TE Connectivity plc (TEL) — Q2 2016 Earnings Call Transcript

Good morning and thank you for joining our conference call to discuss TE Connectivity’s second quarter results. With me today are Chairman and Chief Executive Officer, Tom Lynch; President, Terrence Curtin; and acting Chief Financial Officer, Mario Calastri. During the course of this call, we will be providing certain forward-looking information. We ask you to review the forward-looking cautionary statements included in today’s press release. In addition, we will use certain non-GAAP measures in our discussion this morning. We ask you to review the sections of our press release and accompanying slide presentation that address the use of these items. Press release and related tables, along with the slide presentation, can be found on the Investor Relations portion of our website at te.com. Finally, for participants on the Q&A portion of today’s call, I’d like to remind everyone to limit themselves to one follow-up question to make sure we are able to cover all questions during the allotted time. Now, let me turn the call over to Tom for opening comments.

Thanks for joining us today and please turn to slide three and we will review the highlights on today’s call. Q2 was another quarter of good execution in what continues to be a sluggish global economic environment, adjusted earnings per share of $0.90, which was $0.02 better than the midpoint of our guidance on sales of $2.95 billion, which was slightly below the midpoint of the guidance. Strong operating performance across the company more than offset continued market softness across our industrial businesses. Our adjusted earnings per share was down $0.01 versus the prior year, but foreign exchange headwinds were approximately $0.02. On a constant currency basis, adjusted EPS was up 1% year-over-year. Adjusted operating margins were 14.9% in line with our expectations, but the adjusted EBITDA margins were approximately 20% in the quarter. For the full-year, we are reiterating the midpoint of our guidance of $12.3 billion in revenue and $4 of adjusted Earnings per Share, representing an increase of 11% over prior year EPS. We expect to return to revenue growth in the second half and to generate double-digit EPS growth. Our outlook for organic growth is down slightly at 3% compared to our guidance of 90 days ago. Our auto business remains solid, the industrial inventory correction is largely behind us, and SubCom continues to build momentum. Our recent acquisition of Creganna is part of our guidance as well. These positive factors are offsetting the lower-than-expected growth in most industrial markets and slow growth in our non-transportation business in China. Our EPS growth is benefiting from cost controls, the benefits of our share buyback, and a lower tax rate. We have developed multiple levels to drive earnings growth in a slow economy. During the quarter, we returned $1.2 billion to shareholders, including $1.1 billion in share buybacks. We expect to continue to take a balanced approach with our capital strategy, returning approximately two-thirds of our free cash flow to shareholders over time, with one-third of free cash being used for acquisitions. We generated $165 million of free cash flow in the quarter and $400 million in the first half of the year. We expect our normal strong second half cash generation to continue. We also continue to strengthen the company’s harsh environment portfolio. In March, we completed the sale of our circuit protection businesses. Earlier this month, we completed the acquisition of Creganna, doubling the size of our medical business to about $500 million in revenue and establishing TE as a leading provider of solutions to the high-growth minimally invasive medical market. This morning, we also announced a small sensor acquisition, which will strengthen our portfolio of sensor technologies serving the transportation market. In our SubCom business, we continue to gain momentum with the recently announced award for our project called Hawaiki, which is a new trans-Pacific cable system linking Australia and New Zealand to the mainland United States. This award will generate over $200 million in revenue over the life of the project, and this business has a backlog of awarded projects of $1 billion. I’ll now turn it over to Terrence Curtin, who’ll cover our performance in more detail.

Thanks, Tom, and good morning everyone. Before we get to the segment updates, I want to provide brief insights into our order patterns, which will help provide a baseline for our results as well as expectations. If you could turn to slide four please, it shows order trends excluding our SubCom business. Overall, orders improved again sequentially and are above the low levels at approximately $2.6 billion that we experienced in the fourth quarter of 2015. If you remember, in the fourth quarter of last year, we began to experience the supply chain impact related to the slowing in China as well as the industrial markets. We have seen recovery in orders in both of these areas and feel that the supply chain correction impact has completed in our second quarter as we expected. Certainly, we are pleased with the recovery in the orders; however, the recovery is slower than expected in certain areas. Specifically in China, we previously thought that orders would continue to accelerate through the rest of the year. While we believe the auto orders in China will continue to recover, we now expect orders outside of auto to remain at the current levels that we experienced in the second quarter. Let me now talk about the orders by segment. Overall, transportation orders remain solid, and in autos, our orders were negatively impacted by near-term customer backlog adjustments related to a change in their schedule. I want to highlight that this did not impact demand; it’s really just a change in one of our customer’s processes. We continue to experience strong order trends both in Europe and Asia in automotive. In industrial, orders grew 5% sequentially with growth in both our direct customer orders and those that go through our channel partners and distribution. As I stated earlier, the industrial inventory correction is now behind us. In Communications, excluding SubCom, our orders grew 4% sequentially with a Book to Bill of 1.05, with improvement in both our plans and data and device business. As Tom mentioned, SubCom continues its momentum with the new Hawaiki program, and we will record that order as a booking in our third quarter. If you could please turn to slide five, I’ll discuss Transportation Solution results in the second quarter. Overall, sales grew 3% in the segment organically in the quarter with growth across our businesses. Our auto sales growth in the quarter was driven by strength in China as well as Europe. For fiscal 2016, we continue to expect global auto production to be up 2% to 2.5% with growth in all regions, with strong growth in China. We remain confident that our auto business can grow ahead of auto production driven by electronic content growth as well as a robust pipeline of platform ramps from designs won that we generated over the past several years. In commercial transportation, sales grew 1% organically year-over-year driven by the heavy truck sector in both China and Europe. North America heavy truck markets continue to remain weak, along with continued weakness in global construction and agricultural markets. We’re pleased that organic orders were up year-over-year as well as sequentially as we continue to perform very well in this business against the tough economic backdrop. Turning to Sensors, we saw 2% organic growth, although we began to feel the impact of weakness in the industrial markets in our sensor business. To highlight, about 40% of our Sensor sales go to the industrial markets. We continue to see strong design momentum and long cycle transportation and industrial applications that we expect will drive future growth. From a margin viewpoint, adjusted operating margins in the segment were 19% and were in line with our expectations, although they were up sequentially. The decline year-over-year was driven by currency impacts as well as investments for growth. We anticipate adjusted operating margins for the second half to continue to improve and should be at similar levels as in the second half of last year. If you could please turn to slide six, I’ll discuss the Industrial Solutions segment. Revenue in the segment declined 7% organically year-over-year in the second quarter. Geographically, we continue to see trends across our businesses that are consistent. Europe is steadily growing in many markets. North America continues to see weakness due to oil and gas as well as the supply chain corrections that impacted us the past couple of quarters, and China remains sluggish. We continue to be impacted by the oil and gas market, with a sold 42% organic reduction in sales year-over-year, and the decline in oil and gas drives half of the organic decline in the segment in the second quarter. Low oil and gas prices continue to have a derivative effect on other areas of the industrial segment including factory equipment as well as helicopter demand, which affects our aerospace business. We have included the impacts in our results as well as in our guidance. In aerospace and defense, our commercial aerospace business grew year-over-year, which was more than offset by declines in the defense business due to supply chain impacts that we’re carrying in the distribution channel. Our energy business was down 2% organically, with declines in Asia and Europe partially offset by growth in the US. As we look forward, we expect the industrial segment to grow sequentially and we expect it to be essentially flat organically year-over-year in the third quarter, with a return to growth in the fourth quarter now that the inventory corrections are behind us. Adjusted operating margins were down year-over-year, primarily driven by declines in the higher-margin oil and gas business, but they were up sequentially. We do expect adjusted operating margins to continue to improve in the second half, benefiting from increased volumes as well as the cost actions that we initiated. If you could please turn to page seven, I’ll talk about the Communications segment. In the second quarter, the segment had revenue of $606 million, which was down 10% and 8% organically year-over-year, and it was slightly ahead of our expectations. Our SubCom business saw solid year-over-year growth driven by strong execution from multiple projects, and as Tom mentioned earlier, the value of programs is approximately $1 billion. We now expect SubCom to grow approximately 20% year-over-year, which is an improvement versus our expectation 90 days ago. Our data and devices and appliance businesses were impacted by distribution inventory corrections, as I mentioned earlier, and we believe these are behind us as we head into the second half of the year. Additionally, data and devices growth is impacted by the product exits we’ve been highlighting all year as part of the repositioning effort, which will impact our growth rate throughout this year. Adjusted operating margins in the segment declined 60 basis points year-over-year, in line with our expectations, and we expect improvements in adjusted operating margins as we continue through the second half. Now let me turn it over to Mario, who’ll cover the financials.

Thanks, Terrence, and good morning everyone. Please turn to slide eight, where I will provide more details on earnings. Adjusted operating income of $440 million was in line with guidance and down 13% year-over-year due to currency impacts, investments in transportation, and the lower volume impacts that Terrence mentioned earlier. GAAP operating income was $535 million and included $4 million of acquisition-related charges and net restructuring and other credits of $99 million primarily driven by the sale of our Circuit Protection business. Adjusted EPS was $0.90 for the quarter, down $0.01 from the prior year, with reduced volume from higher-margin products and negative impacts from currency exchange rates offsetting incremental benefits from share buyback. Excluding the $0.02 impacts from foreign currency, adjusted EPS was up $0.01 from the prior year period. GAAP EPS was $1.06 for the quarter driven by net restructuring and other credits of $0.17 primarily due to the circuit protection sale I just mentioned. We expect approximately $100 million of restructuring charges for the full-year, a $50 million increase from prior guidance. Regarding tax, it should continue to be in line with long-term adjusted tax rates of approximately 23% to 24%. Due to the mix of profitability in different regions, we now expect our adjusted tax rate to be slightly lower this year. As we mentioned last quarter, Tyco International, on behalf of which, entered into an agreement with the IRS to resolve all disputes related to the previously disclosed intercompany debt issues. During the quarter, we made net pre-separation tax payments to the IRS of approximately $140 million to prevent further accrual of interests and penalties and help drive this settlement behind us in the near future. As you may know, the Treasury Department proposed tax regulations earlier this month. One proposal addresses the tax characterization of certain intercompany financing arrangements. TE utilizes intercompany financing for efficient capital deployment. We're in the process of analyzing these proposed regulations for any potential impact on TE. Turning to slide nine, while we remain in a challenging environment, our performance was in line with our guidance and we expect improvement across our operating metrics in the second half. Our adjusted gross margin in the quarter was 32.6%, a decline from last year mostly driven by lower volume in areas like oil and gas and distribution, which have higher margins than the company average. Adjusted operating margins declined 150 basis points consistent with our gross margin performance. Total operating expenses were $523 million in the quarter, down 5% from the previous year, reflecting strong spending controls. We continue to tightly manage discretionary spending while balancing our continuing investment into our harsh businesses. Moving to cash flow and capital deployment in the quarter, cash from continuing operations was $155 million, and our free cash flow was $165 million, down from prior year levels due to timing of certain tax payments, but still up in the first half versus last year. We expect full-year free cash flow to approximate net income. We continue to have a balanced capital allocation. In the second quarter, we returned $1.2 billion to our shareholders, including $1.1 billion in buybacks. In the quarter, we bought back $19 million shares executing against our commitment of returning the proceeds from the broadband networks divestiture. Over the past 18 months, we have returned approximately $4.3 billion to our shareholders via buybacks and dividends. As Tom mentioned earlier, we expect to continue to take a balanced approach with our capital strategy going forward. We are also including a chart on adjusted EBITDA margins, which helps explain the profitability performance of our businesses, including acquisitions. Adjusted EBITDA margins in Q2 were 20% and show our margin resiliency despite lower sales levels. We continue to be pleased with the operating performance of our business, especially in light of the challenging macro backdrop. We've also added a balance sheet and cash flow summary in the appendix for additional details. Now let me turn it back to Tom.

Thanks, Mario. Before I get into Q3 guidance on slide 10, let me provide some perspectives on why we will return to growth in the second half. As you know, our first half was characterized by several year-over-year macro headwinds. Unfavorable foreign exchange due to the significant strengthening of the dollar against most major currencies, the significant decline in year-over-year oil prices, which resulted in over a 40% decline in our higher-margin oil and gas business, overall industrial markets weakened leading to supply chain corrections with OEMs and our channel partners, which we believe are now behind us, and weakness across most China markets. In the first half, these factors impacted us significantly, but in the second half, most of these headwinds are reduced. As a result, we expect to return to revenue growth and strong double-digit EPS growth driven by our harsh strategy and the many levers in our operating model. Now, I'll cover the Q3 Outlook. We expect Q3 revenue of $3 billion to $3.2 billion, up 1% on an actual basis, essentially flat organically, and adjusted Earnings per Share of $1.06, up 14% year-over-year at the midpoint. We expect growth in transportation and industrial, which include approximately $60 million from the Creganna acquisition. This is offset by declines in communications from the sale of the circuit protection business and the continuation of our strategy to exit certain product lines in data and devices. We do expect continued growth in our SubCom business. Now please turn to slide 11. We are reiterating our full-year guidance of $12.3 billion in revenue and $4 in adjusted EPS at the midpoint. On a full-year basis, continued strong performance of our transportation segment, the addition of the Creganna acquisition, and growth in our SubCom business more than offsetting the negative impact of exchange rates and softer industrial markets, especially oil and gas in China. As mentioned earlier, the full-year and fourth-quarter include the 53rd week, which contributes approximately $200 million of revenue. This full-year outlook includes an unusually high Q4 revenue and EPS level compared to Q3. So I'll walk you through that. As previously mentioned, this year's fourth quarter includes an extra week, which contributes approximately $200 million of revenue and approximately $0.10 per share of earnings. Excluding the 53rd week, revenue is expected to increase approximately $40 million from Q3 to Q4. The way to think about this is the $240 million revenue will flow through to earnings at a 25% to 30% rate, and this coupled with our typical productivity accounts for the significant sequential increase in EPS. Let me just wrap up with a few comments. As we mentioned earlier, the global economic environment continues to be sluggish. Despite this, we expect to generate another year of solid performance. Our focus on harsh environments driving TE's operating model, strong cash flow and a consistent return of capital policy continue to enable us to significantly strengthen our earnings leverage. The dollar of revenue today generates about 40% more EPS than five years ago. This is serving us very well in a slow growth economy and will deliver accelerated earnings growth as the global economy improves. Now, let’s open it up for questions.

Thanks a lot. Good morning, guys. I have two questions. Tom, maybe carrying on what you saw at the call with the September quarter. Historically, I think in September revenues seem to be down a little bit sequentially, 2% by my math. So, could you maybe talk about what will give you the comfort that sales could be up $43 million sequentially on an organic basis? And then on EPS line, I guess the same thing you know, gives you $0.10; the $40 million would give you another $0.02, $0.03. I still struggle to get the entire $0.20 that you got for September.

Hi, Amit. I think there is a little static on the line, try to get through this. Yeah, normally if you go back over many years, we've had a few years we were up slightly in the fifth quarter, a few years we were down slightly. I mean last year was a really unusual year because that is where China and the industrial price reduction began to occur. This year the pattern to coming into the fifth quarter is different. We have industrial markets improving; we have China not quite as much as we thought it would be. For sure, the auto market is improving as we expected. So, that's really the difference accounting for a slight sequential improvement as opposed to what we've seen over time. We also picked up $240 million in revenue sequentially; a lot of leverage comes with it, and that should flow through at a 25% to 30% rate. The restructuring has been going on through the year and continues to flow in the aggregate, so there’ll be a better benefit in Q4 than Q3 and then a normal productivity momentum, which marches through the year. So when you add all that up, that's how you get what looks like a pretty significant hockey stick or you might feel it's a small hockey stick.

Fair enough. That is helpful to kind of get the leverage there. And then, I guess just the transportation segment. I think you guys adjusted the production or unit expectation up modestly for autos. But the organic growth, I think went from high single digits to mid single digits. Could you maybe just talk about what are the variables that led to the lower organic growth within transportation for the year?

Hi, Amit, it’s Terrence. Two things regarding Auto production estimate. We’ve been around that 2% to 2.5% since last quarter, and really that is China being middle to higher single digits, Europe being about 1%, and US about 4%. So that’s we have not changed those assumptions. When you look overall at the transportation organic growth, it was primarily driven by the comments I made around sensors. We did reduce our expectation for the year around sensors' organic growth, really related to the impact of the industrial markets. So the growth we saw there was lower this quarter than we thought, and we are seeing order impacts due to some of the industrial impacts that we’ve seen elsewhere on the sensor business.

Alright. Thanks, Amit. Next question please.

Yes. Thank you, good morning. Terrence, you pointed out strength in autos in Europe and China. I was wondering if you could talk about the order patterns in North America and Auto. Are you seeing any signs of deceleration in order patterns that are concerning to you at this point, and I have a follow-up?

Thank you for the question. The adjustment in our U.S. business backlog was primarily due to a scheduling change, which was not related to demand. However, we have noticed some leveling in order patterns, and I must mention that there is either an acceleration or deceleration beyond that specific adjustment with that customer. Otherwise, I would say...

Okay. Great, thanks. As my follow-up, transportation margins saw a year-over-year decline despite organic growth of 3% and reported to flat. Can you address what the moving pieces are? I think you called effects and some increase in last months. What are those increases in last month specifically? If you could provide any color on that? Thank you.

When you look at those increased divestments, we had a tremendous number of program wins both in our sensor business as well as in the automotive business, which is a long-cycle business. So we've been putting investment into both of those programs. It’s mainly an engineering and product launch teams both in sensors as well as automotive around this program and that will benefit us for two to three years.

Okay. Thank you, Wamsi. We have the next question please.

I wanted to get a sense of what drivers you’re confident will help the industrial segment improve in the back half of the year. It sounds like you think China is going to be relatively flat, but potentially, I think you’re saying that the inventory situation is better. So, just trying to understand what makes you comfortable that things will get better in the second half. Thanks.

Sure. Thank you, I’ll comment and then I’ll ask Terrence to answer. I think a couple of things. One, when we look at inventory in the supply chain, both with our direct customers and our channel customers, it feels like that has equilibrated right now, and that’s what our channel partners feel as well. Last year, the supply chain adjustment negatively impacted our business. So we’ve been going through that. We do see China gradually picking up; it really began to turn down in the second half of last year. So some of that is to compare. I don’t think we’re producing a robust industrial market. It’s really about things getting more imbalanced. We will have the benefit of the Creganna acquisition, which is in our industrial segment. Terrence, do you want to add more color to that?

No, I think Tom has said it very well. Last year fourth quarter is when oil and gas, as well as a lot of the channel and inventory effects hit us. So in some ways, it’s a weakness compared to the fourth quarter last year on an organic basis, but we do see that leveled out. I think the industrial world is relatively flat right now, and that’s where we see things heading into the third quarter. We expect it to be essentially flat year-on-year, but we're starting to see quite a bit of improvement in overall industrial activities.

Great, that’s really helpful. And then trying to ask a quick question on the communications margins, they were down year-over-year, and I would have thought they would have been a bit stronger given the subsea business's higher contribution. How should we think about the subsea business impacting that margin as we move through the year? Revenue is stronger? Thanks.

Subsea, yes, communications as you know the mix of kind of three businesses are very good appliance business. The subsea business is growing, and first-quarter margins were very high because we had to close out one of the jobs in subsea. We expect to take a couple of more quarters to normalize those margins in the subsea segment. So I expect subsea will gradually improve; the data and devices margins will start to improve later this year based on what we see right now.

Okay, thank you, Sherri. We have the next question please.

Great, thanks. A question on Creganna, understanding it just closed, but if you can just give some anecdotes in terms of customer engagement, number one. Number two, just kind of what that does more broadly for the medical opportunity?

I think secondly, what’s great about what Creganna does for us is it really rounds out our portfolio. So just to remind everyone, 90% of those integrated solutions we’ll have internally. I think the other thing that is very powerful not only is their position in engineering, but their position in the world really balances that medical platform and fills the gap we had around strong presence. Additionally, we are bringing in 225 engineers who know that space, which really doubles our engineering capability. So we now have a solid platform to continue to build upon, and we’re very excited about that.

The one thing I would add, Terrence, is we can’t Creganna in China, but outside of China with our growing medical business, we believe our offerings can help them scale much better given the large and aging population that don't have affordable healthcare in China.

Got it, thanks. As my follow-up on the tuck-in announced this morning, if I look back to the number of tuck-ins and how many deals you have done to kind of build up your base today, just your strategy in the market, it feels like the market is very fragmented. There is a lot of growth and a lot of opportunities, but could we expect more along these lines in terms of you doing these types of $40 million or $50 million type revenue deals?

Craig, I think you said it very well. First of all, it’s a very fragmented market, and what we liked about what was announced today is this is a speed sensor product company that is strongly positioned into both the industrial transportation side as well as automotive in the turbo charger applications. So I think when you look at the sensor space, you’ll continue to see two things similar to this: continuing to build our portfolio as well as what we historically have done, and continue to grow this business. So we’re very excited about the recent acquisition and it helps strengthen our transportation business.

Thank you, Craig. We have the next question please.

Hi, good morning everybody.

Hi, Shawn.

Just to clarify on the buyback, is there currently about $1 billion available, and should we expect the June quarter to return to the typical guidance of around $150 million to $250 million in activity?

Hi, Shawn. This is Mario. We still have about $1.3 billion of authorization, and just to remind you of what we talked about in the comments. Our strategy remains very much consistent with about returning approximately two-thirds to shareholders. Over the past 18 months, we have returned approximately $4.3 billion to our shareholders through buybacks and dividends.

Sure. I would say yes. We’re going to get back fairly to the lower end of the normal range in the next couple of quarters. We purchased $3 billion over the last nine months. We did make the Creganna acquisition, but we feel that the two-thirds, one-third split really works for us. We haven’t seen anything that changes our view from a strategic point of view that that’s the sensible capital allocation. We have experienced that we’re at the higher end of the two-thirds return to capital, and if we make any kind of sizable acquisition, we try to stay below that.

Okay, that’s helpful. And as a follow-up just on auto in general, maybe it’s a two-parter. Have you seen any impacts from the earthquake in Japan? I think Toyota was taking around a $0.5 billion customer hit, and if some 20 or 11 are correct. And then, just also what you think the impact of China stimulus is on the business this year, and how that might affect your business rolling into fiscal ‘17?

Hi, Shawn, it’s Terrence. Thanks for the question. I think first of all about Japan, regarding Toyota, you’re sizing that correctly. We’re monitoring our customer relationships given the earthquake in Japan. We have not seen any disruptions yet as part of the assumed normal patterns, but demand may be impacted in some timing a little bit. However, we’re talking to our customers constantly to ensure we’re helping them in any way we can through this. Regarding the China stimulus, I think that’s a more complex question. While we did see some recovery in our first quarter as China’s overall production improved, we don’t know whether the China stimulus accelerated some production or demand, but we do expect production long-term to stay in line with GDP growth from China.

Okay, thank you, Shawn. We have the next question please.

Yes, good morning, and thanks very much for taking the questions. The first one is a follow-up on the Q4 guidance, and you’ve talked about some of the top-down factors that you’re thinking about in terms of different end markets. Can you help us understand is there anything you’re getting from specific customer forecasts that are giving you a lot of visibility that Q4 is up sequentially from Q3? Anything kind of that normally four to six weeks out seems like it’s more top-down driven, but if you have a bottom-up reconciliation that gives you more confidence, that’ll be helpful.

We have a lot of customers, so there are many data points. I would say the biggest indicators are just the order flow coming in from the OEMs, and we do see that sequential growth in orders continuing. We’ve also seen quite positive feedback from channels and partners that reflect that they’re returning to positivity. I think it gives us confidence. Again, we’re not expecting a boom from Q3 to Q4. This time of year seems steadier than before, and there’s that extra week to consider. So there’s extra revenue from that which increases our EPS level. I mean, we’ll know a lot more at the end of Q3, but given what’s coming in now from our sales orders and customer commitments, our confidence is increasing.

No, I think you said it very well.

I appreciate the color. A follow-up question on the tax rate commentary, and kind of two parts. So I think 23% to 24% was the comment. What sort of effect should we expect from the potential settlement around the Tyco liabilities? Should we be looking for any other income line? And are there any changes there? And then, can you just clarify, does the long-term guidance of 23% to 24% include what you think the potential impact might be around earnings stripping regulation?

I think that what we talked about in the comments, our expectation from longer-term remains 23% to 24%; that does not include any additional regulations related to any potential impacts. We’re still looking at it, and regarding the second half, we do expect it to be slightly lower than the 23% to 24%, primarily driven around distribution profitability.

Okay, thank you, Mark. We have no further questions. So thank you very much for your time this morning. If you have more questions, please contact Investor Relations at TE. Have a great day.

Thank you everyone.

Thank you everyone.