Teledyne Technologies Inc (TDY) — Q2 2015 Earnings Call Transcript

Thank you, good morning everyone. This is Jason VanWees, Senior Vice President, Strategy and M&A at Teledyne. And I’d like to welcome everyone to Teledyne’s second quarter earnings release conference call. We released our earnings earlier this morning before the market open. Joining us this morning are Teledyne’s Chairman, President and CEO, Robert Mehrabian; Senior Vice President and CFO, Sue Main; and Senior Vice President, General Counsel and Secretary, Melanie Cibik. After remarks by Robert and Sue, we will ask for your questions. However, before we get started, our attorneys have reminded me to tell you that all forward-looking statements made this morning are subject to various assumptions, risks, and caveats as noted in the earnings release and our periodic SEC filings, and of course actual results may differ materially. In order to avoid potential selective disclosures, this call is simultaneously being webcast, and a replay, both via webcast and dial in, will be available for approximately one month. Here is Robert.

Thank you, Jason and good morning, everyone. Following the first quarter of 2015, I mentioned that we were confident that Teledyne would achieve sequential improvement in earnings. In the second quarter, earnings per share increased 12% sequentially and revenue increased in all of our four business segments, even with greater currency headwinds. GAAP earnings per share of $1.34 decreased from last year’s $1.47. However, I should note that greater non-operating diesel settlements received last year versus this year accounted for $5.3 million or $0.10 per share of year-over-year variance. Second quarter sales were $577.7 million and reflected the strong US dollar and negative currency translation, as well as expected declines in certain energy-related markets. While these impacts were most concentrated in our instrumented segments, this segment’s operating profit increased, and segment operating margin increased to 102 basis points compared to last year due to strong operating discipline. I want to emphasize that while oil exploration-related revenue declined year-over-year as expected, our businesses related to offshore energy production increased and reported near-record sales. Backlog also remained relatively healthy, with an overall book-to-bill of approximately 0.9 across all of our marine instrumentation products. We continue to benefit from our balanced business portfolio, not just in our instrumentation segment, but across Teledyne due to the strength and diversity of our highly engineered products. While sales to some commercial markets declined, total U.S. government sales increased in the quarter. More broadly, after two years of contraction following the sequestration process and budget cuts, we believe we’ve reached an inflection point in our government businesses, which represent approximately 25% of total sales. In the second quarter, our defense electronics businesses had the highest orders in two years, with strength in all major product categories. So despite lower sales in the first half, we expect growth in the second half. Furthermore, our engineered systems segment is growing and while there are more difficult comparisons in the second half, we expect to grow year-over-year even though we expect full-year revenue this year from one of our flagship programs, the Shallow Water Combat Submersible vehicle, to decrease slightly as we transition from engineering development to production in 2016. Foreign currency translation primarily impacted our instrumentation and digital imaging segments, but acquisitions helped mitigate these declines. Sales to international customers primarily decreased due to currency translation; specifically, while sales to Europe held up well despite currency, we did note a decline in sales to Asia and South America across a number of our product lines. Finally, we remained nimble, aggressively managing our cost structure and deploying capital judiciously. For example, we have reduced total headcount by 4.3% in the first half of 2015 in response to declines in some markets. At the same time, we’ve completed approximately $200 million worth of acquisitions and shares repurchases year-to-date, and our acquisition pipeline remains robust. I will now comment on our business segment, after which our CFO, Sue Main, will review some of the financials in more detail and provide an earnings outlook for the third quarter and full year 2015. Turning to the instrumentation segment, second-quarter sales decreased 1.9% from last year. Sales of marine instrumentation increased 1% despite a significant expected year-over-year decline in sales of the geophysical sensors used for offshore energy exploration and the negative impact of foreign currency, which particularly impacted this group of businesses. As I mentioned previously, sales to the offshore energy production industry remained very strong, with reasonable orders continuing resulting in a stable backlog in businesses primarily serving this market. In the environmental domain, sales decreased 2.4% and reflected decreased sales of laboratory and field instrumentation offset by sales of air monitoring and process gas analyzers. Sales in electronic test and measurement systems declined, with roughly half of the decline due to foreign currency translation. GAAP operating profit increased in the segment and operating margin improved by 101 basis points, despite lower sales due to improved operating performance and strong cost control across each major product category. Turning to the digital imaging segment, second-quarter sales decreased 12.4% compared to last year, primarily due to lower sales from U.S. Government research and development contracts and reduced sales of specialty cameras for semiconductor and electronic inspection. These were partially offset by increased sales of machine vision cameras for general industrial applications and x-ray sensors for medical imaging. As in the first quarter, the year-over-year decline in government research was largely caused by gaps in a number of governmental programs. That said, we believe we’ve hit the bottom of the trough. For example, the U.S. Air Force made a notification on June 25th of its intent to award Teledyne a sole source contract valued at approximately $30 million for additional air crew laser eye protection spectacles. The prior phase of this program ended in 2014, and we will be glad to resume full production later this year. Segment operating margin decreased and was 159 basis points lower than last year. Turning to our aerospace and defense electronics segment, second-quarter sales decreased 3.4%. While U.S. Government sales declined, our commercial avionics business continues to perform very well. Operating profit declined due to lower sales and lower margins in a number of defense electronics businesses. However, due to cost reduction efforts and strong bookings, we expect continued sequential improvement in both sales and margins in this segment in the balance of the year. Turning to the Engineered Systems segment, second-quarter revenue increased 6.2%, but operating profit decreased. Sales benefited from a great mix of marine and space manufacturing programs, as well as higher sales of energy system products such as commercial hydrogen generators. However, lower sales of fixed-price turbine engines and pension expense impacted margins. We also continue to invest in the development of a commercial space-based imaging business based on our multiuser system for earth sensing or also known as MUSES, which is the Earth observation platform. We currently expect MUSES to be operational on the international space station in 2016, with hyperspectral imagery beginning in 2017. We were recently awarded a $15 million advance data purchase contract by NASA, which resolved some near-term cash flow as well as future revenue once our space-based images become available. In summary, when we are faced with events that we cannot control, like government sequestration, currency headwinds, lower oil prices, or weakness in certain economies, we immediately reduce variable costs to get ahead of the curve and we also permanently reduce fixed costs wherever necessary. Since 2012, in response to the sequestration challenges, we have continuously reduced costs through consolidation and operational discipline. For example, we've reduced our manufacturing footprint by 7% and our workforce by approximately 1,500 or over 15%, at a total cost to Teledyne of almost $30 million. Prior to this year, most of the permanent reductions in our cost structure were made within our government businesses. Now that we see the cycle improving, we expect additional margin improvement beyond that achieved over the last two years. Our response to the current market challenges is consistent with the past, but with the majority of 2015 cost actions centered in our instrumentation segment. As in all cases, we have refrained from the temptation to march down the slippery slope of non-GAAP so-called one-time accounting. At the same time, we are offering new products through R&D and expanding our markets through acquisitions outside the United States, where we can use the strong dollar to our advantage. Finally, we have the necessary discipline, unique technologies, manufacturing know-how, good cash flow, and a strong balance sheet to deliver outstanding GAAP earnings now and maintain our lower cost structure during future growth. I will now turn the call over to Sue Main.

Thank you, Robert, and good morning, everyone. I will first discuss some additional financials for the quarter not covered by Robert, and then I will discuss our third quarter and full year 2015 outlook. In the second quarter, cash flow from operating activities was $59 million compared with cash flow of $95 million for the same period of 2014. The lower cash provided by operating activities in the second quarter of 2015 primarily reflected lower net income of $5.8 million, expected change in control severance payments, and higher income tax payments. Free cash flow, that is cash from operating activities less capital expenditures, was $45.4 million in the second quarter of 2015, compared with $86.1 million in the same period of 2014. Capital expenditures were $13.6 million in the second quarter, compared to $8.9 million for the same period of 2014. Depreciation and amortization expense was $22.8 million in the second quarter, compared to $23.4 million for the same period of 2014. We ended the quarter with $704 million of net debt, that is $765.3 million of debt and capital leases less cash of $61.3 million, for a net debt-to-capital ratio of 33.5%. Turning to our pension and stock compensation expense: in the second quarter of 2015, growth GAAP pension expense was $1.1 million, compared with growth pension income of $0.4 million in the same period of 2014. Stock option compensation expense was $3.3 million in the second quarter of 2015, compared with $3.6 million in the second quarter of 2014. Finally, turning to our outlook. Management currently believes that GAAP earnings per share in the third quarter of 2015 will be in the range of $1.45 to $1.48 per share. We are maintaining full year 2015 earnings per share of approximately $5.60 to $5.65. The 2015 full year effective tax rate excluding discrete items is expected to be 29.5%. I do want to emphasize a few items regarding our 2015 outlook compared to 2014. First, our pension assumptions include a discount rate decrease of 90 basis points and changes in mortality assumptions, which will increase non-cash pension expense in 2015. Second, 2014 results benefited from greater net legal settlements, significant discrete tax items, and the 2014 R&D tax credit, which is not currently effective for 2015, as well as a slightly lower tax rate. While our current 2015 outlook includes some estimated discrete tax items in the third quarter, we expect these to be partially offset by additional reduction in force and facilities relocation costs. I will now pass the call back to Robert.

Thank you, Su. We would now like to take your questions. Operator, if you’re ready to proceed with questions and answers, please go ahead.

Good morning.

Good morning, Greg.

Just looking at the outlook, by my calculation, it looks like you have about 150 basis point margin improvement in the second half of the year relative to the first, and you kind of went over some of the moving pieces. I was hoping if you could just give a little bit more of an outlook and where some of those improvements come from?

I think you’re essentially correct. A significant portion of that will come from our aerospace and defense electronics. As I mentioned, we have seen substantial improvements in our defense electronics orders, and we expect these, combined with the cost reductions we implemented in the past few years, to help us enhance margins. The second segment where we anticipate margin improvement is our digital imaging. We are currently working on further cost reductions in that segment, and we expect to see sequential margin improvement as we progress through the rest of the year. I would highlight that these are the two main segments where we foresee margin improvements.

Thank you. And then just on the turbine engines, was there a contract that rolled off or is that just a temporary alignment in shipments?

Primarily it’s the same contract; they go in lots, and it depends on whether the customer has the need for the engines and whether the final customer, which is the government, is pulling the missiles up. It’s a gap in not a huge gap, but it’s nevertheless a slowdown in our shipments. We ship both JASSM engines, which are joint air-to-surface missile engines, as well as harpoon engines that primarily now go to our military sales, and both of those have some gaps, and we think that’s also going to be weaker in Q3 and perhaps improve next year.

Thanks. You mentioned the restructuring and the headcount reductions, what was the cost in the quarter and the full year?

In the full year to date, the cost is approximately $3 million, and we think it will go up probably to over $5 million the rest of the year for the full year, because we are still doing restructuring, as I mentioned, in two of our segments, both instruments and digital imaging. Last year, the cost reduction was about the same. This is just for the reduction in people. So I think the facility consolidation is in addition to that.

Thank you.

Thank you, Greg.

Hi, thank you. You gave some color on how we should think about growth in the defense portion of the business aerospace and defense portion. I think also you are expecting, I guess, some modest growth in engineered systems, if I heard you correctly. I wonder if you could talk a little bit about how we might think about the instrumentation and digital imaging business in the second half?

I got to look at the second half numbers. Let me start with the full year for a second if I may, Jim.

Sure.

I think for the full year right now, we expect instrumentation to be down about 1%. I think digital imaging would follow between 1% to 1.2%. I think aerospace and defense electronics should be up about 1% and perhaps the engineered system by about a couple of percent for the year. And so in total, I think if you look at our sales outlook organically, at least we should be relatively flat for the year.

Got it, that’s helpful. You mentioned a decline in the electronic instrumentation business; how much was the LeCroy business down?

It was down just over 10%. Half of it is certainly currency related and half of it is just a sales decline, and we think that we are going to see pressure in that domain anyways as we go forward. I think some of our competitors that we know, one of them that we’re aware of has projected a 13.5% decline in their revenue in Q3. The more important part is that we’re focusing on the higher margin niche products that and we’ve improved the bottom line by about 7% in our test and measurement or 180 basis points from last year. By the way, Jim, just on an addendum, it might be worth noting the same has happened in our digital imaging in Canada DALSA. We’ve seen strong bottom line improvements and expect those to continue.

Got it. And lastly, Robert, if you could, to the extent you are able to, you mentioned a fairly robust pipeline; is there any sense as to areas that you might be more focused on?

So, Jim, one area that we’re keen on is being able to take a lot of data from our marine instrumentation and related businesses and develop that into a set of data and image reader that would be available in the marketplace. This would be primarily non-oil and gas related. The other area that we like, as we kind of go back to some of our environmental businesses and look at those businesses again. We started our acquisitions very aggressively in that domain, but they got very, very expensive. But now I think now some of that has moderated, especially in the smaller companies that we’re interested in, so we’re going to go back to those, and we see some opportunities there, Jim.

Okay, thanks very much.

Thank you.

Hey, good morning, guys, thanks for taking my questions. Robert, just maybe to stand on that theme of the second half, I mean, so it sounds like you’ve got better visibility into the defense electronic side, but operating income is roughly flat first quarter to second quarter. I mean there is a pretty big jump needed to get to that full-year EPS number. I mean you’re going to have EPS growth of 22% over the first half. I mean are there any other onetime items lower tax or anything else that you see adding to that? I mean any other end markets that you see strengthening that might offset some of the weakening markets that we’re seeing?

I think we’re going to have a little bit of upside in discrete tax items this year in the second half. Nothing like we did last year except if the R&D tax passes, but we’ve not baked that into our projection. We do have a little tax there, but mostly it’s margin improvement in areas where we’ve taken serious costs out. Some that we took out the last two years like defense electronics, some that we took out in the first half of the year, and some that we are doing even now and expect to continue the rest of the year. So it’s a combination; mostly it’s because of the market and cost reduction.

Got it. And then just lastly on that, you guys sound really confident in that defense electronics and seeing maybe a trough in that market in general. Is there any risk at all around kind of the budget being delayed going into a continuing resolution? It seems like you guys have pretty good line of side into those revenue streams?

Yeah. There is always the danger with anything that relates to the government. Having said that, some of our orders that we have, for example in Traveling Wave Tubes, which is one of our mainstay products, our split between the U.S. Government and overseas government and our commercial aviation, of course, is a different story. But I think some of our programs have legs on and we feel okay about that. The government, obviously, anything can happen with the government. There is another part of our government businesses that we are kind of bullish about, maybe not so much this year, but going forward, and that’s in our engineered systems where we have some really good programs in the government domain.

Got it, thank you very much, guys.

Thank you.

Good morning, Robert.

Good morning.

Question to the oil industry, obviously the exploration segment of the industry is immediately impacted by the precipitous decline in oil prices, whereby the development work is more long-term in nature. What visibility do you have as to how the lower energy prices could potentially impact your development spending?

Okay, great question, Mark. As you said, the seismic exploration, which is the discovery phase, is down over 30%, and the other part of it, land oil and gas that we play, which is production, is down over 40%. But there we primarily supply cables and some connectors, in the water and also just energy in general. First, we have good orders early this year. So we expect to be able to hold our own the remainder of this year. We think the production may go down a little more than it already has, but we are, in a way, very fortunate in that we are gaining share; we’ve very aggressively reduced our cost in oil production, both in terms of supply chain and in terms of our own engineering and production costs. Lastly, we are bringing new products, both in optical connectors, Ethernet connectivity, as well as high-pressure, high-temperature connectors. Since we own a lot of that market, especially the optical connectivity market, and have a pretty strong position, probably over 50% in the electrical side, we will become the factor standard in that domain. There we also, as processing at the bottom of the ocean becomes much more robust, need more of our products. It’s a long way of saying I think we will be okay in '15. In '16, probably we might go down a little bit; everybody is projecting that '17 oil prices will pick up, as will production. But we are not counting on that right now we are reducing cost and hunkering down.

Okay. Could you have any comments as to what your customers are saying in the semiconductor and electronics marketplace? I mean everything I guess read over the last couple of months is that there has been underperformance vis-à-vis expectations in the first half. Any sense on what your customer base is looking for in the second half?

At least for us, if we look at our, for example, our DALSA cameras that serve that market. We had a slow first half in the electronic inspection market; we expect to have some pick-up in that domain, primarily because we’ve introduced new line scan products, which are coming out. The only other part of so-called semiconductor market that we participate in, Mark, is really our MEMS foundries in Bromont, Canada, and there our business is really good because we produce a lot of sensors for a variety of applications including stability applications, microphones in your iPads, etc. So as far as we are concerned, we are doing okay there; also we do have some protocol test solutions for mobile devices, which are doing okay. So my visibility into the semiconductor market comes from those two different angles.

Okay, thank you very much.

Thanks, Mark.

Thank you for taking my question, and good morning.

Good morning, George.

First question, just thinking about the instrumentation business as we look forward to 2016. If I look at 2013, the average quarterly run rate was $255 million; in Q1 of 2014, the instrumentation revenue was $260 million; and then this quarter $271 million if I back out $9.5 million of incremental sales on the acquisition that gets me around $260 million. Is that the right way to think about the baseline level of instrumentation being roughly $255 to $260 million looking forward assuming no more shocks in the system, currency or otherwise?

I think, George, that’s pretty good. I couldn’t have said it better. Of course, we’re always praying for positive shocks.

Yes.

But we have to say that also assumes, George, no new acquisitions in that domain.

Yeah, absolutely. And then my second question is have you thought about what the Orion deal means for your business or had any feedback from the customers that you served, both the ratification or acceptance of that deal means to your businesses?

The immediate effect is going to be obvious; there is going to be more oil coming onto the market. They are going to pump as hard and as fast as they can. Having said that, I think that’s going to be a short-term effect for two reasons. In the long term, energy consumption is expected to grow by 30% in the next 20 years, driven by the developing world. Second, as you look at wells and oil specifically, there is a continuing decline in the amount of oil that people are able to pump from the wells. That decline is estimated to be between 5% and 7%, if you take somewhere in between that 5 million barrels of oil per day per year. That’s just because oil wells, the productivity of the wells goes down, in fracking if not go down over the first two years by 50% or more in deep oil ocean. It might go down over a five-year period. But down that it goes, there is no question about that. So when you combine those two facts and when you look at Saudi’s oil, which is 90% of their government revenue, and they are burning through their foreign reserves since October; I think it’s been close to $50 billion. What’s going to happen is there are other factors that are going to drive the price of oil up other than just the short-term uranium oil production.

Got it, thank you. And then just lastly on the EPS guidance. Do you bake in any assumptions for share buyback in Q3 and Q4 with that guidance?

No.

Great, thanks. Nice job on the management.

Thanks, George.

Thank you. Good morning, everybody.

Good morning, Steve.

I know there is a lot of talk about M&A, but in the past, you’ve considered selling units that may have matured, and I’m just wondering if I know you probably don’t want to say what, but are there any things you are considering for sale now and what, if so, what do you think the proceeds might come in for?

Thanks, Steve. Right now I don’t think I am in a selling mood. I want to keep our revenue and spread our fixed costs across as much businesses as we can. There might come a day that we might sell something, but right now I don’t think so. I mean I am more in a buying mood, Steve.

Okay, that sounds good. You were talking about the laser eye protection. What sort of commercial market or even within the business jet market is there for that? I know there have been a number of incidents recently, and we don’t hear much about that product for the commercial market.

Yeah, that product is, Steve, a hugely sophisticated product. Without violating anything, you can have as many as 150 deposition layers of different kinds, and it’s totally under ITAR control. So I don’t think we can do that for any commercial markets, plus it's a very expensive process. There are cheaper processes for that other people can use for the commercial market. But we don’t know if anyone is really using anything right now because nothing bad has happened, as far as I know, recently.

Okay, thanks. And just going back to M&A side again, given that the values might not be so good for selling does that mean there are some opportunities for you to fill some holes? Are there any holes that you feel you need to fill in some of the instrumentation product lines particularly?

Yes, Steve, I think there are opportunities in some environmental instrumentation that some sample preparations, sample also obviously analysis, that’s a very big field with multiple types of processes. We own a significant chunk of that market, but there are significant numbers of other things that we are looking at. That would be if I had my druthers, that would be one of our primary areas. But this whole area of being able to take a consolidated look at all the imagery that we get and being able to develop and deliver that, especially marine imagery, that’s another interesting area for us.

Okay, last one I guess this one would be for Su; I hope I didn’t miss that. You often say how much total liquidity you have available. Did you mention that, or if not, could you mention that please?

No, I didn't mention it. We have at least $500 million to $700 million already available.

Got it, thank you very much.

Thanks, Steve.

Thank you, operator. I’ll now ask Jason to conclude the conference call.

Thank you, Robert. And again, thanks everyone for joining us this morning. If you have follow-up questions, of course, please feel free to call me at the number listed in the earnings release, and all our news releases are available on our website teledyne.com, as well as the webcast. Operator, if you could conclude today’s conference and provide the replay information, we’d appreciate it.