Thank you for standing by. Welcome to the Woodward, Inc. fourth quarter fiscal year 2020 earnings call. At this time, I would like to inform you that this call is being recorded for rebroadcast and that all participants are in a listen-only mode. Following the presentation, you will be invited to participate in a question-and-answer session.

Joining us today from the company are Mr. Tom Gendron, Chairman and Chief Executive Officer, Mr. Bob Weber, Vice Chairman and Chief Financial Officer and Mr. Don Guzzardo, Vice President of Investor Relations and Treasurer. I would now like to turn the call over to Mr. Guzzardo..

Thank you operator. We would like to welcome all of you to Woodward's fourth quarter fiscal year 2020 earnings call. In today's call, Tom will comment on our markets and related strategies and Bob will discuss our financial results as outlined in our earnings release. At the end of our presentation, we will take questions.

For those who have not seen today's earnings release, you can find it on our website at woodward.com. We have 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 December 3, 2020.

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 three.

As always, elements of this presentation are forward-looking or based on our current outlook and assumptions for the global economy and our businesses more specifically, including the expected and potential effects of the ongoing COVID-19 pandemic and related measures taken by individuals, governments and private industry.

Those elements can and do frequently change. Please consider our comments in light of the risks and uncertainties surrounding those elements, including the risks we identify in our filings. 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 turning to our results for the fourth quarter.

Net sales for the fourth quarter of fiscal 2020 were $531 million compared to $737 million for the prior year quarter, a decrease of 28%. Net earnings were $57 million or $0.89 per share compared to $67 million or $1.03 per share for the prior year quarter.

Adjusted net earnings were $48 million or $0.75 per share compared to adjusted net earnings of $79 million or $1.22 per share for the prior year quarter. And results for the full year, net sales were $2.5 billion compared to $2.9 billion for the prior year, a decrease of 14%.

Net earnings were $240 million or $3.74 per share compared to $260 million or $4.02 per share for the prior year. Adjusted net earnings were $254 million or $3.96 per share compared to adjusted net earnings of $314 million or $4.88 per share for the prior year.

Net cash generated from operating activities for fiscal 2020 was $349 million compared to $391 million for the prior year. Free cash flow was $302 million compared to $292 million for 2019. Adjusted free cash flow was $315 million for 2020. Now, I will turn the call over to Tom to comment further on our results, strategies, and markets..

Thank you, Don, and good afternoon everyone. During fiscal year 2020, Woodward and the world experienced incredible volatility brought on by the COVID-19 pandemic. We acted swiftly to ensure the health and safety of our entire Woodward team and took immediate and aggressive actions to mitigate the adverse impacts on our business.

While we continue to grapple with this volatility in our markets, we remain keenly focused on diligent cash management, enhancing our financial strength and flexibility, and optimizing our cost structure to align with the lower demand environment.

Our team has executed well throughout the pandemic, and I am proud of their commitment and dedication to ensure we are able to successfully navigate the headwinds in front of us and position Woodward to emerge stronger. Moving to our markets in more detail.

Our aerospace markets were mixed for the quarter with weakness in commercial OEM and aftermarket, but with strength in defense. Commercial markets were impacted by the sustained decline in global passenger traffic and OEM production activity.

Commercial passenger demand remains weak across the globe with industry sentiment generally predicting a prolonged recovery for travel. With traffic well below past levels, we are seeing a significant number of retirements of older aircraft and the fleet is predicted to be smaller for several years.

On a positive note, the FAA approved the return to service of Boeing 737 Max. Together with the Max, the post-COVID fleet will be comprised of newer aircraft with greater Woodward content. When recovery does materialize, we anticipate the commercial aftermarket will be first which will bode well for Woodward in terms of earnings and cash flow.

In defense, we continue to see strong aftermarket demand related to upgrade and fleet readiness programs. Military OEM remained strong for fixed wing and rotorcraft. Guided weapons volumes have increased substantially over the last several years, and we anticipate some moderation going forward. I will turn to our industrial markets.

In power generation, demand for gas turbines improved from a very weak 2019, but it remained soft driven by impacts related to COVID-19. Engine applications are down across the board except for data center backup power.

On a more macro level, developing economies across Asia such as India and China continue to show signs of energy demand growth with natural gas and renewables expanding their share of the energy mix.

In transportation, marine markets have been depressed in almost all areas as a result of the pandemic, which has caused reduced demand for oil and gas and decreased ship utilization. These headwinds were partially offset by the continued strength of the China natural gas truck market driven by more stringent emission regulations.

Oil and gas markets continue to be pressured due to a drastic decline in oil and gas prices and weak customer demand. However, natural gas and crude oil prices appear to be stabilizing around current levels. Rig counts are increasing, which may indicate the potential for future growth in drilling activity.

The release of an effective vaccine or therapeutic could stimulate demand and lead to higher oil and gas prices and increased investment.

Speaking to our industrial business, overall environmental concerns and related emission regulations continue to drive the move to natural gas and clean burning diesel engines where we have significant content and market share.

Additionally, our focus on controls technology presents growth opportunities integrating new fuel sources, hybrid drive [ph] systems, and advance emission strategies. As the world searches for clear and more renewable fuel sources, we are partnering with our OEM customers to create the next generation of control solutions.

In summary, we have faced continual headwinds since the onset of the pandemic, but many of our markets have started to stabilize. We are working closely with our customers and suppliers across the globe to ensure a lean operational structure, strong balance sheet, and diligent cash management throughout the down cycle.

We continue to monitor the situation very closely and remain positioned to act quickly should the environment worsen or improve. With current market fog generated by the pandemic we anticipate continued headwinds in the near term.

However, we believe that our proactive efforts to mitigate the impact on our business and enhance our financial strength and flexibility have positioned us well to weather this uncertainty.

These efforts, coupled with our very favorable capital structure, our ability to generate significant cash, our completed monetization investments have us poised to deliver on our long-term growth and margin targets. As we go forward and we see clarity in our markets, we intend to return to our pre-COVID capital deployment strategy.

We will emerge stronger from this crisis and leaner than before. Now, I will turn the call over to Bob to discuss the financials in detail..

Thank you, Tom. Aerospace segment sales for the fourth quarter of fiscal 2020 were $336 million, a decrease of 34% from the prior year quarter. Results were mixed for this segment with considerable softness in commercial OEM and aftermarket, offset partially by strong defense aftermarket sales.

Commercial aftermarket sales were down 41% in the fourth quarter of 2020 as compared to the prior year quarter as a result of the sustained decline in flight hours across our markets. Defense OEM sales were down in the quarter, although our backlog remains strong and continues to grow.

Lower sales were primarily related to COVID-19 supply chain issues impacting guided weapons and fixed wing aircraft. Defense aftermarket was a bright spot for the quarter due to continued military spending to improve U.S. fleet combat readiness along with global upgrade programs.

Aerospace segment earnings for the fourth quarter of 2020 were $58 million or 17.4% of segment sales compared to $111 million or 22% of segment sales for the fourth quarter of 2019. Segment earnings were negatively impacted by the lower sales volume, partially offset by cost reduction initiatives.

For fiscal year 2020, aerospace segment net sales were $1.59 billion compared to $1.88 billion for the prior year, a 15% decrease. Aerospace segment earnings for fiscal year 2020 were $310 million or 19.5% of segment sales compared to $389 million or 20.7% of segment sales for the prior year. Turning to Industrial.

Industrial segment sales for the fourth quarter of fiscal 2020 were $195 million compared to $231 million in the prior-year period, a decrease of 15%.

Excluding the renewable power systems and related businesses, which were divested in the third quarter of 2020 and I will now refer to as RPS, industrial segment sales of $195 million for the fourth quarter of 2020 decreased 5% as compared to $206 million for the fourth quarter of the prior year.

Industrial segment sales, excluding RPS, declined compared to the prior year quarter, primarily as a result of the pandemic and low oil and gas prices impacting our global markets, partially offset by an increase in China natural gas engine sales.

Industrial segment earnings for the fourth quarter of 2020 were $19 million or 9.6% of segment sales compared to $11 million or 4.8% of segment sales for the same period in the prior year.

Industrial segment earnings of $19 million for the fourth quarter of 2020 were up compared to $10 million of industrial segment earnings, excluding RPS, or 4.9% of segment sales for the same period last year.

Industrial segment earnings for the fourth quarter of 2020 were positively impacted by cost reductions, but more than offset the impact of the lower sales volume. We continue to focus on industrial segment margin improvement through the strategic divestiture of RPS, segment infrastructure consolidation, and strategic product line rationalization.

For fiscal year 2020, industrial segment net sales were $905 million, compared to $1.02 billion for the prior year, an 11% decrease. Excluding RPS, industrial segment sales for fiscal year 2020 were $837 million, compared to $932 million for the prior year, a decrease of 10%.

Both industrial segment earnings and adjusted industrial segment earnings for fiscal year 2020 were $100 million or 11.1% of segment sales. Industrial segment earnings for fiscal year 2019 were $94 million or 9.2% of segment sales for the prior year. Adjusted industrial segment earnings for fiscal year 2019 were $115 million or 11.2% of segment sales.

Excluding RPS, industrial segment earnings and adjusted industrial segment earnings for fiscal year 2020 were $97 million or 11.6% of segment sales. Excluding RPS, industrial segment earnings for fiscal year 2019 were $97 million or 10.4% of segment sales.

Excluding RPS, adjusted industrial segment earnings for 2019 were $118 million or 12.7% of segment sales. Non-segment expenses were $0.2 million for the fourth quarter of fiscal 2020, compared to $36 million for the same period of the prior year.

Adjusted non-segment expenses for the fourth quarter of 2020 were $12 million, compared to $20 million for the same quarter last year. Non-segment expenses totaled $95 million for 2020, compared to $119 million for the prior year. Adjusted non-segment expenses were $67 million for 2020, compared to $80 million for the prior year.

At the Woodward level, R&D for the fourth quarter of 2020 was $27 million or 5.1% of sales compared to $36 million or 4.9% of sales for the prior year quarter. For fiscal 2020, R&D expenses were $133 million or 5.3% of sales, compared to $159 million last year or 5.5% of sales.

The decrease in R&D for both quarter and the full year was primarily due to cost reduction initiatives and the divestiture of RPS. SG&A for the fourth quarter of 2020 was $41 million, compared to $51 million for the prior year quarter. Adjusted SG&A was $43 million for the fourth quarter of 2020, compared to $53 million for the prior year quarter.

For fiscal 2020, SG&A expenses were $218 million, compared to $211 million last year. Adjusted SG&A, which primarily excludes merger and divestiture transaction costs, was $196 million for fiscal year 2020, compared to $211 million for the prior year quarter.

The decrease in adjusted SG&A for both the quarter and the full year was primarily the result of cost reduction initiatives and the divestiture of RPS. The effective tax rate for the fourth quarter of 2020 was 16%, compared to 12.8% in the fourth quarter of 2019.

The adjusted effective tax rate was 13.8% for the fourth quarter of 2020, compared to 15.5% for the fourth quarter of 2019. The full year effective tax rate for 2020 was 14.7%, compared to 19% in the prior year. The adjusted effective tax rate for the full year 2020 was 17.8% compared to 17.5% for the prior year. Looking at cash flows.

Net cash provided by operating activities for fiscal year 2020 was $349 million, compared to $391 million for the prior year period. Capital expenditures were $47 million for 2020, compared to $99 million for the prior year period. Free cash flow for 2020 was $302 million, compared to free cash flow of $292 million for the prior year period.

Adjusted free cash flow was $315 million for 2020. The increase in free cash flow and adjusted free cash flow was primarily the result of lower capital expenditures, aggressive cost control and effective working capital management.

As a result of closely managing cash and reducing debt, leverage declined to 1.7 times EBITDA at the end of the fourth quarter. We also have significant liquidity available through approximately $1 billion of combined cash on hand and our revolver capacity.

During fiscal year 2020, $51 million was returned to stockholders in the form of $38 million of dividends and $13 million of repurchased shares. Lastly, turning to our fiscal 2021 outlook. The global economic effects associated with the pandemic have been unprecedented in their scope and depth.

We continue to see severe volatility in our markets making forecast of our future business challenging. With that uncertainty, we will not be providing financial guidance for fiscal 2021 at this time, although we are encouraged by recent developments with respect to a vaccine, and therapeutics related to the pandemic.

This concludes our comments on the business and results for the fiscal year and fourth quarter 2020. Operator, we are now ready to open the call to questions..

[Operator Instructions]. And your first question comes from the line of Robert Spingarn with Credit Suisse..

Hi. Good afternoon..

Good afternoon Robert..

Bob, you just talked about the aero margins, and you had a nice sequential uptick here in the fourth quarter.

Is this indicative or how we should think about the first half of next year? I know you are not guiding but I want to get a sense of how that exit rate continues?.

Yes. As you said, it is extremely difficult to give any sort of guidance even in the near term given what's going on. So, we are encouraged we did take significant cost reduction actions that we believe contributed to that on the fourth quarter. We will continue to monitor the situation and respond accordingly..

Okay.

And then Tom with the Max ungrounding a positive, obviously here across the industry, does this help margins at all going into 2021, not so much because of OE, but more because of provisioning?.

We definitely anticipate we will see some pickup in provisioning, but it would probably be in the latter half of 2021. So that's when we expect to see it upfront. We will be working with our customers and trying to see how quickly the Max aircraft are brought back online out of storage, and then what the new production rate ramp looks like.

So overall, if you look out over the next 18 months, it is a positive and it's a very good thing for the industry and very good thing for Woodward..

One of your peers talked about a six, maybe nine-month lag from the time of a recovery in air travel to when the pickup in the aftermarket might materialize.

Would you agree with that kind of timeframe? They, I think, were talking more about their airframe business, but in general, is that about the right lag?.

I honestly think it's a little faster than that, Rob. And in that, I think the airlines have done an admirable job of managing costs and balancing their aircraft to optimize maintenance expenses.

I think as we get the fleets flying again that we will -- I believe, there is a pent-up demand that will be coming fairly quickly once we start – once the vaccines are out there, once the pandemic is over, if you want to call it that.

I think you are going to see pick up and we refer and a lot of people do, but we refer to it as a bullwhip effect in the aftermarket, and we do anticipate both aircraft and industrial markets that we participate in will see somewhat of a bullwhip coming.

It's just hard to pin down when that is, but I believe it's a little quicker than your other client or your other coverage..

Okay. Thank you very much..

You are welcome..

Your next question comes from the line of Pete Skibitski with Alembic Global..

Hi. Good afternoon, Tom and Bob and Don. Maybe, Tom, to start.

Could you give us a sense of the declines that you saw in the industrial niches in fiscal year 2020, commuted [ph] by power gen and transportation and oil and gas?.

By segment? I didn't understand the question..

Power gen, transportation, and oil and gas, was that the question, Pete?.

It was, yes, for fiscal 2020..

How each of those fared?.

Correct..

Well, they were all down. There wasn't a single one up. The only part of our business that was slightly up was China natural gas truck. Everything else was down..

Okay. So just thinking about fiscal year 2021, I know for turbines, for power, I think the GE order book year-to-date has been pretty soft. So, I imagine you are expecting and you have noted that that area lagged. So, I imagine you are expecting power gen to be softish in fiscal year 2021.

I guess I am wondering about the transportation area, marine and China CNG? China CNG, as you know, that seems like a secular play.

Are you seeing continued growth there? And then marine, not many people on the call, I don’t think are marine analysts, but are we seeing a soft comp going into fiscal year 2021 or is there a more downside in marine expected?.

I really expect that our fiscal third and fourth quarter and partly into this first, is kind of the bottom, exactly where it is a little hard to call.

And then we anticipate based on economic recovery, we will start seeing some pickup, but actually going in on the marine market there is no doubt as it's related to marine market, every segment of the marine market was down, and utilization was also down.

We do see over the next few years some brighter spots, in particular when you look at like LNG carriers and like we see strong order book for those and we have good a share on those type of the vessels. Power gen, when you talk about gas turbines, we kind of believe it's at the bottom here.

So, we kind of have seen some movement, and it's kind of a combination. Again, you heard me earlier talk about gas turbine. It's a combination of new builds, but also aftermarket. I believe a lot of inventory in the system has been drained. I think we are going to start seeing some of that.

Once again, as Bob was highlighting, timing is uncertain, but we watch carefully the material and the pipeline, and we do think it's being drained and there is some activity picking up, and we would start to see something there. So, a lot of our markets, everybody has taken aggressive action, people have attacked inventory.

So, as we see little turn in the demand pickup, you are going to see some recovery first and service activity, secondly in filling the pipeline with the inventory and then third with OEM production picking up..

Okay.

So when you comment on the bottom, you meant that for industrial as a whole, maybe we are kicking along the bottom here for the first half of your fiscal 2021 and then better days ahead in the back half of fiscal 2021 for industrial as a whole?.

That's what we are anticipating, again, with some uncertainty of course with if we get a – and we start shutting down the economy again or does vaccines come out and get widely distributed and people start generating economic activity again. So that's the uncertainty, but we would anticipate second half to be seeing some improvements..

Right. Great. Thanks for the color, guys..

Thank you, Bob..

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

Hi. Good afternoon guys and thanks for the time. Bob, you are not guiding on your aero margins on what we should do going forward. So maybe I will ask you on industrial. You guys have gone into the double digits and fell into single digits this quarter. The decrementals were a little bit lower despite, I think, organic declines decelerating.

So kind of puts and takes, I just would have thought your margins would have been better, especially given the divestiture as well?.

Yes. Again, back to nothing, no color in terms of 2021. But we are very confident that we have taken the actions that need to be taken to, a, get us through this crisis and b, provide the long term path to get us to the targets that we have called out in the past. As you know, we have called out 16% as a target and then going from there.

And we believe, on the longer term, we have made those actions. We have taken the right initiatives and we see a path to get there and maybe a way of some renewed confidence in that. But as you point out, it's very, very difficult to see anything in the near term.

And industrial is even buffeted by between the oil and gas prices and COVID, they have kind of got them both. So they are almost even more difficult, if you will, than the aerospace side. But confidence going forward..

Okay. Cool. I will take it. Tom, maybe one for you. it doesn't seem like the aftermarket was down 41%. So sequentially, not much improvement.

Maybe kind of what your are expectations, any details you could provide on what you saw in the quarter on that business? In the commercial aftermarket, sorry?.

Yes. Aftermarket, I would say on it, as we have seen, I will go back to the airlines doing a good job of managing their cost. Depending on which aircraft and which engines, we have seen sharper declines where they are not in service.

The core narrowbody applications from the 320ceo, neo and the 787 like we are seeing, given the pandemic, pretty good activity in those and we expect those narrowbody programs to pick up here shortly in the aftermarket just given their utilization will be the first to rise. So very, very difficult to forecast and to monitor but we track.

We are working with our customers daily trying to make sure we keep them serviced, just to make sure they can fly. But the hours aren't being put on enough to see that turn yet. But we anticipate it will be coming..

Got it. Thank you. Thanks a lot guys..

Thanks..

Your next question comes from David Strauss of Barclays..

Thanks. Good afternoon everyone..

Good afternoon..

Following up on that, on the last question about the aftermarket.

Tom, are you seeing any sort of discernible difference between engine and non-engine, I guess your flight deck products in terms of the aftermarket?.

Well, generally, we always do. Just from a standard, the engine products generates substantially more aftermarket than what we call our airframe products. And even in this downturn, that's continuing. So that is the case.

And as soon as we see more hours on the fleet, we can then forecast forward more aftermarket coming, because we have pretty good analytical tools to the equate what hours per application means in terms of maintenance activity. So it is definitely much more heavily weighted to our engine applications..

Yes. I guess I was just talking about level of decline. I mean, the 41%, is that pretty similar in terms of declines you are seeing across both? I would have thought the flight deck side maybe is a little bit more discretionary than the engine side..

Yes. It's a good question. I don't have it exactly in the head but I am going to tell you as we look at the aftermarket, it's pretty uniform declines..

Okay..

Most of our products, thrust reversers and things like that, they are more of a function of the flight profiles than anything else. And so I think, as Tom said earlier, the airlines have done a good job, you are right, of where they can apply discretionary spending.

But otherwise, it's the engines running 24/7 and the thrust reversers are going twice every flight or once every flight, excuse me..

Yes. Okay. And then what was the commercial OE business down in the quarter? I think you were down 63% in Q3.

What was that in Q4? And how does that break out between business jet and air transport?.

Biz jet hasn't been as bad. Commercial OE was down 64%, so obviously a big decline. Biz jets, the lower end of the smaller aircraft have been more impacted than the larger aircraft. And we kind of refer to it as a flight to safety.

So if you have the ability to fly a business jet during these times as opposed to commercial traffic, some people have taken advantage of that. So it hasn't been down as much as commercial OE..

Okay. And last one, I guess, on cash for next year. I know you are not giving guidance.

But Bob, what's the right way to think about, I guess, working capital, cash taxes, CapEx? Are any of those meaningful headwinds or a tailwind, I guess, either way relative to what we saw you up this last fiscal year?.

Sure. What I can tell you is, CapEx is under our control. And so we intend to hold that down to a number similar to this year. So call it $50 million range is where we intend to hold that. Obviously, equipment isn't being used at the same utilization levels as in the high times. So there is not as much maintenance needed in that regard.

What I will tell you is that the pattern on working capital is, during times of declining sales, working capital generates cash. And in terms of when we start to see increasing sales, it will start to flatten and then eventually be a use of working capital.

One major area that we have been focused on that will be the wildcard next year is our inventory levels. And we have been talking a lot about our operational enhancements and operational excellence and true north and we do believe that that will allow us to make progress towards our long term targets on inventory management as a percent of sales.

And so hopefully that will continue to be a tailwind in 2021 even as we come out of the downturn hopefully..

Okay. And [indiscernible].

Sorry. You are breaking up, Dave..

Sorry.

The cash taxes, is that a meaningful change next year with the payroll deferral?.

No..

All right. Thank you very much..

Sure..

Your next question comes from the line of Gautam Khanna with Cowen..

Hi. Good afternoon guys..

Hi Gautam..

I have a couple of quick ones. First, maybe you said this already.

But the non-segments, I was just curious why it was so low relative to historical levels?.

Yes..

And what we might infer about the future?.

Yes. The best way to look at that, there is a table in the back of a release that will show you all the puts and takes. W we had a fairly large number, as you can imagine, during a crisis and so on of one-off events that we tried to take out of the numbers so that you can see more of what the operational side of the equation looks like.

So they are kind of laid out in the back. And in terms of going forward, net net, we still did cost reduction activities in our non-segment portion of the business as well. And so we do believe that we will run a little bit lower on an ongoing basis going ahead than we have in the past..

Okay. That's helpful. Additionally, any sort of color on go forward tax rate? And pardon me if you already said this and I missed it..

No. We didn't cover it. Well, your guess is as good as ours probably on where the administration is going to. They have kind of made their position known in terms of what they would like to do.

And now it's just a matter of when and if this election ever is finalized and we see what happens with Congress on terms of what the ability will be to make any changes and if so, when. So no, we don't have any forward-looking statements with respect to the impact of our tax rate going forward..

Okay. And then just somebody asked about the aerospace margin improvement on a sequential basis.

And I wondered what we should read in, if anything, to the sequential incremental margins, which is nearly 60%, it looks like? It didn't look like mix was dramatically better, but the aftermarket down as much of it was and are we still down where you do make some money.

But I was just curious, like how should we think about incremental margins? Should we be thinking about it on a sequential basis because are not in kind of a normal seasonal pattern relative to prior years because of destocking and kind of the real-time nature of what's going on in commercial?.

Right. So when you look at the ratio and Bob can jump in here too, the ratio of OE to aftermarket, we are really seeing some favorable ratio there, even though they are both down, but down dramatically.

As we move forward, we keep going back to the uncertainty in the market, but we can tell you and we kind of alluded to that in the prepared remarks, that aftermarket is going to recover first, which carries better margins.

And so as we start to see that recovery, I think you are going see improved aircraft margins that then moderate as the OEM production rates come up.

So it's a little hard to exactly draw that curve without knowing exactly when the utilization will kick up, but that is, we have a very strong aftermarket, I think everybody knows that, very good installed base and the fleet, as we would now say the fleet demographics were working in our favor pre-COVID.

Now we think the aircraft that are going to get the most hours and the like are and the like are going to be more heavily weighted to Woodward content than in the past, which will help lead to generate better aftermarket revenue going forward.

So as soon as things pickup, I think you are going to see good margin growth tied to aftermarket and then tempering as OE production growth..

Yes. The only thing I would add would be the numbers which I think are significant. We said that commercial OE down 64% and aftermarket only down 42%. So that kind of speaks to Tom's comment about the mix. It's a much more favorable mix.

And in addition, sequentially the biggest increase we saw was in military OE which we kind of talked about there isn't as much differential on the defense side between OE and aftermarket. So that's a nice tailwind for overall mix as well..

Good point. And sorry, I did not heard that correctly when you said the mix. That makes complete sense. But speaking to that, with OE down in the 60% range for a few quarters in a row, presumably that's well in excess of the underlying consumption, right. There is some destock leading into that.

Do you have a sense for where that should eventually level out and how long it will take to get back to kind of underlying consumption versus the destock? Thank you..

Yes. I think what we have look at is and then we have to track closely, our customers stated production rates. So obviously, as Airbus moves to their 40 and 47 rates on the A320 and Boeing brings the Max back up and starts working towards their stated 31 per month rate, it's kind of a timing issue when do those rates actually materialize.

But we will start seeing the supply chain and then the stocking in the supply chain as those ramps occur. So we stated earlier that these couple, these three quarters, if you want to look at looking back and looking forward one, are probably the bottom as customers start those ramp rates and then there is the restocking of the pipeline.

So a little challenging to forecast as we highlighted, but the pattern will occur and we will see those ramps and we will see some inventory come in. So as we move into second half of 2021, we will probably see better visibility on that and better able to identify what that looks like for sales and production rates..

Thank you guys..

Thank you..

Your next question comes from Christopher Glynn with Oppenheimer..

Hi. Good evening. I was curious, you used the term severe volatility in the press release. I am wondering about the aero commercial aftermarket in particular.

Is that kind of steady sort of pattern? Or is that all over the place too?.

Well, I think the severe volatility is more on where we were, you could say, in February and where we are today. So we took it as a broader look. I think if your question is, are we seeing month-to-month large swings? No. We see minor swings at this much lower rate, which was high volatility..

Got you. And then them on the cash flow, the working capital looks kind of normal flows for the revenue pressure.

I am just curious about the overall supply chain as some players acting as temporary bankers for weaker players and if it takes a while for aftermarket to pick up whether it's through different sort of strains on working capital flows across the industry?.

Right now and for Woodward, I would only comment on that, we are seeing very good AR management, very good collections. We know various suppliers in the industry are under more stress. But we are doing very well on collections. AR is in very good shape. And we are confident we will be able to continue that going forward.

So from that standpoint, it's positive. We did mention a little bit about supply chain pressure and even some supply chain issues hampering sales. And really what that is all about is more tied to disruptions due to people not being able to be in the factories, transportation around the world.

Things is like that have caused some supply chain disruptions and product flow. And we are managing that quite well, but it's still out there. Especially this month as cases are picking up all over the U.S., we are seeing some impact from that. But we know that will temper with time.

But overall for Woodward, there isn't pressure, I don't want to say that but we are doing very well on AR..

Great. Thanks for that..

[Operator Instructions]. Your next question comes from the line of Chris Howe with Barrington Research..

Hi Tom, Bob and Don. Good afternoon..

Hi Chris..

I wanted to touch on aftermarket. If we kind of break out commercial aftermarket, you are seeing strength in defense aftermarket continue, the industrial aftermarket as well as consideration of the longer term opportunity that we could potentially see for LNG carriers.

Could you perhaps provide some color or just some general thoughts on the mix of aftermarket? And how we could see that potentially play out as we look into Q4 of 2021 and the early part of fiscal year 2022? Could we see a situation where as we normalize with this virus behind us that aftermarket for each of these respective areas normalizes in conjunction?.

Yes. I think you have it right. But I will try to give you a little more color. If we start on our industrial side, we do see strong aftermarket sales in the marine market, in the oil and gas market and if you want to say, in prime power applications. So these are where you get very high utilization of the equipment.

And as we said earlier, all those are down today and we have seen destocking or if you want to say, inventory management occurring.

So we do anticipate as we are looking at those as utilization picks up, which solid economic activity will drive that pick up, we will see both normal utilization driving aftermarket plus we should see some restocking in the supply chain. So we anticipate that. It's just the timing is difficult to predict.

But that would follow a pattern that at Woodward we have seen quite a bit. Bob and I both been here quite a while and we have been through many downturns and that is an exact pattern we see coming out of every downturn. So we t are confident in the pattern. It's just nailing the timing of that. So we do see that.

It is very applicable to the aircraft side as we think there is going to be a pent-up demand for maintenance and as that utilization goes up and the airlines, I always want to make sure I am not saying anything different than this, airlines are flying safe.

But they are being very smart in how to utilize their assets to not generate the need for extra maintenance. But once they are all flying again, that maintenance is there and those hours are accumulating and we will see that kick in. And so again, it's going to happen. It's just exactly when.

And we do think there has been destocking in the aerospace side as well where we anticipate we will see some pickup there. So latter half 2021 or 2022, based on the vaccine being successful probably, but exact dates somewhat challenging to predict..

Okay. Great. Most of my other questions have been taken, but I will try for one more.

Perhaps you can comment on backlog today, where it was last quarter, where it is now? And what your expectations are more specifically to the mix of backlog? What are you seeing there on a more granular level as far as COVID impact and how that backlog starts to accrue or turn the corner as we move forward?.

Yes. We have talked from time to time but we are on real-time systems that the formal backlog isn't very indicative. But to give you kind of some color, we did mention on the defense OEM side that largely driven by the supply chain issues and so forth, we have seen significant increase in backlog related to that.

And the same is true on the aftermarket side. On the industrial side, not as much there. It's probably more in pent-up demand. It's not as much backlog as it is pent-up demand. Tom mentioned the power generation side where we have got a lot of work. Those are utilized a lot.

And when you can't get people in the country to service them and et cetera, et cetera, you don't necessarily see an order backlog but you see the clock ticking down to the time they have to do something. So I think it's more of a, call it, an informal backlog that we are seeing on the industrial side.

On the commercial OEM, obviously there is not a lot of backlog there until we start seeing the production rates increase again..

Very interesting, Bob. I appreciate all the color. I will hop back in the queue. Thanks..

Thanks..

Your next question comes from the line of Michael Ciarmoli with Truist..

Hi. Good evening guys. Thanks for taking the call here and taking the question. Bob, I will go back to the beginning of the call and try and dig into these margins a little bit.

Not asking for guidance, but looking at the SG&A and R&D, I think the combination of both of those down $24 million sequentially, you obviously got rid of the renewable but are those sustainable run rates? And then again, just going back to that non-segment, at close to $40 million of operating expenses gone this quarter.

How do we think about that going forward?.

Yes. There are clearly elements of it that are sustainable. But there is also elements that are purely driven by where we are at in the crisis and phases of the crisis. So I think it is very difficult to say what types of costs are you going to have to put on when things start returning.

So you don't necessarily need to have that activity going on now but as things return you are going to invest in that as we go. There are a number of items. When you go through the list of all the actions that we took that you can see.

For example, forgoing our bonus for the year and so on, some of the salary reductions that were taken, some of the furloughs that we took during the year. Furloughs are temporary. They come back as the demand goes up.

Yes, there were a substantial number of layoffs, a substantial reduction in a lot of the temporary labor and things like that that will not come back early on but may come back as the recovery progresses.

So the only thing I can tell you for certain is that we do believe that the cost reductions and the actions that are sustainable will improve profitability as we go forward. But I can't tell you that when you look at some of the dollar amounts we are showing as savings today that those are all sustainable going forward.

It will be some portion of that, but not all..

Got it. I get it. What about the gross margins down sequentially on higher volumes and getting rid of the renewables. You have the favorable mix with aftermarket.

What drove the sequential decline in margins, gross margins?.

Most of that's still just, you have got a lot of fixed cost base that you get to a point where it breathes into the -- it's not the variable margin but when you get down to the gross margin level that you see the degradation..

Okay. So I guess last quarter you gave one quarter out.

As you sit here today, is your visibility better or worse, do you think, from three months ago?.

Today, I would say, it's worse. We are heading back in, right..

Yes..

Right now, it is kind of like, well, we will see what happens but everybody's starting to shut down again. So I think it's actually gotten worse than it was a month ago and everything was kind of going along, we were bouncing along the bottom and now all of a sudden, you see the cases and everything else increasing. We see states shutting down.

I think the visibility is actually less. And I think that also contributes to the volatility Tom mentioned that everyday we seem to have more news, some negative, some positive. Vaccines, therapeutics, lockdowns, wow, what a month..

Yes..

Tremendous amount of uncertainty..

Yes. I get it. Yes, certainly what you guys are trying to navigate through. All right. Perfect. I will jump back in the queue. Thanks guys..

Thanks..

And your last question comes from the line of Robert Spingarn with Credit Suisse..

Hi. I just wanted to follow up with a couple of things. Tom, have you seen any change in used serviceable material coming into the market? I think in the beginning of the pandemic people were not yet parting out aircraft or taking apart engines.

But have you seen any evidence that this is happening?.

Well, we are confident it is happening. We haven't seen actual impact from that. But you are correct. I think people are parting out. There will be more used serviceable material. A lot of that, we think and once again you have got to look at the fleet, it impacts certain fleets more than others.

Narrowbodies is a sweet spot for us, both on neo, the new narrowbodies Max and neo, but also on A320ceo. I don't think there is going to be much impact from used service material on those applications. But we will see it on some of the much older aircrafts. And we are monitoring that. But to-date, we haven't seen it.

But it's hard to say how much it will impact us going forward..

Okay. And then just as a last one. When we look back at the 787 delays and partnering for success, there were changes in contracts to help Boeing get back on its cost curve.

Has anything like that happened with the Max?.

No..

Okay..

Not for Woodward..

Okay. Good. Thank you very much..

Okay. Thank you..

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

Okay. Well, I appreciate everybody joining us today. We appreciate always talking with you. It's interesting times. I guess, is what you can also call this. We did highlight and I just want to leave you all with message. Woodward is strong. We managed this pandemic well to-date. We will continue to manage it well.

Coming out of it, we are going to be even stronger financially as well as technology and products and growth-wise. So I look forward as we get in the next few quarters. Ideally, seeing a change and inflection point happening and we will be talking about upturns in sales not too long from now, we hope. So thanks, again, for joining.

We will talk to all of you, I am sure, in the next quarter. Thanks again. Bye..

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