Thank you for standing by. Welcome to the Woodward, Inc. First Quarter Fiscal Year 2023 Earnings Call. At this time, I'd like to inform you that this call is being recorded for rebroadcast and then all participants are in a listen-only mode. Following the presentation, you are invited to participate in a question-and-answer session. Joining us today from the company are Mr. Chip Blankenship, Chairman and Chief Executive Officer; Mr. Mark Hartman, Chief Financial Officer; and Mr. Dan Provaznik, Director of Investor Relations. I'd now like to turn the call over to Mr. Provaznik.

Thank you, operator. We would like to welcome all of you to Woodward's first quarter fiscal year 2023 earnings call. In today's call, Chip will comment on our strategies and related markets. Mark 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 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 February 13, 2023. 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 supply chain and labor disruptions and net inflationary pressures. 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. 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. And now I will turn the call over to Chip.

Thank you, Dan, and good afternoon, everyone. Our first quarter earnings were in line with our expectations, although our Industrial segment had a challenging quarter. We continue to see strong demand from our end markets. The ongoing industry-wide challenges from supply chain and labor disruptions and inflation impacted profitability in the quarter as we anticipated and negatively affected our cash flow. These supply chain and labor disruptions are anticipated to begin to subside in the second half of the fiscal year as our strategic investments and mitigation actions translate into improved financial results. Our past due commitments to customers remain elevated as a result of the supply chain and labor challenges, but also because of sustained strong demand. We continue to focus our efforts on improving our supply chain by securing additional capacity with trusted suppliers. Making strategic investments into the creation of rapid response centers and maximizing our current machining capabilities to increase deliveries to customers. In addition, we continue to focus on developing and retaining talent. I'd like to recognize our Woodward members, who are working hard to serve customers better and improve our company's results. During the quarter, we announced streamlined Aerospace and Industrial organization structures with leadership designed to enhance the sales experience for customers, simplify operations, and increased profitability through improved execution. Within the Aerospace segment, this new structure enables advancement of our missiles and space programs. In December, Randy Hobbs joined Woodward as President of our Industrial segment. Randy is an accomplished executive with significant global leadership and lean manufacturing, lean enterprise management expertise. Randy and I are working closely to transform Woodward's Industrial segment as significant changes required. He is already driving multiple initiatives to improve our operational execution. We have three priorities in addition to accelerating operational recovery. First is rightsizing the…

Thank you, Chip. Net sales for the first quarter of fiscal 2023 were $619 million, an increase of 14%. Sales growth for the quarter was driven by increased volume and price realization, but negatively impacted by approximately $95 million, due to the ongoing global supply chain and labor disruptions. Sales were also impacted by approximately $19 million, due to unfavorable foreign currency exchange rates. Net earnings were $30 million or $0.49 per share for the first quarter of 2023. For the first quarter of 2022, net earnings were $30 million or $0.47 per share and adjusted net earnings were $36 million or $0.56 per share. Aerospace segment sales for the first quarter of fiscal 2023 were $396 million, an increase of 18%. Commercial OEM and aftermarket sales were up 32% and 47% respectively, driven by continued recovery in both domestic and international passenger traffic and increasing aircraft utilization. Segment sales were negatively impacted by $35 million in delayed shipments caused by global supply chain and labor disruptions. Defense OEM sales were down 15% in the quarter primarily due to lower sales of guided weapons. Defense aftermarket sales were flat. Aerospace segment earnings for the first quarter of 2023 were $55 million or 14.0% of segment sales, compared to $51 million or 15.2% of segment sales. The increase in segment earnings was primarily a result of price realization and higher commercial OEM and aftermarket volume. Segment earnings including as a percent of segment sales were negatively impacted by inflationary impacts on material and labor costs; increases in costs related to supply chain disruptions; inefficiencies related to training new hires; and the return of the annual incentive compensation. Turning to Industrial. Industrial sales for the first quarter of fiscal 2023 were $223 million, compared to $205 million, an increase of 9%. The…

Thank you. The question-and-answer session will begin at this time. [Operator Instructions] Our first question comes from the line of Robert Spingarn with Melius Research. Your line is now open.

Hey, good afternoon.

Good afternoon, Rob.

I'm not sure who wants to take this, but I -- it's about margins. And I just want to understand what deteriorated from last quarter to this quarter or what pressures got worse? I understand comp went up, but it would seem the other things would have been relieved by like you mentioned higher volumes and the fact that it's -- these margins are lower both quarter-over-quarter and year-over-year. Perhaps you can offer some clarity on that in that?

Yes. So let me take a stab at that and just for clarity, let's first start with the sequential, because I think that Rob, that's where your question started. If you actually look at sequentially, the volumes are actually down, which is what we had anticipated just based on the lower number of working days that we were talking about in the November call. And in addition to that we also had the variable compensation increase that we also discussed at the November call. And then the one other headwind on the earnings side was really on the industrial side of the business was the currency related impacts, which of course we can't forecast what the currency rates are going to do and that's primarily driven by the euro and just translating the euros to U.S. dollars. So sequentially that was really the drivers around the sequential earnings decline both in dollars and in rate.

Without going through all the math, if you didn't have the fewer working days in the currency, would at least on the aerospace side, would sequential revenues have been up just given that those businesses are recovering and ramping, so the normal seasonality, I would think shouldn't apply?

Yes, I mean, we always have a little bit of normal seasonality in our fiscal Q1 quarter just based on it's a lot of our customers year-end, they're Q4. And so our Q1 is always a little lighter and some of it's just how they're managing their inventories and then the other is just the number of work days around the holidays. So this isn't -- our sequential decline in revenue is not related to demand at all. It is truly just a matter of output and how our customers are pulling product from us.

Okay. And I assume it's not inventory in the channel. That sounds like that's not an issue.

That's correct.

Okay. And just tip for you just higher level you've talked about last quarter and touched on it this quarter about improving the business. Bringing more machining in-house and just solving problems. Does the business need more help looking at it today than you thought three months ago as you get more time to dig into it and see what's really going on?

Well, we are making some progress, Rob, in terms of the number of parts that we're moving to better performing suppliers than the ones that we're bringing in-house. And we've graduated over 30 suppliers from watchlist, the elevated watchlist and we still have more than 20 on it, but we've gotten 32 folks to improve and we've got some of our machining centers to improve. So I see us making progress, but having that make it all the way through the supply chain to affect the daily build rates of assembly and test and shipping to our customers is the piece of the puzzle that we're working on this quarter. In terms of needing more help, we're always on the hunt for talent. We're -- we brought some very talented folks on to the team like Randy Hobbs and whenever somebody new comes in, it looks at a business they’ll find things that we're asking them to do a full detailed look and roll up in terms of capability of our operations, as well as how we're running the business and E&I are partnering with the places that need more action and more attention. So I'd say that we are seeing a little bit more in the industrial space attention needed, but most of those were things I thought needed attention three months ago. We're just confirming it…

You are still in discovery mode, if I hear what you're saying?

I would say we're in confirmation mode. I really had most of those thoughts on my mind already in terms of especially the product portfolio actions that we need to really scrub through from a product to good olfaction product lifecycle management approach. So we're on it.

Okay. Thanks so much.

Sure.

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

Hey, good afternoon, guys. Maybe Chip, kind of, a macro question for you. Obviously, industrial revenue this quarter was pretty solid. Can you give us a sense about order flow was through the quarter in industrial? Are you guys seeing any signs at all of, kind of, macro weakness out there, like some of the strategists or anything could happen?

So we're seeing those signs from our customer demand signal remains strong and increasing. We were under a lot of pressure at the end of Q4 from our major OEM customers to serve their increasing rates on their lines and preparations for taking their lines up in 2023. That was just a lot of pressure we were getting to prime the pump for them to increase their build rates in 2023 coming out of 2022 and as well from a service standpoint restocking dealer shelves with remanufactured or new parts. We don't see any softening of demand at this point up to now.

Okay. So your full-year outlook for industrial is flat to plus 5%, do you feel that's on the conservative side perhaps?

I feel like it’s -- we're not metered by demand. We're metered by our ability to produce units. A lot of this demand is in some cases dropping in inside lead time and we're trying to manage with our customers how to make promises and keep them and they can count on our delivery forecast. So really a lot of the constraint is us, as well as some FX headwind on the top line from a dollar standpoint.

Right. Okay. That's helpful. Last one for me just on the $95 in COVID disruption, it's helpful to see kind of by segment here. It seems like for a year, Aerospace has gotten better and you've had less issues there through this quarter where industrials actually got worse. Could you maybe -- is there anything that you haven't touched on in industrial that's kind of leading to that performance falling behind?

Yes. So you're right, Pete, that Aerospace did get slightly better in the quarter and industrial did get worse. As Chip was just talking about really the supply chain and labor disruption got worse on industrial, really related to the demand. The customer order volume continues to be strong and so that demand is still there. It's still -- we've talked previously that the electronics availability is still limited in our output capability on the industrial side is one of the big drivers and the other is the machine components and it's still both of those is what's driving that increase based on their availability.

Okay. Components less so than labor?

Well, there's a labor factor of this across the board in that $60 million both from our supply chain availability and getting our -- the labor that we brought in, trained and improving output on the line.

Okay. Thanks guys.

You bet.

Welcome.

Your next question comes from the line of Christopher Glynn with Oppenheimer. Your line is now open.

Hey, thanks. Good evening. Wanted to ask about some of the incremental strength in industrial turbomachinery. Are there any positive inflections you're seeing more pronounced now? Relative to the past few quarters, maybe certain process verticals stepping out, kind of, investment mode?

I don't know that we see all the way through to the exact end market application that you're asking at the end of your question. But for us, we see a -- just a definite step function in OEM demand for land-based gas turbine-controlled accessories that we provide. So that's where the bulk of that increase is coming from for Woodward. Yes, there's the -- we can postulate that it's this splits between power generation and an oil and gas process, but we're not sure.

Okay, great. And as you look at the supply chain and labor outlook to subset, the issue is to subside. Or to begin to subside in your back half. Is there one where, you know, you have more certain visibility, you know, you've made some real investments. Where are you starting to see the traction, where you have more of a tighter timeline?

So I don't know about the tighter timeline, but traction and things that are within our control, the rapid complex machining centers that we're standing up at a few different locations at Woodward plants. That equipment is starting to hit the floor next quarter and be in the installation and commissioning phase, so that by third quarter and our fourth fiscal quarter for sure, we'll be producing quite a number of parts and controlling our own destiny and be able to offload some of our struggling suppliers in the machining category. So that's something that we have a good line of sight to and are able to control the actions that will lead to that benefit.

Does that lead to any, sort of, increment step-up in the run rate as a proportion to your current base revenue outlook?

It certainly will alleviate disruptions and so I believe that will translate into consistency, which will give an overall uplift to output. But we are essentially going to be trading planned capacity that's not producing to actual capacity that we can count on, if that makes sense.

I think so. Thank you.

Your next question comes from the line of Matt Akers with Wells Fargo. Your line is now open.

Hey, good afternoon, guys. Thanks for the question. I wanted to ask about guided weapon, and you said they're down? Are they down year-over-year, sort of, on a tougher compare? Do they sort of slow down sequentially? And just help us understand kind of where we are? Is there more downside? And I guess specifically, are you seeing any more demand there around either Ukraine and for a while, we're talking about some JDAM or just general, kind of, restocking of munitions that, that could maybe pick up a little bit?

Yes. So I'll take the two questions, Matt. And so the JDAM decline on the guided weapon side continues to be soft. I mean, there is a year-over-year, but it isn't really the tough comp you may recall from following us that we had a sizable step down really in fiscal 2022, compared to fiscal 2021. We are still anticipating and talked about another continued softness on the guided weapon side of our business. It's not as significant of a step down as what we've seen in the prior year, but it's still there just based on the ordering volumes that they've had. Which then transitions into your second part of your question around have we seen any uptick in orders from anything in the Ukraine conflict? And we haven't yet at this point, you hear of some opportunities that might be out there, which is -- for us and typically on foreign military sales, the ordering pattern and I'll call it more of a drop in type order that we don't have a lot of visibility to versus a lot of the -- on the DoD side of our business, we have orders out for a couple of years typically. So that would be the opportunity for us. That some of that may come forward for us. But at this point, we haven't seen any firm orders.

Thank you.

Welcome.

Your next question comes from the line of David Strauss with Barclays. Your line is now open.

Thanks. Good afternoon.

Good afternoon.

Mark, could you just -- could you comment on the inventory levels you're carrying? And it looks like the inventory balance is basically where it was pre going back to 2019 sales or 20% lower. I mean, how much excess inventory are you running today? And when do you expect some of this to reverse out?

Yes. So we're significantly increased on the inventory and well above where we want to be, that is for sure. Really with the supply chain and the labor disruption, our inventory has gone up, it continued to go up here in Q1. It increased in fiscal ‘22 and continued to go up here in Q1. What we're focused on as a team is, as we mentioned in our prepared remarks to begin improving here in the second half of the year, both around output and that would help with reducing inventory. So at this point, it's at, like you're mentioning, almost all-time highs from that perspective and something the team is very focused on making improvements. And with the output increases that were anticipated in the second half of the year that would help reduce some of that inventory as we go forward.

Okay. And on the Defense side, I mean it looks like the Aero, the Aero OEM and aftermarkets coming back as would be expected. But what is the right run rate and I'll think about for the defense business was $750 million revenue a year business that now looks like it's $600 million? I mean, is that the right way to think about as a baseline for the business going forward? Or is there something that's going to fill in the, I guess, the gap that JDAM has left?

So on the Defense side, I would say that it's in the ballpark of what we're looking at based on of the decline in the JDAM. Now we have spoken about there is some increases both with the small diameter ROM, SDB and AIM-9X, which is a weapon of choice on the F-35. But the volumes aren't at what the volumes were of the JDAM back, when it was the weapon of choice back in the last decade or so. On the Defense aftermarket side, we do see strong demand there. A lot of our supply chain and labor disruption is impacting that defense aftermarket side of the business. So what we've talked about for fiscal ’23 is we anticipate defense to be stable throughout the year. Obviously, some headwind as I was just describing on the guided weapons side, offset by some improvements on the defense aftermarket side. Based on output improvement that we've spoken about here in the second half of the year. So that's kind of in that stable world is kind of where we're at from a revenue perspective for FY ‘23, compared to FY ‘22.

Okay. And last one for me. You said your Q1 came in line with your, I guess, internal plan. Obviously was, you know, a fair amount below what the [Indiscernible] was looking for. Any help you want to provide to calibrate us on Q2?

So we don't give quarterly guidance as you know. I'll go back to really a lot of discussion that we had in November that I also had in my prepared remarks today. This is a second half improvement recovery is, kind of, where we are starting to see, that's where it will begin to subside. So if you look at Q2, we will have the variable comp that I spoke about, right, the $50 million increase is what's anticipated for the year, compared to FY ‘22. We did book $12 million more in Q1, than we did the prior year, but that will still be there. As Chip was mentioning, for example, with the Rapid Complex Machining, improvements that we're making. Again, that won't really be producing many parts here in Q2. It's more of a back half opportunity for us. And so what we're really looking at is continuing to stabilize the business here in Q2 make some improvements just based on some more working days. We don't have the holiday periods that we had in our Q1. We don't have the seasonality effect that we had in Q1 of our business, but really not at our full not even full, not really improving much as we move through Q2, but really into the second half of the year is where we're going to start seeing some of that disruption impact subside.

All right. Thanks very much.

You're welcome.

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

Thanks. Good afternoon, guys.

Yes. Thank you.

So maybe just to follow-up on slide 16 and the 5% price realization? Is that gross price or net price? And what did you see in Q1? And, can you talk to us about the timing of the contracts, whether it's an Industrial or Aerospace? How it's going to flow through?

So that's net price, Sheila.

Okay.

And as far as timing goes, our long-term agreements in both Industrial and Aerospace are come due when they come due. They're not sort of in some cases annual. It's just -- it's the month that expires. And so that plus catalogs are spread out through the year. The annual, sort of, long-term agreements with OEMs that are under contract like Life Program or things of that nature, do adjust on January 1. So there's a bit of lumpiness on the January 1, and then the rest of them are kind of spread out and what we're saying is that 5% is what we'll see through the year.

Okay. And then just maybe switching gears onto your commercial aftermarket. You know, I think it grew like double the peer average thus far given limited numbers. But what are you seeing in your aftermarket narrow body versus wide body initial provisioning. And you also mentioned China in your script. So how far below is your China business versus peak?

Well, just to take a -- maybe one at a time, but I'm not sure I can remember all of those points. So we have very strong inputs to all of our service shops right now and our team is doing a pretty good job of turning those units and getting them back out the door. We have had some initial provisioning for narrow body. Not extremely strong, but we've had some. China is pretty quiet for us. In most of the case, I can't really think of much China business that we did in the last quarter or two, kind of, looking for that to take off for us in the coming years hopefully, but not predicting that. We've got a good demand from our Europe and the Americas and the Middle East right now.

Great. Thank you so much.

Yes.

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

Hey, thank you. Good afternoon, guys.

Good afternoon, Gautam.

I just wanted to ask two questions. One, on the guidance, how much of the $95 million supply chain related delinquencies? Do you anticipate catching up in the fiscal year? And, then I have a follow-up.

Yes. So when we went into the year just to get everybody grounded again, we had $85 million at the end of September of 2022. Obviously, the guidance range has a wide range to it and there's varying points in that range based on both market demand and supply chain and labor disruption impact. What we had said previously was we are anticipating as you get towards the higher end of our sales guidance range, you would be seeing improvements. From that $85 million that we started the year with, kind of, the middle, you would be kind of right in that range and the low end at, maybe things would get a little worse. And so it's not a specific number that we're really focused on, but really that was a part of what we took into account related to the range that we gave.

Okay. And could you elaborate on what you're seeing, what changed quarter-to-quarter with respect to supply chain constraints? What got better? What got worse? If there's any trend you can discern?

I think overall, Gautam, I’d say that more suppliers are recovering that's a general statement. But we've taken more off the elevated attention list than we have put on. So that's a good sign in terms of things getting better. We've had better output in some of our value streams and in the front ends of some of our lines, including machining. So that's also we're feeling like we're starting to get more of our newer machinist and operators up to speed. So I think sequentially that's a good thing. We're doing less hiring, because people are staying in -- more people are staying, so I think those are the three maybe good trends that we're seeing, but we were having this discussion earlier whether two points as a trend or we need three quarters to say we're feeling better about those three items.

Right. Makes sense. And last one, if I may. What are your preliminary thoughts on the industrial portfolio? Is it -- are you thinking like to skew management? Is it where you make stuff? Is it markets you participate in? Like, what's your initial impression Chip of where you could actually do better?

I think the initial impression is kind of where you went first with the SKU rationalization is what I would use as an old term from another company. But the product portfolio is vast in the industrial segment. And not all our children are top of the class in performance. So we've got some work to do that we do work with our supply base or make strategy as well as our customers to try to rationalize and take good action on things in the latter stages of the product lifecycle. That need to be managed differently in conjunction with supporting our customers, as well as things that we have that are actually upgrades to some of the older things that we sell that we could standardize upon. So there are a number of different moves we could make with that portfolio that are, sort of, well-known tried and true ways to improve our results and reduce our complexity. That's the really the main focus of it.

Thank you very much guys. Good luck.

Thank you. Welcome.

Your next question comes from the line of Louis Raffetto with Wolfe Research. Your line is now open.

Good evening, guys.

Good evening.

Good evening.

So a little bit of deja vu here from a year ago, we were kind of same spot tough first quarter and looking at a second half recovery and we kind of know how that story played out. So if I look at just Industrial now, I think your guide is kind of implying 11% margins in that business the rest of the year on average. I mean, is that realistic?

Well, we are taking action to achieve that. Like I said, our three focuses in addition to recovering our operations are on rightsizing the business, so that's a key action. Price realization, we've got some opportunities to do a little better there and we need to push that through and get the value that we're looking for our products. And then the product portfolio rationalization that I was talking to. So none of these are easy things and none of these -- and each of these things take some time, which is why it moves it to the back half. If things that we were in many cases planning to execute on this year, but we knew it would take time to start to see the benefits of them.

Great. Thank you. And then just -- can you tell me what you guys are seeing on the OEs side from Aerospace? What about you are 737, 787, A320, any pull from the OEs?

We're seeing the same sort of schedules, I mean, there are a lot of, I would say, small changes in reschedules going on out there, but there's nothing that's changing our overall build rate or rate break plans from last year. So we're in tune with the engine and airframe folks and following their lead and trying to make sure we support them.

All right. And then just lastly just on the variable comp, so I guess most of that's flowing through the cost of goods. SG&A was pretty much flat year-over-year.

It goes across all three lines on the P&L, cost of goods sold, R&D and SG&A.

Okay. Thank you.

You're welcome.

Thank you.

[Operator Instructions] Your next question comes from the line of Michael Ciarmoli with Truist Securities. Your line is now open.

Hey, guys. Good evening. Thanks for taking the questions. Maybe I don't know if you want to super mark just to go back to -- I think Rob's first question on Aerospace, you guys are one of the companies that help us out and disclose these operating income bridges. So if I looked in the Aerospace segment this quarter, I mean, was price mix and productivity, did that improve sequentially from the fourth quarter?

Yes. So we don't have sequential bridges as you know Michael in 10-Q overall. But where really the price mix and productivity inflation impact is, kind of, the other side of it. In essence, as we've achieve that 5% price realization, which we did here in the quarter, that's offsetting the inflation both on the material and the direct labor side that we're seeing.

Okay, okay. And then I guess just back to the previous question, this confidence level in the industrial margins, I know you're not going to give us second quarter guidance. But I mean, should we expect -- are we going to see a step function improvement in the second quarter? Or just -- it sounds like most of your new capacity comes online in second half? And I mean, it really sets up for what's going to look like I don't know 13.5%, 14% margins to kind of get to that flattish. Is that the right way to think about it? Or should we expect maybe some more pronounced improvement in the second quarter here off of this 5% level?

Yes. I'll say consistent with our prepared remarks. And as you mentioned, this is a second half story here. As Chip was mentioned earlier on the call a lot of the activities that were, as he mentioned, confirming and then working it towards they take time. And so that's why we are talking about this is really a second half improvement.

Okay. Is a stable supply chain good enough to get you there for the second half? I mean, most of the peers that are reporting are seemingly calling for a stabilized environment and you guys unfortunately strike your fiscal quarter for September, which kind of puts you in a little bit of a bind there too. I mean, is stable enough to get you there for the second half?

Stable is enough, because we have a lot of inventory as you can see and we have a lot of assembly and test and shipping capacity. And we need some stabilization and not missing those final one or two parts that hold us up. So we've got some good plans around Rapid Response Centers and shift balancing to get us that capacity and capabilities delivered in the second half.

Got it. Perfect. Thanks, guys.

You're welcome.

Your next question comes from the line of Noah Poponak with Goldman Sachs. Your line is now open.

Hey, good evening.

Good evening, Noah.

This is going to be a little repetitive, but I guess I'm just struggling to piece together all the margin inputs, because you know, I just heard you saying stable is enough. Your -- you know, description to the question prior sounded like supply chain was stable, if not a little better. You've got better pricing, it sounds like? And then just general cost input inflation, supply chain disruptions we've been dealing with. I guess, I'm trying to better understand why the margins were worse in the quarter. You know, putting the back half ramp aside for a moment, just still struggling to square. I guess it's hard to really answer without showing me, but the line-by-line cost inputs, but it's hard to understand why the margins are worse and it seems like some of them that you've had were stable and some of them that you've had were better?

So no, I was pointing to some of the improvements that we've seen, but there's in no way would I term our supply chain stable right now? What we're trying to do internally, there are two places where the costs show up right now from our labor and training and so people who are in training are not even applying their labor to making a part. And then once they graduate from a step of training and are on a machine making a part, they're making fewer parts than to standard or a proficient operator would make. So those are two places where costs are accumulating and impacting our margins that by the time we get to the second half, we're planning to have more people be proficient by that time. So that's an internal stability factor. But then externally, we have -- even though we've graduated more than 30 suppliers off that watchlist, we've got more than 20 on it right now. And as you know, you need all the parts to make the unit. And so the fact that in some cases we're not getting good signals and we're not getting the parts we need on time. We end up very much sub-optimizing our internal factories. So that's sort of a double whammy on cost where we're not getting the output and we're resequencing or doing work at it, having traveled work or having to re-sequence it.

Okay…

I just want to be clear that. This is not stable right now. I just want to be clear about that.

Okay. No, that's helpful. On the product rationalization piece or the SKU review, is that all industrial? Is there any Aerospace and what are the characteristics? Is it too much OE, not enough aftermarket, too much competition? What are the disruptors in those things?

Well, I mean, the simple answer is too many part numbers. If I showed you all the things we made here, I think you'd be surprised. And a number of whom we don't make very often and when we do, it's very disruptive to the value stream we inserted into. So there's hidden costs associated with that, as well that show up on the -- maybe a manufacturing overhead or a period cost that isn't trapped in cost of goods sold just, because of what it takes to actually bring that product to life that quarter. So getting better alignment with an understanding of what we should make and what we should offer and how we should price it. These things are -- you might say basic product management, but that's the tool we're going to use to improve our ability to serve customers and generate higher margins.

And what percentage of the SKUs are under review roughly?

All of them.

All of them?

Well, all of them really. I mean, but we'll do it in groups. It's -- there are some logical groupings.

Last one for me. Mark, just on the free cash plan. Understanding it's a back half loaded year, just the ramp from 1Q to 4Q implied is pretty steep, compared to history and especially with the elevated capital plan this year? Anything, you can add to that on how you do that if its working capital related or something else?

Yes. So a couple of comments there. So you hit the last -- the most impactful one first. It really is that working capital improvement I mentioned earlier on the call as to we are significantly higher on inventory that we have initiatives that we'll be working and that improvement in the second half of the year will be -- what will help drive that cash flow. We have had, I'll say, cash flow seasonality in the past. If you do go back and look at Q3 and Q4 free cash flow generation that has historically been consistently strong for us. And so it obviously with where we're at today and where inventory balance is today, we'll be a back half story like we're, kind of, implying with the reduction in past dues, getting the inventory out and then getting the collections and the customers that working capital piece will be important. Your CapEx note there, we guided to $80 million, we did spend more than just the $20 million here in Q1, so it was a little first half loaded. The other one was the timing of tax payments, that's going to -- we talked back in November, we will have higher cash tax payments, primarily related to the R&D, the U.S. Tax law change for R&D deduction here. And so that has an impact too. But really, I mean, the big one comes down to the production capability getting the past due improved and which will allow us to reduce inventories and collect that cash.

Okay. Thank you.

Thank you. You're welcome.

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

I’d like to thank you for your participation and look forward to seeing you next quarter.

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