Teledyne Technologies Inc (TDY) — Q2 2023 Earnings Call Transcript

Thank you, Dom. This is Jason VanWees, Vice Chairman. I'd like to welcome everyone to Teledyne's second quarter 2023 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; Senior Vice President and CFO, Sue Main; and Senior Vice President and General Counsel, Chief Compliance Officer and Secretary, Melanie Cibik. Also joining is Edwin Roks, Executive VP. After remarks by Robert and Sue, we will ask for your questions. Of course, 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 our earnings release and our periodic SEC filings. Actual results may differ materially. To avoid potential selective disclosures, this call is simultaneously being webcast and a replay will be available for approximately one month. Here is Robert.

Thank you, Jason, and thank you for joining our earnings call. In the second quarter, we achieved all-time record quarterly sales, with overall sales increasing 5.1%. Furthermore, sales, as well as GAAP and non-GAAP operating profit and operating margin, increased year-over-year in every segment. For the total company, GAAP and non-GAAP operating margins increased 105 and 73 basis points, respectively. Excluding foreign currency headwinds, which negatively impacted second quarter sales growth by approximately 40 basis points, growth in local currency would have been 5.5%. GAAP operating margin of 18% was a second quarter record, and non-GAAP operating margin was 21.4%. Second quarter GAAP earnings per share were $3.87, and non-GAAP earnings of $4.67 were also second quarter records. And finally, including continued debt repayment through July, which totaled about $620 million year-to-date, our consolidated leverage ratio declined to 2.1x. I'll now comment further on the performance of Teledyne flare and the announced cost reductions and the outlook for the balance of the year. In the 2 years since we've owned FLIR, we've resolved the most significant legacy tax matters, exited the consent agreement with the Department of State, consolidated leadership in marketing and operations for the FLIR Defense portfolio, and corrected some historical product quality issues. As part of this effort, we also took a much more focused view of the Defense business, aggressively pursuing those opportunities where we have truly differentiated technology. I am pleased to report that the order book and backlog of FLIR, specialty FLIR Defense, significantly inflected during the second quarter. For reference, the commercial business across digital imaging, both DALSA to FLIR grew organically in the second quarter. While FLIR Defense sales declined year-over-year, nearly all of this was due to lower revenue in unmanned ground systems as we achieved the milestone of shipping our 1,000th man transportable robotic system increment to the U.S. Army. Overall, orders at FLIR were 1.18x sales and 1.5x sales at FLIR Defense. Large orders included the recently announced Black Hornet Nano UAV to the U.S. Military, additional UAVs for customers in Europe, counter UAV systems, and missile systems utilizing both FLIR imaging, radar, and AI-based software systems. Additionally, more surveillance imaging systems for U.S. and foreign customers. Having stabilized the business, including achieving a stronger backlog, it is now time to focus on execution and additional margin improvement. Thus, the charges announced this morning are for the further reduction in the FLIR operating footprint and related headcount. We are eliminating 3 lease sites; all of those activities will be relocated to other FLIR Defense facilities. Today, we are reaffirming our prior 2023 full-year sales and non-GAAP earnings outlook, excluding the $10 million to $12 million charges covered. Supply chain challenges have continued to improve, and we exceeded our original second quarter sales and earnings outlook by pulling forward some revenue from the third quarter. On revenue specifically, we continue to see total 2023 growth of approximately 5% or sales of approximately $5.73 billion, with the third quarter being roughly $1.4 billion. We continue to see non-GAAP earnings of $19.10 at the midpoint of our guidance, excluding the charges referenced above. I will now further comment on the performance of the 4 business segments. Second quarter sales in our Digital Imaging segment increased 2.3% due to greater sales of X-ray products, commercial infrared imaging components and solutions, and industrial scientific cameras. This was partially offset by lower sales of unmanned ground systems for Defense applications. GAAP segment operating margin increased 51 basis points to 15.7%, and adjusted for reduced intangible asset amortization non-GAAP segment margin was 28 basis points higher at 21.5%. Turning to our Instrumentation segment. Second quarter sales increased 5.1% versus last year. Sales of marine instruments increased a healthy 10.5% in the quarter, primarily due to the ongoing recovery in offshore energy markets and greater sales of autonomous underwater vehicles. Sales of electronic test and measurement systems, which include oscilloscopes, digitizers, and protocol analyzers, collectively increased 4.9%. We encountered some softness in sales of analyzers for electronic storage and data center applications, but this was more than offset by growth for wireless and video protocols and continued strong sales of oscilloscopes. Sales of environmental instruments were flat compared to last year, with greater sales of air quality, process gas, and safety analyzers offset by drug discovery and laboratory instruments. Overall, Instrumentation segment operating profit increased 10.6% in the second quarter, with GAAP operating margin increasing 123 basis points to 24.8% and 80 basis points on a non-GAAP basis, excluding reduced intangible asset amortization to 25.9%. In the Aerospace and Defense Electronics segment, second quarter sales increased 10.2%, driven by growth of both Defense Electronics and Commercial Aerospace products. GAAP and non-GAAP segment operating profit increased over 20%, with margins approximately 250 basis points greater than last year. In the Engineering Systems segment, second quarter revenue increased 18.5% and operating profit increased 33.7%, representing a 112 basis points increase in margin from last year. In conclusion, our short-term, more economically sensitive businesses remained resilient in the second quarter, collectively growing year-over-year, although comparisons for some become more difficult in the second half. In addition, our longer Cycle Medical, Aerospace, Defense, and Marine businesses continued to perform very well. Quarterly operating margin in our Instrumentation segment was an all-time record. Operating margin in our Aerospace and Defense Electronics segment was the second quarter record and slightly less than the fourth quarter of last year. Through a combination of sales growth, operating leverage, and more aggressive cost actions mentioned earlier, I fully expect digital imaging margins to grow considerably over time. I am now going to turn 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 third quarter and full year 2023 outlook. In the second quarter, cash flow from operating activities was $190.5 million. Free cash flow, that is cash from operating activities less capital expenditures, was $163.2 million in the second quarter of 2023 compared with $176.1 million in 2022. Capital expenditures were $27.3 million in the second quarter of 2023 compared with $20.8 million in 2022. Depreciation and amortization expense was $80 million for the second quarter of 2023 compared with $82.7 million. We ended the quarter with approximately $2.99 billion of net debt. That is approximately $3.35 billion of debt less cash of $364.2 million. Stock-based compensation expense was $8.4 million in the second quarter of 2023 compared with $6.4 million in 2022. Turning to our outlook. Management currently believes that GAAP earnings per share in the third quarter of 2023 will be in the range of $3.76 to $3.90 per share, with non-GAAP earnings in the range of $4.70 to $4.80. For the full year 2023, our GAAP earnings per share outlook is $15.60 to $15.88. On a non-GAAP basis, we are maintaining our prior outlook of $19 to $19.20. Both the third quarter and full year non-GAAP outlook excludes estimated pretax charges for further FLIR integration costs. The 2023 full year estimated tax rate, excluding discrete items, is expected to be 22.3%. I will now pass the call back to Robert.

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

I wanted to talk a little bit, Robert, if I may, about digital imaging. If we exclude the acquisitions, it looks like your revenues were down year-on-year and sequentially. Some of this may be partly due to what you're seeing at FLIR. But I wonder if you could just expand on what you're seeing in digital imaging, just because it's a large category that covers a lot of ground?

Thank you. What you're referencing is the organic growth or decline year-over-year, which experienced a decrease of just over 1%, specifically 1.5%. There are several factors influencing this: Firstly, government programs in digital imaging, particularly at FLIR, have declined year-over-year. However, we had a strong first half of the year, especially in the second quarter, with successful orders for products in both the U.S. and Europe, indicating that part of the business has stabilized. In healthcare, which is a segment of our digital imaging, we have seen significant growth, as well as in commercial aerospace, particularly in areas like satellite communication. Although we face some challenges in the commercial sector of digital imaging in the Far East, our exposure there is relatively low. We are compensating for this with new products that leverage our artificial intelligence capabilities, giving us confidence in the commercial segment of our digital imaging. Overall, there is some pressure in the Far East, especially China, but this is balanced by the strong performance of other products we manufacture for Europe and the U.S. I would anticipate that machine vision will remain flat or possibly experience a slight decline year-over-year, while other segments of digital imaging are expected to remain robust. We are optimistic about our diverse portfolio, which spans space, medical, and machine vision for automated semiconductor inspections and flat panel displays. Teledyne has proven to be quite resilient across various economic conditions.

And follow-up question, I wonder if you could talk a little bit about just an update on the rate at which you may be burning through some of that higher cost component inventory that you had. Just in general, it sounds like supply chain has gotten better, and how you're seeing that part of the business?

Yes. I think you're right. As I mentioned earlier, our supply chain issues have significantly moderated. We're still paying some premiums, but that's down about 65% to 70% lower than we did at the first quarter of last year. That’s positive. Our inventory remained fairly flat between the first quarter and second quarter. But as these supply chain issues relax, we will reduce our inventory for the remainder of the year. I feel good about how we've dealt with the supply chain. We really didn't lose a whole lot of revenue because of it.

If I could just slip one more in, apologies, but you did talk about some pull-in from Q3. I wonder if you would size that for us.

I'm going to say approximately $10 million, not a whole lot. But when we have the opportunity, and I hope we will have in the future, we're going to try and do that. The flip side is that a lot of our customers have also ordered a lot of inventory anticipating shortages. So they're resistant about letting us ship all the stock that they have ordered before, but we're balancing that because again, our balanced portfolio helps us along in all of those directions.

I want to continue first on Digital Imaging. I would say 90-plus percent of the questions I get from investors are about the margins there. I mean, I think they have come in a little below what you thought. I know there's some elements, high-margin machine vision, probably market declines there. But can you talk about what's been slightly different than you thought on the margin side? How should we really think about that business kind of into 2024, like what's realistic for a baseline margin assumption?

Let me start with second quarter margin. Actually, second quarter Digital Imaging margin is up about 28 basis points. That's a 30 basis points year-over-year increase. We think for the year, it might be probably flat, maybe down about 10 or 15 basis points but relatively flat. I think what's going to happen is that the FLIR margins are going to increase somewhat, and the historic or legacy digital imaging may decline a little bit. Basically, we think year-over-year it will be flat. We've had, as I mentioned before, a slower revenue and lower revenue in Defense in the first half of the year. But as mentioned earlier, that's turning around now, so I think that's going to help us for the rest of the year. That's really all I can say about the margins. I think second quarter year-over-year we saw an improvement of about 28 to 30 basis points. For the whole year, it might be flat or down maybe 15 basis points, but not much. Again, the balanced portfolio is really going to help us. The flip side of it is if you look at our Aerospace and Defense segment, the second quarter margins increased 247 basis points, and for the year, we're projecting an 80 basis points expansion. So sometimes, when we look at Defense, yes, we differentiate Defense; that's in digital imaging, what I've talked about before. But we have numerous Defense programs in our Aerospace and Defense portfolio which are doing really well. Overall, I think we're okay.

Just one quick clarification. I know the Digital Imaging margins were up year-on-year, but sequentially, they were down on higher revenue. So was there like a mix change going on there? I have a quick question on Test & Measurement.

I don't know. They were down sequentially about 20 basis points. I'm not so concerned about that. There's so many moving parts in there that it just balances itself out. That's not something that worries me. That's all I'll say about that. Go ahead with your other area, please.

Just curious if you have any color on the order intake for oscilloscopes versus the revenue delivery now? I know the revenue is strong; are orders starting to slow there? I'm just curious about what that revenue trend looks like? How much backlog do you have? How fast is that coming out? Is it being replenished at the same pace?

Yes. As you know, in Test and Measurement, we have 2 distinct product lines. One is oscilloscopes, the other is protocols. Both of those are relatively short-term revenue. So a big backlog doesn't make a whole lot of difference. Our oscilloscopes revenue in Q2 was outstanding, really good. Our protocol revenue was relatively flat, and partly that's because new protocols are coming out in September, so we expect that revenue to pick up. For the whole year, we think that we're going to have something like 3.5% to 4% growth in our oscilloscope and protocol products. We think the third and fourth quarters are going to be all right. They may not expand as much as the first quarter, but year-over-year, we're going to be fine. In terms of just answering your question on backlog, book-to-bill in Test and Measurement is very close to 1, it's 0.98. So I would say it's 1. Again, it's not something that concerns me right now.

Could you clarify something? It appears that while you didn't change the guidance for the year, you did lower the expectations for digital imaging. You mentioned the strength in Aerospace and Defense. Has there been any update to the overall company margin guidance for the year, considering that Aerospace and Defense seems to be performing well and instrumentation is slightly exceeding expectations?

Yes. I'd say if you went back to April guidance versus today, probably margin is going down 10 basis points. Again, nothing significant. For the full year, we expect margin to go up about 26 to 30 basis points year-over-year. Overall, it's not something that concerns me because, as I've mentioned several times, our product diversity helps out. For example, Instruments' margin will go up 80 basis points year-over-year. Aerospace and Defense, similarly, 80 basis points. Even Engineered Systems will go up about 38 to 40 basis points. So a flat digital imaging doesn't change anything at this time.

And then, you talked about FLIR Defense and kind of what you're seeing on the order front, and A&D performance top line was really strong in the quarter. I mean, what are you seeing across Teledyne as it relates to Defense? How are you thinking about runway just given orders and some of the 2023 budget money coming through?

Yes. As you mentioned, there has been a change in the budget for a long time. The budgets look healthy, but money wasn't coming through and it started to come through more recently. Overall, I would say we are fairly comfortable with our Defense businesses, probably across everything, achieving mid-single and single digits growth year-over-year. We are enjoying good margins and orders in our legacy Defense businesses. As I mentioned, our FLIR Defense businesses are turning around and had a good book-to-bill in Q2. It's not just the U.S. Defense. If you look at Defense also in NATO countries, expenditures are increasing, and we have significant sales overseas, in both our Defense as well as Defense, including products like traveling wave tubes for missile defense in places like South Korea. It’s a healthy environment right now.

I just had a quick question on the backlog for Defense. Are you guys seeing any specific constraints that could put the deliveries at risk? Also, for those wins, should we expect the majority of them to come through for 2023 or extend that into the out years?

Some will come in 2023 and some will start in Q4. For example, we have some counter drone products going to Europe, likely around $25 million to $26 million, most of which will be in '23. On the other hand, the Black Hornet 3 we announced for the U.S. Army is valued at $94 million; only about 10% will be delivered this year, with the remainder coming in future years. It's a balance. I think we'll receive some of it this year, with a larger portion in the years to come.

Robert, I think you said in your prepared remarks that digital imaging margins should grow considerably over time. Could you flesh that out a little bit for us? What is over time? Could this mean that digital imaging margins exceed the sort of 24% levels I think that delivered in 2021?

Yes. The answer is, yes. The reason I say that is the margins in our legacy businesses are already around that and even higher than that. I think FLIR margins will increase especially as we take the costs out that I just mentioned. Overall margins for Digital Imaging this year are projected to be 22.3%. To go in '24, that’s a 170 basis point expansion. Yes, we can do that.

I think last quarter, you pointed out negative mix and lag of price increases in the Medical business. Was there any other mix effects besides Defense that you talked about in Q2? Is there anything else we should be aware of that may have held back margins? Because I think 3 months ago, you expected sequential improvement and 30 basis points up for the full year.

Yes. I think in the healthcare business, things are really good for us. We've had significant expansion in our X-ray products, our panels, as well as components for X-ray systems. As I stated earlier, there has been some slowdown in China. If you look at China as a whole, they’ve had a contraction, even though you may not hear about it; there has been some contraction. On the other hand, less than 10% of our portfolio is sold to China. Again, our balanced portfolio helps us. Also, we've gotten some good higher-margin product development programs that are helping overall Digital Imaging. Shipments have been slow, but bookings are okay. It’s not something that worries me. Where we don't have, let's say, a commercial imaging system that someone would buy in China, we have custom products that we're developing, which are more profitable than commercial. I sit here today and I’m just looking at our portfolio, and I wouldn't change it with anybody else's considering all the uncertainty around the world. One area may go down, but we'll pick it up somewhere else. That’s the resilience of our earnings year-over-year, quarter-over-quarter.

Just one last one for me. In Aerospace and Defense Electronics, I think previously, you mentioned that you benefited from a particularly good mix there. Is that presumably continued in Q2 and will it continue in the second half given your guidance for the margin?

Yes. We think we may have a little lower revenue in the second half. On the other hand, the products that we make in Aerospace go primarily in commercial aircraft. That market has expanded, as you know, very close to pre-COVID levels. Q3 and Q4 margins for Aerospace and Defense might be a little lower than Q2, but they will be higher than Q1. Again, I don't see major inflections in that area.

You gave us some book-to-bills, and I'm just wondering if you could provide us the book-to-bill in the different segments. I feel like I've got pieces of it.

Sure, Jim, in Instrumentation, our book-to-bill is about 1.05, so over 1, led by our Marine businesses, which are doing well, both in underwater vehicles as well as oil discovery and production. In Digital Imaging as a whole, the book-to-bill is about 1.07. In Aerospace and Defense, that’s a little more lumpy. Engineered Systems, those orders are much more variable quarter-over-quarter, but it’s not affecting revenue much because we expect both segments' revenue to grow. Overall, across the company, our book-to-bill is about 1.

Okay. Last question for me. Just given the debt pay down, I'm wondering if anything has changed with respect to thinking about acquisitions, including any change in areas you might be pursuing? I know you can't be specific, but I'm just wondering what your appetite is for M&A looking out over the next several quarters?

Well, as I mentioned earlier, Jim, we paid down $620 million this year effective today. That’s taken our net debt-to-EBITDA ratio to 2.1%. We have about $60 million of variable debt, which we pay 6%; out of the $3 billion plus that Sue mentioned, the rest is fixed. Other than that $60 million, our interest payments are at 2.1% in future years, which is a very healthy place. If we don't make any acquisitions or if we don’t do anything else, our debt-to-EBITDA ratio will go below 1 in about a year and a half. We are bullish about acquisitions, including larger ones, if we can find them. We are continuously looking into that. The last question was, what areas? Right now, I would say in the general instrumentation area is what's very attractive. We have executed some digital imaging acquisitions. As you know, we made the ETM acquisition and made other acquisitions. It would be nice if we could find some things in our Instrumentation area.

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

Thanks, Robert. To give the replay information to the audience, I would appreciate it. Again, all our news releases are available and for those who want to talk to me, please feel free to call me at the number in the earnings release. Thanks, everyone. Bye.