Kaman Corporation
Q3 2016 Earnings Call Transcript

Published: 29 Oct 2016

[Operator:]

Good day, ladies and gentlemen, and welcome to the Third Quarter 2016 Kaman Corporation Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will be given at that time. [Operator Instructions] As a reminder, this conference call may be recorded. I would now like to turn the conference over to Mr. Eric Remington, Vice President, Investor Relations. You may begin.

[Eric Remington:]

Good morning. Welcome to the Kaman Corporation third quarter 2016 earnings call. Conducting the call today are Neal Keating, Chairman, President and Chief Executive Officer, and Rob Starr, Executive Vice President and Chief Financial Officer. Before we begin this morning, please note that some of the information discussed during today's call will consist of forward-looking statements, setting forth our current expectations with respect to the future of our business, the economy and other future events. These include projections of revenue, earnings and other financial items, statements on the plans and objectives of the company or its management, statements of future economic performance and assumptions underlying these statements regarding the company and its business. The company's actual results could differ materially from those indicated in any forward-looking statements due to many factors, the most important of which are described in the company's latest filings with the Securities and Exchange Commission, including the company's 2015 annual report on Form 10-K and the current report on Form 8-K filed yesterday evening together with our earnings release. In addition, we expect to discuss certain financial measures and information that are non-GAAP financial measures as defined in applicable SEC rules and regulations. Reconciliations to the most comparable GAAP measures are included in the earnings release filed with yesterday's 8-K, a copy of which can be found in the Investor Relations section of our website, which is www.kaman.com. With that, I'll turn the call over to Neal Keating. Neal?

[Neal Keating:]

Thank you, Eric. Good morning and thank you for joining us on today's call. Yesterday, we reported third quarter performance that was in line with our profit expectations as we executed well in our Aerospace segment and navigated through continued difficult end market conditions in our Distribution business. At a consolidated level, sales were $453.5 million, an increase of 4.5% over the prior year. This reflects a 30% increase in Aerospace segment sales which includes strong organic growth of 17% and an $18 million contribution from recent acquisition. Earnings in the quarter were $17.5 million or $0.62 per diluted share which is essentially flat with prior year results. While net earnings were flat, adjusted EBITDA increased 8.4% to $42.3 million when compared to the prior year. Moving to our segment performance, Distribution sales were $274.4 million compared to $296.3 million in 2015 which reflects one less business day and a 6.3% decline in organic sales per sales day. Sales came in below our expectations with mixed results across our customer base, end markets and product platforms. When we delivered our updated outlook last quarter, we were expecting slightly positive sequential sales growth in the third quarter and instead, we ended up with slightly negative sequential sales growth due to continued weakness year-over-year in mining, paper, chemical manufacturing and transportation equipment. On a year-over-year basis, 25% of our third quarter sales decline was attributed to oil, gas, and mining end markets which now account for less than 5% of segment sales. Both OEM and MRO sales were down about the same percentage year-over-year with fluid power platform stronger than bearing and power transmission and automation. While September was our strongest month of 2016 to date, in fact the strongest month in September 2015 we could not offset the weakness experienced in both July and August. Segment level operating profit was $11.9 million, 4.3% of sales or $12.2 million and 4.5% of sales when adjusted to eliminate restructuring and severance costs. This compares to $14.4 million or 4.9% of sales in the prior year. The margin decline was primarily due to deleveraging associated with a lower sales base and we are encouraged by the fact that our dropout rate was less than 12%, significantly better than it would have been absent the impact of our productivity and efficiency initiative. As discussed in previous quarters, we continue to invest in operational process improvements in data analytics, primarily focused on expanding operating margins and these efforts are providing the expected level of benefit. However, the benefit has been largely offset in the near-term by the implementation expenses associated with this initiative which were $2.8 million in the third quarter. We expect the majority of these costs to begin to moderate as we enter 2017. In addition, we continue to manage operating expenses and staffing levels. However, given the lower sales volume and one less sales day, these efforts were not enough to offset the impact of deleveraging, which is mainly lower absorption of our fixed costs and lower vendor incentives in the quarter of $1 million year-over-year. Turning to Aerospace, we delivered strong sales growth of 30.3% or $179 million during the quarter driven by an exceptionally strong quarter in our fuze business and an $18 million contribution from GRW and EXTEX. As Rob will detail later, we expect strong segment level sales to persist through the fourth quarter, primarily driven by fuze backlog, strong bearings performance and acquisitions. In bearings product lines sales continued to grow organically in the quarter and were up sharply versus the prior year as a result of our 2015 acquisition. I'm pleased to report that both acquisitions are performing in line with our expectations and both were accretive to net earnings and cash flow in the quarter. However, they are a drag on segment operating margin given the approximately $2 million in associated depreciation and amortization. With respect to our fuze business, the volume of shipments increased by 150% year-over-year and in total we shipped approximately 9500 fuzes during the third quarter. We expect shipment levels to remain elevated through the balance of the year and well into 2017 as we deliver against the strong pipeline of orders already in backlog. During the quarter, we also continued to make progress on our structures program and believe we are moving in the right direction to address the operational issues we encountered earlier in the year. As we look to the balance of 2016 and into 2017, we are encouraged by our ability to execute in a dynamic landscape. In distribution, we are pleased by the positive impact from our productivity initiative and the potential long-term implications for margin levels. That being said, we are operating in an exceptionally choppy environment and as we enter the final quarter of the year we remain focused on the factors we can control and executing our plan. Now, I would like to turn it over to Rob to provide you with a closer look at our numbers and outlook. Rob?

[Robert Starr:]

Thank you, Neil, and good morning, everyone. I'd like to begin this morning by providing financial details and adding some additional context to our results. GAAP earnings per share were $0.62, the same as the prior year and on an adjusted basis diluted earnings per share were $0.64 flatly higher than 2015 despite a tax rate that was 120 basis points higher. The higher tax rate resulted from international rate differentials and discrete items requiring additional provision in the quarter. Looking more closely at our consolidated results for the period, gross profit performance remained strong with the margin in the quarter at 29.9%, down 10 basis points from the prior year. For the quarter, profit margin percentage improvement seen at distribution was offset by margin declines at aerospace, driven primarily by significantly higher mix of USG JPF deliveries. If you recall, in the third quarter of 2015 approximately 80% of our JPF Fuze deliveries for direct commercial sales as compared to 3% in the third quarter 2016. Taking a closer look at SG&A expenses we experienced 4.2% or $4.3 million increase in consolidated SG&A, which includes $5 million in expenses from our 2015 acquisitions. Organic SG&A decreased by 0.8% over the prior year period and consolidated SG&A as a percentage of sales decline 10 basis points. We benefited from lower corporate expense in the quarter as we have favorable experience across a number of line items and continue to focus on tightly managing expenses. Earlier Neal provided an overview of the results for the segments and we thought it will be helpful to provide some additional color on performance of aerospace in the third quarter. On a GAAP basis the operating margin declined 370 basis points. The change in year-over-year operating margin is largely attributable to previously discussed change JPF product mix, a 50% increase in intangible and fixed asset amortization, acquisition and integration related costs of $0.5 and a $3.4 million negative differential and EAC adjustments when compared to last year's third quarter. I would now like to turn to an update of our 2016 outlook. Based upon our performance of the first nine months, we have updated our expectations for the remaining quarter of the year and we've made corresponding adjustments to our full year outlook. At Aerospace we continue to expect significant top line year-over-year growth, although we have lowered our expectations due to some program shifts into 2017. We now expect sales to be in the range of 700 million t 710 million down slightly from our previous range of 710 million to 725 million. Our revised expectations correspond to an increase of approximately 20% year-over-year. The reduction in our aerospace outlook is due to a number of program push-outs from 2016 to 2017. Programs experiencing push outs include a significant JPF ECS order. The Peru SH-2 program due to contract modifications and certain _____ fuze programs. Also affecting our outlook our weaker than expected helicopter MRO results as flight hours on the commercial K-MAX fleet have been lower than anticipated. We now expect full year aerospace operating margin to range from 16.4% to 16.6% for 17.2% to 17.4% when adjusted for one-time acquisition related costs of approximately $5.5 million primarily involving storage step ups and integration expenses. Our reduced profit margin expectations are primarily driven by the push out of a large JPF ECS order we had previously expected would occur in December. The change in our delivery expectation is due to a delay in receiving the necessary government approvals. While we expect to be able to partially mitigate the shipment and timing of this ECS delivery to higher levels of USG JPF deliveries, the profitability differential between commercial sales and U.S. Government sales has caused us to adjust our operating profit expectations for the quarter and for the full year. In spite of the JPF delay, we are forecasting a strong fourth-quarter for Aerospace with an expected margin of approximately 20% driven largely by our bearing product lines. Looking at distribution, the lower than expected sales levels used in the third quarter and market conditions overall have caused us to lower or sales range for the full year to $1.11 billion to $1.12 billion. This compares to our previous range of $1.12 billion to $1.15 billion. In addition to market conditions approximately $5 million of engineered project work within our AC&E product platform will be pushed out of 2016 into 2017. Given our revised top line expectations we are adjusting our expectations for operating margin for the year to a range of 4.3% to 4.4% from our earlier range of 4.5% to 4.8%. Our lower corporate expense results in the third quarter will carry through the balance of the year and we are lowering our expectation by $3 million to $52 million. Our year-to-date strong cash flow performance gives us confidence to raise the lowering of our outlook for the cash flow from operations for the year, coupled with slightly lower expectations for capital expenditures this allows us to raise our target for free cash flows for the year to a range of $55 million to 65 million from our prior guidance of $50 million to $60 million. This positioned us to achieve our long-term target for free cash flow conversion 80% to 100% of net income and would result in a three-year average free cash flow conversion well in excess of 100%. With that, I will turn it back over to Neal for his closing comments.

[Neal Keating:]

Thanks, Rob. I'd like to close with just a few comments highlighting both our near-term performance and several developments that will help drive longer-term growth across Kaman. The diversity of our products and the markets we serve has been one of our key strengths and this quarter was no exception. While our distribution business dealt with more challenging market conditions than anticipated, Aerospace delivered a solid performance led by bearings and JPF. We are also encouraged by the early contributions of our new acquisitions, EXTEX and GRW. Looking at the fourth quarter, facing a push out of DCS JPF shipments the team was able to pivot and maintain production levels to satisfy other customer demand. And as we look to the longer-term, we see progress towards margin expansion and distribution and demand across the portfolio in Aerospace. Overall, we've seen progress so far in 2016 and our position to close out the year on a solid note and enter 2017 on a very strong footing. With that, I'll turn it back over to Eric for questions. Eric?

[Eric Remington:]

Thanks, Neal. Nicole, may we have the first question please?

[Operator:]

Thank you. [Operator Instructions] And our first question comes from the line of Edward Marshall of Sidoti & Company. Your line is now open.

[Edward Marshall:]

Hey guys, how are you? Good morning.

[Eric Remington:]

Good morning, Ed.

[Neal Keating:]

Good morning, Ed.

[Edward Marshall:]

So, I'm curious, is it possible to quantify the amount of fuzes that were shifted into 2017?

[Robert Starr:]

So Ed, this is Rob. I don’t think we want to specify the exact number, but it is in the call it few thousand range.

[Edward Marshall:]

Okay.

[Neal Keating:]

And maybe that's a significant Ed.

[Robert Starr:]

It was meaningful.

[Edward Marshall:]

Yes, right, I mean I guess maybe ask another way then, could you talk about maybe the margin dollars associated with it or may be the EPS impact that would have been, because obviously I realize they are higher margin product than DCS? Just kind of order of magnitude>

[Robert Starr:]

Yes, I know, I understood. As you know, certainly direct commercial sales are priced significantly higher than our USG just given the nature of the business and the cost to produce the fuzes are pretty much at par relative to each other. So, let's just say the profit, the difference on the sale dollars Ed drops through pretty over 100% just given the price differential relative to no cost differential and I think our USG pricing is pretty much in the public. It's a little bit north of $3000. I'm really not at liberty to really talk too specifically around our DCS pricing Ed.

[Edward Marshall:]

Yes, I had to try and that's for sure.

[Robert Starr:]

No, no, absolutely not, no it's not. And you know Ed given meaningful, given the impact that it did have on the fourth quarter because of this shift into 2017, we did anticipate the question, but we do have to recognize the nature of the business and the fact that it is - direct commercial sales are negotiated individually, priced individually, so it it's a significant portion of the impact for year.

[Edward Marshall:]

I understood. I was just seeing if I get the information back into numbers that you haven’t provided before, that's all. So you know, as we look at kind of, as we look at kind of Aerospace cycle and what's going on specifically with wide buy, I was curious about the bearings business in particular because that's really the place that I think you are most exposed on to commercial aerospace and it has some of the highest margins in the company. So can you talk about what you're seeing coming through bearings and potentially how you're preparing for say 2017?

[Robert Starr:]

Sure Ed. You know, Ed we continue to have organic growth in our bearings business in addition to the strong growth in the acquisitions. As we look at it and certainly work with our customers, there is a lot of talk about some downturn in widebody deliveries that will occur out a few years into the future as they may adjust their rates, begin to adjust their rates down, but you know, quite frankly, we have some offsetting growth there as well. We've talked about the A350. Clearly, that's the delivery rates for the A350 are accelerating. We've had a very nice tick up from year-to-year in our business with Airbus on that aircraft and we anticipate and are planning for continued growth next year, as well as content that Rob Patterson and his team have been able to get on a number of the new business jets, which while smaller in content will help to offset some of the downturn that we may see specifically in the 777 aircraft. But it is something we were keeping our eye on. We think that the impact is a couple years out yet and we've had other programs that we've worked very hard to win that are still in their growth mode.

[Edward Marshall:]

Got it. And you've been generating more cash as of late, I'm curious, I understand acquisitions is always something we talk about, but when you look at the capital deployment I'm curious about historically you haven't been a big acquirer of your own stock. Is that something that is not in the pecking order for capital or is that something that if, you know if we did see a downturn in the shares here that you would kind of step into the market, I'm just kind of curious about the philosophy?

[Neal Keating:]

Yes, Ed. An excellent question. Certainly as we look at capital deployment in terms of rank order priorities, certainly we want to grow the business. That is our highest priority in terms of capital deployment. So we've seen really a significant portion of our cash was dedicated towards acquisitions and capital expenditures. So we've never turned down a capital expenditure request certainly from our bearings business and elsewhere in the organization where it makes sense. As it relates to the share repurchase we have certainly put a program in place to offset dilution relating to management grants and employee stock grants and that remains in place. And now as we talked about when we put the $100 million authorization out there, certainly if there was a dislocation in the market and we felt there was a disconnect, significant disconnect between the value in the stock, we would certainly give a consideration to take some action.

[Edward Marshall:]

Great. Thanks guys for all your info. I appreciate it.

[Neal Keating:]

Thank you, Ed.

[Operator:]

Thank you. Our next question comes from Ryan Cieslak of KeyBanc Capital. Your line is now open.

[Ryan Cieslak:]

Hey, good morning guys.

[Neal Keating:]

Good morning, Ryan.

[Robert Starr:]

Good morning, Ryan.

[Ryan Cieslak:]

First of all I just wanted to maybe get a little bit more color on the distribution sales trends. I mean, you know you mentioned that September was the strongest month for you guys. Maybe just specifically, how do we think about the daily sales rate in September relative to what it was for the full quarter and any commentary on what you're seeing, what you saw here in October?

[Robert Starr:]

Yes, July and August were two of the three weakest months that we had had in the year so far Ryan. In fact only January was lower. September was a good tick up. As I said, our strongest month of the year and our strongest months in September of 2015 it was, and September of 2015 was actually a very good month as well. So that was kind of the cadence to the quarter. We actually did pretty well at the beginning of July. We were down maybe 2% to 3%, but the tail end of July and all of August turned down and then we saw that tick up in September. Right now as we look at it we're down between 2% and 3%. So far month to date it is, obviously we haven't closed. And if you look at our outlook for the year, the way that we approach it, as we said, we were feeling a little bit more confident as we were entering the third quarter. Hence we had our projections up between 1% and 2% and we ended up down between 1% and 2%. If you look at our rate for the third quarter and you just have that flap through the fourth quarter, that gets us to the low-end of our range and that would be obviously again down from year-to-year. So we felt confident in putting that out there, but we'd certainly like to see some uptick and get closer to the high end of that range know what that would do for the profit contribution for the business.

[Ryan Cieslak:]

And then Neal, was there anything in particular, certain product line or your end market EBIT call out, where you saw the greatest weakness relative to your expectations in the third quarter?

[Neal Keating:]

You know there's two parts to that. We had anticipated that the oil, gas, and mining markets would be flat year-to-year and that was what gave us confidence. We kind of felt we were at the bottom. We were - actually continued to be down a couple percent there and that was a contributing factor. When we look at it sequentially, we actually were up a little bit in our fluid power business which we were glad to see. We were down low single digits in our traditional bearings and power transmission and our AC&E platform was actually our weakest. It had been stronger earlier in the year and that caught us a little bit by surprise in the third quarter. So I'd say the combination of weaker AC&E platform sales and sales into oil, gas, and mining continue to decline with the two things that that were different than when we'd anticipated last time we were on the call.

[Robert Starr:]

Yes, Ryan, I would just make one other comment that will hopefully give some additional context to what Neal just mentioned. In our AC&E we have a pretty large exposure into the kind of commercial construction and other markets. And I think if you had read, I'm sure you did read Wesco's report, their reports came in weaker than the expected as well. So saw a downturn in some of those markets that just we had not expected as we entered into the call at the end of the second quarter, certainly contributing.

[Ryan Cieslak:]

That's really good color, Rob. Is there any way to think about, you know nonres construction or construction in general as a percent of your AC&E business or anything specific around that?

[Robert Starr:]

It's certainly, we have a greater exposure that that than the rest of our distribution business does. Certainly it has an impact on them. But there were other reasons for the miss, but that is certainly a contributor. I mean, it's not, to the overall distribution portfolio Ryan it is not all that material, but it certainly did not help in the third quarter.

[Neal Keating:]

Yes, and I would say Ryan, that probably a bigger impact is the continuing strength of the dollar and how that impacts our exporting OEMs, because it is a much more OEM and capital expenditure for machinery and equipment correlated business than the balance of our distribution portfolio of products.

[Ryan Cieslak:]

Okay and then is there any way to think about what Hurricane Matthew might have had or is having in regard to the sale or I guess it is not just distribution, but also on the impact to the aerospace business?

[Neal Keating:]

You know, we haven't seen any impact to the aerospace business. We did lose a couple production days, but anticipated primarily in our - obviously in our Jacksonville and Orlando facilities, but we didn't have any damage to the facilities. We had to allow for our employees to be able to make sure that their homes were secure and families were in good shape prior to coming back to work, but we would anticipate being able to make that up over the balance of the fourth quarter. So we were, I'll say we were lucky there. We prepared for the worst, but actually came through it with no real - no damage at all. On the distribution side, we did a little work as you would expect with Steve and his team on the impacts. We've lost some branch sales days, but we really haven't had a big impact yet. So hopefully, we will benefit some from requirements to replace products that may have been damaged in flooding or other wind related damage, but not a big impact to us.

[Ryan Cieslak:]

Okay. And then the last one I had and then I'll jump back into the queue, on the JPF order push outs and it sounds like it was a government approval issue, and Neal is this something that you view as one time or is there any indication that this is something that's different that's going on within the industry from commercial or international standpoint, just any color there would be helpful?

[Neal Keating:]

Yes Ryan, it's a little different, but I think that it is primarily driven by where we are in the election cycle and the, you know what people want to be seen as doing before the election. But we think we'll get through the election and things will return to whatever is considered normal anymore, but we view it as a onetime event.

[Ryan Cieslak:]

Okay, thanks guys.

[Neal Keating:]

Thanks, Ryan.

[Robert Starr:]

Thanks, Ryan.

[Operator:]

Thank you. Our next question comes from the line of Matt Duncan of Stephens. Your line is now open.

[Matt Duncan:]

Hey, good morning, guys.

[Robert Starr:]

Good morning, Matt.

[Neal Keating:]

Good morning, Matt.

[Matt Duncan:]

So, I want to take another stab on the push out and let's look at instead of just at JPF kind of the total amount of push out if we can Rob, I mean if I look at prior guidance, the assumption that you had in that guidance for the third quarter and where you actually came in you did a little better when you thought you were going to. It looks to me like the total push out is somewhere around call it $20 million out of the fourth quarter into next year. First of all is that a pretty accurate number and secondly, does that just kind of all follow into the first quarter or how do we think about the timing of where that revenue goes?

[Robert Starr:]

Yes, no Matt, you math is fairly accurate, though that thoroughly corresponds to what we're seeing, so that's really spot on. In terms of the timing as those programs get pushed into 2017 we expect a good portion of those to be in the first half of 2017. I mean, ultimately it really will depend on when we receive approval for the DCS order, that will certainly be the gating item on that portion of it. The other items that we talked about that haven’t been pushed out whether it be Peru or some other structures programs, we do anticipate making some of that up in the first half for sure. How much of that's really going to fall into the first quarter versus the second quarter? Very difficult to say right now. We will be able to give a little bit more color certainly we are on the year end call and we have more visibility into that Matt.

[Matt Duncan:]

Okay. And then I would think that that's going to have a net positive effect on the year to year margin comparison given that those DCS sales for JPF are pretty high margin sales, right?

[Robert Starr:]

It will ultimately come down to, I would say this, if you were to look at our overall projections for the year, we expect somewhere in the range of about two thirds for this year will be USG and about approximately one third will be DCS orders, that's rough math.

[Matt Duncan:]

Okay.

[Robert Starr:]

The year-over-year margin contribution will somewhat depend Matt, but holding everything else constant you are not incorrect, it just depends what happens with our DCS order ratio next year for the full deliveries in 2017.

[Matt Duncan:]

Okay, yes, that makes sense.

[Robert Starr:]

Yes, at this stage it is hard to tell, but certainly we're comfortable that this is timing and we feel really good about the JPF franchise oveall.

[Matt Duncan:]

Okay. All right, back on to the KIT side of things, I know you talked a little bit about the monthly progression, maybe I missed it, but did you say by any chance sort of how the trend is is looking in October in terms of year-over-year sales change?

[Neal Keating:]

Yes, Matt, we're between 2% and 3% through the first little bit of the month.

[Matt Duncan:]

Okay and then my recollection is that what - and I think you may have a little bit of a sales day difference 4Q this year versus 4Q last year. Rob, how many selling days do you have 4Q this year versus last year?

[Robert Starr:]

Yes we had 61 days this year versus 60 last year. So we're up one.

[Matt Duncan:]

Okay, so midpoint of the KIT guide for the year is kind of flat organic sales in the fourth quarter with the benefit of an extra day is kind of the way to think about that. So really the selling, sales per day down low single-digit, but you benefit from an extra day, is that kind of where we're at?

[Robert Starr:]

Yes, the implied range is sequentially flat with the third quarter and about call it between 1% to 2% down relative to prior year, not yet given the midpoint.

[Matt Duncan:]

Yes, I mean the comp is significantly easier in the fourth quarter as well, I think you were down kind of low teens 4Q last year versus down low single digits in the 3Q. So I know the comp is a little bit easier, but other than the comp is there anything else that's causing the rate of change to the slowdown here? I mean you've been seeing sales declines at KIT call it kind of mid-single digits per day, mid-to-high single digits per day for most of this year. Is it just that easy in comp or are you seeing business trends that are making you a little more optimistic?

[Robert Starr:]

Yes, I mean part of it is clearly just on a year-over-year basis is the easier comp from last year, but really part of what's driving this as well as on the AC&E product platform we're expecting an uptick just based on what we have in the backlog. Now some of that did get pushed into 2017 as we talked about in our prepared comments, but the overall product platform there is expected to show up pretty positive fourth quarter and then really just expecting stabilization elsewhere in the business. What we've seen on the fluid parasite is we're feeling increasingly comfortable that we kind of along the bottom here in particular on our fluid power product and then in our other bearings and power transmission we're just seeing some stabilization once again for the fourth quarter.

[Matt Duncan:]

Okay, that's very helpful. And then on segment margin, I know you guys talked about some of the cost that's flowing through on the productivity initiative, it sounds like most of that's going to roll off by year end. So how do we think about the impact on segment margin on a year-over-year comparison basis? How many basis points of margin are you going to pick up by benefiting from the benefit to those actions without you know just being sort of overshadowed or at least canceled out at this point by the cost of taking them?

[Robert Starr:]

Yes, no, that's an excellent question. You know, we do expect as we enter into 2017 for the majority of these costs to begin to diminish. So I mean if you were to do the math which I'm sure you have based on the numbers that we've provided, I think you're looking at somewhere in the 50 to 70 basis point range is certainly fair holding everything else constant.

[Matt Duncan:]

Okay, fair enough. Then last thing from me just on the corporate expense coming in a little bit low. If I understand correctly, there's kind of three things, your employees were healthier, so that's obviously a good thing. You guys seemed to be managing costs a little bit there because you mentioned overall expense management and then there's lower incentive comp. I look at where corporate expense came in versus where it was implied to be on a quarterly run rate in your guidance and it's about $3 million below. Is there any way you can help us think through kind of how each of those items impacted that line item this quarter?

[Robert Starr:]

Yes, I mean I don’t want to get into too much specifics Matt, but certainly on the healthcare side we did see a pretty meaningful variation for the positive in kind of I give the HR team some credit here. I mean we've been putting wellness initiative in place for some period of time and certainly we would hope that's translating into the group experience. As it relates to the incentive comp, I mean I would argue that, you know, call it 20% or 30% of that healthcare, you know not to do similar percentage and the rest is really just flat out expense control where we have some discretion on some of our corporate expenses. But certainly, expect us to carry through the balance of the year some of these items may or may not carry into 2017 as we start thinking about next year and we'll have more color on that on the next call.

[Matt Duncan:]

Okay, perfect. I appreciate all the color guys, thanks.

[Robert Starr:]

Certainly now, you're welcome.

[Operator:]

Thank you. [Operator Instructions] Our next question comes from the line of Chris Dankert of Longbow Research. Your line is now open.

[Chris Dankert:]

Hi good morning, guys. Thanks for taking my question.

[Robert Starr:]

Good morning.

[Neal Keating:]

Good morning, Chris.

[Chris Dankert:]

I guess first off, about the K-MAX program can you just give us any color at all about how the shape of the year for those deliveries, kind of as those begin to roll out will we see those already in the first quarter or that will be more of a back half type of thing and you know, just any update on all the friends were interested in the program?

[Neal Keating:]

Chris, it's Neal. I think that we will begin delivering aircraft to customers in the first half of next year, probably late first quarter early second quarter we'd anticipate and I believe that we're planning to turn over about four aircraft next year over the course of the year and be on a cycle of about one every other month from that point. So that's how we're viewing it right now. You know, obviously there may be a little bit of a shift one way or the other simply because these are the first aircraft that we've built in a while and the first two are going to a new customer in China. So there may be a little variation there in initial deliveries. But we feel good about where we are in the program right now. And actually we had an update just Wednesday of this week. A lot of activity right now primarily in Europe and Asia for the aircraft, but we haven't, we can't report that we've signed any additional firm orders. We believe we are close with a couple and hope to have certainly some positive news either in the fourth quarter call or it is significant enough with a press release between now and then.

[Chris Dankert:]

Great, great, thanks. And then I guess, kind of in a similar vein any update on the progress working with Egyptian Military on the newly acquired SH fuze?

[Neal Keating:]

No, we continue to work with them. We're working with both Navier and the Egyptian Government on that. I think I'd probably feel most comfortable Chris leaving it at that point right now. The final configuration of the aircraft is really what they're working through, what equipment they need to have on it, what's the current state-of-the-art if you will on that equipment is both for availability and also for sale to Egypt.

[Chris Dankert:]

Okay, that's very fair. And then I guess kind of lastly, moving over to KIT, looking at the fourth quarter I guess, you guys has kind of anticipated some flat oil and gas activity in the third quarter. I guess what are you kind of baking into fourth quarter? Are you expecting further incremental declines in oil and gas in the fourth quarter, are you expecting things to be more flat? I guess some color there will be helpful?

[Robert Starr:]

Yes, Chris, this is Rob. As it relates to the oil and gas and mining, we are forecasting relatively flat sequential quarter over quarter performance there. We're not expecting any large uptick or down tick and I think similar to what a number of others have reported, I think the third quarter came in weaker than most expected certainly if you have downstream exposure. So we know it was flat.

[Chris Dankert:]

Okay great, thanks again so much guys.

[Robert Starr:]

Thanks Chris.

[Neal Keating:]

Thank you.

[Operator:]

Thank you. Our next question comes from the line of Shannon Burke of Gabelli. Your line is now open.

[Shannon Burke:]

Hi, Neal and Rob, how are you?

[Robert Starr:]

Good, Shannon how are you today?

[Neal Keating:]

Good.

[Shannon Burke:]

Thanks for taking my question. So just on KIT, if my math is right, with the actions you've taken place we should see margins above the 5% level in 2017 even if volumes stay flat, correct?

[Robert Starr:]

No, I think that's a very fair assessment Shannon.

[Shannon Burke:]

Okay, so if volumes, how much of an uptick in volumes would you need to get to that 7% goal would you say?

[Robert Starr:]

I would say Shannon, it would be difficult to see a scenario in 2017 certainly where the volume would uptick enough. That will be great if it did. If you think about the general rule of thumb that we talked about and this goes back a number of quarters, typically organic growth drops to at about a mid-teen range give or take and I don’t have exact math in front of me what we would need to get to 7%, but certainly I think you would definitely need to see a more robust demand environment for us to get there. And these are the initiatives that we've talked about do have a significant impact and certainly move us in the right direction given the demand environment that we're in. So, we're certainly in much better position from a cost perspective and then operational perspective to get there than we had been. But we need a little bit of help from the market here for sure.

[Shannon Burke:]

Okay, great. Thank you. And then on Aerospace, so the margin has bounced around a bit this year, how should we think about 2017? How long are you, will the amortization charges last and how confident are you in getting that DCS shipment is it because it is a new customer? And then also if you could touch on the operational issues if that's still having an effect from the margin?

[Neal Keating:]

You know, I'll start Shannon. The JP we're very confident in the JPF shipment that has shifted out of the fourth quarter of this year into 2016. It is an existing customer that we have provided product to for a number of years, a very good U.S. ally it is just again as we said the political environment right now with very few foreign military sales or direct commercial sales in this case are being approved.

[Shannon Burke:]

Okay.

[Robert Starr:]

Yes, and then Shannon just addressing your other question, we experience and we do anticipate $5.5 million of integration cost and inventory step up relating to the acquisitions, those will certainly drop off. They already have begun to if you look at our adjusted profile we incurred about $0.5 million in this quarter. We expect about another $600,000 to $700,000 in the fourth quarter to get to 5.5. In terms of the amortization there is really, there are two pieces there Shannon. I mean there's the amortization that the acquisition kind of brought with them so to say, those would be expected to continue. We continue to invest in certainly CapEx and other things in that business. The other piece relates largely to the intangible amortization and those will go on for a period of years and then they are typical amortization periods you know call it 10 to 12 years give or take. So that drag which is probably in the $1.5 million to $1 million range we would anticipate going out through our forecast period.

[Shannon Burke:]

Okay, thank you. And then the operational issues, are they, is it still hurting the margin or is it just something that's going to affect your full year and because of the Q2?

[Robert Starr:]

You are speaking specific up to the structures. You know, we continue to work on that as Neal touched on his comments. We're pleased year-to-date with the progress we've made in addressing those issues. So we would expect that to be predominantly a 2016 issue, certainly in 2017 we will provide more color as we enter into the year-end call.

[Shannon Burke:]

Okay, and then just lastly on the K-MAX you commented that MRO flight hours were down. Is this something that you think is just a onetime thing or is this sort of a change in the margin how the K-MAX is being used?

[Neal Keating:]

No, Shannon, we view this as likely a onetime or infrequent event. The way that many of the firefighting contracts are led Shannon is that our customers contract ahead of the fire season and their aircraft are positioned in certain locations. As it turned out last year we were positioned in areas where they flew a lot and this year interestingly enough the fires were not predominantly in the areas of coverage for our aircraft. So it was – we kind of scratched our head a little bit as well and then it became obvious to us what the issue was that was impacting the flight hours and then directly back into the business that we're able to do on an MRO basis or overhaul basis. So we would view that as an infrequent event rather than a trend.

[Shannon Burke:]

Okay, great. Thank you so much.

[Neal Keating:]

Thank you, Shannon.

[Robert Starr:]

Thanks, Shannon.

[Operator:]

[Operator Instructions] Our next question comes from the line of Robert Kirkpatrick of Cardinal Capital. Your line is now open.

[Robert Kirkpatrick:]

Good morning.

[Neal Keating:]

Good morning, Rob.

[Robert Kirkpatrick:]

Just a point of clarification. In your 10-Q in the outlook section it mentions that the adjustment to the operating margin outlook for Aerospace is due to the underperformance on the structures programs and not due to the JPF. Would you like to take the opportunity to kind of straighten the record?

[Neal Keating:]

Yes, no Rob I appreciate that and certainly you are correct the Q would have indicated that structures was the larger contributor. Certainly as we have close to the quarter we recognize that with the DCS sort of not taking place that, you know the larger contributor to the operating margin really relates to the timing on DCS. There was some impact clearly the MRO business that we touched on, on the structure side has a nice margin with it as well and that's certainly impacted. But certainly the greater impact related to DCS being pushed. On the top line, certainly the structure is some of the structures timing there had a meaningful impact in being pushed out whether it's Peru or some of the MRO work and then also we had some timing on our AH-1Z deliveries. So the structure side took the larger slice of the pie in the top line and DCS on the bottom line. So certainly that's really what was happening under the surface.

[Robert Kirkpatrick:]

Great, thank you very much and then a couple of other questions. One, can you provide us with any update on a program of record for K-MAX?

[Neal Keating:]

Rob we don’t have any update on that right now. We continue to, as we've said in prior quarters we continue to work that with the Marine Corps. We anticipate we understand that there is going to be additional funding for the aircraft to operate in [indiscernible] and add some capability to it in the upcoming year as we continue to work through adding some of the additional capability that will make it easier for the Marine Corps to move it into a program of record. But we do not have a timeframe that we can talk about right now.

[Robert Kirkpatrick:]

And the additional capabilities, do you feel comfortable discussing those?

[Neal Keating:]

You know, Rob, what they'd like to do is to have more than a single mission aircraft Gen. Davis who is the Assistant Commodore at the Marine Corps for Aviation really wants to have multi-capability platforms because it enables him to have more flexibility as they develop the concept of operations. So what they've talked about is the ISR so that you can trade cargo for fuel and have a longer loiter time and provide surveillance capabilities. They've also talked about some limited arming of the aircraft as well so that it could provide to put metal on a target if required. So those are the kinds of additional capabilities that they're asking us to work through. We've done things with as you know already with beyond light of site communications and now we've also got real-time video capability on the aircraft as well. So we continue to make progress there, but those are the kinds of capabilities that they are looking to add to the K-MAX and the reason that they are striving to add those capabilities.

[Robert Kirkpatrick:]

And on the four firefighting side in terms of the U.S. Forest Service, can you provide any update on that with respect to unmanned?

[Neal Keating:]

Yes, thanks Rob. I'm glad you asked the question because we probably should have included it in our prepared remarks. We actually have an upcoming demo next month at Griffiss Air Force Base, the old Griffiss Air Force Base in New York with unmanned firefighting demonstration that was requested. If you remember Griffiss is where we did the initial demonstrations now about almost two years ago I guess. But we have been requested by the Department of the Interior for an additional capabilities review and that will take place next month.

[Robert Kirkpatrick:]

Great and then finally could Rob provide a little more detail as to what the $8 million to date has been spent at KIT on in terms of the productivity initiatives revolving around process improvements and data analytics, it is more labor, is it software that you had bought, that you've installed, help me understand that a little bit better if you could please?

[Robert Starr:]

Yes, now Rob, good question and I'll give you some additional color there as much as we can. It really is a combination of costs that we've incurred in this initiative. We have certainly invested in the data analytical side in IT software, certainly systems capabilities in order to provide the field with the decision tools support that they need. We've also in order to accelerate the rollout we've engaged both outside and then have increased internal resources to really expedite the rollout of the program given the effect that it has on the performance. So it is a combination and you know we're very pleased today with the effect that it is having on the business.

[Robert Kirkpatrick:]

Great and the 50 to 70 bps improvement all the things being equal that you mentioned earlier is a combination of the cost of the implementation going away and receiving the benefits from that, is that correct?

[Robert Starr:]

You know, Rob, I think that is correct, but I would say a lot of that is really just based on the cost going away, holding everything else constant and holding the theme that we've got today.

[Robert Kirkpatrick:]

Great, thank you so much. I appreciate it gentlemen.

[Robert Starr:]

Thank you, Rob.

[Neal Keating:]

Thanks, Rob.

[Operator:]

Thank you. And our next question comes from the line of Ryan Cieslak of KeyBanc Capital. Your line is now open.

[Ryan Cieslak:]

Hey guys, just a really quick followup if I may, in the distribution segment you guys went through some cost actions earlier this year and I know it seems like the top line has been weaker than your expectations. Are you guys, and sorry if I missed this, but are you guys looking at additional cost actions as we look for the balance of the year or how do we think about maybe again some opportunities on the cost side considering the top line has been weaker than what you expected?

[Neal Keating:]

Ryan, you know we did have some additional rate reductions in the quarter relatively minor. The big reset was in the fourth quarter of last year. We've seen a lot of that benefit flow through. And I think we did a pretty good job at that point in time to size the business to where it needed to be for the volume and in particular when you consider as Rob just talked about some of the additional staffing that we added to be able to support our productivity initiatives. So we would not expect given where we are today any additional impacts on our staffing levels.

[Ryan Cieslak:]

Okay, and then just really a quick last one from me, some of the headwinds you've seen in Aerospace on EBIT from the changes in your contract estimates this year, how do we think about that going into next year, does that been or become tailwind or is that headwind roll off or is just at the end f the day how to really identify it as based off on where you guys are with the program?

[Neal Keating:]

Yes, Ryan, good question, I'll start and Rob can chime in. If you were to look back over a five-year period of time on average we've had about $1 million negative EAC adjustment, but it does vary significantly from year to year. So we would like to believe that we've got those behind us because it comes with the EAC accounting as well. Sometimes you'll see those larger chunks because you have to take - all of your adjustment is within the period, so you have to essentially have a true up for both retrospectively and prospectively. So, you know, we believe that we should have those certainly current and without a degradation in operating performance should be okay from year to year. But all in all, you know, it's been a significant change from year to year. You are absolutely right, part of that is driven by the favorability that we had last year was that, was better than we'd historically had. So it's one of those that you wish was more an average over the two years rather than the divergence, but it's just how the programs roll and the appropriate accounting for how we incur the cost and predict future costs.

[Robert Starr:]

Yes, Ryan, I would just make one other comment as it relates to what to anticipate in the future. I mean certainly how we perform on the programs relative to the expectations we have built today will play an important role in any future EAC adjustments to the plus or the minus. The other thing to keep in mind and this is going out even beyond 2017 is, as we think about the upcoming revenue recognition standard changes, that will certainly have an impact as well on EAC accounting. We will have probably some level of programs that may not today be EAC accounting that may all into EAC accounting. So we would anticipate that to become a more important feature as that standard gets implemented in 2018. But that's a ways off, it's just something to think about.

[Ryan Cieslak:]

Now that's all really good color I appreciate it guys, best of luck.

[Robert Starr:]

Okay, thank you, Ryan.

[Neal Keating:]

Thank you, Ryan.

[Operator:]

And our next question comes from the line of Robert Kirkpatrick of Cardinal Capital. Your line is now open.

[Robert Kirkpatrick:]

Sorry, one more. With the convertible that becoming current as a result of the price at which the stock traded at, do you want talk about the potential options you are examining to take care that maturities that comes up in 2017?

[Robert Starr:]

Yes, Rob, excellent question. The notes for the fourth quarter are convertible at the option of the bond holder. We certainly do not anticipate anyone presenting the bond, just given the corporate finance aspect of it we would be very surprised to see anyone, but we're prepared for that should someone elect to convert their bonds during the quarter. As it relates to on the capital structure side, we are certainly evaluating our refinance options. We do have another year in which to do this. The rate environment has remained favorable. I know rates have picked up a little bit in the last few weeks, but the convertible bond market or other capital market options available to us are very robust at this stage. So we have a lot of options. And certainly I would anticipate some time now in 2017 in advance of the maturity we will certainly look to address the upcoming convertible maturity.

[Robert Kirkpatrick:]

Great, thank you so much.

[Robert Starr:]

Okay, thank you, Rob.

[Operator:]

Thank you and I'm showing no further questions at this time. I'll turn the call back over to Eric Remington for any closing remarks.

[Eric Remington:]

Well, thank you for joining us for today's call. We look forward to speaking with you again when we report our fourth quarter results in February.

[Operator:]

Ladies and gentlemen, thank you for participating in today's conference. This does conclude today's program and you may all disconnect. Everyone have a great day.