Teledyne Technologies Inc (TDY) — Q3 2023 Earnings Call Transcript

Thanks John and good morning everyone. This is Jason VanWees, Vice Chairman, and I'd like to welcome everyone to our third 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, and Senior Vice President and CFO, Sue Main. Also joining today are Steve Blackwood who will assume the role of SVP and CFO on December 1st; Melanie Cibik, currently Senior Vice President, General Counsel, Chief Compliance Officer and Secretary will be promoted to Executive Vice President on January 1st; and Edwin Roks and George Bobb, currently Executive VPs of Teledyne will assume the roles of CEO and President and COO, respectively, on January 1st. 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 the earnings release and our periodic SEC filings and of course actual results may differ materially. In order to avoid potential selective disclosures, this call is simultaneously being webcast and a replay, both via webcast and dial-in, will be available for approximately one month. Here is Robert.

Thank you, Jason, and good morning and thank you for joining our earnings call. These are exciting times for Teledyne. We have new leadership coming in, but we also have continuity and resilience in our programs, in our operations and our ability to meet what we say we would do in our earnings. In the third quarter, as an example, we achieved record operating margin and earnings per share. GAAP operating margin of 18.8% was a third-quarter record. On a non-GAAP basis, the operating margin was 22.8%, which was an all-time record for any quarter. Likewise, GAAP earnings per share of $4.15 was a third-quarter record and non-GAAP earnings per share of $5.05 was an all-time record for Teledyne. Compared to last year, GAAP and non-GAAP operating margins increased 119 and 86 basis points, respectively, and both GAAP and non-GAAP earnings per share increased approximately 11%. Our overall third-quarter performance was led by growth in our marine, medical, aerospace, and certain defense businesses, coupled with vigilant cost control. There was, however, some deterioration in certain end markets such as industrial automation and laboratory instrumentation. Nevertheless, given our focus on operational excellence, operating margins increased both sequentially and year-over-year in Digital Imaging and Instrumentation segments, helping generate record earnings. Given continued debt repayment through September, which totaled about $680 million year-to-date, our consolidated leverage ratio declined to just under 2 times. And finally, we're pleased to have added Xena Networks to our test and measurement businesses which also continued to perform very well in a challenging environment. In terms of our outlook, we now see total sales for 2023 growth of about 4% or a little less than the second half versus our July outlook with the fourth-quarter sales being roughly $1.45 billion. Approximately half of this change in incremental sales is due to incremental currency translation headwind from July to now, and the balance being further deterioration in industrial automation and laboratory instrumentation markets mentioned earlier. However, given the strong margin and earnings achieved in the third quarter, we're raising our non-GAAP earnings outlook to $19.25 at the midpoint from a prior outlook of $19.10. I will now further comment on the performance of our four segments. Third-quarter sales in our Digital Imaging segment were flat compared to last year. Sales of x-ray products, infrared imaging detectors, and surveillance systems increased year-over-year but were offset by lower sales of unmanned ground systems and micro-electro-mechanical systems or MEMS. Sales of commercial marine hardware and software were flat, but declined organically. Finally, cameras and sensors for industrial automation declined compared to last year. Like Teledyne as a whole, the Digital Imaging business portfolio is exceptionally well-balanced across market segments and geographies. With the help of bolt-on acquisitions and growth in our medical and defense markets, we were able to offset declines in industrial automation and the small portion of our overall portfolio that is associated with consumer discretionary spending. Despite the flat revenue, margin performance improved considerably to record levels with the FLIR businesses collectively slightly higher than segment average margins. Turning to our Instrumentation businesses. This segment consists of marine instruments, test and measurement, and environmental instruments. Overall, third-quarter sales in the Instrumentation segment increased 7.4% versus last year. Sales of marine instruments increased 20.5% in the quarter, primarily due to ongoing recovery in offshore energy markets and greater sales of acoustic imaging systems. Sales of electronic test and measurement systems, which includes oscilloscopes, digitizers, and protocol analyzers, collectively increased 2.5%. We continue to see some softness in sales of analyzers for electronic storage and data center applications. But this was more than offset by sales of devices for wireless and video protocols as well as continued strong sales of oscilloscopes. Demand for high-speed networking customers remains very healthy, and we see the Xena acquisition enhancing our offerings in this market. Sales of environmental instruments decreased slightly compared to last year, with sales of air quality and gas and flame safety analyzers offsetting some decline in drug discovery and laboratory instruments. Overall, the Instrumentation segment operating profit increased over 20% in the third quarter with GAAP operating margins increasing 277 basis points to 26% and 253 basis points on a non-GAAP basis to 27%. These were all-time records for this segment. Third-quarter sales in our Aerospace and Defense Electronics segment increased 8.1%, driven by growth both in defense electronics and commercial aerospace products. GAAP and non-GAAP operating profit increased 11.5% with margins 81 basis points greater than last year. Finally, in the Engineering Systems segment, third-quarter revenue increased 4.1%, but operating profit declined slightly, given an unfavorable product mix but also a tough comparison with the prior year period. So, in conclusion, we are pleased to continue to do what we know best, grow sales and margin in businesses with favorable markets, while cutting costs and protecting margins in those businesses where market trends are more challenging. At the same time, especially now that our leverage continues to decline, we should acquire and integrate complementary businesses. Before turning the call to Sue, I want to thank her for her more than 34 years of service to Teledyne, and I wish her a very, very well-earned retirement. I will greatly miss her. And finally, I want to congratulate our other executives on their well-deserved promotions announced yesterday, and I and the entire Board are delighted that the same talented group of executives will continue to serve Teledyne's leadership.

Thank you, Robert, for the kind words, 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 2023 outlook. In the third quarter, cash flow from operating activities was $278.2 million. Free cash flow, that is cash from operating activities less capital expenditures, was $255.2 million in the third quarter of 2023 compared with $252.2 million in 2022. Capital expenditures were $23 million in the third quarter of 2023 compared with $16.7 million in 2022. Depreciation and amortization expense was $76.9 million for the third quarter of 2023 compared with $80.8 million. We ended the quarter with approximately $2.74 billion of net debt. That is approximately $3.24 billion of debt less cash of $508.6 million. Our stock-based compensation expense was $8 million in the third quarter of 2023 compared with $6.7 million in 2022. Turning to our outlook. Management currently believes that GAAP earnings per share in the fourth quarter of 2023 will be in the range of $4.07 to $4.21 per share with non-GAAP earnings in the range of $4.95 to $5.05. And for the full year 2023, our GAAP earnings per share outlook is now $15.82 to $15.96. And on a non-GAAP basis, we are raising our outlook to $19.20 to $19.30. Both the fourth 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 22.1%. I will now pass the call back to Robert.

Thank you, Sue. Operator, we'd now like to take questions. If you're ready to proceed with the questions and answers, please go ahead.

Congratulations, Sue, and congratulations to everyone else on the new appointments. Robert, maybe a question for you. You talked about the booking strength at FLIR last quarter. And I'm wondering how that business fared in Q3 from a booking standpoint? And what does the near-term outlook look like in the Teledyne FLIR business? And maybe as a follow-up, if you could provide a little bit more color on the overall level of bookings and the various bookings at the segment level. Thank you.

Thank you, Jim. Currently, we're seeing an increase in FLIR to 0.93, 0.95, driven by improvements in the Defense segment, which is expected to exceed 1 for FLIR. We witnessed a significant change in the Defense business during the second quarter, and we have received some promising new awards in that area. Regarding the overall book-to-bill ratio, if we exclude Engineered Systems due to its unpredictable large orders, I believe we will be above 0.9 at this point. This is not a major concern right now, as despite some weaknesses in certain markets, we're gaining strength in sectors like energy, defense, and healthcare, which is contributing to the improvement in our margins. We anticipate better earnings moving forward.

Got it. And can you give an update on the facilities realignment at FLIR and when do you expect to see meaningful improvement in margins as it relates to these moves, or maybe you're already starting to see some of those benefits?

Yes, Jim, we're already seeing those benefits. First of all, most everything will be completed in the March to April timeframe. The majority of the workforce reductions have occurred, and the remaining ones will take place in the fourth quarter. The facility closures and the transfer of one facility to another will occur early next year. Regarding margins, FLIR margins have improved this quarter due to cost reductions and the mix of businesses we have, including Digital Imaging, which encompasses DALSA and e2v. At the end of last quarter, we anticipated a slight margin decline of 15 basis points, but that has reversed. We expect margins for the year to increase by 20 basis points, reflecting an improvement of about 35 to 40 basis points over the quarter due to our focus on cost.

This is Jordan on for Ron. I just had a quick question. Could you guys walk us through any of the exposure you have to the Israel-Palestine conflict? And if you're seeing any increase in heritage FLIR program interest or any changes coming from outlays?

We have some background on this topic. Essentially, we anticipate that in the long term there will be orders in our defense businesses as a result. We are a supplier, and unfortunately, the conflict is what it is. While I can't disclose specifics, we have played a role in some of the defense mechanisms used by Israel. The first outcome we expect is a replenishment of stockpiles in the defense sector, driven by the conflict in Israel and also the conflict in Europe. These situations present long-term opportunities for both the FLIR defense program and our Aerospace and Defense segment, which includes numerous components and subsystems utilized in various products.

Just curious on the management changes that you articulated for January 1st. Is there any real change in the org structure internally just in terms of how the businesses are going to roll up? You have a COO now. Like, just curious if there's any kind of structural changes in how the business is going to report.

Yes. I think that's a good question, Joe. Two things. First, we have one sub-segment, which is in the instruments businesses. You remember instruments consist of marine, environmental test and measurement. The marine already refers to George Bobb, the test and measurement and environmental reports to me. Those would begin reporting to George in January. Edwin has been running our biggest segment, which is our Digital Imaging segment. He will continue running that for a while. But as time goes on over the next 12 to 18 months, they will begin harmonizing, George learning more about the Digital Imaging businesses and Edwin learning more about the businesses that George is running at the present time. The resilience to all of this is that I'm not going anywhere. We'll continue to work together, the three of us, also, of course, with others like Jason and Steve Blackwood and Melanie, to make sure that all the assignments and changes happen slowly, orderly, and don't offset any of our market-leading products that we're focused on. So, I see this as a continuum but one in which both Edwin and George take more responsibility and I move to worry more about how to allocate capital with Jason, do more M&A and also improve our margins, which is something we have to do continuously.

I appreciate that color there. If I go over to DI margins, I mean, obviously, that's been a focus area for investors and for you guys. It was pretty substantially higher than maybe what people anticipated this quarter. Curious if there was any kind of one-off type benefits going on this quarter that maybe we have to consider reversing out? And then into next year, we have time before we get there, but I think you guys have been at conferences recently talking about maybe 23% is a good target for next year. Is it an early target? You're kind of going to be there now. If you think this year is off of 20 bps, you're kind of going to be almost at 23 for this year. So, does that target not just become that much more conservative? How should we think about that?

That's a good one. Actually, you're right. The margins have improved. Right now, we're projecting for the full year '23 to be at 22.7%. So, it's very close to the 23% that you mentioned. Moving further up, of course, that's what we're going to strive for. We have to take a little more cost out in DALSA, e2v as we've done in FLIR, and we're doing that right now. And the other part that I think would affect it is that some of the markets that are declining like semiconductor, automation sensors in our vision systems, those are going to come back. And then finally, we have some new markets for our Digital Imaging, for example, inspection of lithium-ion batteries. You remember now, most of that manufacturing is beginning to switch back to North America. And we do have some really good systems for quality control. And you can guess lithium-ion battery, a flaw can be catastrophic. So, these new cameras and new markets will offset some of the declines we have now, but I also think that the semi market will come back. So, if all of that takes place, as I've just outlined, obviously, our margins should improve.

If I could just ask one last question. Considering your oscilloscope business, I know it is currently experiencing rapid growth due to backlog deliveries. However, thinking about the order trends throughout the year, if we don’t see an immediate uptick in orders, could this lead to a decline in that business based on your backlog and what you are delivering this year, especially looking into 2024?

No, we feel very positive about our test and measurement business. First, as you mentioned, part of it includes oscilloscopes, part includes digitizers, and a rapidly growing segment is our protocol analyzers, especially following our recent acquisition of Xena. The book-to-bill ratio in that sector is currently between 0.94 and 0.95. In the realm of protocols, we are not seeing declines; rather, we observe a slight push-out as new standards are continuously evolving, and our protocols are leading those changes. Therefore, people will be adapting to these advancements. Although there has been some softening, our oscilloscope business is performing well because we are also introducing new products. The market may not appear as exhilarating as it once did, but we find it very exciting.

Maybe just to level set the guidance for the year in terms of revenue. I mean, you mentioned industrial automation and laboratory instrumentation softening. But, can you just remind us where FX is the biggest headwind given you said that was half of the impact? Just kind of thinking about the segments for the rest of the year.

Yes. The FX that I mentioned is versus what we were looking at in July, and things have tightened and it's costing us about 1%. And it's mostly focused in our Digital Imaging and Instrumentation businesses. Having said that, overall, if you look at year-over-year, we do get a little tailwind. But it tightened significantly from our July meeting to today. We'll deal with it, like we deal with any market softening here and there. I mean, basically, focus on getting products up where there's a good market, cut costs where we don't have the market, improve our margins, and if we can do what we just did, beat and raise.

And then, the operating discipline definitely comes through. Given those two markets that you did say were deteriorating, how does price play into this? Just thinking about maybe what you're able to capture does that kind of change the pricing equation at all thinking about into year-end?

Yes. I think what we have been able to do is increase prices successfully in businesses that are doing well, like on our Aerospace and Defense businesses or certain parts of our environmental. And for example, marine where we have a really strong market at the present time, we've increased prices. That offsets prices that we have not been able to increase in the environmental area. So, it changes across our portfolio up and down. But generally, we are successful in raising prices across the board, we have been this year versus let's say last year. And we think that sustainability that's happening for our businesses will allow us to increase prices but more modestly going forward than we have aspirations for. But if things turn around, we'll do it.

You mentioned that your book-to-bill is just over 0.9, which isn't especially encouraging as we approach 2024. However, you expressed some optimism in areas like Digital Imaging and certain markets beginning to recover. Can you share your expectations for the upcoming year? In the last quarter, you indicated that the defense backlog might convert into Q4, and you seem more hopeful about new awards materializing. I'm curious if the book-to-bill could improve as we head into the new year, and how you feel about January and February.

Yes. To get to the point, we still have over $3 billion in backlog, which is quite healthy. There are some short-cycle businesses that have experienced brief downturns, particularly in the environmental sector. The slight decrease does not concern me, especially since we are launching several new products. For instance, we recently introduced the Black Hornet 4 nano-drone through FLIR Defense, which can ascend to 20,000 feet, doubling the altitude capability of its predecessor, the Black Hornet 3. This new model lasts longer and offers various enhancements. We are also developing new programs in counter-UAS technologies. Another aspect that excites us is our growing understanding of how to integrate artificial intelligence into our systems. Currently, we have around $250 million to $300 million in products that are evolving from mere sensors into intelligent systems that provide valuable information. Therefore, I am not worried about the minor dip in backlog, mainly because certain market segments, such as semiconductors, are facing challenges. However, the semiconductor sector constitutes less than 10% of our overall business at Teledyne, so it's not a significant concern. The crucial factor is our ability to continue introducing new products and pursuing acquisitions, which we are now positioned to do since our leverage is reduced. We aim to maintain our strategy of acquiring, integrating, and enhancing our earnings per share.

Yes. Okay. Well, that dovetails into my next question around M&A. With your leverage now back below 2ish, what are you seeing in the pipeline for next year? And then, maybe if you don't see M&A materialize, what are your thoughts on share repurchase just given where your valuation is?

I'll answer the M&A question. Share repurchase is something that we haven't done. We've only purchased shares I'm going to say, 10, 12 years ago about $400 million, when you look at our market cap versus that very small fraction. I think our M&A opportunities are there. We're looking at smaller acquisitions at the present time with one or two what I'll call, midsize, several hundred million dollar acquisitions in the potential pipeline. The one thing we have to be careful about is there are some really outrageous prices that people are paying for some of the acquisitions we've looked at. Multiples of sales going 15 times. And that's just not us. Well, we are looking at smaller acquisitions, both here and in Europe and they'll come along just like we've done before, what we call the string of pearls, and we will make those acquisitions. If we don't make any acquisitions on the flip side, by the end of next year, our leverage ratio would be 1, which was actually less than that before the FLIR acquisition. And cash also will help our earnings, but our primary focus is going to be acquisitions.

Just a couple. Can we run through each segment and what you're embedding for organic and margin expectations just for the rest of the year? And then also, just hit on your net leverage comment there. Is it safe to kind of assume that you guys are going to be able to produce above like maybe $1 billion in free cash flow in '24?

Let me answer the last question first. We're right in the middle of our planning cycle for our operating plan and made presentations to our Board yesterday, and the answer is yes. Let me now go back to the organic question that you asked for this year. Fundamentally, we're going to have - organically, we're going to be relatively flat in our overall Digital Imaging business, maybe a little down, but that's partly because we're also cleaning up some stuff that is not profitable. On the other hand, we will have organic growth of almost 6% in our Instrumentation businesses, which, as I said, is environmental, test and measurement, and marine. We're going to have similarly, over 6% in our Aerospace and Defense organic growth, and about 8% in our Engineered Systems. So, those are very healthy growths for this environment that we're all experiencing.

I have a question regarding the test and measurement sector. You mentioned a new protocol product that will be launched in September. What has been the customer response so far? Could this potentially provide an additional advantage to that part of the instrumentation in the fourth quarter?

Yes. The new protocol is the PCI Express Gen 7. The life cycle of that is usually a couple of years. I think we'll see some benefit from that next year, probably later next year. But the flip side is the protocol business that we just bought, Xena is fulfilling a gap that we had in our protocol businesses, which was the high-speed network protocols, and they fill that gap very well. So we love our protocol businesses and hope that we can buy more of them as time goes on.

Congratulations on the leadership changes. Robert, I hope that this change means you get some extra free time.

I hope so, too. I have my new leaders shaking their head, across the table from me, but I hope I will. Yes. Thank you, Kristine.

Well, great, and it's been wonderful to follow your career and what you've done for Teledyne. So, maybe with the leadership changes, I mean, sometimes there's also a change in strategic focus. I mean, Teledyne is a much broader and bigger company than it was over 20 years ago. You mentioned earlier that M&A is still a priority over share buybacks. I guess, as we look out the next 5, 10, or even 20 years, and maybe that question is a little too broad of a scope for this call, but how do we think about the strategic direction for Teledyne? Like where to from here?

Well, first, let me answer the first question. The way we operate in the current Teledyne is a lot of the M&A ideas come from our businesses. Now, we are proactive. At any one time, we have a large funnel of businesses that we're looking at. But that will not change because it comes from Digital Imaging, it comes from Instrumentation and marine and A&D. And these are areas that the two leaders that are taking over are responsible for. So I don't think in the short term, things will change. Also in the short term, at least, I'm still going to be here. And of course, Jason helps make a lot of the capital allocation decisions. But having said that, we will probably focus more on commercial businesses as we go forward. And we will get some defense businesses, but we don't want our defense businesses to grow beyond where they are today. We have a healthy balance of 25% defense, 75% commercial. Almost half or 47% of our commercial businesses are overseas. We're also expanding some defense business in the NATO countries and the Middle East. But having said that, I think my colleagues and I agree that we do not want to change our portfolio from what it is today to something that is not sustainable. If you're singularly focused on one market, when that market suffers, then it takes the whole company down. Our balanced portfolio is our resilience and our ability to tolerate changes. And as you can see, while we have some weakness in certain areas, we have strength in other areas. We have growth in instruments, in A&D, Engineered Systems. And so I don't think that will change. Now I'm talking about three years. If you go beyond that, then I can't predict, because the world is changing so much right now. I mean, it's such a difficult environment in some cases. It will depend on what happens and our strategies will evolve.

Congratulations to everybody on the new seats or responsibilities. Robert, I just want to go back to the DI margin. You just printed a number that you previously said you would get to in two years. It sounds like you're saying the majority of the explanation for that is that you performed an incremental cost out. And so, if that's the driver, wouldn't that kind of sustain in the margin from here? And therefore, why would that margin pull back from the level that you just reported?

I mentioned the margin for the year of 22.7% in Digital Imaging, which is 35 basis points higher than what I quoted in Q2. The importance of cost reduction is significant because it involves not just personnel but also the consolidation of our facilities, which we have not yet accomplished. Initially, our focus was on resolving export control issues and addressing our tax liabilities, which we are still somewhat working on. However, the defense business at Digital Imaging, specifically FLIR, is improving. Although machine vision is currently facing challenges, it is expected to recover eventually. I was cautious about next year's margins and stated them as 22.7%, possibly around 22%. Nevertheless, in the long term, there is no reason these margins couldn't match those in our Aerospace and Defense sector, which we expect to be 27.6% this year, or our instruments with 26.1%. There is potential for margin improvement in these businesses.

Okay. That's helpful context. I understood part of the challenge to be that there's been volatility in defense outlays compared to what's been authorized at the end market level. And so, with regard to your defense business inside of Digital Imaging, you were gearing up for higher defense revenue that then just kind of surprisingly didn't come through. And so, did that come through in the third quarter, or what was the growth rate, I guess, in the defense piece of Digital Imaging in the quarter?

We have several significant programs that materialized in the third quarter. For us, substantial means projects that are around $10 million to $20 million. We achieved a notable success with counter unmanned vehicle systems, collaborating with Kongsberg. Additionally, we've made strides with our nano-drones that are now entering the Indian market, and we received a commendable award from there. Furthermore, our surveillance program required us to resolve some issues related to gimbals and vibrations in products that we acquired. We addressed those challenges and have secured a Navy contract worth approximately $35 million. Thus, surveillance experienced growth in Q3. With our array of drones and newer products, we anticipate favorable outcomes. We expect our unmanned programs to expand in Q4. Overall, we have effectively improved unprofitable segments, consolidated facilities that were unnecessarily separate, and concentrated on deliverable unmanned systems that utilize our own sensors. Other entities use our sensors in their unmanned systems for various engagements, and while we're pleased to provide our sensors, we can also integrate them into our own systems. We believe that the defense segment within Digital Imaging has reached a turning point and is now trending positively.

Okay. That's helpful. And then just one last one in DI. What do you now expect the rate of decline to be for the year in the machine vision piece? And do you have enough order book or visibility to have a sense for what that revenue does in '24, or is it too short cycle?

I expect that overall, we will see an increase in revenue for DALSA, the e2v part of DI, of up to 6%, with some of this growth coming from acquisitions. In the FLIR segment of DI, we anticipate a slight decline, estimating it to drop to 1.834 from 1.84, which is a minor change compared to last year's 1.86. This decline is partly due to Raymarine, where consumer products are currently more discretionary. However, I don't foresee a significant downturn in Digital Imaging since DALSA and e2v have shown growth. We are managing the downturn in some of our other commercial products effectively. Additionally, there's strong potential for growth in sectors like healthcare, where we experienced nearly a 12% revenue increase in Q3. Overall, the situation is balanced.

Sorry. Those comments are on total Digital Imaging revenue, you're saying?

Total Digital Imaging revenue. Yes.

I just want to clarify that I was inquiring specifically about machine vision within Digital Imaging.

Just machine vision? Yes. There's different parts of it. There's the machine vision at DALSA, e2v and there's some machine vision in FLIR. I haven't added those two together. If I were to add those two together, I'd say, the full year might be down 2%. But again, could be a little higher, but it doesn't bother me that much, Noah, only because, as I mentioned before, we have new products like in battery inspection, and we're more emphasizing our ability to put some information and intelligence into our devices, cameras, a move up market. So, this market is going to turn. It's not going to stay where it is. Semiconductor is not going to stay down forever. And I think we're well positioned for growth once those turn a little bit.

Yes. That's interesting. It's much different than the peer set. So, yes, it seems well positioned. Okay. All right. Well, thanks again. Thanks for the time. I appreciate it.

Thank you very much, Noah.

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

Thanks, Robert. And again, thanks everyone for joining us today. If you have any follow-up questions, please feel free to call me. The number is on the earnings release or of course, send me an email. And all the press releases are available on our website as is the replay. John, if you could give the dial-in information for the replay at the end of this call that would be great.