Earnings Call Transcript
Woodward, Inc. (WWD)
Earnings Call Transcript - WWD Q2 2024
Operator, Operator
Ladies and gentlemen, thank you for standing by. Welcome to the Woodward, Incorporated Second Quarter Fiscal Year 2024 Earnings Call. This call is being recorded for rebroadcast. Joining us today from the company are Chip Blankenship, Chairman and Chief Executive Officer; Bill Lacey, Chief Financial Officer; and Dan Provaznik, Director of Investor Relations. I would now like to turn the call over to Dan Provaznik.
Daniel Provaznik, Director of Investor Relations
Thank you, operator. I'd like to welcome all of you to Woodward's Second Quarter Fiscal Year 2024 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 the 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 again included some presentation materials to go along with today's call that are also accessible on our website. An audio replay of this call will be available by phone or on our website through May 13, 2024. The phone number for the audio replay is on the press release announcing this call as well as on our website and will be repeated by the operator at the end of the call. I would like to refer to and highlight our cautionary statement as shown on Slide 2. As always, elements of this presentation are forward-looking or based on current outlook and assumptions for the global economy and our businesses more specifically. Those 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, Woodward is 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 and related schedules. We believe this additional financial information will help in understanding our results. Now I will turn the call over to Chip.
Charles Blankenship, CEO
Thanks, Dan. Today, prior to my commentary on our company's financial performance, I want to start with safety, which is how we normally begin our operating meetings. In our industry, we must wake up every day thinking about safety and how to sharpen our safety culture. While Woodward has a strong, even world-class safety record, there's always room to improve. As I've shared previously, we prioritize our work in the order of safety, quality, delivery and cost. Delivery and costs are incredibly important, but we stop our work if there's an unsafe condition. And it is not acceptable to pass along a defect to meet a product delivery goal. This disciplined order of battle is ingrained in our operational culture. At the same time, as we aspire to zero safety incidents due to the existence of layers of protection and zero quality escapes due to a thorough understanding of built-in quality of the source, we know there are opportunities to improve. One way we're enhancing the safety culture at Woodward is through the rollout of Human and Organizational Performance, also known as HOP, an approach that builds an engaged, proactive workforce focused on preventing errors and providing for fail-safe outcomes. Key tenets of HOP are that the absence of a significant event and low energy rates do not mean a company has a robust safety program. In my prior experience leading HOP implementations and seeing them in action, I know it's a game-changing system. As a simple example of HOP in action, a few years ago, I visited an aluminum-rolling mill facility with a mature HOP system in place and was told my visit was the high-risk task of the day for the site, not because I'm inherently dangerous, I hope, but because my presence was a distraction and represented a significant interruption to the normal work patterns. It's partly this keen awareness of human interaction with the environment that makes this system so effective and why we've chosen to implement it at Woodward. Last week, during a management and board visit to our Glatten facility in Germany, I asked the value stream leader in the pump fuel assembly area what the high-risk task of the day was. Without leading the witness, he said, 'This tour.' I was pleased with our progress. Following a successful launch of HOP at our Rock Cut plant last year, we're making progress across our other sites and have accelerated certain aspects of this system to all plants this year, including fatality and serious injury prevention assessments and gap closure projects. The fatality and serious injury approach, FSI for short, focuses on key risks inherent to manufacturing, assembly and test operations. In pursuit of excellence, Woodward has aggressive targets to reduce quality escapes to customers. Our commitment to quality is essential to support OEMs and their customers' own goals for safe and reliable operation. As an error reduction methodology, HOP provides tools to help members reduce errors that could impact delivered quality. This is not just a quality function responsibility. It's everyone's job. We have conducted quality standdowns to support members and to emphasize our dedication to getting it right. Additionally, we have embarked upon enhanced rigorous training in areas such as quality management systems, metrology, problem solving and HOP. I'm pleased to see how members embrace these methodologies in their daily work, and we want to continue building a culture where they feel empowered to raise issues and help resolve them. Next, I'd like to provide a brief update on strategic planning. We recently performed a deep dive into the R&D and CapEx investments necessary to meet near-term financial commitments, prepare for the next single aisle aircraft program and prepare for our critical role in the energy transition. My leadership team and I spent time studying innovation roadmaps with our aerospace and industrial businesses and technology teams and with our nine Woodward innovation network teams, who work on breakthrough technologies, in some cases, leveraging innovation breakthroughs across our two business segments. I'm pleased with our progress on optimizing both the focus and the breadth of our R&D portfolio to ensure Woodward's competitiveness and unique value proposition to our customers' future products. On the CapEx front, we continue to explore additional automation investment opportunities with strong calculated returns inside the planning horizon. Moving forward on these calls, I'll continue to touch on topics like these related to our interconnected value drivers of growth, operational excellence and innovation. And I hope you'll find them interesting. Turning to our results. We delivered significant sales growth and margin expansion year-over-year across both our Aerospace and Industrial businesses. The compounding impacts from our focused efforts on operational excellence are enabling us to capitalize on continued strong end market demand. While there is still more work to do, I am proud of our team's efforts and dedication. Moving to our markets. In aerospace, we continue to see strong commercial airline, domestic and international passenger traffic, resulting in high aircraft utilization. Transatlantic traffic remains strong. Further increases in aircraft utilization are expected as international passenger traffic in Asia Pacific continues to recover. While the overall macro environment remains strong, we are monitoring OEM build rate dynamics and modeling potential impacts on our business so we can actively manage these risks. In defense, recent escalation in geopolitical tensions is driving increased demand as U.S. and foreign militaries look to replenish inventories. The amount of government R&D proposals and procurement dollars available are rising, and suppliers are ramping up to meet this demand. In industrial, rising global power demand is driving increased investment in gas-fired power generation for both prime and backup power, which is attributed to global development, primarily in Asia. Data center demand for backup power, which is primarily diesel-fueled reciprocating engines, appears to be growing sharply. And the outlook for capacity-firming applications supporting renewable energy and grid stability remains optimistic. In transportation, the global marine market remains healthy with elevated shipbuild rates driving OEM engine demand and high utilization rates fueling current and future aftermarket activity. Demand for alternative fuels across the marine industry continues to increase. Demand for natural gas heavy-duty trucks in China has been strong. While the mix of heavy-duty truck production in China has been trending towards natural gas engines, recent discussions with our customers indicate there may be a softening in demand this summer and potentially a return to the stronger demand towards the fourth quarter of calendar 2024. We continue to monitor the economic environment and the durability of this demand and remain in close contact with our customers in China. Regarding oil and gas markets, uncertainty in the United States for LNG exports continues as application reviews remain on pause, although global demand outside of the United States remains strong. Positive sentiment in this space is driven by strong performance and outlook in domestic shale oil as well as refining and petrochemical activities in China and India. In summary, ongoing market trends indicate strong and sustained demand. Our second quarter performance reflects the hard work and dedication of Woodward members and the progress we've made to strengthen our value proposition and fulfill our purpose. We believe we are well-positioned to capitalize on current and future opportunities, and we remain focused on driving profitable growth, operational excellence and innovation to enhance shareholder value. I'll now turn it over to Bill to share our financial results.
William Lacey, CFO
Thank you, Chip, and good afternoon to everyone. As a reminder, all comparisons are year-over-year unless otherwise stated. Net sales for the second quarter of fiscal 2024 were a record $835 million, an increase of 16%. Earnings per share and adjusted earnings per share for the second quarter of fiscal 2024 were $1.56 and $1.62, respectively, compared to earnings per share and adjusted earnings per share of $0.58 and $1.01, respectively. Aerospace segment sales for the second quarter of fiscal 2024 were $498 million compared to $437 million, an increase of 14%. Commercial OEM and aftermarket sales were up 15% and 18%, respectively, driven by increased aircraft utilization as a result of continued growth in passenger traffic and price realization. Defense OEM sales were up 4%, and defense aftermarket sales were up 17%. Aerospace segment earnings for the second quarter of 2024 were $98 million or 19.8% of segment sales compared to $73 million or 16.8% of segment sales. The increase in segment earnings was primarily a result of higher volume and net price realization. Turning to Industrial. Industrial segment sales for the second quarter of fiscal 2024 were a record $338 million compared to $281 million, an increase of 20%. We saw growth in transportation, up 46%. Empowered generation increased 14%. These increases were partially offset by a 16% decrease in oil and gas. Sequentially, oil and gas sales were up 7%. The increase in transportation sales was primarily led by on-highway natural gas trucks in China, which totaled approximately $65 million in the second quarter, driven by significantly higher demand compared to the prior year quarter. Although we saw a significant increase year-over-year, China on-highway sales were lower sequentially as expected. Given the market dynamics Chip mentioned, in Q3, we don't expect the same run rate that we've seen over the past several quarters. For the third quarter, we are expecting a range of $35 million to $40 million of China on-highway sales. As we move into the second half of our fiscal year, we expect Industrial sales growth rates to moderate, given the high comps in the back half of fiscal 2023. Industrial segment earnings for the second quarter of 2024 were $65 million or 19.3% of segment sales compared to $38 million or 13.4% of segment sales. The increase in Industrial earnings was a result of higher volume, largely due to the heightened demand for our China on-highway business, net price realization and operational improvements, including increased output and efficiency gains. Excluding the impact of the China on-highway natural gas truck business, Industrial segment margins were in line with the first quarter at approximately 14%. Nonsegment expenses were $33 million for the second quarter of 2024 compared to $58 million. Adjusted nonsegment expenses for the second quarter of 2024 were $29 million compared to $23 million. At the Woodward level, R&D for the second quarter of 2024 was $36 million or 4.4% of sales compared to $38 million or 5.3% of sales. SG&A for the second quarter of 2024 was $81 million or 9.8% of sales compared to $76 million or 10.5% of sales. The effective tax rate was 19.1% for the second quarter of 2024 compared to 11.8%. The adjusted effective tax rate was 19.3% for the second quarter of 2024 compared to 17.8%. Looking at cash flows. Net cash provided by operating activities for the first half of fiscal 2024 was $144 million compared to $40 million. Capital expenditures were $56 million for the first half of fiscal 2024 compared to $44 million. Free cash flow was $88 million for the first half of fiscal 2024 compared to negative $4 million. Adjusted free cash flow for the first half of fiscal 2024 was $90 million compared to negative $1 million. The increase in free cash flow and adjusted free cash flow was primarily due to increased earnings, partially offset by higher capital expenditures. Leverage was 1.2x EBITDA at the end of the second quarter compared to 2.2x EBITDA. $28 million was returned to stockholders in the form of dividends in the first half of fiscal 2024. Lastly, turning to our fiscal 2024 guidance. Based on visibility into the third quarter demand for the China on-highway natural gas truck business and anticipated improved operational performance in the second half of fiscal 2024, we are raising certain aspects of our full year guidance. Total net sales for fiscal 2024 are now expected to be between $3.25 billion and $3.35 billion. For fiscal 2024, Aerospace sales growth is now expected to be 12% to 14%, and segment earnings are still expected to be 18% to 19% of sales. For fiscal 2024, we now expect Industrial sales growth to be 13% to 15%, and segment earnings to be 17% to 18% of segment sales. At the Woodward level, the adjusted effective tax rate is now expected to be approximately 20%. We expect adjusted free cash flow to now be between $325 million and $375 million. Capital expenditures are still expected to be approximately $100 million. Adjusted earnings per share is now expected to be between $5.70 and $6 based on approximately 62 million fully diluted weighted average shares outstanding. This concludes our comments on the business and results for the second quarter 2024. Operator, we are now ready to open the call to questions.
Operator, Operator
And your first question comes from David Strauss with Barclays.
David Strauss, Analyst
Your increased guidance on the Aerospace division, moving from 10% to 14% and now to 12% to 14%, what is that due to? Is it related to the OE aftermarket? Chip, could you provide an update on your current position regarding MAX rates and 787 rates?
Charles Blankenship, CEO
Yes. So taking the second one first, because I think it's a really relevant question, I think we might hear a couple of different ways today. As I've said before, we don't really clock our business to exactly the build rate, that we're in very close connection with all of our customers that lead us to the MAX, so whether it's an engine supplier or another integrator. We are just responding to the exact signal that we get from those sources. And we're in close contact with them and having discussions about the necessity for, at some point, the amount of material flow to probably reduce. But as of now, we haven't seen any strong signals that reduce the rates within the next quarter. We think that our fourth quarter and early '25 is when we would see adjustments potentially. And you saw Boeing said they're working sort of supplier by supplier to make sure that they've got clear to build and visibility to where they want to go. So we think there's potential risk to having lower MAX-related volume in the fourth quarter, but that's built into the guidance that Bill shared.
David Strauss, Analyst
Okay. And the change in your guidance? And then I know it's only a slight change, but what's that attributable to? And then a quick follow-up on LEAP. We're starting to see shop visits on LEAP. Are you seeing any aftermarket activity yet on your LEAP business?
William Lacey, CFO
For Chip, it's LEAP. The tightening is based on what we've observed in the first half for Aero, and we'll continue to refine our forecast with half a year remaining. We expect tighter visibility in the Aerospace range. The OEM sector continues to perform well, and the aftermarket is also stable. That’s why we are adjusting our forecast to 12% to 14%.
Charles Blankenship, CEO
Yes. I'd say just a little more confidence that the low end of the range is not going to be what we're going to see. We're going to see the middle to up, and that's why we tightened it up to 12% to 14% on the range. As far as LEAP, yes, we are seeing some material flow, FMUs, some fuel pumps, things of that nature from the LEAP engine, not a lot. Obviously, a lot of those early visits are more check and repair and specific item-related. But every once in a while, we do see a removal that we've had the opportunity to test our R&O shop layout and capability that we've laid in place.
Operator, Operator
And we will take our next question from Scott Deuschle with Deutsche Bank.
Scott Deuschle, Analyst
Bill, can you say what the price realizations were this quarter and how that splits between the segments?
William Lacey, CFO
Yes. Scott, we continue to see excellent price activity that helps us counter the inflation we're experiencing. It will be around just below 8% price realization at the company level. I can also mention that each segment played its part in achieving that overall result.
Scott Deuschle, Analyst
Okay. And then Chip, it looks like you ended the quarter with about $317 million of cash on the balance sheet, and you didn't buy back any stock this quarter. I guess the question is, does this reflect the change in your capital allocation priorities? Or are you still planning on buying back more stock in the back half of the year?
Charles Blankenship, CEO
Yes. It does not reflect a change. Actually, a lot of timing and other decisions in the mix there for the second half, though I will say that we are raising the priority of the buyback in our capital allocation strategy. Definitely want to offset dilution and make some progress on that and return some cash to the shareholders.
Scott Deuschle, Analyst
Okay. And last question, Chip, is there anything you can say about your content on this power JDM variant that Boeing is working on?
Charles Blankenship, CEO
Not at this time.
Operator, Operator
And we will take our next question from Robert Spingarn with Melius Research.
Robert Spingarn, Analyst
So Chip, when a new CEO or CFO joins, it's common to introduce a lean program or another operating system, which can take time to yield results. You've experienced strong outcomes so far, so I wanted to ask how that's unfolding. Additionally, could you clarify why you're seeing quicker progress compared to others? Also, Bill, is there a way for you to differentiate how much of the improvement in performance and margins comes from lean initiatives and execution versus factors like price and volume?
Charles Blankenship, CEO
So I guess I'll start with the first question. Woodward has been on a lean journey for about eight years, and it has evolved over time in terms of focus. When I joined, along with a few others, we built on the existing foundation. A lot of the terminology and understanding were already in place. The main challenge we face is not from our experienced team members but rather from the number of new people on the team. This is our challenge in both our production facilities and our production system: helping new employees and frontline leaders adapt and ensuring expectations are clear. As mentioned, it's a lengthy process. We have managed to stabilize parts of our supply chain and increase output in several plants, but there's still considerable variation in performance regarding on-time delivery and productivity across different plants. There's still much work to be done, and we see significant potential for improvement over the next two to three years, particularly as we enhance inventory turns and make our production lines more efficient.
William Lacey, CFO
Yes, Rob, I find it challenging to break that down. However, the margin expansion has certainly benefitted from our focus on pricing, and our operational efficiency has enabled us to enhance our output. We are experiencing margin growth due to our capacity to translate that into increased volume. Regarding lean initiatives, as Chip pointed out, we are in the process of implementing them, and I believe there are many more opportunities to explore in the years ahead. Effective execution, along with strong pricing and volume, has significantly contributed to our margin expansion.
Robert Spingarn, Analyst
I know people often say that lean is an ongoing journey. Based on what you both just mentioned, Chip indicated it might take 2 or 3 years to mature. Can we define what stage we are at with lean?
Charles Blankenship, CEO
I think we're in the early innings. So it's kind in 2 or 3 year. We've got a lot of things to work with in terms of our ability to improve and get more out of our production system.
Robert Spingarn, Analyst
Okay. And then just one more quick thing. Woodward has typically spent about 6% of sales on R&D, but recently it's been a bit below that, around 4% or the low 4s. Looking ahead, what is the appropriate amount to spend and where are you focusing your R&D efforts?
Charles Blankenship, CEO
Sure. As you probably know, we operate in long-cycle businesses in both the Industrial and Aerospace sectors. When new product opportunities arise, such as launching a new industrial engine, gas turbine, or airplane, our R&D spending increases due to the extensive work required for designing, developing, testing, and certifying these new products. Currently, we don't have much of that activity taking place. We have a few components related to missiles and space, some P2X renewable fuel opportunities in Industrial, and the large ZEROe Airbus fuel cell demonstrators. We are engaged in various technology development and smaller customer product development projects, but there aren't any major platforms in progress with customers. This situation has allowed for some reduction in R&D spending. However, our net engineering expenses have increased as we've allocated engineers to enhance production and productivity through lean initiatives. It's not that we are investing less in our products, people, and future; rather, we are reallocating funds to different areas based on current needs.
Operator, Operator
And we will take our next question from Gavin Parsons with UBS.
Gavin Parsons, Analyst
Guys, on the Industrial guidance revision, can you parse out how much of that was China truck versus non-China truck?
William Lacey, CFO
Yes. In general, Gavin, we recognize that China's on-highway volume in the third quarter, along with our non-on-highway performance in the first half, indicates we expect consistency moving forward. This combination is what prompted us to raise our Industrial guidance.
Gavin Parsons, Analyst
Okay. I think non-OH might have had some mix or pull forward in the first quarter. Is that, to your point, still going to be a sequentially stable margin in the back half?
William Lacey, CFO
Yes. We believe that, that will be sequentially stable.
Charles Blankenship, CEO
Yes. We're working with our customers. What we anticipated for the future based on customer feedback did not happen as we expected. The shift in mix between the first half and the second half did not materialize, so that has contributed to the change in our guidance as well.
Gavin Parsons, Analyst
Okay. That's helpful. And then maybe just in China on-highway going out to 2026. The guide doesn't have much in there. Is there a way to either expand the geographic base of that technology or maybe expand that technology into different engine types? Or any way to think about dampening the revenue unpredictability?
Charles Blankenship, CEO
We're really evaluating a lot of different ideas to dampen the revenue volatility, Gavin. So we're looking at different regions. We're looking at like how much we want to invest, how much do we want to have that be a part of our portfolio from that standpoint. If we grow it, it might be more volatile. So we're in the strategic planning phase, looking at the next three years right now, and that team is actively bringing forth different scenarios or ways to grow that business but also to potentially, as you're saying, make it less volatile by spreading the customer base, the regional base and other plays like that. So early days on that. You'll hear more from us later on it.
Operator, Operator
And we will take the next question from Louis Raffetto with Wolfe Research.
Louis Raffetto, Analyst
Could you quickly clarify if you have the sequential data for the other businesses in the Industrial sector, given that oil and gas is up 7%?
Charles Blankenship, CEO
So transportation is flattish sequentially. I'm looking at the red thing.
William Lacey, CFO
You're right. Yes. You're right.
Charles Blankenship, CEO
And then power generation is up, say 7%, 8%, maybe high single digits.
William Lacey, CFO
Right.
Louis Raffetto, Analyst
Okay. Great. Bill, could you clarify if there was anything exceptional in Aerospace? It performed well, but I want to understand how it correlates with the second quarter results and the outlook for the remainder of the year. It seems like margins might decrease by about 100 basis points. Is there a specific reason for that or is it just a cautious estimate?
William Lacey, CFO
Yes, I’d like to build on your last point. We are certainly considering conservatism as we evaluate the current situation. The first half has concluded with Aero at approximately 18.5% between the first and second quarters, suggesting that the second half should mirror the first half. We experienced some strong service sales and a favorable mix in the second quarter, and we expect to maintain a solid Aerospace margin rate. With that in mind, we anticipate being at the higher end of our guidance of 18% to 19%, while also remaining cautious about supply chain issues and OEM demand.
Charles Blankenship, CEO
Demand, yes.
Louis Raffetto, Analyst
Great. And just one quick one. Chip, I guess, is it fair to think that you still think OE will grow faster than aftermarket? Or are we less certain today?
Charles Blankenship, CEO
We're less certain today than we were on our last call with the Boeing rates. So one way to think about it is when we develop this operating plan at the start of our fiscal year, we were thinking that third quarter would be higher OE volume and the fourth quarter would be even higher yet from an OE standpoint. And now we're thinking it's going to be a little bit softer, so the mix will be better from a rate perspective. And we will be working on different margin expansion levers because we were sort of planning on a higher volume and better flow-through and better amortization of our fixed costs for fourth quarter based on that OE. And then just looking at all the different levers we have to work on margins, we'll prioritize some of the others that are not related to the OE volume increase and make sure we can deliver in that range.
Operator, Operator
And we'll take our next question from Pete Skibitski with Alembic Global.
Peter Skibitski, Analyst
Another solid quarter. I have one more question about China. It sounds like you are projecting at least $185 million, possibly between $195 million and $200 million for this year. How should we think about fiscal '25 based on what you know now? Should we expect it to be up, flat, down, or significantly down? What would be a reasonable perspective on that?
Charles Blankenship, CEO
I am unsure about the best way to approach this, to be completely honest. Our focus is on ensuring that all aspects of the Industrial business are prepared to make 2025 a solid foundation for our commitments in 2026. We are addressing every part of the Industrial sector and ensuring we are ready to meet any demand from China that could improve our margins and serve our customers effectively. That's our current perspective. We view the situation as being at a breakeven level, which does not negatively impact our plans. The two reasons driving our cautious approach are the lack of visibility into market dynamics that we can predict trends for and customer volatility that may lead to sudden drops in volume within a quarter. These factors necessitate the planning and actions we are currently taking. If there are changes in either of these areas, such as increased visibility into genuine market dynamics or longer-term commitments from our customers in China, we would adjust our plans accordingly. However, for now, this is our strategy.
Peter Skibitski, Analyst
Okay. Understood. Appreciate that. Last one for me. Just on pricing. The pricing has been pretty solid for you guys in this environment, and inflation doesn't seem to be going away, right? We're in that kind of 3%, 3.5% range. Is this an environment where you're going to continue to kind of press on pricing until something meaningfully changes?
Charles Blankenship, CEO
I think we have to, Pete. We have to be mindful that until we see a signal of deflation going on in the general markets on commodities and, even potentially, labor, we've got to be mindful of the fact that these are long-cycle businesses, where commitments were made a long time ago. And we're happily stuck with our customers and we're happily stuck with our suppliers, but trying to make sure we don't get squeezed in the middle. We've got to be active on price from the aftermarket standpoint and catalogs as well as when long-term agreements come up, the opportunity to negotiate a fair price agreement.
Operator, Operator
And we will take our next question from Gautam Khanna with TD Cowen.
Gautam Khanna, Analyst
Yes. Congrats on the numbers. I had a question on the OH business. Do you guys have a sense for the level of sales required to breakeven in that business in a given quarter?
William Lacey, CFO
We have a clear understanding of the situation, and as Chip mentioned, this is how we plan the business around that breakeven point. During the first half of last year, we experienced a challenging environment that ranged from breakeven to a drag.
Charles Blankenship, CEO
Yes. I can't give you that. But we do have a good idea, and we use those for planning purposes.
Gautam Khanna, Analyst
Okay. And I'm just curious, thus far, we're like a month into the quarter, is it consistent with that $35 million to $40 million rate in Q3 that you're expecting? Or are you running above that and expecting a slowdown later in the quarter?
William Lacey, CFO
We are in line with what we guided in the $35 million to $40 range, yes.
Gautam Khanna, Analyst
Okay. I want to follow up on an earlier question about the LEAP aftermarket so far. With the OEM and CFM having many service contracts linked to the LEAP, are you noticing any aftermarket pricing opportunities for those products you're currently selling in the aftermarket? Or are they primarily going through the CFM service shops and therefore being sold at prices similar to OE sales? I'm not sure if you have any insights on that.
Charles Blankenship, CEO
Yes. It's not exactly how it works. So we price to the aftermarket to anybody who we work with. We work with CFM shops. We've got agreements with other airline shops. We've got agreements with independent MRO facilities. So whoever we work with, there's an aftermarket agreement for how we're going to do terms and conditions and price and turn times, et cetera.
Gautam Khanna, Analyst
Last question for me was just on cost inflation on Industrial. Was there much of a change sequentially in the March quarter relative to the December quarter? And do you expect much of a change in the second half of your fiscal year relative to what you experienced in the second quarter?
William Lacey, CFO
Yes. We do not anticipate any significant changes beyond what we expect regarding inflation. We are focused on maintaining strong pricing and productivity to further enhance our margins and achieve the guidance we provided for the Industrial business.
Operator, Operator
And we'll take our next question from Tony Bancroft with Gabelli Funds.
George Bancroft, Analyst
Great job in the quarter. Chip, since you've taken over, you've really done a fabulous job. Any thoughts or changes to your thinking? I know we sort of talked about this in the past, but maybe an update on doing something transformational, either a large acquisition or maybe more in the within or without outside Aerospace or even financial engineering similar to some of your contemporaries, like, i.e., GE, Crane that had something like that. Just maybe just give us an update there and just your thoughts if anything has changed.
Charles Blankenship, CEO
You're welcome. So really, I think if you look back at our Investor Day presentation, almost everything that we're thinking about for the future of the company is represented there in terms of our desire to grow our Industrial and Aerospace businesses, have them be collaborative and synergistic, capture all the market opportunities that we see in front of us with the aftermarket in Aerospace and the energy transition and the new fuels in Industrial. We think that's plenty of opportunity to work with. As far as M&A goes, we are always looking at bolt-on or strategic adds that might help us achieve those goals that we shared at Investor Day in an even more efficient and more impactful way. And that's kind of where our focus is.
Operator, Operator
And we will take our next question from Sheila Kahyaoglu with Jefferies.
Sheila Kahyaoglu, Analyst
Chip, I wanted to ask a few questions about Aerospace since the performance was very strong. Regarding commercial, let's start with pricing. How do you view pricing within Original Equipment? You mentioned the aftermarket. When we look at a 15% increase in Original Equipment and consider the engine manufacturers, fleet shipments remained flat, but revenues increased by 30%. PAT saw a 40% rise in shipments, but revenues were up 60%. Can you discuss the difference in your shipments compared to Original Equipment growth?
Charles Blankenship, CEO
Our shipments have increased significantly, and in some instances, we've expanded our scope. This increase has contributed to the growth in our year-over-year revenue. Regarding pricing, most of our contracts are long-term, with some lasting the entire program and others spanning decades. We are able to implement escalation clauses to a certain degree, which means that year-over-year pricing can be quite substantial due to indexes that have risen significantly in the high inflation environment. The factors driving this include shipping a larger number of part numbers, favorable escalation clauses, and an increase in demand from manufacturers. However, it is challenging to determine where inventory is getting stuck in the system, whether at the airframer, in built aircraft at the delivery stage, at the airframer facility concerning engines, or in the incoming inventory of engine manufacturers. There is considerable variability in the system, and demand may have outpaced the shipments being delivered by the engine manufacturers as they work to coordinate with various suppliers.
Sheila Kahyaoglu, Analyst
Okay. Got it. That makes sense. And then maybe on military aftermarket, really great performance, up 30% for the first half. What's driving that? And how do you think about the exit rate out of the year? Is there more upside, just given supplemental funding coming through as well?
William Lacey, CFO
Yes. Regarding the aftermarket, last year during the first half, we faced some supply chain challenges, which led to lower numbers. However, we saw an improvement later in the year, resulting in higher comparisons in the second half. Currently, we believe we are at the right level, and we expect this to continue for the rest of the year. However, the comparisons will become more challenging because supply chain conditions improved last year.
Charles Blankenship, CEO
Yes. And Sheila, in working on our opportunities there, I mean, there was some discussion earlier in the call about lean. We truly believe that's a growth area for us longer term. As we get our turn times down, we can go after more business. So we think there's opportunity there that we haven't captured yet.
Sheila Kahyaoglu, Analyst
And last one on Aero. Is there one thing that is the most favorable mix within the subsegments that you would call out?
Charles Blankenship, CEO
Most favorable mix?
Sheila Kahyaoglu, Analyst
Yes. In terms of margins, whether it's defense aftermarket or aero aftermarket.
Charles Blankenship, CEO
The commercial aero aftermarkets are currently our best opportunity for returns. Despite strong travel demand, deliveries have not increased, leading the legacy fleet to operate longer and harder than we had anticipated. When we developed our operating plan, we assumed we would be moving past the peak of certain overhauls like V2500 fuel controls and CFM56-5 HMUs, predicting that these would decline. However, given the current conditions, we believe that peak might extend significantly longer than expected. This is an important factor we've considered for the second half of the year.
Operator, Operator
And we will take our next question from Michael Ciarmoli with Truist Securities.
Michael Ciarmoli, Analyst
Nice results. Chip, in relation to Sheila's questions, you mentioned that the aftermarket is quite strong both sequentially and year-over-year. Is there anything specific to highlight? I understand that the second quarter is typically strong for you, but is there anything noteworthy? Was it mainly due to provisioning, or is there any additional insight beyond the OE challenges? What is driving that particular strength?
Charles Blankenship, CEO
Yes, there was some provisioning during the quarter. As you mentioned, this is seasonal, along with some provisioning, and we didn't see a drop-off in the legacy fleets. Additionally, we had a bit of LEAP and some GTF fuel nozzles contributing to the overall performance, helping it align better both sequentially and year-over-year.
Michael Ciarmoli, Analyst
Okay. Okay. Got it. And then just maybe all the way back to build rates. I know you kind of said it's a little bit of a moving target. But GE taking down their LEAP production for the year, I guess, round numbers, maybe it's like 160 engines at the midpoint. I mean, were you shipping to them based on that original plan? Do you have line of sight to see if they have excess inventory? I mean, I know, obviously, we got the aftermarket mix and the demand there. But any color on how you're building to GE's revised plans?
Charles Blankenship, CEO
We are in constant communication with them, and the feedback indicates that we are aligned with their plans, so we will continue to stay updated. We want to inform you that there are various expectations for the second half of the year, some of which will depend on how much the fourth-quarter schedules may shift. We believe the third quarter is fairly settled because sudden changes in the supply chain are uncommon, except perhaps for specific cases. However, we anticipate some fluctuations in the fourth quarter, and that's why we are concentrating on other strategies to ensure we can manage any delays that may arise.
Michael Ciarmoli, Analyst
Understood. One last question about China. Can this aspect of the business sustain itself long-term, even if not at the current levels? Is there a possibility that work could be handled internally, developed in-house? I'm trying to gauge your confidence in maintaining your position with your customers in that region over the long term.
Charles Blankenship, CEO
Yes. It's always a risk in our business that an OEM, who is very strong, very well funded and very well supported by a deep engineering team, can decide to in-source the fuel systems. We're in strategic discussions with our customers about long-term collaboration. And you used the term underwriting. We want to underwrite any investment we might make with improved future terms and conditions and commitments. So we're talking to various customers about how to dampen the volatility. And if we're going to invest in the next series of fuel systems, we want to have more assurances that will not only get a return but be able to plan better. So we're working on it. I don't know how it'll turn out, but it's not for the lack of engagement and willingness to talk about it and collaborate with our customers.
Operator, Operator
And we will take our next question from Noah Poponak with Goldman Sachs.
Noah Poponak, Analyst
Have you ever modeled out how large the LEAP becomes as a percentage of the total company earnings whenever that aftermarket stream becomes close to steady state?
Charles Blankenship, CEO
The LEAP plus GTF represents a significant aftermarket stream in our models over several years. By the timeframe of 2026 and 2027, we don't anticipate a major contribution; it will be more around 2028 to the early 2030s when we can really expect those to come in for repair and overhaul. I want to emphasize that we are planning to grow the rest of the company alongside this. There's no need for concern about concentration, as we have many other opportunities and business avenues to develop as we reach the late 2020s and early 2030s.
Noah Poponak, Analyst
Okay, that makes sense. If I examine the Aerospace margin from the incremental perspective, in the first quarter, it was in the mid-30s, but that was an easy comparison. The second quarter presented a tougher comparison, yet the incremental rose into the 40s. It didn't seem like anything particularly unusual, possibly just a bit of a mix. The guidance suggests a drop back down to the low to mid-30s in the latter half, and the two-year forward outlook is at 30%. Do you have a way to determine the appropriate level of sustained drop-through in the Aerospace business? I understand that you're currently facing pricing costs above the very long-term normal. I am trying to get a clearer picture of what is achievable regarding Aerospace incrementals going forward.
Charles Blankenship, CEO
I’ll let Bill provide further details on this question. It’s a combination, and the specific details of that mix are not critical when calculating the flow-through. Our sequential mix has slightly increased its aftermarket component, which may elevate the flow-through a bit.
William Lacey, CFO
Yes. In general, Noah, we feel like that business ought to deliver 30% to 35% incremental, and so that's kind of how we look at it. And like Chip said, depending on where we are, that can be higher. But over the long term, we think about it between 30%, 35%.
Noah Poponak, Analyst
Okay. Great. Chip, when you were discussing potential strategic changes to how you sell in China for on-highway, what would that actually look like? Are you referring to minimum purchases over short periods, or how might that actually take shape?
Charles Blankenship, CEO
Well, we don't have anything to say that's firm or negotiated at this time. We would just like to get more information on the market. We like to understand more about build rates. We'd like to protect ourselves in terms of when we've got inventory flowing from a lead time perspective. But as of now, the agreements that we have or the agreements that we have with the customers, we've got to come up with a good value proposition reason to decrease our risk and increase theirs from the customer standpoint. And there's multiple folks to work with in China, and the system might be useful for other regions in Asia as well. So we're looking to see what we can do on that front.
Noah Poponak, Analyst
Okay. In the near term, is it correct that you guided third quarter revenue for on-highway to between $30 million and $40 million? And did you mention anything about the fourth quarter estimate?
William Lacey, CFO
$35 million to $40 million for the third quarter, Noah. And for the fourth quarter, again, just minimal amount at this point.
Noah Poponak, Analyst
And that, Bill, is minimal just guiding one quarter at a time? Or is that what the orders are indicating?
William Lacey, CFO
The correct information, based on our visibility and our comfort level, is that we are looking at a forecast for three quarters out, which is more than what we projected at the beginning of the second half of last year. We have gained additional visibility, and that’s what we currently have to work with.
Operator, Operator
And we will take a follow-up question from David Strauss with Barclays.
David Strauss, Analyst
Great. At this time, has anything changed with regard to what you laid out in terms of your forecast for 2026, either aerospace or industrial end markets or overall revenue, free cash flow? Anything that's changed at this point in terms of how you're thinking about?
Charles Blankenship, CEO
No. We're just working on the path to that answer for 2026. And we feel like we're on track quarter-by-quarter so far, and no changes.
David Strauss, Analyst
Okay. And your data center, backup power for data centers, how big is that business today, Chip? And what are you actually seeing there? Are you seeing demand signals? Or are you actually seeing it manifest itself in the numbers yet?
Charles Blankenship, CEO
So over the past couple of years, that's grown. And I think we're just going to keep that in the power generation call-out, but it's grown inside that. And we have multiple OEMs that are competitive in the data center space for standby power. Caterpillar and mtu are both very well known in that space, and there's some other Asian OEMs coming into the space as well because there's quite a lot of demand. And so we're seeing the signal, but we're also seeing the data centers get built and big long rows of reciprocating engines and day tanks for diesel fuel get put in.
Operator, Operator
And Mr. Blankenship, we have no further questions at this time. So I will now turn the conference back over to you for closing remarks.
Charles Blankenship, CEO
I'd just like to thank everybody for joining the call, and we'll talk to you again next quarter.
Operator, Operator
And ladies and gentlemen, that concludes our conference call today. If you would like to listen to a replay of this conference call, it will be available today at 7:30 p.m. Eastern Time by dialing 1 (800) 770-2030 for a U.S. call or 1 (609) 800-9909 for a non-U.S. call and by entering the access code 2819144. A rebroadcast will also be available at the company's website, www.woodward.com, for 14 days. We thank you for your participation on today's conference call and ask that you please disconnect your line.