Curtiss-Wright Corporation (CW) Earnings Call Transcript & Summary

Hi. Good afternoon, everyone, and thank you for joining us for our next session with Curtiss-Wright. I'm Kristine Liwag, Head of Aerospace and Defense Research here at Morgan Stanley. Before we continue, the same disclosure I have to read for everybody. For important disclosures, please see the Morgan Stanley research disclosure website at www.morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley sales representatives. And before we continue, I think, Jim, you're going to read safe harbor statements before we do final introductions.

Thanks, Kristine. Good afternoon, everyone. I just want to provide a brief statement on our safe harbor, which is available in the latest investor slide deck on our website. Please note today's discussion may include certain projections and statements that are forward-looking as defined in the Private Securities Litigation Reform Act of 1995. These statements are based on management's current expectations and are not guarantees of future performance. We detail those risks and uncertainties associated with our forward-looking statements in our public filings with the SEC. So with that, I'll turn it back over to you, Kristine.

Thanks, Jim. And with that, I'm very happy to present with us today, Lynn Bamford, President and CEO of Curtis Wright; and Chris Farkas, VP and CFO. Thank you very much, guys, and thank you for joining us at today's session.

Thank you.

Thank you.

Great. So for the audience, to remind you, if you want to ask a question, please type into your portal, any questions you have there. I'll read and ask the Curtiss-Wright team. And I could start with the first one. Lynn, at your Investor Day, you laid out some underlying assumptions for base sales growth, I think, of about 5% CAGR through 2023 and minimally double-digit EPS growth CAGR as well. What gives you the confidence to achieve these goals? And where do you see potential for upside or downside?

Thanks, and it's great to be here today. Overall, our new Pivot to Growth strategy really balances out maintaining many of our key financial metrics while driving organic and inorganic sales growth. We're really feeling good about what we put forward, put a lot of thought and analysis into it. And we believe we'll, in general, achieve that sales growth, both organically with a new and improved focus on R&D, assuring that we're really driving our dollars to the best projects that we can that will align with growth vectors in the industry. And so we have some new systems we've put in place with our innovative operating system that gives much better visibility to where we are spending our R&D and allows there to be better collaboration across the company. So we're continuing with that. We also maintained our strong focus on acquisitions. And as always, our preference for acquisitions is to find companies where we build relationships and identify companies and get them to go sole source with us and come with us. And so from a leadership standpoint, we're not taking our eye off of any of the operational excellence programs that we've had, and you saw that in the operational growth platform. And that stuff is still there. But we're adding more management oversight and focus on the things that are critical for growth like innovation and strategy and really taking some new and improved approaches to those. So with that, you saw us, our -- the guidance of growth in all of our end markets, which is a real positive fact that we haven't always been afforded. And so rising tides lifts all boats, so good thing is we really see optimism in a lot of our end markets. There's room for things that could be upside, could be anything from the infrastructure bills to the top-ups that maybe is going to get added to the President's budget that was proposed a little bit ago to a lot of the activity in the nuclear markets, where there's a lot of new starts of small modular reactors and advanced reactors. So there's a lot of good things. We feel like we're very well aligned with markets that have good growth opportunities in them. And that's why we're pivoting to growth to really say we're going to invest in ourselves where we need to make sure we have the right products to capture those growth vectors. If I think of headwinds, COVID still does remain to be a headwind that stand the chance of really from a supply chain perspective, really impacting our ability with that. And the rebound of the commercial aerospace markets, having that -- seen if that comes as predicted, and we laid out our expectations in the Investor Day are really the 2 things, supply chain-oriented COVID things and the commercial aerospace rebound. Maybe I'll turn it over to Chris to add a little more color.

Yes. I mean, just adding to what Lynn said, Kristine, I mean we have an opportunity to reach a 10% revenue CAGR through strategic M&A. We have a baseline assumption of 3.5% to 5% of organic, some of that being enabled by the growth initiatives that we outlined here in Investor Day but also with the contribution of PacStar. Beyond that, we have a very, very strong balance sheet and the opportunity to lever up and lever up, I would say, conservatively but to be more assertive with our balance sheet in acquiring a PacStar-like acquisition once per year over the next several years. And if we were to do that, then that gets you from the 5% revenue CAGR to the 10% revenue CAGR. Now we're not going to grow just for the sake of growing. We took a lot of time at Investor Day to outline why it was important, what our criteria is for our acquisitions from a strategic standpoint and then also a financial standpoint, and we're going to be very judicious in the way that we use our capital. But if those acquisitions don't come through, we remain committed to returning capital to shareholders, and we believe share buyback is the most effective way to do this. So in the absence of an acquisition, we're still going to achieve that 10% EPS CAGR through the return of capital to shareholders in the form of share buyback.

That's really helpful. And Lynn, touching on what you said earlier about potential plus-ups. When you look at the portfolio today, Defense is now 50% of the portfolio. So when you look at the fiscal year '22 budget, we've seen some plus ups in some programs. Can you give us more color in terms of how Curtiss-Wright programs fared with those plus ups and where opportunities are? And then also as a second to that, I mean, shipbuilding is a big significant part of your defense portfolio, too. Where can we see movement there? And what does that mean for that organic growth outlook?

Okay. I guess I'd start off with a little bit of framing about Curtiss-Wright's defense business and how we've compared to the defense budget over really the past 20 years for some that maybe are a little less familiar with us. Curtiss-Wright has grown at or above the base -- DoD-based budget consistently over the last 20 years. And that's through Republican administrations and Democrat administration. So I think that's one really important starting point. We're well positioned on key platforms that have strong bipartisan support, whether it's the CVN-80/81, Colombia or Virginia-class subs and the F-35, just to name a few. The. FY '22 precedents initial budget was $715 billion and really was very well aligned with where we hope to see funding in that budget. Strong funding for the lines where PacStar gets their -- a lot of their revenues from, network modernization was actually much stronger than we would have anticipated. So that was fantastic to see. And just really many other programs were well funded. Now as it's moved through the Senate and the House, as you mentioned, we've seen roughly another $25 billion being proposed. Now it's not timed in July yet, but there really, again, does seem to be very strong bipartisan support for the increases that are being proposed in that. And again, nothing's a done deal, but there's a good chance there could be a third Virginia class added, a second destroyer, some additional helicopters. These are all good things for Curtiss-Wright and very much aligned with where we have content on platforms. We're looking forward to seeing the 5-year defense program, which is now anticipated in March of next year. And there's talk it may be flat to down. But again, down slightly, maybe a couple of percentage points, but we'll see. I don't think that's -- I think that we need to see what plays out in a lot of things over the next couple of months before we know where that will go. But again, we work really hard to make sure we're investing our dollars and pursuing programs that are really high priorities within the defense budget. And with that, we feel that we're fairly insulated from trimming. I mean half of our defense business roughly is in the naval shipbuilding, which has very long visibility and is on the rise, not just here in the U.S., but we have content around the globe and free navy's. And then you look at the other portion of our defense business, it's really very diversely spread across hundreds and hundreds of programs. So it's not vulnerable to a trimming on any 1 program. I mean, there could be an impact, but it's not needle moving or material to Curtiss-Wright. And so we feel really good about how we've positioned ourselves in our defense businesses and the future of that business.

Thank you for the color. And I think, Chris, so you touched on M&A earlier. So circling back on M&A, I think at your Investor Day, you've talked about the different framework that you have there. Can you remind us again what your thresholds are for financial metrics for your M&A criteria? And why is it that M&A is a significant priority here? I think, Lynn, right, your predecessors, your predecessor, I think Dave Adams, he wasn't as keen on M&A, but all of a sudden, M&A is a big priority for you. Why is that? And can you give us context into the relative importance of this strategy versus previous strategies.

So it's a great question. Absolutely, our -- we are very focused on growing organically. So as much as we do spend time talking about M&A because we think it can be very complementary to our organic growth and allow us to go off to very specific targets that can fill in maybe missing pieces to be able to offer complete solutions to our programs or maybe get us access to customers where we think our products are applicable though it's much more efficient and timely to do through acquisitions and to build organically. But when it's things that's incremental and then where we already have a core capability, those are places where we would look to grow organically. We did slow our acquisition pipeline quite a few years ago, and that was really because we had not done a lot of the work that was needed to integrate the companies that we had bought and to get ourselves into really better solid financial performance across those acquisitions. As that was achieved over the years, we did return to acquisition even under Dave's leadership. And over -- since 2017, we've done 6 acquisitions. And with that, our ability and our memory muscle, I would say, of what we do in due diligence to really analyze companies, again, both from the strategic fit and from the financial performance and how they are better as part of Curtiss-Wright and how we make them better and we're better also as a company. And so with that, we -- the companies that we brought in during the last year with PacStar being the last 1 at the end of last year, these have been really great solid acquisitions for Curtiss-Wright. We put the scorecard in the Investor Day because it's really to show that we've earned the right and we know how to do acquisitions. And we know how to build it, bring in acquisitions that really make us a stronger company. And so with that, I would say we're continuing down that journey. We have a very active pipeline. But I'd also comment already this year, we put in initial offers of -- indications of offer on probably 2 handfuls of companies and have chosen not to act on those as we've learned more about the businesses and where they are financially that they weren't those good strategic fits for us. And so we're going to keep going. You do a lot of work to find those great acquisitions. And so we need to keep it up on the focus. So we're churning through those properties so we can find those ones that really are just absolutely great fit for Curtiss-Wright. Then maybe I'll turn it over to Chris to talk a little bit about the multiples.

Yes. So I mean, we've seen a slight ramp in multiples in recent months on commercial businesses. I think for the properties that are out there and for sale, there's a lot of people that are still banking on the recovery from the pandemic. We've seen defense multiples have been relatively flat. I mean we did see some uplift at the end of this last year as we started to kind of pull ourselves out of the pandemic a little bit. But those have been relatively flat. Kristine, you had asked about financial metrics and the M&A criteria. And really, we're looking for businesses that have long-term sustainable organic growth. We want them to be EPS accretive in year 1, and we want them consistent with how we've treated each of these successful acquisitions in the past for our return on invested capital to exceed our cost of capital by year 3. And those are just a few of the metrics. Now it's important to note that not every acquisition is going to meet every criteria all of the time, but all of these will contribute to our goals to achieve top quartile performance. And if the right opportunity becomes available and supports our Pivot to Growth strategy, then we're absolutely going to seize it. I mean we're really proud of our balance sheet. I said a little bit earlier that we would lever up. I mean we'll lever up, but we're going to maintain an investment grade rating of 3x or lower net debt to EBITDA, and that's going to allow us to maintain those attractive financing rates similar to those notes that we took out this last year prior to the acquisition of PacStar. So if something transformational comes along and we see it as a real opportunity and have a high degree of confidence in that, then we'll lever up more. But we'll quickly delever back down to that 3x net debt to EBITDA with the free cash flow that we generate from the acquisition.

Great. And Chris, I just wanted to follow up on what you said. You mentioned that, look, if you can't find a good deal, you'd consider returning capital to shareholders in the most likely ways through a buyback. What's the time frame that we should think about in which you would start thinking -- making that decision, right? Is it looking at acquisitions over the next 6 months? Is it by year-end? Is it through next year? And then if you are to do a buyback, how do you balance something that would -- shareholders would be happy with but, at the same time, keeping some dry powder in the balance sheet so that if the right acquisition comes available in the future, you've got that flexibility?

Yes. We have a lot of dry powder. We've got an untapped revolver right now, $500 million and a $200 million accordion feature that we could execute at any time. The market is certainly still right for going out and taking on some additional debt, and we certainly have a lot of banking interest in extending that debt to us given the success that we've had and the process that we have within our acquisitions. But what we do every year, and we meet with the finance committee of our Board 3 times a year. These are the types of discussions that we have. We evaluate our active pipeline, understand our leverage, and we will make those decisions as to how much should we returning capital to shareholders versus how much would we push towards M&A, given the pipeline. And back at the Investor Day in May, we had mentioned that we repurchased more than $620 million of stock over the past 5 years. That's an average of $130 million per year. We took advantage of the low prices in the market last year during the pandemic when some -- most companies were struggling to find cash. We bought back $200 million in shares. So we firmly believe that we have an opportunity to be more assertive with our balance sheet and return of capital to shareholders and share repurchase authorization. And share repo is part of that equation, and we're meeting with the Board of Directors this week again. So these conversations are at the forefront of our mind.

Great. Thank you. Lynn, maybe switching gears to embedded computing. I know that's where you came from, too. So this is probably a really good question for you. Embedded computing has been getting a lot of attention out there in the public market. How do you think about your business versus the competition? What are key differences? And can you talk about your ability to increase margins there? Because I think for valuation, if you compare your valuation to pure play out there for embedded computing, I mean, there's a very significant difference.

Thanks for that. And yes, it is always an area I'm happy to move the conversation to, so I appreciate that. So we really are the leading supplier of embedded computing technologies in the open standard arena. We've been in this business since its inception back in the mid-'90s when the initial Admiral Perry memo was issued to push the military to use more COTS in designing their systems for affordability and speed. So over that time, we've participated in over 4,000 programs. And so really have a broad customer reach and a great reputation in this space. The applications range from sensor processing, C5R mission computers, fire control computers, networking in the battlefield, it's just such a broad capability. And it's not just for the U.S. It's about 25% of the business is outside the U.S., and 75% is in the U.S. So you can see that's a huge customer and geographic reach. This is one of the areas where we have consistently invested our R&D dollars over the year and has the largest single area of R&D investment across the company. I think Chris mentioned earlier, we're increasing our R&D investment in this segment, $8 million this year alone. And some of that is really because we feel like we made a great move when the next wave of open standards, the most recent through the Tri-Services memo, was pushed out in the end of 2019. We just wanted to be very active yet again in forming those open standards and bringing products to market in those open standards. And so with that, right now, we have the broadest MOSA portfolio of products available in the marketplace, which is really going to be in the center of increased outsourcing from our defense customers. And we really think we've positioned ourselves through being a true player in the open standards market and being able to have those products. Something else though that on top of just the new products. One of the things Curtiss-Wright has really honed an outstanding capability in is our ability to provide life extensions on older products. Sometimes the customers don't have the R&D money or don't have a technical need to upgrade a certain system within a platform. And we work very hard with those customers to understand they're going to have those needs and provide life cycle extensions on those platforms. And so that really makes us a really good partner to our customers because we're there with the latest technology or will extend the technology that we are building. And that team obviously has very healthy margins. It's not -- it's an area where we could have raised the margins this year and not invested that R&D. We're doing those trade-offs year-over-year case by case. And where we feel like there is really good paybacks for the investments, we're going to make the investment in that business. So we're there and can sustain the great growth we've had in that business.

Thank you, Lynn. And the audience, as a reminder, if you have any questions, feel free to type them in your portal. This is meant to be an interactive session. With that, Lynn, when you think about your seat now, I mean, you've been in the CEO position for more than 8 months. If you kind of look back to where we were earlier in the year to today, what areas of the business are stronger now? And which areas of the business do we have better or worse visibility in terms of outlook?

So I'd open by commenting that when we put forward our Q2 results in early August, we chose to raise guidance on the full year based on our A&I segment, but overall for the company. And so I think that should show that we're feeling really good that we're going to have a great year and felt the confidence to be able to do that. With that, the portions that are stronger as our defense backlog remains very strong, particularly in the naval defense. We had a press release on some strong orders in Q2, and we're expecting strong orders in the back half of the year for that to continue. So that business, we've got great visibility, great stability in that business. It's going very well. I talked about our position in MOSA. That continues to make us very well positioned. And we've been trying -- I don't know if you've noticed, we put out a few more press releases on where we're winning major system wins with that MOSA architecture. So you can see how those R&D investments are turning to real wins in the marketplace. PacStar is off to a great start for the year. They're having a very strong year. The integration is going very well. We were very open about them being diluted to margins when we bought them. And the integration to help them climb up the margin curve is squarely on track. And so we feel positive about that and the uptake of their products within the Army and the Marines predominantly. So that's great. But it's not just the defense. If I flip to the commercial side of the business, you probably may have noticed in our last earnings call, our book-to-bill and our commercial business is quite strong at 1.1x, which we were really pleased to see. Our industrial vehicles, the rebound is really quite outstanding in the uptake in our ability to win new platforms. So we feel great about that. And we're seeing a rebound in our sensors and actuation group mostly around the commercial half when we were anticipating that really ticking up in the second half. We're also really pleased as you probably know, last year, we did a lot of restructuring and we're seeing the restructuring savings come through as we anticipated. And so those are all things that are really stronger in the business. In the visibility, I mentioned the orders. I'd say the one place where we are still waiting to see the anticipated rebound turn into orders is really with our surface technologies around the commercial aerospace business. The dialogue is good with the customers, and they are making sure that we're ready to be there for them. But it's -- that's the one area I would say we're still -- we need to see in the order book to feel more confident in that. And risk on the year, the risk of COVID are still real. And all our factories are up and running. We have good safety protocols in place. So I feel like we're doing everything we can and being successful in that area. I think it's more -- it's almost in the supply chain, where we're seeing some delays in materials from smaller suppliers maybe that have had outbreaks and things along those lines. The other thing that we're really watching very carefully is the chip shortage, that it has continued to become more of a challenge as the year has progressed. And the end is a lot of people are saying that this is going to carry on into '22. So we're really aggressively pursuing strategies to battle against this, whether it's dual source or getting our DPAs rating so we can be prioritized for chip shipments. They're working with the executives and the suppliers to help make sure they understand the absolute criticality of Curtiss-Wright, getting the electronics for our national safety. So the team is doing a great job, but that's definitely a watch item for us.

So actually, Lynn, it's interesting. That's a great segue because that's a question we have here in the portal about the chip shortage. You mentioned that to get your security or rating or derating to be able to get a priority, can you expand a little bit more on that? Like what percent of your business would qualify under that? And what does it mean for you to get government priority as a defense contractor for national security reasons to be able to access the chips? And then also, what percent of your business is affected by the shortage? And lastly, the other part would be for vertical integration, seeing how disrupted the supply chain is and with your role in embedded computing, is there an opportunity for you to think about vertical integration here and have a U.S. or a Canadian supplier?

So starting with the DPAS rating. I wouldn't feel comfortable saying off the top of exactly what portion of our embedded computing technologies has received DPAs rating, because that is definitely something that is not meant to be made public. So we've had some programs in the past. We've very actively been working with our customers to make sure we have it everywhere we can. And I think I'll leave it at that. But when you think of where our electronics go, it would be reasonable to think that we could achieve this on a reasonable portion of our revenues, given these are all going into end platform, C5ISR type of assets in situations like that. But that's a journey, and we definitely have revenues that are not protected by the DPAS. So I don't want to leave an overtone that we've got the whole defense Electronics segment covered through that. From a verticalizing the supply chain, it is something that we have talked about. It's -- for a company of our size to be quite transparent, it's not very practical that we are buying, we are sourcing chips from Intel, NVIDIA, micro memory. And -- but really, our better approach there, those are single source supplies, and we just need to work with those companies very carefully, maybe spend a little bit of more of our money ahead of time and have a greater visibility. One of the great things is our customers are being very, very transparent with us on their future needs to help us plan so we can work with our supply chain. So it's really helped open up a really good dialogue with a lot of our customers so we can do the best we can with what we have. But to go into the chip making business and that sort of stuff, I don't see that in Curtiss-Wright's future. But if it's not those big things, you can dual source a lot of the other things, and we are very actively looking where we can have dual sources of components and making sure we get those qualified. And I think there was another of your question that I might have skipped over.

Well, I think it's more about percentage of what is exposed to chip shortage in terms of your business. But I'm not sure if you would quantify that, so I figured. I thought that we'd try, right?

Yes. Thank you for that.

I think moving on to the power gen market for nuclear power, can we -- I guess I have a 3-part question. So I'll just do them in pieces or if I could -- I mean, I could just say them all. So for the nuclear power gen market, first of all, how are you thinking about this industry? What is the long-term growth outlook that you think of when you think of nuclear power gen? Second, when should we expect a new AP1000 order coming into play again? And then third, with your previous agreement with Chinese customers and AP1000, you had a technology transfer agreement. So where is the domestic Chinese competitor there on AP1000? And how does that change the opportunity for growth that you see in the long run for that business?

Chris, why don't I let you start off with some of the numbers and then I'll take it from there.

Yes. I'll Let Lynn handle the really hard questions, Kristine. But just to kind of talk about the current year and what we're seeing. Obviously, last year, the business and our nuclear aftermarket was really affected by the social distancing orders that many of our customers put into play. And we really didn't see most of that start to take effect until the second and third quarter of this last year. So we started off initially here in the year. We were a little bit down in our nuclear aftermarket. But I will say that in Q2, our nuclear aftermarket sales were up 10% year-over-year. So that's U.S. MRO and then also Canadian plan life extensions. And we are expecting a fairly strong ramp in the second half of the year. We've got a strong second half outage season that's ahead of us. But then also, we're starting to see more and more funding come in from the Department of Energy for these advanced reactors, microreactor-type technologies and various initiatives in support of their 10-year strategic plan. Overall, for the year, we are projecting low single-digit growth in this market. But I would also remind you that we are winding down on the CAP1000 program. So the growth rate is good in the nuclear aftermarket facing a little bit of headwinds as we wind down in that program. Now we have removed the CAP1000 or any new CAP1000 orders from our 3-year outlook, so those targets that we just set back in May. And it's a low single-digit growth rate for that market, excluding an AP1000. But we are seeing a lot of exciting things right now in nuclear. And maybe, Lynn, I'll turn it over to you.

Yes. So on the Chinese competitor, we do know that they are working to produce their own version of the reactor coolant pump. We believe they may have constructed their first RCP. We don't really know the quality of it. And honestly, we do not have any insight as to when it will be fully tested and certified. But I think in the end, we do feel comfortable anticipating a good market for us in China, that they put forward their 5-year energy growth plans and it has quite a significant ramp-up in their nuclear -- their energy coming from nuclear to 20%, 25% and 30%. And with that, we feel that they will need to leverage the full global nuclear supply chain to be able to achieve those goals. AP1000s have done great over there. We get great feedback from the power operators that have those AP1000 plants and know that they see it as a really capable, safe solution for within China. But even the other exciting thing, specifically with the AP1000, is there continues to be more and more interest from the Eastern European countries and India continues on. And so we see these -- this is a long-term game. And I know you know that, but we do still see things moving in the right direction to give us optimism that it's more of a win, not even if we'll have another significant AP1000 order. But to reemphasize what Chris said, it's not in our 2023 targets. We're not looking for an order or anticipating an order in that time frame. Of course, it would be great if one happened, and that would really just be a fantastic thing for Curtiss-Wright, but it's not in those targets. And the good things with other AP1000 orders and then in our aftermarket in the new build market, there's just a lot of really good things going on with our nuclear segment right now. And we're way more optimistic about the future than possibly we had been in some prior years where things were fairly stagnant.

Great. I mean not having the new AP1000 order in your 2023 outlook really derisks that outlook. So does that mean that you don't expect any orders for new AP1000 order from now until 2023? Or could we see a surprise?

Surprise is always possible. But we're -- I think what's important is we're managing the company and can see the financial targets that we put forward around building operating income, growing that faster than growing sales. So incremental operating margin expansion after we get to the 17%, we're managing the company to we think what is very successful financial results without that order. So like I said, that order would just be juice on top of that.

We certainly have the capacity, and we're ready, Kristine. So anytime it comes, we'll be ready for it.

Yes. It was great to visit your facility outside of Pittsburgh and see that in construction a few years ago. Great.

That's a [indiscernible].

Yes.

Well, I think with that, that's the time that we have. Lynn, Chris, Jim, thank you very much for joining us today at our Morgan Stanley Virtual Conference. We hope that next year, this will actually be in person, and we'll all be in Laguna because it will be time for our cocktail hour.

Absolutely. It was nice seeing you again, Kristine.

Yes. Thanks, Kristine.

Take care guys. And this concludes our session today.