Teledyne Technologies Inc (TDY) — Q4 2015 Earnings Call Transcript

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 fourth quarter and full year 2015 earnings release conference call. We released our earnings earlier this morning before the market opened. Joining me today are Teledyne’s Chairman, President and CEO, Robert Mehrabian; COO, Al Pichelli; 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 this 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. We ended 2015 with our strongest quarter of the year. Sales and earnings per share were significantly higher than the preceding quarters. In fact, earnings in the fourth quarter of 2015 were nearly a record, just under last year’s record results. Year-over-year revenue declined on an especially difficult comparison. However, given past R&D investments and the resulting new products as well as improving aerospace and defense markets, we achieved sequential quarterly improvement in revenue throughout 2015 in both our digital imaging and aerospace and defense electronics segments. In addition, GAAP, and I emphasize GAAP, operating margin increased sequentially throughout 2015. And on a full year basis, despite the lower revenue and an increase in pension expense coupled with greater severance charges, we were able to maintain operating margin. Before commenting further on our results and segment financials, I want to provide some additional perspectives on our Company. First, our balanced business portfolio is not dependent on any single product or market. For example, while a weak offshore energy market is impacting our marine instrumentation product, this end market only represents approximately 15% of total sales. On the other hand, our defense business, which represents over 25% of total sales, contributed to the growth of our aerospace and defense electronics and engineered systems segments in the fourth quarter. In addition, given our content on U.S. submarine programs as well as growth of our autonomous underwater vehicles, our U.S. government business also mitigated declines from oil and gas products. Second, Teledyne knows how to manage change. It’s part of our culture, our DNA. As a reminder, U.S. government budget cuts or sequestration and a corresponding shrinking defense business resulted in over $100 million of lost annual sales between 2012 and 2015. From the outset, we began aggressive cost reductions and facility consolidations. At the same time, we invested wisely across our continuing businesses and added complementary acquisitions. Three years after sequestration, total Company sales, gross margin, operating margin, and earnings per share are all significantly higher. In 2015, and continuing throughout 2016, we are again consolidating facilities and businesses but this time, our efforts are largely focused on marine instrumentation. And while the overall instrumentation service revenue declined in 2015, we were able to maintain margin. In summary, while we cannot predict the duration of market cycles, be it defense, aerospace, energy or others, we can and have managed through many such events in the past. Turning back to quarterly results, GAAP earnings per share of $1.57 decreased from last year’s $1.62. The $0.05 decline largely resulted from the 3.6% decrease in revenue as greater severance charges, negative pension effects and other expense were essentially offset by greater tax benefits and a reduced share count. Sales to international customers decreased slightly due to lower demand for marine and test and measurement instrumentation as well as foreign currency translation. On a full year basis, foreign currency translation affected sales negatively by approximately 1.5% but acquisitions offset this decline. I will now briefly comment on our business segments after which Sue Main will review some of the financials in more detail and provide an earnings outlook for the first quarter and full year 2016. In our instrumentation segment, fourth quarter sales decreased 11.1% from last year. Sales of marine instrumentation decreased 11.6% due to lower sales of interconnect systems and other marine sensors and systems for energy production, partially offset by higher sales of interconnect and marine systems to the U.S. government. In the environmental domain sales decreased 7.9% and it reflected a tough comparison as well as reduced sales for lab and field instrumentations domestically that was partially offset by higher sales of ambient air analyzers used in pollution controls. Sales of electronic test and measurement systems declined where sales to Europe and especially Asia were impacted by both weak demand and currency headwinds. GAAP segment operating profit declined and operating margin decreased 108 basis points due to lower sales as well as severance related charges. Turning to the digital imaging segment, fourth quarter sales were essentially flat with last year while GAAP operating, segment operating profit increased 47.4% and operating margin increased 365 basis points. Turning to aerospace and defense electronics, fourth quarter sales increased 5.6% from last year. U.S. government and defense sales were flat year-over-year but considerably higher than in the first half of the year. In addition, our commercial avionic business continued to perform exceptionally well. GAAP operating profit for the segment increased 6.5%. Turning to the engineered systems segment, fourth quarter revenue increased 4.2% but operating profit decreased 13%. Sales increased from nuclear and aerospace manufacturing programs as well as commercial hydrogen generators but lower shipments of high margin cruise missile engines and additional pension expense impacted margins. In summary, 2015 was fraught with challenges, a weak industrial economy, contractions in corporate capital spending, and wild swings in energy prices and foreign exchange rates. I am proud of our efforts to address these challenges and our financial results in light of the circumstances. Because we expect some further deterioration in our offshore energy businesses and since we remain cautious in other commercial markets given the challenging global economic environment, we feel it is prudent to be measured in our outlook for 2016. Our acquisition pipeline is strong and our long-term focus remains growing the Company through both acquisitions as well as investments in new products. Nevertheless, we will weigh share repurchases versus acquisitions, given relative valuations. 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 first quarter and full year 2016 outlook. In the fourth quarter, cash flow from operating activities was $61 million compared with cash flow of $85.6 million for the same period of 2014. The lower cash provided by operating activities in the fourth quarter of 2015, primarily reflected lower net income and higher income tax payments and then a reduction in accounts payables near year-end. Free cash flow that is cash from operating activities less capital expenditures was $45.6 million in the fourth quarter of 2015 compared with $71.8 million in 2014. Capital expenditures were $15.4 million in the fourth quarter compared to $13.8 million for the same period of 2014. Depreciation and amortization expense was $22.4 million in the fourth quarter compared to $24.2 million for the same period of 2014. We ended the quarter with $696.9 million of net debt, that is $782 million of debt and capital leases less cash of $85.1 million for a net debt to capital ratio of 34.1%. In the fourth quarter 2015, we amended the $750 million credit facility to extend the maturity to December 2020. Also in the fourth quarter, we issued $125 million of senior unsecured notes. The notes consisted of $25 million at 2.81% due in November 2020 and $100 million at 3.28% due in November 2022. On January 26, 2016, Teledyne’s board of directors authorized a stock repurchase program for up to an additional 3 million shares of Teledyne common stock. Turning to pension and stock compensation expense, in the fourth quarter of 2015 gross GAAP pension expense was $1.1 million compared with gross pension income of $0.3 million in the same period of 2014. For your reference, our pension, which is primarily for legacy retirees remains fully funded as of year-end 2015. Stock compensation expense was $2.5 million in the fourth quarter of 2015 compared with $3.9 million in the fourth quarter of 2014. In 2015, in an effort to reduce costs, we granted no stock options but we will do so in 2016. Finally, turning to our outlook, management currently believes that GAAP earnings per share in the first quarter of 2016 will be in the range of $1 to $1.10 per share. We expect our full year 2016 earnings per share outlook to be $5.05 to $5.15. The 2016 full-year effective tax rate excluding any discrete items is expected to be 28.8%. I do want to emphasize a few items regarding our current 2016 outlook compared to 2015. The 2015 results benefited from significant discrete tax items and a lower tax rate of 28.1%. Collectively, these tax items generated approximately $0.32 per share of headwind for 2016 compared to 2015. I will now pass the call back to Robert.

Thank you, Sue. We would like to now take your questions. Alan, if you are ready to proceed with questions and answers, please go ahead.

Robert, could you provide more insight on the cautiousness you've mentioned not only in the offshore energy market, which seems reasonable, but also regarding potential weakening in other areas of the commercial business? I'm assuming some of this might pertain to the electronic test and measurement segment, but I would appreciate it if you could elaborate further on your observations in the other commercial sectors.

I think Jim, generally, what I can say is that like almost all other companies in our businesses, we are not really forecasting weakening. We are just being cautious because there isn’t a day that passes by that you don’t read about the various economies across the world, in China as an example, weakening and the dollar getting stronger. I just feel that we have to be cautious at this time till we start marching through the various quarters in 2016.

Is there any insight you could provide regarding how we should consider growth in some of the businesses throughout the year? It appears you are finding more comfort with certain government-related business, particularly in aerospace and defense, and engineered systems seems to have improved as well.

Jim, I can provide an overview of our current outlook for the different segments. We believe that due to the decline in the offshore energy market, where we hold a significant position—albeit a small part of our overall business—we anticipate further declines. We expect to offset some of that with our government-related energy and marine businesses. Overall, if we consider our instrumentation segment, which has revenues of just over $1 billion this year, it would be wise to expect a decrease of around 5% next year. For our digital imaging and aerospace and defense segments, which also contribute roughly another $1 billion, we expect a revenue increase of about 5%, which will balance out the decline in instrumentation. In terms of energy engineered systems, we anticipate it will remain relatively flat year-over-year. Looking ahead to 2016, I’ve shared my thoughts, but for 2017, while it’s early to predict, we have programs that hold potential for significant growth, especially in engineered systems, like the shallow water combat vehicle and our multiuser platform on the international space stations. We expect these initiatives to gain momentum by early 2017. Thus, while engineered systems may not show growth next year, we foresee a strong performance in the following year. I hope that provides clarity.

It helps. Aerospace and defense, is that may be mid single-digit growth; is that the way just given your bookings?

Yes, I think about 5% is appropriate.

Just before we get to the 2016, Robert, just in the fourth quarter on margins, can you just explain what was going on in the aerospace and defense? I mean the margins were down sequentially, even though you guys seemingly had a little bit higher volume. Was that a mix issue or just trying to understand why the margins declined from 3Q to 4Q.

We had some estimates of completion that we took down because we thought again it would be prudent to do so. We also saw a little weakness in our business in electronic manufacturing services, which is a very low margin business but we took some charges there. But overall, I think there is nothing very significant other than those.

And then just going back to what Jim was asking, I guess on the digital imaging, even for the full year, it sounds like it’s going to be more back end loaded. You guys usually have more back end loaded years. But 5% growth on digital imaging, what kind of line of sight do you guys have now; and maybe what are you even seeing with the current January trends in that specific business, to give you that confidence?

I think the 5% that I noted was about digital imaging and aerospace and defense combined. Yes, I would hesitate to specify exactly 5%, but I believe that combined, it’s around 5%. Digital imaging has three main components. One part shouldn’t count toward earnings because it pertains to our research lab, where we have both outside sponsored research and Teledyne sponsored research. Although we generate about $40 million in revenue from this, there is no profit as we reinvest everything and more from our own sales. Thus, when we assess digital imaging from an internal perspective, we exclude the scientific research lab. The second component is our government imaging business, particularly in high-end infrared imaging, which tends to be inconsistent due to the large programs we undertake, including national classified space programs and various instrumentation initiatives, both in space and on the ground. Generally, we view this as a stable, though not rapidly growing, business, and it has declined this year compared to last. The third part includes our digital imaging DALSA operations in Canada, where we are seeing significant progress with new management, especially in the midrange camera market. We have numerous products, including smart camera software, and our x-ray business within life sciences is performing very well. Additionally, we have recently taken on a lidar business, which focuses on laser-based range finding, and we have made management changes there as well, expecting improvements. Overall, we believe that while growth may be slow in 2016, we see it as acceptable. Long-term, considering all these factors along with our infrared operations, this is a promising business for us.

And then just the last one, I guess two housekeeping ones. On 2016, is there any buyback factored into the earnings outlook you’ve given?

No.

And then what about pension for next year?

Pension this year is going to be relatively flat. While the discount rate is increasing, I believe the rate of return will decline due to market conditions.

Could you discuss where you are allocating some of your R&D budget and how that aligns with customer needs? I have noticed that the Department of Defense is increasingly focused on marine and naval opportunities as well as long-range strike capabilities, which aligns with some of the strengths you have. Can you provide more insight on that?

First, while I think long-term, I also pay attention to quarterly results. In the marine space, we are investing in next-generation products, including connectors suitable for high-powered, high-pressure environments. Surprisingly, we receive $15 million in marine R&D investment from our customers even today. We are also preparing for replacements for the Ohio class submarines, given our strong position in that area. In our DGO business, we experienced about a $15 million decrease in our oil and gas segment; however, we compensated for that loss and more with our submarine hull connectors. We are also focusing on position navigation and timing products for the future. We plan to put our chip-scale atomic clock into production this year, and while we won't profit from it this year, I am confident we will next year. We have developed a MEMS gyro that is now in production in our plant in Canada. Overall, we believe the position navigation and timing sector is a key area for investment. Additionally, we are investing in new products in our test and measurement businesses, particularly in electric motor drives and nuclear valve tests, along with significant funding for new DALSA imaging products. We hold sole-source positions for data acquisition systems on Boeing aircraft for the next dozen years and are investing heavily to maintain that position while meeting their expectations. In total, we are spending about $170 million on R&D, with an additional $100 million coming from external sources, making our total investment over $250 million a year, or approximately $270 million, which is about 12% of our revenue. We are indeed spending a lot, but it is an investment in future products.

Marine has performed better than expected, but it seems that we haven't hit the lowest point yet. Could you share some insights on your planning approach and what your customers are doing regarding inventory surplus, and how you anticipate that will resolve?

You've raised an important issue that concerns us greatly. Our customers are definitely experiencing challenges, particularly in the offshore market, and onshore fracking has also decreased significantly. In 2015, the oil and gas segment of our marine business, which represents a portion of the total marine operations amounting to about $600 million, had revenues of around $340 million to $350 million. We anticipate a significant drop, possibly around $100 million for this year. The reasons for this decline are clear, largely due to oil prices and various factors affecting the market. However, we also have onshore businesses in oil and gas. I believe that oil prices will eventually rebound; history shows that the fluctuations we are witnessing are comparable to the lows experienced in 2008 and 2009. When prices do rise, I expect a rapid recovery in certain areas, especially on land where we have a substantial presence, since restarting operations involves fewer barriers. We are preparing for this scenario and enhancing our R&D efforts, particularly with our technology for underwater manifolds, where we aim not only to maintain but to increase our market share. While we expect significant short-term declines, our government business may help offset some of the losses. Overall, although the marine business will decline, it shouldn't be as drastic as the downturn in oil and gas. The $50 million decline I mentioned will likely originate from there. Ultimately, when the market recovers, we believe we will be well-positioned.

Thanks, good morning everybody. In terms of consolidation in your instrumentation business, is that at all like aerospace where you need customer approval or is it something you can pretty much do as you see fit?

Fortunately, this is something we can handle internally. In our marine segment, we have 24 businesses. We started the year with 2,500 employees in marine, and we have already reduced that by about 350, which is roughly 14%. Overall, we have let go about 655 employees. A significant portion of this reduction is in marine. We have also consolidated the 24 businesses into a single management structure along with one development, sales, and marketing team. This has allowed us to eliminate a lot of unnecessary expenses related to leadership, supply chain, and SG&A, while also consolidating facilities globally, both in the U.S. and abroad. When we emerge from this situation, we will be much stronger, more streamlined, and more efficient. We are confident in our ability to make these changes without needing anyone's approval. Additionally, we are investing not only in submarines and other marine projects but also in autonomous underwater vehicles. Overall, the most significant consolidation in our instrumentation business is within the marine sector.

In terms of concerns over global economic conditions, are you seeing more M&A opportunities come out or are the prices any more favorable? And if your liquidity position, I would guess you could be aggressive if that was the case.

We can definitely be aggressive. It's interesting to observe that some smaller public companies haven't yet grasped the reality of their situation. Many of these companies have seen their stock prices drop by 50%, 60%, or 70%, but they still believe they deserve multiples of 30 or 40, while their current multiples hover around 25 with minimal earnings. It takes time for reality to sink in, but when it does, we'll be ready to acquire companies in that space. With private companies, we have had more success because these entrepreneurs prefer selling to someone who won't dismantle their business or change its name; they want to maintain their staff, and we have performed well in this area. We have some potential acquisitions lined up, but we need to be cautious about overpaying, especially given our current stock valuation. Our stock is trading at approximately 9 to 9.3 times EBITDA. If we make an acquisition at that valuation, it would be modestly accretive at first, primarily because we typically see about 25% to 30% in intangible amortization. However, if we can enhance the bottom line by 50%, like we did with DALSA in Canada, then it could become significantly accretive, potentially by $0.12 to $0.14. We must be careful, as acquiring a company with a multiple of 13 to 14 times EBITDA means we would need to double its profitability just to break even. That's the challenge we face.

Last one, also on marine instrumentation. Is there a market for replacement here that you think will pick up? I know on some of the other calls, I’ve heard something similar to what you said that when energy turns around it will be abrupt.

I believe that's true, particularly regarding land-based systems. For our deep ocean systems, we have long-term contracts in place. Many of these contracts will continue despite current conditions because commitments have been made, and progress can't be halted when there's $10 billion already invested and work has begun. However, there are other sectors, especially in exploration. For instance, there are only two manufacturers globally that produce airguns, which generate the acoustic waves that reach the ocean floor and return; we are one of them. We acquired the company Bolt and have our facilities in this country. The only other competitor is a firm in France. When the market rebounds, it will come down to the two of us, and I anticipate that we will be very profitable. That's just one example.

I wanted to ask about the repurchase program and the authorization for 3 million shares. You said there’s no share buyback planned in the ‘16 guidance. What timeframe do you envision starting that buyback for the number of years you plan to complete it?

George, I think we need to consider buybacks alongside acquisitions. Currently, we have the capacity to generate between $200 million to $250 million in cash this year, plus our line of credit, and we aim to keep our debt to EBITDA ratio below 2.5. We might exceed that ratio temporarily, but we prefer to stay within that range, and right now we're at about 2.1. With that in mind, our primary focus is on acquisitions. We anticipate buying some shares back in 2016, though I can't specify how many at this moment, but we do have the authorization for it. We will evaluate share buybacks against acquisitions. Buying back shares is appealing because it provides immediate benefits, but we need to be cautious and balance that with acquisitions, which not only enhance revenue but also help improve our debt to EBITDA ratio. In summary, we will buy back some shares, but I can't say how much. Last year, we repurchased approximately $250 million worth of shares, and while I don't expect us to reach that level this time, we may consider repurchasing around $50 million.

And if I could just follow-up on, you talked about the M&A activity or acquisition pipeline and in recent years it’s really focused on the instrumentation side of your business within the four segments. Do you see, going after other areas in the acquisition activities going ‘16 and ‘17 or one particular area or across the board?

I think we might consider acquiring some software in the marine sector. I don’t see us investing in oil and gas for the time being. We may put money into our test and measurement division. Although that business has declined a bit year-over-year, the margins have improved by nearly 250 basis points since we acquired LeCroy, and it’s contributing about 20% to our EBITDA. I find that area appealing. Another area of interest is digital imaging, particularly related to life sciences. Lastly, we are drawn to environmental instrumentation. We were very active in this area in the early 2000s, but then prices became unmanageable, so we had to step back for a while. I believe the market is starting to stabilize, making this area attractive once again.

Just one last one, CapEx this year $47 million, $43.5 million a year ago; $50 million a reasonable estimate for CapEx in 2016?

I’ll let Sue address that.

We’re tracking around $50 million to $60 million.

I had a question on pricing, but not M&A but on product pricing and competitive discounts that you might be seeing. How is the pricing environment holding up across each of the different business segments?

When we sell things in China, we used to have to take a lot of discount, especially in environmental instrumentation. Interestingly, now that has stabilized. I was just going to start by saying the instrumentation is taking a lot of price hit. But right now that has stabilized because the Chinese environmental quality, air quality laws have been tightened so much that they need really high end instruments, and we don’t have to really compete with locally produced instruments. In the test and measurement, there is always price pressure, especially in our oscilloscope business. In A&D, I don’t think we have much price competition. We actually are doing really well especially in our aerospace and as well as our government programs. I would say in oil and gas, we’re taking some hits in our prices but I think overall I’d say we’re neutral.

So, the pricing environment has remained stable throughout 2015 and you expect it to remain stable in terms of the trend line in ‘16?

Yes, aside from foreign exchange, we can't predict how the dollar will behave. If it weakens, that will benefit us; if it strengthens, that will be a disadvantage. Overall, I believe the situation is relatively neutral.

Could you remind us which areas are most affected by foreign exchange movements?

Yes, I can do that. I think the highest exposure is in our instruments and the estimated impact to our revenues were about 3% last year in ‘15. Digital imaging would be next I’d say about 1%. In aerospace and defense much less, maybe 0.3%, and in engineered systems nil. So overall, last year I’d say our revenues suffered 1.5% because of FX, the most being in instruments followed by digital imaging.

And you had those memorized, right?

I have everything handed to me by my good friend, Jason. But I do have them memorized too.

Thank you, Alan. I will now ask Jason to conclude our conference call.

Thanks, Robert. And thanks everyone for joining us this morning. And of course, if you have follow-up questions, please call me at the number listed on the earnings release, and of course all our earnings releases and the web replay are available on our website. Alan, if you could conclude the call and provide the dial-in number? Thank you.