Operator: Ladies and gentlemen, thank you for standing by. Welcome to the Woodward, Incorporated Second Quarter Fiscal Year 2024 Earnings Call. At this time, I would like to inform you that this call is being recorded for rebroadcast. [Operator Instructions]

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: 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: 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 0-safety incidents due to the existence of layers of protection and 0-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 in 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 aspect to 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 9 Woodward innovation network teams, who work on breakthrough technologies, in some cases, leveraging innovation breakthroughs across our 2 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 remain 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: 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 Instructions] And your first question comes from David Strauss with Barclays.

David Strauss: Your increased guidance on the Aerospace side going from 10% to 14%, now 12% to 14%, is that -- what is that attributable to? Is it OE aftermarket? And could you -- Chip, could you address where you currently sit in terms of MAX rates and MAX rates and 787 rates?

Charles Blankenship: Yes. So taking the second one first, because I think it's the really -- a 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: Okay. And the change in your guidance? And then I know it's only 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: And maybe for Chip, it's LEAP.

Just on the tightening, it's just based on what we've seen in the first half for Aero, and then tighten it up as we have half a year left. So we just see tighter visibility of that Aerospace range. OEM is -- continues to perform well. Aftermarket is also holding in. So that's really, David, why we're tightening it up to 12% to 14%.

Charles Blankenship: Yes. I'd say just a little more confidence that 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: And we will take our next question from Scott Deuschle with Deutsche Bank.

Scott Deuschle: Bill, can you say what the price realizations were this quarter and how that splits between the segments?

William Lacey: Yes. Scott, we continue to see really great price activity to help us offset our -- inflation that we're seeing. It'll be around 8 -- just below 8% price realization at the company level. And I'll just say that each segment contributed their fair share to that overall outcome.

Scott Deuschle: 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: 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: 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: Not at this time.

Operator: And we will take our next question from Robert Spingarn with Melius Research.

Robert Spingarn: So Chip, often when a new CEO comes in, a new CFO, you implement a lean program or some other kind of operating system. It can take a while to bear fruit. You've had very good results so far. And so I wanted to ask you how that's taking place?

And then maybe as a follow-up. In other words, why -- you're getting faster traction than some others. But also, Bill, is there any way for you to parse out how much of the improvement in performance in margins is lean and execution as opposed to obviously, price and volume?

Charles Blankenship: So I guess first question first. Woodward has been on a lean journey for close to 8 years or so. And it's taken different -- it's had different chapters to it, in terms of what the focus has been on. So when I joined and brought a few other folks along with me, we're building on that foundation that was here. So a lot of the language was in place, a lot of understanding.

I'll just say that the challenge really hasn't been with what we started with from the seasoned veterans in the company. The challenge that we face is what everybody else faces, and it's the how many new people are on the team. So that's our challenge in our production facilities and our production system is getting the newer people acclimated, the newer frontline leaders acclimated and expectations set. And it's just -- like you said, it is a long process.

And we've been able to stabilize some of our supply chain. We've been able to stabilize and then grow output in a number of our plants. We still have quite a bit of variation between plants' performance in terms of on-time delivery and the productivity journey. So there's a lot more to do, and there's a lot of upside over the next 2 to 3 years that we see based on really getting traction and moving to the more advanced levels of increasing inventory turns and really getting more productive on the lines and in the flow of our products.

William Lacey: Yes. And Rob, I think it's going to be hard for me to split that out. For sure though, we have -- the margin expansion has benefited greatly from our focus on price, but also our operational excellence has allowed us to improve our output. And we are getting margin expansion because of our ability to deliver on that in the volume and getting that levered through.

I think on lean, as Chip mentioned, we're in the process, and I think that there's a lot more opportunities for that in the coming years. But great execution and good price and volume flowing through has really contributed to our margin expansion.

Robert Spingarn: I know that people like to say lean is this never-ending journey. But based on what you both just said, is there a way -- I think, Chip, you said 2 or 3 years to get all of this fairly mature. Is there a way to characterize what inning we are in with lean?

Charles Blankenship: 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: Okay. And then just one more quick thing. Woodward's typically spent about 6% of sales on R&D, and you're a bit below that lately, 4% or low 4s. Longer term, what's the right -- the appropriate amount to spend and where are you focusing the R&D efforts?

Charles Blankenship: Sure. As you probably know, that these are long-cycle businesses we're in, both the Industrial and the Aerospace. And when new products -- new product opportunities come along for us to participate in, whether it's the launch of a new industrial engine or industrial gas turbine or a new airplane, our R&D expenditure goes up when one of those programs comes in because there's just so much involved in designing, developing and testing and certifying those new products.

Right now, we don't have a lot of that activity going on. We've got a few components here and there on missiles and space. We've got a few P2X new renewable fuel type of opportunities underway in Industrial. And then we've got this really large ZEROe Airbus fuel cell demonstrators. So we've got a few of these more technology development and smaller customer product development going on. We don't have any really big platforms underway with the customers. So that's what's allowing some of the R&D to be a little bit lower. And quite frankly, our net engineering expenses are up. So we've deployed engineers to help with the production and productivity and what we're trying to do with lean.

So I think it's not as much about we're investing less in our products, people and the future. It's just taking some different color of money and putting it in different places right now where the needs are.

Operator: And we will take our next question from Gavin Parsons with UBS.

Gavin Parsons: Guys, on the Industrial guidance revision, can you parse out how much of that was China truck versus non-China truck?

William Lacey: Yes. I'll just say in general, Gavin, it is, as we talked about, recognizing that China on-highway third quarter volume -- and we did see, based on our non-OH performance in the first half, that we are expecting that to stay consistent throughout. And the combination of those 2 is what led to us increasing our Industrial guide.

Gavin Parsons: Okay. I think non-OH might 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: Yes. We believe that, that will be sequentially stable.

Charles Blankenship: Yes. We're working with our customers. We -- that was our -- what we said we saw in the future based on customer input. But that pull forward different mix first half versus second half actually didn't materialize. So that's a piece of the change to the guide as well.

Gavin Parsons: 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: 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 3 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.

Gavin Parsons: Okay. Great. No, it's a small but significant piece of the business, so I appreciate all the color.

Operator: And we will take next question from Louis Raffetto with Wolfe Research.

Louis Raffetto: Maybe just quickly, I know -- I think you said that oil and gas is up 7% sequentially. Do you have that for either and/or both the other businesses in the Industrial?

Charles Blankenship: So transportation is flattish sequentially. I'm looking at the red thing.

William Lacey: You're right. Yes. You're right.

Charles Blankenship: And then power generation is up, say 7%, 8%, maybe high single digits.

William Lacey: Right.

Louis Raffetto: Okay. Great. And then, Bill, maybe just for you here. Was there anything in the Aerospace -- a great performance. So anything sort of, I'll say, onetime nature there? Just trying to sort of square what you did in the second quarter with sort of the guide for the rest of the year. It almost looks like margins are going to step down like 100 basis points. Is there any reason for that or conservatism?

William Lacey: Yes. I think I'll pick up in your last word. Conservatism is definitely a thought that we have as we look at the environment of -- where first half, finishing up at where Aero is, right around 18.5% between the first quarter and the second quarter. So that implies, for the second half, roughly the same amount that we saw in the first half. And so there were some good service sales, a little bit of good mix in the second quarter, but we think we'll continue to have a solid Aerospace margin rate come out there. And all that comes through, we'll be at the upper end of our 18% to 19% guide, but we are also being mindful of supply chain as well as our OEM demand.

Charles Blankenship: Demand, yes.

Louis Raffetto: 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: 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 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: And we'll take our next question from Pete Skibitski with Alembic Global.

Peter Skibitski: Another nice quarter. One more question on China. I just wanted -- the way you guys are talking, it sounds like you'd be at least $185 million, maybe a little -- maybe $195 million, $200 million for this year. How would you suggest we all think about fiscal '25? What's reasonable in terms of everything you know today? Directionally, at least up, flat, down, a little down a lot. What's the right way to think about that?

Charles Blankenship: Well, I don't know what the right way to think about that is, to be just completely candid. What we're doing is making sure that we're working on all the other parts of the Industrial business to have '25 be a really good stepping stone towards our 2026 commitments that we put out there. So we're working on every other part of the Industrial business and making sure that we're ready to respond to the -- any demand we get from China that can make that story better from a margin standpoint and serve that customer well. So that's how we're thinking about it. We kind of model it in there as a very breakeven kind of level for us, something that does no harm to our plans.

And we -- like I keep kind of saying is there's 2 things that drive us to behave that way: one is a lack of visibility to a market dynamic that we can predict a trend for and really customer volatility that can result in volume disappearing within a quarter. So those 2 things, I believe, require us to plan and act the way we're acting right now. If there's a change to either one of those, like we start getting a lot more visibility to real market dynamics, where we have longer-term customer commitments from all of our customers in China that would allow us to have a firmer view on what a forecast turning into shipments would be, we would plan differently. But for now, that's our approach.

Peter Skibitski: 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: 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: And we will take our next question from Gautam Khanna with TD Cowen.

Gautam Khanna: 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: We do have a good sense of it, and that sort of -- as Chip just mentioned, as we're looking out, that's kind of how we plan the business at that roughly breakeven point. The first half of last year, where we didn't have much, OH, it was in that breakeven to a drag kind of environment.

Charles Blankenship: To negative, yes. Just negative.

William Lacey: And so then as we started seeing it creep up, that's where we started to get a lot more leverage and was able to get above that. But we do have a good sense of where that point is.

Gautam Khanna: Would you mind sharing that with us? Last year, first half, I have about $40 million of estimated sales.

Charles Blankenship: Yes. I can't give you that. But we do have a good idea, and we use those for planning purposes.

Gautam Khanna: 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: We are in line with what we guided in the $35 million to $40 range, yes.

Gautam Khanna: Okay. And just following up on an earlier question about LEAP aftermarket thus far. I'm curious, given the OEM -- and CFM has a lot of service contracts attached to the LEAP. Are you seeing much in the way of aftermarket pricing opportunity for those products that you're selling into the aftermarket right now? Or are those going, I would imagine, more and more through the CFM service shops and, therefore, going out at the same price as an OE sale? I don't know if you have any view on that.

Charles Blankenship: 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: 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: Yes. There is -- we don't see any major changes beyond what we expect in inflation. We continue to drive good price and productivity to continue to expand our margins and kind of yield the guidance that we provided on the Industrial business.

Operator: And we'll take our next question from Tony Bancroft with Gabelli Funds.

George Bancroft: 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: 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: And we will take our next question from Sheila Kahyaoglu with Jefferies.

Sheila Kahyaoglu: Chip, I wanted to ask a few Aerospace questions, just given the performance was really good. On commercial, starting with maybe price. How do you think about pricing within OE? You talked about the aftermarket. When we look up 15% in OE and when we kind of look at the engine manufacturers, fleet shipments were flat, but revenues were up 30%. PAT was up 40% on shipments, but revenues were up 60%. So can you talk about your shipment delta versus [indiscernible] OE growth?

Charles Blankenship: So our shipments are up quite a bit, and we've, in some cases, added some scope. So that has also caused what little step functions inside our uptick of revenue year-over-year.

The -- as far as pricing goes, as you know, most of those contracts are long-term -- very long-term contracts. Some are life of program. Others are just decades. And we are able to capture escalation, to some extent. And so the pricing year-over-year can be quite substantial with indexes that have performed quite -- have moved quite high in the high inflationary environment. So it's a combination of shipping a little more number of part numbers, having the escalation clauses come in reasonably favorably and then also the rate and demand go up from the manufacturer.

So that's one of the things that we can't see very well is where the inventory is getting bound up in the system, whether it's ending up at the airframer, in terms of built aircraft, all the way in at the flight line delivery and weighting or it's at the airframer facility, in terms of an engine, or it's sitting in the incoming inventory, our part sitting in the incoming inventory of the engine manufacturers. So there's a lot of spring and damp in the system. And demands may have been higher than the shipment that was being achieved by the engine manufacturer quite easily since they're trying to sort out all their different suppliers and they don't want to turn people on and off.

Sheila Kahyaoglu: 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: Yes. Just on the aftermarket, Sheila, this time last -- the first half of last year, we were having some supply chain challenges. So we saw some depressed numbers in the first half throughout the year, though we saw that improvement come back. And so the comps are a lot higher in the second half. So we see that our -- we're about at the right level, and we expect that to sustain through the rest of the year. But again, those comps are going to get tougher because the supply chain did improve last year.

Charles Blankenship: 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: 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: Most favorable mix?

Sheila Kahyaoglu: Yes. In terms of margins, whether it's defense aftermarket or aero aftermarket.

Charles Blankenship: The commercial aero aftermarkets, what I'd say, is our place where we can get the best returns. And the situation with deliveries not increasing where -- when the demand is so strong for travel is resulting in the legacy fleet flying longer and harder than we forecast. So one of the good things that's different from when we put together this operating plan is we were thinking that we would be coming off of the peak of things like V2500 fuel controls and CFM56-5 HMUs, that these sorts of fuel control overhauls would be less and less and that we would have seen the peak already. But with the current situation, we believe that peak may extend quite a bit. And that's one of the things we factored into the second half, is that not going down.

Operator: And we will take our next question from Michael Ciarmoli with Truist Securities.

Michael Ciarmoli: Nice results. Maybe Chip, just to stay on kind of Sheila's questioning, and you talked about that aftermarket, up pretty strong on a sequential basis, on a year-over-year basis. Was there anything -- and I know that the second quarter tends to be seasonally strong for you. But anything to call out? I mean, was it more provisioning? Or any different color there aside from these OE challenges? Anything driving that particular strength?

Charles Blankenship: Yes, there was some provisioning in the quarter. So -- and that -- like you said, it's seasonal, plus some provisioning, and then not dropping off on the legacy fleets and having a little bit of LEAP come through and a little bit of GTF fuel nozzles come through. These sorts of things all happening a little -- contributing a little bit to making it fit better both sequentially and year-over-year.

Michael Ciarmoli: 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: We're talking to them continually, as you might imagine. The feedback is that we're on plan with them and to stay tuned. And so we're staying tuned. And we're telling you that there's a range of things to expect for the second half. And some of it depends on just how much schedules get pushed out in fourth quarter. We think third quarter is pretty well kind of baked because it's -- you don't make sudden moves in the supply chain, unless you're China on-highway. Note to self. But we're looking at fourth quarter -- our fourth quarter and saying there's probably some movement to expect there. And that's why we're focused on the other levers that we had to make sure we can cover anything that gets pushed out.

Michael Ciarmoli: Got it. Got it. And just last one. You just bought up the China again. I mean, is this sort of the business -- maybe not at these levels, but can you underwrite this sort of work and these opportunities in perpetuity? I mean is there a potential outcome where they bring work in-house, they go something homegrown? I guess, just trying to figure out how confident you guys are in your position there over the long term with your customers.

Charles Blankenship: 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: And we will take our next question from Noah Poponak with Goldman Sachs.

Noah Poponak: Have you ever modeled out how large the LEAP becomes as a percentage of the total company earnings whenever that aftermarket stream become -- hits something close to steady state?

Charles Blankenship: Well, the LEAP plus GTF is a pretty impressive aftermarket stream in our models. We are talking about quite a few years. Because in our 2026, '27 type of horizon, we're still not seeing a huge contribution. That's more like a '28 to early '30s as far as when it really -- those come home, if you will, for the repair and overhaul.

One thing I'll tell you is we're planning to grow the rest of the company alongside that. So I'm not bringing any panic bills about concentration because we're -- we've got a lot of other irons in the fire and a lot of other business to grow by the time we're talking about late '20s, early '30s.

Noah Poponak: Okay. That makes sense. The Aerospace -- if I look at the Aerospace margin from the perspective of an incremental margin, in the first quarter, you were in the mid-30s, but it was a pretty easy compare. Second quarter was a lot tougher compare, but the incremental went up into the 40s. It didn't sound like anything super abnormal in there, maybe a little bit of mix. I guess the back half -- the guidance implies you kind of drop back down in the low to mid-30s. And then from there to the '22 outlook is 30 -- I'm sorry, the 2-year forward outlook is 30%. I guess do you have a framework for the right kind of sustained drop-through in the Aerospace business? And I know right now, there's kind of -- you're getting both pricing costs above very long run normal. But just trying to get a better sense for what's possible from you on these Aerospace incrementals moving forward here.

Charles Blankenship: I'll let Bill answer the rest of this question. But I mean, it is a mix. It isn't very important about what the mix is when you calculate that flow-through. So our mix -- sequential mix got more aftermarket in it by a little bit. So that can turn the wick up a little bit on the flow-through. Bill?

William Lacey: 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: Okay. Great. Chip, when you were just talking about in looking at strategic changes to how you sell China on-highway and things of that nature, what would that actually look like? What -- are you talking about minimum buys in short windows of time? Or how could that actually manifest?

Charles Blankenship: 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: Okay. And then just last -- the -- in the near term, is it correct that you guided 3Q, down on-highway, to $30 million to $40 million revenue? And did you say anything about the fourth quarter sizing?

William Lacey: $35 million to $40 million for the third quarter, Noah. And for fourth quarter, again, just minimal amount at this point.

Noah Poponak: And that -- Bill, is that minimal is just you're only going to guide one quarter at a time? Or is that what the orders are telling you?

William Lacey: The -- correct, based on our visibility and our feeling comfortable about that. It's kind of 3 quarters out, which is more than what we had sort of at the beginning of -- or sorry, the second half of last year. We did get a little more visibility, and that's what we have to work with for now.

Operator: And we will take a follow-up question from David Strauss with Barclays.

David Strauss: 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: 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: 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: 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: 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: I'd just like to thank everybody for joining the call, and we'll talk to you again next quarter.

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.

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