analyst

Okay. Fair enough. Just one follow-up. On the pilot controls product line sale, is it fair to conclude that this product line has less aftermarket than the engine portion of aerospace? And so I'm wondering if the divestiture is sort of margin accretive for you in Aerospace? And how much revenue is involved in that product line?

Chip Blankenship, Chairman and Chief Executive Officer

We won't share the revenue specifics there, but it's not super significant. It is accretive to carve that out for us. That's one of the criteria we would use to examine a divestiture opportunity. In our strategic review process, we identified this as an area where we'd have to put a lot more resources into becoming a leader. Where we are a leader is in enabling technology components and subsystems that go into pilot controls like throttle quadrants—precise motor controls, motors themselves, sensors, LVDTs and hall-effect sensors. We'll remain a supplier of those components to the company we're selling the main business line to. It was a difficult call, but it's accretive to let it go.

Peter Skibitski, Analyst

Okay. So Niles will remain open. There are more production areas there than the pilot controls, that's right?

Chip Blankenship, Chairman and Chief Executive Officer

Yes. This was a relatively small value stream in the Niles facility.

Operator, Operator

And our next question comes from the line of David Strauss with Wells Fargo.

David Strauss, Analyst

Chip, I think if I caught it correctly in your prepared remarks, you talked about additional step up in interest from your IGT customers and the potential that you might be looking at some sort of capacity expansion to be able to handle that interest. Did I get that right? And maybe if you could expand on that?

Chip Blankenship, Chairman and Chief Executive Officer

Yes, not just our IGT customers. Gas turbine, reciprocating engines, diesel-powered and natural gas-powered backup and prime power applications—across the board multiple OEMs in each of those categories have come to us and said they want capacity studies for forecasts between now and 2030-plus. We've been digesting those requests. It's not one customer; it's not one technology, but it's largely driven by data center power generation demand. I've been meeting with investors and analysts and said we have the footprint and the ability through Kaizen, continuous improvement, elimination of waste, lead time reductions, to solve for the capacity that's needed. This new later-breaking information says we may need to consider capacity increases.

David Strauss, Analyst

Okay. We'll check back in on that later wherever you come out. If I missed it, I apologize. Did you talk about where LEAP and GTF aftermarket revenue volumes are relative to legacy at this point and where the crossover point is?

Chip Blankenship, Chairman and Chief Executive Officer

I didn't mention it in the prepared remarks, but it's a question we discuss frequently. As we grow LEAP significantly, the legacy narrow-body fleet continues to provide inputs to our shop, and we're seeing legacy fuel control units grow at a good clip as well. We're not changing the forecast right now—we still expect the crossover around end of '26 into '27 as a reasonable assumption. A fuel price shock could change that. Right now, this quarter and last quarter, the total amount of service revenue is about the same for LEAP/GTF compared to the legacy narrow-body, if you include spare LRU items. So from a repair standpoint, the crossover is a few quarters out, but we're already in very similar numbers from LEAP/GTF compared to V2500 and CFM56-5 when including all service products.

David Strauss, Analyst

That's great. You predicted my next question or follow-up question.

Operator, Operator

And our next question comes from the line of Ken Herbert with RBC Capital Markets.

Ken Herbert, Analyst

I wanted to follow up on the free cash flow guide. It didn't change with the sales and EBIT increases. Is that just reflecting higher working capital spend or working capital as a percent of sales? Is that the right way to think about it? Or is there anything else impacting free cash flow?

Bill Lacy, Chief Financial Officer

Ken, that is the right way to think about it. Simply stated—higher inventory levels as we prioritize meeting customer demand impacts free cash flow in the near term.

Ken Herbert, Analyst

Okay. That's helpful. I wanted to follow up on the announcements with Lufthansa Technik and Air France KLM. How quickly will those scale as third-party MRO providers? Should we expect movement of spare parts or inventory in the next few quarters as they ramp?

Chip Blankenship, Chairman and Chief Executive Officer

The rate-limiting step for our licensed service providers is getting test stands procured, installed and calibrated. That's typically nine to twelve-plus months away depending on procurement cycles. So it's not a 2026 ramp. We'll provide more color on how these partners will affect our Service business at Investor Day late in the calendar year.

Operator, Operator

And our next question comes from the line of Christopher Glynn with Oppenheimer.

Christopher Glynn, Analyst

Have you evolved any different angles on visibility to the China LRU markets?

Chip Blankenship, Chairman and Chief Executive Officer

As far as new angles, not really. We're starting to see more across the board based on airplane deliveries—customers ordering spare LRUs to provision for their fleet operations and maintenance cycles. I think we can take the China moniker off the table for now; orders are coming from Europe, the U.S., Latin America and others, reflecting how many planes customers have.

Christopher Glynn, Analyst

Okay. And on the L'Orange model, do they have much military exposure? I suspect they do. I don't think your guided missile destroyer program was L'Orange, but rather your Power Gen business. I wanted to check on the military business pipeline overall for Industrial and whether it resides or doesn't within L'Orange?

Chip Blankenship, Chairman and Chief Executive Officer

I would consider L'Orange to be essentially commercial. It's not something we consider significant from a military standpoint. For the DDG class destroyers powered by gas turbines, both for propulsion and onboard power gen, that's the business we participate in: electronic control systems for controlling power from the gas turbine and propulsion systems.

Operator, Operator

And our next question comes from the line of Louis Raffetto with Wolfe Research.

Louis Raffetto, Analyst

Maybe, Bill, just on China On-Highway: you said $30 million of sales in Q3. Should we expect to see similar profitability levels that we saw in the last two quarters?

Bill Lacy, Chief Financial Officer

For Q3, that's correct operationally. I do want to highlight that there will be a restructuring charge that flows through as we go through the quarter, so you'll see that separately.

Louis Raffetto, Analyst

Okay. And, Chip, coming back to what you mentioned about the LRUs: as you get to fiscal fourth quarter, you're coming up on a tough comp. Are the LRU sales you saw this quarter China-driven or is it one big global bucket now?

Chip Blankenship, Chairman and Chief Executive Officer

I'm saying the latter—there's really not a China bucket anymore. Earlier step-ups in LRU sales were driven by China-specific orders, but recent orders are spread across Europe, the U.S., Latin America and other regions. We largely have LRU orders in hand for Q3 with a good mix of customers, so less risk of nonrepeat. Visibility into Q4 is normal for this point in the year—it's not fully clear who will order and how much—but we have confidence in our OE and Service levers across both segments to support our guide.

Operator, Operator

And our final question comes from the line of Gautam Khanna with TD Cowen.

Gautam Khanna, Analyst

Could you quantify what the guidance revision was for just China On-Highway relative to the prior outlook?

Bill Lacy, Chief Financial Officer

We didn't take a material guide change specifically for China On-Highway. At the beginning of the year, we estimated it around $60 million, and with what we've had and the last-time buy, it will probably be somewhere around $90 million in total. That was sort of within the range of our guide, and that's how we handled it.

Gautam Khanna, Analyst

Okay. And in terms of profit variance, when you had the $60 million, what was the expected profit? And then if it's $90 million, what's the new expected profit?

Bill Lacy, Chief Financial Officer

We talked about at certain levels it starts to go beyond breakeven and then it flows through quickly. We are at that point, and that's what sort of generated—this quarter China On-Highway was worth about 230 basis points to the overall Industrial earnings increase.

Chip Blankenship, Chairman and Chief Executive Officer

I would emphasize that China On-Highway wasn't really driving the revision to overall guidance. It's more the success we've had in the first half with Commercial Aero services and continued strong OEM in both segments.

Gautam Khanna, Analyst

To Pete's earlier question on Industrial underlying margins over time, how far along are you guys in the process of deciding which SKUs to stock, which to retire—operational turnaround within Industrial? How far along are you in that journey, and do you have any ballpark sense for where margins ultimately can get to in that segment?

Chip Blankenship, Chairman and Chief Executive Officer

I've said before we're in the early innings, but honestly I feel we're in the middle innings in the industrial portfolio rationalization. The team has pulled together and made difficult decisions. You see the China On-Highway exit; that was a difficult call. Some product lines we've exited were difficult calls around small engines and other areas. We're introducing a standard disciplined product management approach. For example, I discussed an actuator in my prepared remarks entering service in 2027, now in test phase; industrializing it will replace a complicated portfolio of actuation for reciprocating engines. We're creating a more efficient factory, more resilient supply chain, and customers get more value from a broader torque range and lower form factor. That's the kind of work going on in Industrial. That's why I say we're in the middle innings—moving from deciding what to stop and what to keep, to refining the approach where we want to compete.

Bill Lacy, Chief Financial Officer

To add, we're focused on recouping our service franchise in Industrial. We have a plan and we'll see the art of the possible. The other piece of margin expansion will be how we grow that service franchise. We'll talk more about this at Investor Day and what's possible for Industrial margin rates.

Operator, Operator

Mr. Blankenship, there are no further questions at this time. I will now turn the conference back to you.

Chip Blankenship, Chairman and Chief Executive Officer

Thank you. I'd just like to thank everybody for joining our Q2 call and look forward to talking to you again soon.

Operator, Operator

That concludes our conference call today. A rebroadcast will be available at the company's website, www.woodward.com for one year. We thank you for your participation in today's conference call. You may now disconnect.