Teledyne Technologies Inc (TDY) — Q3 2016 Earnings Call Transcript

Thank you and good morning, everyone. This is Jason VanWees, Senior Vice President of Strategy and M&A at Teledyne and I would like to welcome everyone to our Teledyne's third quarter 2016 earnings release conference call. We released our earnings earlier this morning before the market opened. Joining me are Teledyne's Chairman, President and CEO, Robert Mehrabian, COO, Al Pichelli, Senior Vice President and CFO Sue Main and SVP, General Counsel, Chief Compliance Officer and Secretary, Melanie Cibik. After presentations by Robert and Sue, we'll 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 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's Robert.

Thank you, Jason and good morning, everyone. In the third quarter, we continued to achieve organic growth in our commercial imaging and aerospace businesses. Sales of electronic test and measurement instrumentation also increased nicely, outpacing other industry participants. I'm very pleased with our exceptional execution across Teledyne. Given aggressive cost control and growth in three of our four segments, Teledyne's overall GAAP operating margin was an all-time record. Furthermore, other than marine instrumentation which has been impacted by energy markets, margins were at or near-record levels for most business segments and the majority of product groups. We also believe that our marine instrumentation businesses collectively have bottomed. Despite financial cost cutting, our emphasis on new product development, through internally funded R&D, increased from last year in both dollar and percentage terms and was approximately 8% of sales. Coupled with relevant externally-funded R&D, we spent approximately 11% of our revenues on new technologies and products. It's also worth noting that despite the major year-over-year decline in offshore energy markets, we expect to receive an all-time record, $25 million of customer-funded R&D in our marine businesses in 2016. Next, cash flow from continuing operations of $98.9 million was also a record for any third quarter. Year-to-date, we have generated over $200 million of cash after capital expenditures. Our current debt is at the lowest level in two years, providing ample flexibility for cash flow development and deployment. As an example, yesterday we announced a small asset acquisition of industrial ozone analyzers which will be relocated and integrated into one of our strongest performing air monitoring businesses. Turning back to the quarterly results, GAAP earnings per share from continuing operations of $1.49 were a record for any third quarter, increasing 8% from last year. I should note, while this year included $0.15 of net earnings from these discrete tax items, offset by restructuring costs, last year also included approximately $0.15 of net earnings from similar items. 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 fourth quarter and full year 2016. In our instrumentation segment, third quarter shares decreased 13.4% from last year. Sales of marine instrumentation increased 28.5% due to lower sales of interconnected systems and other marine sensors for energy exploration and production. This was partially offset by higher sales of interconnected marine systems for U.S. government applications. In the environmental domain, sales decreased 5.3%, but operating margin and operating profit increased. Strong cost control and a higher margin mix of pollution and particulate monitors helped offset low emissions monitoring systems for domestic coal-powered generation. Sales of electronic test and measuring systems increased 19% overall and 7% organically. Sales of protocol analyzers, used by engineers to troubleshoot data communication systems and test interoperability were especially strong in the quarter. GAAP segment operating profit declined and operating margin decreased solely due to lower sales and margins within the marine instrumentation, partially offset by increased profitability among both the environmental and the electronic test instrumentation product lines. Turning to the digital imaging segment, third quarter sales increased 2.9% and operating margin increased 101 basis points. The increase in sales primarily reflected in radar machine vision cameras for semiconductor and industrial applications, microelectromechanical systems (MEMS), and geospatial software. In the aerospace and defense electronics segment, third quarter sales increased 4% organically, primarily as a result of increased sales of commercial avionics. Segment GAAP operating margin was a record 21.6%, increasing 415 basis points from last year. In the engineered systems segment, third quarter revenue increased 2% and operating margin improved 388 basis points. The higher revenue resulted from higher sales of commercial hydrogen generators and government energy systems, partially offset by the decline in certain government programs. In conclusion, our balanced business portfolio is very resilient and not dependent on any single product or market. Aerospace and defense businesses now represent approximately 40% of total sales. Also, a broad range of industrial markets, including factory automation, medical imaging, analytical instrumentation, satellite communication, and ocean science represent over 50% of our portfolio. Today, oil and gas exploration and production represent less than 10% of our total sales and only about 40% of our total marine businesses. We have now taken the necessary steps to restructure our marine businesses for a total annual run rate of approximately $415 million. Despite an annual revenue decline of approximately 35% in 2014, our marine businesses remain profitable and achieved a double-digit GAAP operating margin in the third quarter. Before turning the call over to Sue Main, I want to make a few general comments regarding the fourth quarter of 2016 and the year of 2017. Please recall that fourth quarter 2015 was a 14-week quarter as part of a 53-week year. So, we would have just one more quarter of difficult year-over-year comparisons before heading into 2017. At the moment, our full planning process for 2017 is not complete and we plan to issue our formal outlook in January as we have done in the past. Nevertheless, we're expecting modest overall revenue growth in 2017 and we believe most of our commercial businesses will grow. Marine instrumentation comparisons will ease significantly and our government businesses will continue to see a recovery. Finally, our acquisition pipeline remains very healthy, but as always, we'll be disciplined in employment and weigh acquisitions versus share appropriately. Now I'm turning the call over to Sue.

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 fourth quarter and full year 2016 outlook. In the third quarter, cash flow from operating activities was $98.9 million, compared with cash flow of $72.3 million for the same period of 2015. The higher cash from operating activities in the third quarter 2016 primarily reflected higher customer advance payments and lower income tax payments. Free cash flow – that is, cash from operating activities, less capital expenditures – was $84.5 million in the third quarter of 2016, compared to $62.1 million in 2015. Capital expenditures were $14.4 million in the third quarter, compared to $10.2 million for the same period of 2015. Depreciation and amortization expense was $22.4 million in the third quarter, compared to $21.8 million for the same period of 2015. I should note that our quarter-end balance excluded $19.5 million in restricted cash which resulted from the sale of vacant real estate from the second quarter. Early in the fourth quarter, we utilized this restricted cash to purchase a Teledyne-occupied facility that we were leasing, utilizing a section 1031 like-kind exchange. Full year capital expenditures are expected to be approximately $60 million excluding the recent facility purchase with restricted cash. In the third quarter, Teledyne also completed the sale of the assets of Teledyne’s printed circuit technology business for $9.3 million in cash. We ended the quarter with $513.5 million of net debt – that is $613 million of debt in capital leases, less cash of $99.5 million for a net debt to capital ratio of 24.9%. Turning to pension and stock compensation expense. In the third quarter of 2016, pension income was $0.5 million compared with pension expense of $1 million. For reference, our pension which is primarily for legacy retirees remains fully funded. Stock option compensation expense was $2.5 million in the third quarter of 2016, compared with $2.6 million in the third quarter of 2015. Finally, turning to our outlook, management currently believes that GAAP earnings-per-share for continued operations in the fourth quarter of 2016 will be in the range of $1.32 to $1.37 per share. And we're increasing our full year 2016 earnings-per-share outlook to $5.26 to $5.31 from our prior outlook of $5.10 to $5.20. The 2016 full year effective tax rate, excluding any discrete items, is expected to be 27.6%. As Robert indicated, we will issue our 2017 earnings outlook in January. However, it is worth noting now that there will likely be headwinds from noncash pension expense given current bond yields as well as less discrete tax benefits than in 2015. Currently, each of these could contribute $0.10 per share of headwinds. I will now pass the call back to Robert.

A question first on capital spending. In your press release, you stated that you're clearly seeing a weaker spending outlook. Is there a specific catalyst which you're seeing in that area? And how would you characterize the normal seasonal uptick in capital spending that benefits the fourth quarter?

Well, there are different, obviously different markets that we participate in, Mark. The marine market is the obvious one and I don't need to dwell on that one, except to note that some of our customers are indicating conditions of weak capital spending even in 2017. And for that, as I've indicated, we have done all of the cost adjustments that we need to do. And I think in Q4, because of that, plus the fact that frankly, Mark, other than in the commercial aerospace business and some of our government programs, we don't see a very strong economic incentive. The GDP is still or was very low. We think sequentially in Q4, to be more specific, we should be relatively flat with Q2. We see a little uptick in the immediate future. Now 2017 may change that.

You're obviously seeing very strong margin improvement in the aerospace and defense sector. The third quarter was operating margin of 21.6%. That compares to a mid to low teens quarterly margin last year. Moving forward, do you see that as sustainable? Where do you see that potentially going over the next two to four quarters?

I think, Mark, we have an exception of third quarter primarily because of our avionics businesses and that was driven by customers, specifically in China, that had indicated and have implemented a process for deploying all of their commercial aircraft using our wireless ground link. We think going forward that will moderate somewhat once we get through this bump. And I think we'll see margins in the aerospace and defense sector in the upper teens – maybe not over 20%, but certainly in the upper teens.

Okay. Final question for me, you stated I think on the call that you had $25 million of customer R&D in 2016, in the marine area. Could you flush that out a little bit in terms of what you were doing and how long will those activities continue?

We started really getting customer funded R&D going back about five years and it has gradually increased every year. Collectively to date, we probably received over $60 million in customer-funded R&D. The primary drivers for that are first, very high-powered connectors for downhole and for those purposes, we're using ceramic connectors which were developed in our scientific laboratories here at corporate. Second, there is a desire for looking at longevity of products that are put on the ocean floor. As you know, we have had a long history of building robust, durable, and reliable structure materials for space, where you can't bring products back just to repair. The same applies to underwater, especially deep water. They want our products to have a minimum life of 25 years or more, so our research lab here is taking lessons learned and technologies developed for space and applying those same principles for materials testing, accelerated testing, and other properties in the underwater products.

The question I had – Robert, thanks for providing a little bit of color too, as we think about 2017. I wonder if you could talk though, a little bit about your confidence level that you could see modest growth coming back to the business in 2017. Is that mostly just a function of the easier comparison to the instrumentation business? Are you seeing some things in your bookings numbers across the segments that give you that confidence?

Thanks, Jim and yes, both of those are accurate. First, the comparisons are going to become easier. We took about – I'm going to say approximately 100 – we expected it to be $170 million to $190 million decrease in our marine instrumentation business year-over-year. Now, we made some of that up, maybe $60 million or $70 million of that up in other businesses. But nevertheless, next year's comparisons are going to be a little bit more favorable than were this year's. Second, the book-to-bill that we're looking at the present time, while not really that robust in the marine business, is just below 1. In the remainder of our portfolio, we're seeing book-to-bill ratios of 1.01, 1.05, 1.10 and we have loan programs that are maturing that we expect to have more revenue from. So that's why I think we should be relatively comparable to do better next year than we did this year, compared to last year.

Okay. The other, I think, thing that jumps out, as you look at the year the way it has unfolded, is you have really shown pretty solid improvement in gross margins and as we think about next year, is there any reason why we won't see this kind of margin profile continue? Or do you see some changes, perhaps in the mix?

Well, I think what will happen is, our margin will probably moderate a little bit in Q4, it won't be as high as Q3. But having said that, it will be going forward, it should be in the 39%, 39% and a tad bit over range going forward. That's primarily because we've taken a huge amount of costs out in our businesses. As an example, last year in 2015, when the marine businesses started going south, we took out about 465 of our people. This year, another 460 have gone, so a total of 1100. And that's more than 11.5% of our workforce. Very unfortunate to have to do that because we don't have the business. We also consolidated a lot of our facilities and have taken a lot of fixed costs out. And I expect to maintain that going forward. And if we're very disciplined which we will remain disciplined, I think that kind of cost control will help our overall margins as we move forward. So those are kind of the various aspects that give you some confidence for the future.

I guess at this point you're probably used to operating under a CR to start the new fiscal year, but I was wondering if you could talk about any trends that you're seeing in defense and any visibility as we head to 2017.

I think overall, as you know, under a CR, you can't get new programs started. Putting that aside, we have a healthy set of existing programs. And I'll give out a few of them that I expect to continue and be favorable for us. And frankly, it has been okay. It has been a good year for our defense businesses. First, even in the marine domain, 60% of our marine businesses are ocean science and a big chunk of it is defense. The Virginia submarine production continues and we supply penetrators and cables to those and that's a substantial program for us. I don't expect that to change. In the shallow water combat vehicle which we're building for special ops, we have now our engineering model that has been tested with our special ops for over six months and doing very well. We should go into production with our first two boats and then hopefully we'll get a production order for the next two in 2017. Similarly, in other defense businesses, if you go underwater, we make ROVs for the Navy to dispose of underwater explosives. And we just received two sequential contracts of $6 million each to produce a total of 30 such vehicles and we also have similar programs for other defense programs for the Navy. For mine countermeasure assistance, we have a $50 million program there. And finally, our overall programs in traveling wave tubes electronic warfare are moving along pretty well, both for U.S. defense as well as places like Korea which is important obviously. So I think from a defense perspective, the CR should not be affecting us much. But if it continues far too much in the future, since we continue to compete for new and bigger programs, it might affect us. But short term, I don't see, I don't see any problems.

And just to go back to oil and gas. At one point the market will turn. Maybe it's not in 2017, but it seems there has been a lot of consolidation across oil and gas and I think you guys have done a good job of kind of tying yourself to customers. Do you see any opportunity from consolidation in a market recovery or a chance to kind of grow your market share?

Well, I think we're already enjoying improvement in our market share, primarily because our products are so robust and we have been able to take the costs down. The market itself is up. It's interesting. Of course there's the onshore market which deals with shale. Most people would agree that with the marine studies, the break-even there is around $60 for oil price. It's already hit close to that this year and we have seen some rig count increases in the onshore market. By the way, we do make cable products for the onshore. Right now people are using existing rigs and maybe salvaging stuff to put new rigs in, but there has been substantial improvement in that market. In the offshore, there are three scenarios. There's the shallow water which would be 1,000 feet or less. Again, there the break-even is about $50, $55. Onshore, as I said, it's $60, maybe $50. The same applies to shallow water. Interestingly enough, deep water is much more expensive, but ultra-deep water is a little cheaper and ultra-deep water, people predict about a $65 oil price. And that's primarily because also in deep water, you hit larger reservoirs. So the answer to your question, the long-winded way of answering is it's getting close to the price where some of these projects will become justifiable. And of course projects that have already started, they are going. So between us making better products, with our research making more robust products that can perform at higher temperatures, higher voltages, higher amps and having taken costs down and the fact that people want to do more processing on the ocean floor, so they have to use more connectors like we make, we have more content per tree or manifold, all of those things favor Teledyne. So I think we've bottomed out. Whether it's end of 2016 or early 2018, it's going to come back as you've said and I think we're going to be in the best positions to join that. And frankly, the consolidations to date have not hurt us. I don't know if they have benefited us, but they haven't hurt us at all.

Robert, I wonder if you could talk a little bit about some areas of the commercial business where you've seen some decent growth. I was surprised that you've seen some growth come back – organic growth coming back in that area of testing and measurement with LeCroy. What seems to be driving that?

In the test and measurement sector, we've accomplished several things. Firstly, we've been concentrating on key areas, particularly oscilloscopes, which remain our core focus. Additionally, we've explored two main avenues. We've introduced a small amount of protocol business from our acquisition of LeCroy and have significantly expanded our protocol offerings. Protocols, which are the communication rules between devices, represent a new market for us and have contributed to our growth. We've made two acquisitions in this area, enhancing device-to-device connectivity—such as Bluetooth, Wi-Fi, and HDMI—where we hold a leadership position. This has driven our growth. Secondly, we've leveraged our oscilloscope capabilities to explore new applications, including motor testing and motor drives. We've launched motor drive analyzers that are performing well in the market, and we're also applying our electronic measurement expertise to torque sensors and strain gauges. We've set up a center in Detroit to strengthen our presence in automotive testing, which is further supporting our growth. Regarding our automotive test and measurement segment, one area where we are excelling is in Machine Vision. We are seeing success in industrial Machine Vision for applications like flat panel displays and semiconductors, and we've also developed new designs for X-ray systems used in medical and dental imaging. These factors, combined with a robust commercial avionics business, position Teledyne for positive growth moving forward.

On the topic of Machine Vision, there has been more talk of opportunities, growth opportunities in 3-D machine vision. And it sounds like that's an area where potentially you guys could play in. Is that something you're looking at?

We're always looking at that area. So far, we're not a big player. We do have obviously some 3-D vision products. Our whole optic or laser three-dimensional laser imaging business is all about that. Both ground-based and from aircraft. That's all a bit of the three-dimensional vision system. On the other hand, there are other people that are playing in the 3-D vision for manufacturing. But we're not in it. But we're always looking at that.

Okay, final question from me is – just in general, the acquisition pipeline, are you seeing more smaller deals that are attractive to you, interesting to you? Or are you also looking at potentially something that might be a little bit more sizeable?

We are interested in both types of acquisitions. Sizeable acquisitions for us would fall in the range similar to what we have done with DALSA and LeCroy, around $200 million to $300 million, or perhaps a bit more. Those would be very appealing, and we are currently exploring some of those opportunities. At the same time, we excel at smaller bolt-on acquisitions, having completed over 54 of them, and we are adept at integrating them for profitability. We have a diverse array of bolt-on acquisitions in our pipeline, which we are actively evaluating and competing for.

Thanks Robert and thanks everyone for joining us this morning. Cathy if you would go ahead and give them the replay information and of course the replay is available on the website via webcast also. Thanks again.