Ladies and gentlemen, thank you for standing by and welcome to Hexcel's 3rd Quarter 2019 Earnings Call. At this time I would now like to hand the conference over to your speaker today, Patrick Winterlicht, HEXL's Chief Financial Officer. Please go ahead, sir.
Thank you. Good morning, everyone. Welcome to HEXL Corporation's third quarter 2019 earnings conference call. Before beginning, let me cover the formalities. First, I want to remind everyone about the Safe Harbor provisions related to any forward looking statements we may make during the course of this call.
Certain statements contained in this call may constitute forward looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 They involve estimates, assumptions, judgments, and uncertainties caused by a variety of factors that could cause future actual results or outcomes to differ materially from our forward looking statements today. Such factors are detailed in the company's SEC filings and last night's news release. A replay of this call will be available on the Investor Relations page of our website. Lastly, this call is being recorded by Hexcel Corporation and is copyrighted material It cannot be recorded or rebroadcast without our expressed permission. Your participation on this call constitutes your consent to that request.
With me today are Nick Stanage, our Chairman, CEO and President and Kurt Goddard, our Vice President of Investor Relations. The purpose of the call is to review our third quarter 2019 results detailed in our news release issued yesterday. Now let me turn the call over to Nick.
Thanks Patrick. Good morning everyone and thank you for joining us as we share our third quarter results. It was a strong quarter with our operating margin exceeding 19%. We delivered a 12.5% increase in earnings per share versus Q3 2018 and we continue on track toward a record year for cash flow. These results reflect the commitment and Let me highlight some of the $72,000,000 were up 6.6% year over year in constant currency.
Adjusted diluted EPS was $0.90, compared to $0.80 in third quarter of 2018. We delivered 3rd quarter operating income of almost $110,000,000 which was up almost compared to quarter as we continue driving efficiencies, increasing productivity and focusing on continuous improvement. Our people are committed to constantly looking Clearly, our commitment to operational excellence throughout the business is working and gaining momentum. Now, turning to our 3 primary markets. Commercial Aerospace sales in Q3 were $386,000,000 an increase of 3.6 percent in constant currency as compared to Q3 2018, driven primarily by the A320neo Boeing 787 and Airbus A350 programs.
We are encouraged by the strong growth of almost 17% in other commercial air space, which includes regional and business jets. The growth was primarily driven by Gulfstream programs. We continue to see growth in commercial aerospace, although slowed by the effects of the Boeing 737max grounding. The decrease in MAX production did not significantly affect our sales during the first half of the year, as we benefited from a few Boeing suppliers taking advantage of the grounding to catch up and build inventory in Q2 However, as the grounding extended, the channel inventory grew and as Q3 progressed more than 2 thirds of our 7 37 MAX shipset sales were affected by the lower build rates. Today, we remain optimistic for a 7 37 MAX return to service and resumption of growth with higher production levels following regulatory approvals.
Unfortunately, the uncertain timing of return to service has pushed sales to the right and required us to revise reflects lower sales volume for the 7 37 MAX program, along with softening due to uncertainties in the global economy that are impacting some of our industrial To add some perspective our reported sales are now expected to be lower by approximately $30,000,000 for the year as a result of the sustained a stronger dollar leads to lower costs for our European operations and results in a net tailwind to margins. We remain cautiously optimistic for the remainder of the year and more positive as we head into 2020 when we expect 7 37 MAX to return to service and build rates to increase, driving growth for more than 2 thirds of our MAX Chipset content. Sales from other key commercial aerospace programs remain strong. We are currently at rate on the A350 and the A320 continues to grow steadily, while the 787 continued to ramp during 2019 and will be at full rate for the 1st full year in 2020. Backlogs remain robust at over 12,000 aircraft Composites adoption and secular penetration continue to accelerate and our market share is strong and growing.
Excel has a sustainable competitive advantage, excellent customer relationships and a leading sole source position in key markets with high barrier stentry. With innovative technology, the broadest aerospace composite product portfolio in the industry and $3,000,000,000 of global gross value property, plants and equipment, there is no other company in our Advanced Materials space that is better positioned to take advantage of the growth opportunities ahead It was another terrific quarter with double digit growth over Q3 2018. Sales were almost $110,000,000, reflecting an increase of 22.7 percent in constant currency. Growth was driven primarily by the F-thirty 5 Joint Strike Fighter Program, along with increasing strength in military rotorcraft. Our ARC Technologies business continues to perform well and is $77,000,000 for the 3rd quarter, which was essentially in line with Q3 2018 though up about 3% in constant currency.
While demand for composite materials in wind turbine blades remains strong, growth in this market is stabilizing as we near the end of a steep ramp up. For the past few quarters, Hexcel has benefited from strong growth in wind sales. Going forward, global demand appears to be leveling out at current elevated levels. Coupled with short term softness in both the automotive and recreational markets these factors are likely to keep industrial sales relatively constant in the near term ahead of expected growth in 2020. In summary, we continue to demonstrate year over year growth, margin expansion, exceptional cash generation and strong returns on investment.
Backlogs are healthy. Customer relationships have never been stronger and Hexcel continues to win in the marketplace and create value for shareholders. Other than revising our sales guidance related to The remainder of our 2019 guidance is unchanged. Now, I'll turn the call over to Patrick to discuss more of the quarter's financial details.
Thank you, Nick. I will provide a review of our markets and as usual, these year over year comparisons are in constant currency. As Nick already said, currency movements influence our reported sales and some of this impact may not be intuitive. The majority of our sales are denominated in dollars However, our cost base is a mix of dollars, euros, and British pounds as we have a significant manufacturing presence in Europe. As a result, when the dollar strengthens against the euro and the pound, our sales translate lower, but our costs also translate lower resulting in a net tailwind to margins.
Accordingly, we prefer a strong dollar to a weak dollar. In terms of currency hedging, we employ a disciplined hedging strategy to protect our operating income that layers in hedges over a 10 quarter horizon. Commercial Aerospace represented approximately 68% of total 3rd quarter sales. Commercial Aerospace sales of $386,000,000 increased 3.6% compared to the third quarter of 2018 driven by production rate increases, including the A320neo increasing to 60 aircraft per month and the 7 87 increasing mid year to 14 aircraft per month, tempered by the lower 7 37 MAX production rate. Base And Defense represented 19% of sales.
For the 3rd quarter, Space And Defense sales totaled $110,000,000 an increase of 22.7% compared to the same period in 2018. Growth was driven by the F-thirty 5 programs supported by other fixed wing programs as well as the Blackhawk and V22, including the wide cord rotorcraft blades. Industrial comprised 13% of 3rd quarter sales. Industrial revenues totaled $77,000,000 increasing 2.7% compared to the strong prior year period. Wind Energy remains the largest submarket within industrial, comprising just over 60% of industrial sales.
Our wind energy sales are stabilizing following a very steep period of growth that began in in some of these markets, notably automotive, which is not unusual for our business. On a consolidated basis, gross margin for the 3rd quarter was 27.6% compared to 26.5% in third quarter of 2018. We continue to focus on operational excellence, which drives higher margins, and when combined with the absence of some headwinds we experienced last year led to over 40% incremental operating margins year over year. Total depreciation expense increased $3,200,000 in the third quarter of 2019 compared to the prior year period as we continue to invest to support future growth. For the third quarter, selling, general and administrative expenses increased five point 4% year over year in constant currency.
Research and technology expenses increased 4% year over year in constant currency. We continue to expand our leading technology positions through investments in research, supported by 7 global R And T Centers of Excellence located in Europe and dollars or $13,400,000 year over year. The operating income margin expanded to 19.2 percent of sales for the third quarter of 2019, which is one of the highest quarterly operating margins ever posted by Hexcel. The strong margin performance compared to an operating margin of 17.9 percent for the third quarter of 2018. The year over year impact of exchange rates was favorable by approximately 10 basis points.
The Composite Materials segment represented 78% of total sales and generated an operating income margin of 21.2% for the third quarter of 2019 as compared to a 20.6% margin in the prior year period. The Engineered Products segment, which is comprised of our Structures And Engineered Core Businesses, represented 22.2 percent of sales, and generated an operating income margin of 16 point compared to 14.4% in third quarter of 2018. While the operating margin is lower than the composite materials segment, Engineered products requires a much lower level of investment, generating strong returns on invested capital. The adjusted effective tax rate for We continue to forecast an underlying effective tax rate of 24 percent for the fourth quarter of 2019. Net cash from operations was $120,100,000 in the quarter and is $277,000,000 year to date.
Working capital represented a use of cash of $1,000,000 in the third quarter of 2019. Capital expended $28,200,000 in the same period in 2018. We target a gross debt to EBITDA leverage ratio of between 1.52 times At the end of the third quarter, our leverage ratio was 1.9x. This represents a continued decrease from the first quarter of 2019 as we repaid a portion of the debt used for financing the January 2019 acquisition of ARC Technologies combined with strong and growing EBITDA. We repurchased approximately $56,000,000 of our common stock during the third quarter of 2019, and have $318,000,000 remaining under our share repurchase program.
Our capital allocation priorities continue to be investing in organic growth, followed by targeted and disciplined M and A and our commitment to returning greater than 50% of our net income to shareholders through dividends and stock buybacks. Before turning the call back to Nick, I would like to review the 2019 guidance included in the earnings release issued yesterday. We released our 2019 sales guidance range to a forecasted $2,340,000,000 to $2,400,000,000. When we first issued this sales guidance in January 2019, we were expecting the math production rate to reach 57 per month by mid year 2019, consistent with the publicly disclosed build rates issued by Boeing. When we reaffirmed guidance last quarter, we were experiencing expecting the MAX return to service early in the fourth quarter of 2019, consistent with industry expectations at that time.
We have now reduced our sales guidance due MAX returned to service being delayed further than initially expected, combined with some other unanticipated short term headwinds, including foreign exchange rates and a general flattening of industrial sales due to recent softness in the global economy. We are maintaining our guidance for EPS, capital expenditures and free cash flow reflecting our confidence in our employees and our focus on operational excellence to drive earnings and cash generation. Our EPS guidance is a range of $3.43 to $3.53 per share. Recall that we raised our EPS guidance last quarter increasing the midpoint by $0.03 to $3.48 per share from $3.45 per share. Capital expenditures are expected to be cash flow is forecast to exceed $250,000,000 as we again expect to generate significant cash in the fourth quarter of 2019.
With that, let me turn
we are on track to deliver record organically and through M And A. Our teams are working diligently with our customers on next generation materials, to support future programs and growth opportunities. Our business development pipeline We remain committed to finding areas and opportunities to expand our technology portfolio to better serve our customers and deliver solutions that benefit the future We expect to share We are at the beginning stages of rolling up our plan for next year and our initial view is that we have robust growth for the A320neo as air buffs moves toward a rate of 63 per month in 2021 and 4th Boeing 787, which should achieve its first full year at the and Airbus A220. On the 7 37 MAX, we remain confident in its long term success and look forward to its return to flight and gradual ramp up in production during 2020. Currently, the largest part of our demand for the MAX is at a rate of 42 and we expect positive growth from that base as we move through 2020.
The outlook for our Space And Defense business continues to be extremely positive. Wind power as a source of energy generation continues to become more cost competitive and we see many possibilities and more broadly with significant numbers of electrification and light weighting projects emerging, HEXO's composite materials becoming increasingly relevant to enable We expect our results this year will demonstrate solid growth, exceptional cash generation and a strong return on investment for shareholders. We continue to benefit from aircraft program ramp ups, continued secular adoption of advanced composites, and strong demand focusing on operational excellence, investing in the future and by delivering on our commitments to customers and shareholders. Julian, that ends our prepared remarks. So we're ready to take questions.
Your first question comes from Gautam Khanna from Cowen and Company. Your line is open.
Yes. Thank you. Sorry for the background noise here in an airport. I just wanted to follow-up on some of your comments on the map. Are you seeing any one of your top somewhere below 42 at this point, or are you saying there's a mix to sum at 52, right, to it?
And then 44. Or you can kind of perturbations below that?
So, Gautam, I think I picked up most of the question. There is a lot of background noise We believe that the bulk of our customers on the Max now are trending to the 42 level. You know, we've had broad customer base and it's hard to have exact visibility into that. But when we do our sanity checks, and we look at what some of the key suppliers to the MAX have stated they're at, it ties together where we're pretty comfortable, but that somewhere between 2 thirds 3 quarters of our, of our shipset content is at the 42 whereas another portion, the balance is somewhere between $42.52.
Thank you very much guys.
Your next question comes from Mike Sison from Wells Fargo. Your line is open.
Hi guys. Nice quarter there.
Thanks Mike.
In terms of your range this year, Nick, from the low NOI and the guidance, you know, it's it's about $0.10. Is is the Delta generally within your control to get to the top or the bottom, or is there is it the top more driven by sales growth in either the segments?
So we, we, we look at both the upside potential as well as the downside risk. And we believe it's very centered. So, I think there's as much opportunity for us to over deliver and depending what could happen with supply chains tightening as they normally do and for quarter. How cash may become an issue within commercial aerospace given the MAX issues is a question mark. So we think we're covered.
We think our guidance is accurate based on what we see and know today. And believe we can deliver that.
Great. And then I know it's a little bit early to give specific sort of outlook for 2020. But if if the max stays at 42, I guess, for the full year, it does sound like you have other programs that will drive growth for commercial air space. So is that really the case that you can still get pretty good growth next year in commercial air space sales even if the max stays at 42?
Well, we certainly have growth in other programs and we're broader than the max, but let's not forget at $400,000 per ship set, the max is a meaningful program for Hexcel. And pick a number. If it's 10 down or 15 down from where Boeing intends to go, you can do the math on that onto what it would equate to for a full year impact. But to answer your question, we are seeing strength in many programs across our markets, including other Space And Defense has been incredibly strong and we're very bullish on it as well. Great.
Thank you. Thanks, Mike.
Your next question comes from Robert Spingarn from Credit Suisse. Your line is open.
Good morning, Robert.
Just on that, following that last question, not so much on Max, But you've talked about the growth embedded for the 787 and you also mentioned the 777x, but you know, there's some concern that 787 rates are gonna have to come down, maybe not in 20, but in 21. And, And of course, the 777x has been shifting to the right. So how does that cloud your view for 2020?
So again, if you look at the build rates, even if Boeing stays where they are today and do not even other order. They still have close to 3.5 years of backlog. A350 is at 5 plus. So We don't view 2020 being a risk item relative to those build rates in those programs. We're also bullish on wide body replenishment being required.
Now whether those rates start or orders start coming in in 2020, 2021, but we're hopeful that they do and they can justify the existing build rates for both Boeing And Airbus.
Okay. And then just as my follow-up, just switching to industrial, you talked about growth resuming in 2020. What, you know, what are your assumptions on what drives that? Does wind come back? Is it automotive?
Is it something else?
Well, so we're rolling up the plan as we speak and I don't want to get ahead of ourselves, but seeing some lumpiness especially in automotive and rec is typical. We see that where we'll have a big quarter and then we'll have a down quarter and it has to do with timing and Keep in mind, a lot of our business in the automotive is on the very high end, premium cars where build rates are not necessarily ex per month on a steady basis. Rec is similar with claim it and with some seasonality in there. So, we're comfortable that that's going to come back. When We continue to work that.
There's been some restructuring with VESTS on their mix. We feel real good about our positions and our new technologies there Having said that, we're not going to see the kind of growth we've experienced over the past few quarters simply because they're at very high rates and we expect those rates to continue going forward. So the growth rate will come down compared to where we have been over the last few quarters, but we're still looking for a nice business growth in those segments.
Thank you, Nick.
Thank you, Robert.
Your next question comes from Myles Walton from UBS. Your line is open.
Thanks. Good morning.
Good morning, Bob.
Wondering maybe this is for Patrick first. So Patrick on the implied 4th quarter margins, I'm just struggling with why they would decline, I guess implied, as much as they would if you're at the high end of the sales range. Perhaps maybe it's looking to the low end of the sales range and for a more modest margin decline, but maybe just talk about the moving parts on margin in the fourth quarter. And also engineered products margins in particular in the third quarter, if you could touch on that.
Sure. Good morning, Myles. I mean, I would say, as Nick said, with the EPS, I would say again, we're fairly centered in terms of the sales range we're kind of trying to balance ourselves at the midpoints as opposed to the top or the bottom. And based on those ranges, December is always a bit of a funny month in terms of the volumes and the overhead recovery and all the rest of it. But we expect to continue to drive decent margins going into the 4th quarter.
There's nothing exceptional in terms of cost. We will drive the incremental margin leverage as strongly as we can. And I would say we are reasonably centered. In terms of the engineered products, third quarter, the 16 plus percent, which does stand out, it was kind of exceptionally high. There's probably a couple of factors there.
I mean, the ARC Technologies is all being reported through engineered products and that is starting help and perhaps weight that segment up a little bit. And it was just then combined with a strong of program, which we can get a bit of lumpiness in Engineered Products. So it was those two things together that I would say that drove the 16% whether we'll be able to repeat 16% time will tell, but that was certainly a high outlier for now.
Okay. And then on ARC, Nick, I think you mentioned the growth in Space And Defense driven by the F-thirty 5 was ARC a bigger contributor or was the F-thirty 5 a bigger contributor? I guess, how about maybe ARC would have been the bigger?
Well, arc was the bigger contributor and keep in mind when we talk F-thirty 5, arc does have a good position on F-thirty 5 as well as legacy Hexcel before ARC. So in total F-thirty 5, but the bulk, was clearly the acquisition and the role in quarter over quarter of the ARC business.
But Myles, I would also add the underlying growth in Space And Defense was high single digits. Even without ARC.
Yes. I've got it. And the last one, Patrick, on the FX effect on OI, operating income, was it a net push or a net tailwind to, to the adjustments?
FX at the operating income level was a slight benefit. It was a small tailwind. But only small basically because of the hedges we do when we are the hedges protect the operating income and we got a slight boost.
Makes sense. Thanks again.
Your next question comes from John McNulty from BMO Capital Markets. Your line is open.
Yes, thanks for taking my question. Regard to the or with regards to the incremental margins, they were clearly higher than, than we've seen in a long time. And it does sound like maybe there was a little bit of lumpiness in the engineered products, but anything else that was driving that? I mean, certainly relative to the first half, I mean, they were notably better even though you had some, what I would have argued, were some easier comps in the first half. So I guess, how should we think about that?
Well, I think you touched on the easier comps simply because of some cited. Rucion is up and running full speed and getting it is getting more productive every day. So really there wasn't anything unusual. I again, I have to applaud and I'm very proud of the job that our team is doing with respect to productivity and efficiencies throughout our operations. That is helping the business which obviously we're counting on sustaining that level of performance and continuing to stretch ourselves.
So the productivity improvements that we've seen have been fantastic, even causing us to look at our CapEx and some opportunities to push some of that to the right. So, it's a combination of all those factors that give us confidence in continuing to drive market margin strength.
Great. Thanks. And then with regard to the outlook for 2020. Look, you've had a huge margin step up this year. Is there more to come for 2020 if kind of things play out the way you think where the MAX starts to get back on track next year?
And when comes back, I guess, how should we be thinking about the potential for further mark expansion as we look to 2020?
Well, John, it's a little early for me. I, they're rolling up the 1st pass. I haven't my first look. But as I've said on this call before and as my team knows, I expect continuous improvement and not only year over year, quarter over quarter ideas and opportunities to drive productivity and it's no different for 2020. With the max stepping back up with some of our sites running as efficiently and full as they are.
It just gives, and provides opportunity for very strong leverage.
Great. Thanks very much for the color.
Thanks, John.
Your next question comes from Chris Olin from Longbow Research. Your line is open.
Okay, good morning.
Good morning, Chris.
I just had a quick question on the other commercial aerospace sales line and that 17% growth that you guys posted. I think you highlighted Gulfstream. I guess my question would be, Is that run rate sustainable or would that include some type of like channel fill inventory management. And then I guess I would have the same type of question in terms of the growth rate on sales and defense. Guess thinking outside of the F-thirty Five, should we start thinking about the cost cutting buffer?
So let me, let me start with other. And you pointed out, as we did, Gulfstream drove a large portion of that And it was pretty broad based at Gulfstream, although the G500, was really big in the quarter. I wouldn't expect 17% quarter over quarter growth, but I would say our positions in engines and nacelles and our positions on the new platforms being launched continues to be very good. So we see other to continue to do well. On on the space and defense, you know, it's a combination there.
Obviously, we expect more growth with the F Thirty 5. We expect more growth and contribution from our acquisition of ARC Technologies. And then we've got broad based growth with new programs like the CH53K, continued steady performance and growth with the rotorcraft, on the military side and other drones and unmanned vehicles that we're supplying materials too that probably won't be material in size, but they provide great opportunities because there's more and more of them being looked at evaluated and ultimately will translate into production.
Okay. Thank you.
Your next question comes from Paretosh Misra from Berenberg. Your line is open.
Thank you. Good morning. How big is this other commercial aerospace business for U. S. Percentage of commercial aerospace?
Sorry. Peritesh. So it's about it's about 15% or so of the total commercial aerospace.
Got it. Thanks. And then just to follow-up on your Decatur facility, any updates, how is that coming along? And would the CapEx on that facility be largely done by theendofthisyear?
To your question on how we're doing there, we're doing great. We're, actually on track or maybe even ahead of schedule on that. There was never a plan for that CapEx to be completely spent or completed this year, What we had said was we would have it completed next year where the lines would come online and then qualified sometime in 2021. But overall, the project has gone very well.
Thank
you. Your next question comes from Sheila Kahyaoglu from Jefferies. Your line is open. Good morning and thanks Nick and Patrick. Nick, I wanted to turn to something you said in, as you close off the finishing, the prepared remarks.
Talked about growing the business organically and through M And A. It seems more and more that the M and A will not happen. And maybe the focus will shift to future small aircraft. Maybe can you talk about how you view Hexcel's technology, the maturity of the offering when it comes to high volume composite
we are always working with our customers, whether it's Boeing, whether it's Airbus, whether it's the engine guys, Embraer, Bombardier, on next generation materials, whether it's for primary structures, wings fuselage, impinage, secondary structures, which could include interiors or a growing market for us where we have very good positions in engines in the cells. And that hasn't changed. We're working aggressively, on materials that lay down faster, cure faster provide a better economic package for the customers for expanded secular penetration. Whether or not the NMA gets launched, I'm a believer that there will continue the upgrades. There will continue to be neos and Maxes of next generation airplanes.
There will continue to be growth in the other commercial. And I think we're the best positioned in the marketplace to provide the solutions that our customers are going to need for those applications going forward. So I'm not, I'm not, as pessimistic on NMA not going. I, I like to stay optimistic and we'll be ready if and when it does.
Next question comes from Noah Poponak from Goldman Sachs. Your line is open.
Patrick, can you give us the old and the new
Well, so the year to date is obviously just the average of the three quarters. I think it's just over 22%. I mean, as I say, Noah, I mean, as we go into the 4th quarter, the underlying starting point effective tax rate that we will use is 24%. Now, obviously, historically, we get tweaks and adjustments to that, but as I sit here today. I don't know what those will or won't be and how many sort of stock options, etcetera, get get exercise we'll move that needle.
But the starting point for the fourth quarter is 24% and then you combine that with obviously the year to date. Average for the 1st 3 quarters. That's what the final year number is going to be. So it's going to be under 24% in total, but how much I don't know?
Okay. Any reason you can't just give me the specific numbers? To that question?
But, Noah, I never, but, Noah, I don't know the number.
But you had prior earnings guidance and you have new earnings and both of them had a tax rate assumption, right? Or am I So
So I'll answer this and then we'll move on. The first three quarters 1 through 3 were the actual tax rate and our guidance midpoint has 24% as the assumption for Q4.
Okay. On the max, I had interpreted your prior comments to suggest that you were closer to right in between $42.52. And I think you've even suggested you know, building a variance versus Boeing that would then need to unwind as Boeing was ramping back up. But but today, your comments suggest closer to 42 And so I'm wondering if that is, you know, somebody like the engine manufacturer stayed close to 52 while they improved their position in the supply chain, cleaned things up a little bit, and then has gravitated lower or if it's that you've been closer to 42 all along. And that's just an effort to better understand whether or not you have any variance that would then need to burn off as Boeing goes higher.
Yes. So just to clarify, to my knowledge, we never said that we were going to build excess or capacity or inventory in anticipation of the market moving one way or another. We did not do that, did not plan to do that. We did say And we do believe and we did experience the fact that there was suppliers when we reported last quarter that basically were behind that their supply chain was empty. They weren't at rate and we knew for a period time that they would stay at an elevated rate, I.
E. Above 42 in some cases at 52 in some cases, perhaps even higher to catch up. And we saw that. And that's why over the 1st 2 quarter or the second quarter, we basically saw a little if any impact third quarter, it doesn't take long at 10 per month for inventories to build up and we saw a pretty abrupt change with some big suppliers, especially around engines, that drove a change that swung our ship set rate closer to the 42 than the 52. So it's really a timing and the amount of inventory that was built over the past quarter.
Your next question comes from Chris Hatch from Loop Capital. Your line is open.
Yeah. Just following up on that. I'm assuming the guidance is based on continuing the ship that I'm sorry, the, the rate closer to 42 for the fourth quarter. And then also just wanna try one more time to sort of reconcile the the delta between the, the reduced sales guidance and the and the reaffirmed earnings guidance. It sounds like you said that not much really of a tailwind from the FX given the rolling hedges.
So a lot of it sounds like it's a combination of operating leverage as well as mix. I'm wondering if you and maybe a little bit of tax rate. Could you parse out those, those contributors to the delta there?
So I'll take the first part, the easy part, and then I'll turn it over to Patrick, but your assumption is correct. We had built into our guidance that will stay pretty much at the current max delivery that we're on right now. And that's the guidance we shared at, just over 2 thirds being at the rate 42 and the balance being above that towards 52. No. I mean, in relation to, I mean, we moved guidance to 343 to 353 midpoint 348.
The end of last quarter and where we're standing by that, essentially we see with and you've seen a very strong incremental margins, the 19.2 percent absolute level of operating income in the 3rd quarter. We can just see if we sustain those levels and there's no reason we won't with the productivity efficiency and operations drive another strong 4th quarter of income, we should be able to deliver that. Tax, as I talked about, I'm not expecting anything exceptional on tax, but it's going to be more about cost control productivity. Even with the reduced level of sales. And you've obviously got to take into account where we were in the first three quarters and see we carry on doing that, it should roll out, to be honest.
Got it. Thanks. And then just one follow-up on the Industrial segment. You mentioned sort of broad based weakness, but including weakness in automotive, I'm assuming that means the composite sales into the auto industry more skewed towards Europe. And in Europe, there's pretty pronounced weakness in the auto end market currently, part maybe partly on Brexit, but seemingly like, you know, the demise of diesel is a bigger contributor there and there's an acceleration in the move to electrification.
Just wondering if you have an early view on on the likelihood of composite adoption in a paradigm over there where, you know, where there's this accelerated transition to electrification over time. Does do composites play more or similar to what you've been seeing in some of the higher end vehicles?
Yes. I mean, I think in the medium to longer term, we would still be extremely positive about the opportunities for composite material adoption with all the electric vehicles the electrification as you suggest that the light weighting is still going to be a very important factor. It's relatively short term lumpiness market softness in Europe as you suggest that there's hitting us in the near term, but longer term as vehicles weight becomes more and more important that the battery adoption, the integration of batteries is an integral part of vehicles where composites has a lot to offer. We remain very optimistic for the future of composites in the automotive sector. Got it.
Thank you.
Your next question comes from Hunter Keay from Wolfe Research.
Good morning guys. This is Will Forhonor. Do you have a sense of initial sense of how much depreciation will step up in 2020 when the pen and fiber lines indicator come online?
Well, those lines, as Nick kind of indicated, probably won't be qualifying online until actually 2021. So we shouldn't see much impact from those lines in 2020. Given a CapEx spend as we've called out in the range of $170,000,000 to $190,000,000, I would look at whatever this year's depreciation step up has been I would say about 1,000,000. Obviously, this year we had the ARC acquisition, which pushed out the D and A a bit, but I would say about $15,000,000 or so next year.
Your next question comes from David Strauss from Barclays. Your line is open. Hi guys. This is Kate Coppell's on
for David. Wanted to talk about the sequential drop in aerospace sales from Q2 to Q3. Was there anything else large in there besides the Max?
The major factor was that the max as we've called out that movement as Nick went into detail on really the shift in the engine guys and the demands moving towards 52 in third quarter that that was really the step change.
Okay. And then you guys have talked a lot about productivity improvements. So I guess wanted ask how you feel about working capital, how much you're carrying and then kind of in the context of your kind of out year 2020 2023 free cash flow targets. Does working capital grow proportionally with sales or do you see opportunities for efficiency there?
I mean, we're always going to drive, efficiencies as much as we can in the longer term on working capital. I mean, in the near term, we'll undoubtedly drive as we nearly always do in the second half and the last quarter of the year, drive out some cash from our working cap it's the normal cycle that you will have seen many times. And going forward, we will as we grow our working capital base will grow to some extent. Obviously, what we will try to do is to make that growth as efficient as possible. And improve our receivable days, improve our inventory days, which is what we're always striving to do.
Your last question comes from Ronald Epstein from Bank of America Merrill Lynch. Your line is open. Hi guys. This is Caitlin Delante on Quran. Looking at the skyline for the Boeing 787, if Boeing doesn't get more orders, it looks like the production rate for the program may have downside risk starting in 2022.
If they do cut production rate in 2022, which is your 2021, how should we think about your sensitivity
Well, if you do the math and you pick a number, if they go from 14 to 12, my math says that's about 1.3%. On a full run rate basis and basically that'd be the impact.
Okay. Thank you very much. We have no further questions. This concludes today's call. Thank you for participating.
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