Teledyne Technologies Inc (TDY) — Q4 2016 Earnings Call Transcript

Good morning, everyone. This is Jason VanWees, Senior Vice President Strategy and M&A at Teledyne. And I would like to welcome everyone to Teledyne's fourth quarter and full year 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 Senior Vice President, General Counsel, Chief Compliance Officer and Secretary, Melanie Cibik. After remarks 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 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's Robert.

Thank you, everyone, and good morning. We concluded 2016 with our strongest quarter of the year. Most of our commercial sectors, including imaging for Machine Vision, life sciences, environmental and electronic test and measurement instrumentation, and commercial aerospace avionics, saw organic growth compared to last year. As expected, sales of marine instrumentation declined, but we anticipate that comparisons will be much easier in 2017. Our government businesses continued to receive strong orders, which contributed to an overall backlog that was about $120 million higher than last year. GAAP earnings per share from continuing operations stood at $1.49. Excluding $0.16 in charges related to the upcoming e2v acquisition, earnings were $1.65. I want to clarify that our fourth quarter earnings outlook of $1.32 to $1.37, shared on November 3, 2016, did not factor in the charges for the e2v transaction, which we announced on December 12, 2016. Additionally, our full-year cash from operations and free cash flow reached all-time highs, each rising over 50% from the previous year. Before discussing our business segments, I want to point out that the sales and comparisons reflect that the fourth quarter and full year of 2016 had 13 and 52 weeks, respectively, compared to 14 and 53 weeks last year. Thus, we had one less week this year to ship products. In the instrumentation segment, fourth quarter sales fell by 15.7% compared to last year. Marine instrumentation sales declined by 33.2% due to reduced sales of interconnect systems and other marine sensors used in energy exploration and production. However, sales to defense markets over the last two years have helped soften the decline related to energy. The long-term prospects for our products related to U.S. submarine programs and our autonomous underwater vehicles look very promising. In the environmental sector, sales rose by 5.7%, and both operating margin and operating profit grew significantly due to ongoing demand for our pollution and particulate monitoring instrumentation. Sales of electronic test and measurement systems enjoyed a 14.5% increase overall. Sales of protocol analyzers, which engineers use to troubleshoot data communication systems and test interoperability, remained robust. Although GAAP segment operating profit and operating margin saw a decline due to reduced sales and margins in marine instrumentation, margins for both our environmental and electronic test and measurement product lines reached record levels. In the digital imaging segment, fourth quarter sales rose by 8.6%, and operating margin increased by 253 basis points. The sales increase was largely due to higher demand for machine vision cameras in industrial and semiconductor applications, X-ray detectors for life sciences, MEMS, and geospatial software and laser-based mapping systems. Sales of infrared sensors and government-funded research saw a slight year-over-year decline, but orders were very strong, with our government backlog in this segment up over 45%. In the aerospace and defense electronics segment, fourth quarter sales grew by 2.2% organically from the previous year, primarily thanks to rising sales of commercial avionics. The segment's operating margin improved by 410 basis points to 19.2%. In engineered systems, fourth quarter revenue dropped by 15.6%, although operating margin increased by 389 basis points. The decline in revenue was attributed to challenging comparisons and the timing of deliveries from specific marine manufacturing programs, which were partially offset by higher sales of cruise missile engines. In summary, I am more optimistic than ever about our current business portfolio and the market outlook. Over the past few years, we faced reductions in defense spending and significant downturns in offshore energy markets; however, we responded proactively by cutting costs. In 2016, we achieved a record operating margin in the third quarter, generated unprecedented full-year cash flow, and largely maintained GAAP earnings even after accounting for e2v acquisition-related expenses. We are a much more streamlined company today than we have been in years. There are no apparent issues on the horizon for Teledyne or our largest markets. I am also personally enthusiastic about the upcoming acquisition of e2v. Our combined market competencies and engineering-focused cultures cover a wide range, from industrial machine vision and space-based imaging to microwave devices, as well as specialty semiconductor and MEMS capabilities. Our smaller acquisitions in 2016 significantly enhanced our software capabilities and our involvement in life sciences markets, along with adding key product lines to our top-performing businesses. Finally, we divested a lower margin build-to-print business that was a remnant from our spinoff 17 years ago. Looking ahead, excluding e2v, we expect modest overall revenue growth in 2017. We believe that most of our commercial sectors will experience growth, comparisons for marine instrumentation will be fairly stable, and our government sectors will rebound as we capitalize on our improved backlog.

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 2017 outlook. In the fourth quarter, cash flow from operating activities was $63.9 million compared with cash flow of $61.1 million for the same period of 2015. The higher cash provided by operating activities in the fourth quarter of 2016 primarily reflected lower income tax payments, partially offset by higher working capital. Including a facility purchase with the use of restricted cash pursuant to a 1031 like-kind exchange, free cash flow, that is cash from operating activities less capital expenditures was $40.7 million in the fourth quarter of 2016 compared with $45.7 million in 2015. Capital expenditures excluding the facility purchase were $16.7 million in the fourth quarter compared to $15.4 million for the same period of 2015. Depreciation and amortization expense was $22.1 million in the fourth quarter compared to $22.2 million for the same period of 2015. We ended the quarter with $519.2 million of net debt; that is $617.8 million of debt and capital leases less cash of $98.6 million for a net debt to capital ratio of 25.0%. Regarding taxes, while the fourth quarter of 2016 contained discrete tax benefits of $9.4 million or $0.26 per share, the fourth quarter of 2015 also contained discrete tax benefits as well as the retroactive adoption of full-year 2015 R&D tax credits which collectively contributed $7.2 million or $0.20 per share last year. Turning to pension and stock compensation expense, in the fourth quarter of 2016, pension income was $0.6 million compared with pension expense of $1.1 million; and for reference, our pension which is primarily for legacy retirees remains fully funded. Stock option compensation expense was $2.8 million in the fourth quarter of 2016 compared with $2.5 million in the fourth quarter of 2015. Finally, turning to our outlook, management currently believes that GAAP earnings per share from continuing operations in the first quarter of 2017 will be in the range of $1.15 to $1.17 per share and for the full-year 2017 our earnings per share outlook is $5.40 to $5.50. The 2017 full-year effective tax rate excluding any discrete items is expected to be 28.0%. Please note that our current outlook excludes e2v and corresponding transactional related expenses.

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

Good morning. You had in digital imaging you had mentioned that backlog was up and you expected better volumes for DOD going into 2017. Can you maybe discuss what drove that backlog increase and maybe the cadence of some of that backlog turning to revenues?

Good morning, Greg. Thank you. There are really two key areas. First, as you may remember, we manufacture laser spectacles for laser eye protection, and we have a substantial program with the Air Force that we announced last year. The second area of significant interest to us involves national space or classified programs. Traditionally, we haven't been heavily involved in that area, but we've made considerable progress in introducing new infrared sensors and detectors in those businesses. So, those two are the main drivers. We also have other significant programs, but in terms of new increases, those are the ones.

Thank you. And then just in oil and gas, the comps obviously are better in 2017, what are you seeing in terms of order activity and is it too early to call the bottom and maybe modest growth or flat going from here?

I think right now if you listen to everyone, people think that at least in the oil and gas domain, we probably have been or are close to have or have hit bottom. And for example, the number of subsidiaries that are used in exploration and production especially production; they were at the lowest level in 2016 and are expected to grow somewhat in 2017. Our overall book-to-bill in the marine business was about 0.96 for the year. So we still think there might be a little difficulty in the comps but nothing like we experienced this past year because partially because of what has happened to our marine businesses, oil and gas back in 2014 used to be 60% of those businesses and science, construction, defense, security, and other businesses that we have underwater were 40%. With the serious declines that we've seen in the last two years that has flipped over, so oil and gas is more like 40% and the remainder of our marine businesses are 60%. And as I mentioned in my earlier comments, our defense businesses in the marine domain are improving and we have really long-term contracts. So I think the comparisons are going to be easier obviously. We might see a little downside, but everybody is predicting a pickup in late 2017.

Thank you. And then just quick housekeeping, sorry if I missed this but what is your assumption for pension income in 2017 versus 2016? And then also do you have any restructuring included in the 2017 numbers?

I think in the pension we anticipate that the discount rate will go down but we know it’s not going to go down by so much. So overall, I would say the 30 or 40 basis points will drive our pension income down by about a nickel. On the second part of the question, we don't have any restructuring charges. Greg, as you know in our history, we've always been a GAAP company, GAAP; everything has been GAAP; we've always kind of absorbed our one-time charges, restructuring charges, and also acquisition charges. The only thing I anticipate in 2017 is, significant from our perspective, significant charges related to the acquisition of e2v; and that could be significant for us. It could be as much as $30 million which we probably cannot totally absorb as we have with our previous acquisitions.

Hi, good morning. Couple of questions, Robert, I'd be interested in your perspective on the e2v acquisition, what is it that really excites you about the business and given that there is a similar portfolio of businesses of e2v, how should we think about the speed with which this business can be integrated?

Let me start by saying that while the businesses are similar, they're very complimentary. For example, Jim, in the sensor domain our focus historically has been and our strength has been in infrared sensors. For example, we practically are the major player in infrared sensors, both sensors for space imaging as well as ground-based astronomy. e2v is exactly the mirror image of us, except they are in the visible imaging domain. Actually, the seven or eight programs that we currently are aware of that we acted in, we provide the infrared images, sensors, detectors, and they provide the visible detectors. The same is true in a number of other businesses including machine vision. We're strong in certain areas of machine vision especially in CCDs and some CMOS but they're much stronger in complementary metal oxide semiconductors, and more importantly, they are very strong in two-dimensional imaging which is a larger market for machine vision. And then, finally in the medical arena, our strength lies in detectors. We need to reduce CMOS detectors that are the most sensitive detectors that reduce the amount of X-ray exposure to the patient and are much more sensitive in terms of the quality of the pictures that you get. They, on the other hand, are the leading providers of magnetrons which are essentially electronic accelerators or microwave accelerators by traveling wave tubes, except they impinge on a constant substrate and produce x-rays that are used for cancer treatment. So in that area we have probably a lot of common customers. When you do radiography, you also want to do complementary imaging to make sure that you are not damaging surrounding tissues. So those are some observations about the complementary nature of our businesses. In terms of integration, I feel very comfortable about that for the following reasons. First, they're a public company, so they have a very well-documented financial and other processes. Secondly, we have already acquired two fairly large companies, LeCroy and Dalsa in the last five years, and we've been able to integrate those very successfully relatively quickly, and the margins in both of those large acquisitions have more than doubled in the interim period. So I think we would integrate this acquisition, assuming we're successful, we have some more hurdles to pass in terms of regulatory hurdles. I think we will integrate this successfully in 2017.

Thanks. That's helpful. And just with respect to the existing business, Robert, can you give us a perhaps feel for how we might think about the growth across the four business units? I think you've given us some color as to how we should think about marine instrumentation, but digital imaging showed decent growth in Q4; I'm not sure what was organic in that, and you also saw good growth in the electronic test and measurement business. But again, I don't know how much of that was organic. Can you give us a feel as to how we might think about growth broadly across some of the business units?

Of course, let me actually just go down the list for you, if I may. Organically overall in the instrument businesses, which would include environmental test and measurement and marine, I would say in 2017 organically the growth would be about 3%. In digital imaging, it should be higher, perhaps as much as 4% to 5%. In aerospace and defense, it could be closer to instruments 3% to 3.5%, and we have a really good backlog in our engineered systems and I expect that in that domain our upside can be closer to five. When you roll all of that, I think the overall organically, we should have 3% to 4%. We do have some acquisitions from 2016 that we should enjoy a little the full-year benefits of those, those may add another percent. So when you do the math, Jim, I think we're talking about 4% to 5% all in; that's excluding e2v.

Okay, and that's really helpful. So the optimism that you have entering 2017 is really based it sounds like on both what you are seeing in both the commercial and government business; I think that's kind of what you've been saying as well. So it sounds like on the commercial side perhaps a little bit more positive but you are seeing I guess fairly good order intake in the engineered systems business.

Yes, we do. We have a good backlog there. We have stronger expectations; we know exactly how many missile engines we're going to be making in 2017; it's going to be one of our better years in recent history. We have good backlog in our shallow water and underwater vehicles for our special operations, and we feel good and this is as good as we've felt about our overall business portfolio in a very, very long time.

Thank you. I just want to follow-up on the organic growth and thank you Robert for the commentary outlook on how it looks for 2017. Can you just run through over the full-year 2016 organic growth figures by those four product lines?

I think mainly in 2016, if I had to let me start with marine because that was obviously the big negative for us right. We were down almost 32% from 2015 to 2016 for a hefty $196 million. If you look at our overall decline year-over-year in revenue was actually less than that. So marine declined significantly but everything else together actually grew a little bit maybe $20 million or $25 million. Our environmental businesses were relatively flat; we had ups and downs, so I’d say overall it was a wash. Our test and measurement was up about 2%, 2.5%; digital imaging, I'm talking organic only, was up about 2.5%. If you throw in our acquisitions, it was higher than that. Our engineered systems were down about 5%, 5.5%, but I'm not concerned about that only as I mentioned because we had really strong orders. It’s just I know everybody talked about timing, but in this case I can assure you it was timing. So aerospace and defense electronics was a really strong performer; it was up about 5%, with our avionics business up about almost 18%, which this is the business that provides data acquisition on commercial aircraft and that's been a very strong performer, almost made up for the decline that we had in terms of earnings in our marine businesses. I hope that's helpful.

Yes, that's great, Robert. Thank you very much for that detail. And then the last question, just looking at the free cash flow conversion this year based on net income was 131%, 83% last year. So what do you target for free cash flow conversion in 2017 as it relates to net income?

About even, about the same as this year, a little less from a percentage point of view.

All right, thanks for taking my questions. Just got a couple of follow-up questions. First of all regarding your commentary earlier on the energy sector, I'm curious when you think that business may shift from stabilization to growth? Is that going to require, in your estimate, further increases in oil prices or do you think just for long stability in the energy market could facilitate growth as you look right into 2017 or 2018 and beyond?

Ben, if I'm correct, if I'm going to go to oil and gas specifically, I think what's happened is the declines have been very significant and the prognosis right now is that everything is stabilizing. With oil prices hovering in the 50-plus-dollar range close to $53 on West Texas Intermediate, what that does is it helps really the first 11 days fracking businesses which have breakeven prices of about $50 a barrel and we're seeing already usage starting to go up, we do have some land-based products there, so we're enjoying some of that. When you go to the ocean, then the breakeven prices there shallow water is closer to 60 bucks a barrel; deepwater, which is between 1,000 to 5,000 feet, is about 65-plus dollars per barrel, or actually maybe $70, $75 per barrel. It's the very deepwater units that are interestingly, it's better; it's closer to 65% because the reservoirs are larger and the breakeven is lower than deepwater. So having said all of that, a lot of our products go into deepwater and ultra-deepwater, and we think that source CapEx will probably not improve until later in 2017 or 2018. We're seeing some pickup but nothing like we had in prior years. And so I think you summed it up correctly; the future we think is going to be for us in deepwater and ultra-deepwater. The only other thing I will add is that we don't supply directly to the final customers like Shell or BP. We supply to intermediate customers that provide, for example, trees in the water, Christmas trees for oil production, etc. And we have frame agreements now developed with those customers to be able to enjoy 70% to 75% of their businesses going forward. Those frame agreements are based on the fact that we have unique capabilities in products. So I think when it does come back, we're in a really good posture. I hope that answers your questions.

Yes, very much thank you for the commentary. One other quick question, I know regarding the e2v acquisition given the regulatory issue that you can't really comment too much, but you said that integration would hopefully occur in 2017. I'm wondering if you think it's regarding the timing of that; I mean are you expecting that in the near term, or do you think that could be more of a second half event? Can you give any kind of context regarding timing?

I believe we aim to complete the process in the first half of the year, with optimism for a potential closure in the first quarter. We have already held the general shareholder meeting successfully, but there are still some regulatory steps to navigate, including approvals from German, French, and U.K. authorities. Additionally, we need to hold a court hearing in the UK. I am hopeful that we can finalize everything by the end of the first quarter, but if all goes smoothly, we anticipate completing it within the first six months. However, we can't predict the outcomes of the various inquiries we are facing.

Perfect. Thank you very much for the time. I'll jump back in queue.

Alan, thank you. I think we exhausted that; if it's okay, then what I would like to do is turn the call over to Jason to conclude our conference call.

Thanks, Robert, and again thanks everyone for joining us today. If you do have a follow-up questions, please feel free to call me at the number on the earnings release. All our news releases are available on our website teledyne.com. I want to conclude the call to get the replay information; we would appreciate it. Thanks everyone.