TE Connectivity plc (TEL) — Q1 2019 Earnings Call Transcript

Good morning and thank you for joining our conference call to discuss TE Connectivity's first quarter results. With me today are Chief Executive Officer, Terrence Curtin, and Chief Financial Officer, Heath Mitts. During this call, we will be providing certain forward-looking information, and 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, and we ask you to review the sections of our press release and the accompanying slide presentation that address the use of these items. The press release and related tables, along with the slide presentation, can be found on the Investor Relations portion of our website at te.com. Note that all remarks on today's call will reflect TE continuing operations. We completed the sale of our SubCom business during our first quarter and it is reflected as discontinued operations and not included in our results or guidance. Finally, due to the increasing number of participants on the Q&A portion of today's call, we’re asking everyone to limit themselves to one question to make sure we can give everyone an opportunity to ask questions during the allotted time. We're willing to take follow-up questions, but ask that you rejoin the queue if you have a second question. Now let me turn the call over to Terrence for opening comments.

Thanks, Sujal, and thank you everyone for joining us today to cover our first quarter results and our revised outlook for 2019. Before I get into the slides, I’m going to provide an overview of the key messages in today's call. First off, I am very pleased with our results in our first quarter. We delivered revenues at the midpoint of our guidance and adjusted earnings per share at the high end of our guidance range in a market that continued to soften through the quarter. Our results reflected resiliency, as well as the diversity of our portfolio, with our Industrial and Communications segments offsetting lower than expected sales in Transportation. While our first quarter results demonstrated solid execution, softer market conditions are resulting in us having to reduce our outlook for the rest of our fiscal year. I want to stress that the change in our guidance versus our prior view is entirely due to market softness that we're experiencing. If you look at this change by region, it is primarily driven by China, along with a slower global auto production environment than we anticipated 90 days ago. We continue to be focused on content growth to outperform these slower markets, while we execute on other non-growth levers in our business model to drive improvements and profitability as we move through this year. And with this as a backdrop, let me tell you how we’re thinking about financial success in 2019. We have a portfolio with content growth opportunities that will allow us to outgrow, as well as partially buffer the weaker market conditions we're seeing. We remain committed to our long-term business model; we’ll pull the non-growth levers to improve margin and EPS, while ensuring we invest in long-term opportunities to drive future content growth. When we look at earnings power, we expect to demonstrate earnings per share performance in the second half of 2019 that is above our exit rate in fiscal 2018, while absorbing the FX headwinds we're experiencing and that we'll talk about in the call. Finally, we believe this success will position the company to be backed by the business model performance which we've demonstrated over the past two years when markets return to growth. With that as a backdrop, let me get into the slide and highlight the quarter on Slide 3. Sales during the first quarter were $3.35 billion, which was flat year-over-year on a reported basis and up 2% organically, driven by 5% growth in both our Industrial and Communication segments. In Transportation, our sales were flat organically with a slight decline in auto revenue being offset by growth in commercial transportation and sensors. Global auto production was down 7% in the first quarter, well below our guidance expectations. In auto, our sales were down only 1% on an organic basis compared to that 7% decline in production, demonstrating the resiliency of content growth in our auto business even in a tightly controlled production environment. In the quarter, we delivered 16.9% adjusted operating margins. Our revenue was down over $160 million sequentially as expected, and I'm pleased that we could maintain operating margins that were essentially flat from our 2018 exit rate on a much lower sales volume. Adjusted earnings per share was $1.29 in the quarter, which was at the high end of the guidance. From a free cash flow perspective, during the quarter we generated $69 million, which was in line with our expectations and similar to quarter one of last year. We returned $645 million to shareholders through dividends and share repurchases in the quarter. Let me turn from the first quarter and talk about our revised outlook. Back in October when we issued guidance for the year, we highlighted that we were entering a slower market environment. During the first quarter, our order trends were below our expectations, with weaker global auto production and lower order levels in China in our Transportation and Communication segments. Our overall orders in the first quarter were down 4% sequentially and on a year-over-year basis, total orders were down 6%, with China orders declining over 20%. Based upon these trends, we now expect fiscal year sales at the midpoint of $13.65 billion versus our prior guidance of $14.1 billion. This reduction is primarily driven by China, with some weakness in European auto as well. If you look at the change by segment, approximately two-thirds of the reduction is in Transportation, with the remainder primarily in Communications as both segments are being impacted by the weakness in China. In Transportation, we are now assuming that global auto production will decline by 4% to 5% in our fiscal year compared to our prior outlook of flat production. Our expectations for the industrial segment are consistent with our prior view, with ongoing strength experienced in the end markets specifically commercial, aerospace, defense, and medical. With this revised sales outlook, we are adjusting our earnings per share to now expect $5.45 at the midpoint, a reduction of $0.25 from our prior view. This change in our EPS guidance is entirely driven by the market change, and the headwind from currency exchange effects that we highlighted last quarter remains essentially unchanged at $375 million in sales and $0.16 on EPS. If you could please turn to Slide 4, let's look at order trends. As I mentioned earlier, orders were below our expectations. When we guided 90 days ago, we were expecting that our orders in quarter 1 would be similar to our quarter 4 levels at $3.5 billion. Instead, orders declined sequentially by 4%, and our book-to-bill in the quarter remained at 0.99. On a year-over-year basis, organic orders were down 4% driven by declines in China of 22%, along with declines in Europe of 6%, partially offset by growth in North America of 7%. By segment, you can see on the slide we continue to see strong industrial orders that support our growth outlook that is consistent with our prior view. However, as you can see in Transportation and Communications, the weakness we’ve experienced in orders primarily relates to China, and that's impacting our outlook. Let me get into things by segment. If you could turn to Slide 5, I will start with Transportation. Transportation sales were flat organically year-over-year. Our auto sales were down 1% organically versus auto production declines of 7% in our first fiscal quarter, and this was well below our production assumption. We did see growth in the Americas, which was offset by lower sales in China and Europe. China auto production was especially weak, declining 15% year-over-year, much worse than we expected. Even in this weaker environment, the 7% decline in auto production allowing our results to outperform production. In commercial transportation, we have been expecting growth to moderate from the strengths we've had in previous years. During the quarter we grew 2% organically versus markets that declined 7%, driven by China, and our growth continues to be driven by content and share gains. In our sensors business, we grew 4% organically year-over-year, with growth driven by industrial applications, and in auto sensors we continue to increase our design win value across a broad spectrum of sensor technologies and applications. Adjusted operating margins for the segment were 17.9%, essentially flat sequentially as we expected. In 2018, as we discussed, we increased investments to support a strong pipeline and new design wins including those in electric vehicle and autonomous driving applications. With production falling considerably in both China and Europe, we are continuing to balance near-term margin performance with long-term growth opportunities and while we're currently running below our target margin levels in this segment, we expect that cost actions we will be taking will enable us to return margins back to target levels. Let me turn over to Industrial Solutions and that's on Slide 6. Industrial segment sales grew 5% organically year-over-year as expected with growth across aerospace, defense, and in our energy business. Aerospace, defense and marine business delivered strong 13% organic growth, with double-digit growth across each of its businesses. In commercial aerospace, growth was driven by content expansion and share gains, and in defense over the past year, we've seen good growth driven by favorable market conditions, as well as some new product cycles. In industrial equipment, our sales were down 1% organically, with strength in medical offset by the expected deceleration in factory automation. Lastly, our energy business grew 6% on an organic basis driven by growth in North America. Adjusted operating margins for the segments expanded 60 basis points to 14.9%, in line with our expectations. Our plans continue to remain on track to optimize our factory footprint in the industrial segment, aiming to expand the adjusted operating margins to the high teens over time. Please turn to Slide 7 as I’ll get into our Communications segment. Communications grew 5% organically as expected, with strong growth in data devices being partially offset by weakness in appliances. Data and devices grew 9% organically, driven by high-speed connectivity and data center applications. Our appliance business was down 2% organically due to weakness across Asia, partially offset by growth in North America. Adjusted operating margin for the segment was 16.4%, in line with our expectations. Before I get into guidance in more detail, I'm going to turn it over to Heath to get into more details on the financials in the first quarter.

Thank you, Terrence, and good morning, everyone. Please turn to Slide 8, where I’ll provide more details on the Q1 financials. Adjusted operating income was $565 million with an adjusted operating margin of 16.9%. GAAP operating income was $484 million and included $75 million of restructuring and other charges, and $6 million of acquisition charges. As a result of market weakness, we are broadening the scope of our cost initiatives across our business and accelerating cost reduction and factory footprint consolidation plans. You should expect us to aggressively pursue incremental restructuring to reduce our fixed cost structure, while balancing the investment opportunities that enable future growth. We're confident that with these initiatives, we expect to exit the year with a more nimble cost structure, which will enable future margin expansion and earnings growth. We're currently working through these restructuring options and we'll update our estimates as the year progresses. Adjusted EPS was $1.29 at the high end of our guidance range and included $0.05 of headwinds from currency and tax rates. GAAP EPS was $0.11 for the quarter, again including restructuring and other charges of $0.16 and acquisition-related charges of $0.01. The adjusted effective tax rate in Q1 was 18.1%. Looking ahead, we do expect a slight decline in our tax rate in Q2. For the year, we expect the full-year adjusted effective tax rate to be in the 18% to 19% range. If you turn to Slide 9, sales of $3.35 billion were flat year-over-year on a reported basis and up 2% organically. Currency exchange rates negatively impacted sales by $73 million versus the prior year. We expect the full-year impact of currency exchange rates to be $375 million, consistent with our prior view. Adjusted operating margins were flat sequentially as expected at 16.9%. And as Terrence mentioned earlier, I'm pleased that we could hold operating margins flat in the fourth quarter with over $160 million of sequential revenue decline. We do expect Q2 margins to modestly drop from Q1 levels as we adjust our operations to the lower outlook. In the quarter, cash for continuing operations was $328 million, that's up 16% year-over-year with free cash flows nearly $70 million, which is in line with our typical seasonality with $209 million of net CapEx. We returned $645 million to shareholders through dividends and share repurchases in the quarter, including the return of proceeds from the sale of our SubCom business that we completed last quarter. As I’ve told you in the past, our balance sheet is healthy, and we expect cash flow to be strong, which provides us the ability to provide organic growth investments to drive long-term sustainable growth, allowing us to return capital to shareholders while still pursuing bolt-on acquisitions. With that, I will turn the call back over to Terrence to cover guidance.

Thanks, Heath. And let me start with the second quarter on Slide 10 and build on some of the things he said. With the slower market conditions we're experiencing, we do expect quarter two revenues and adjusted earnings per share to be roughly flat with quarter one, certainly building on the orders chart I talked about earlier. Second quarter revenue is expected to be $3.3 billion to $3.4 billion with adjusted earnings per share of $1.25 to $1.29 for the quarter. At the midpoint, this represents year-on-year reported and organic sales declines of 6% and 2%, respectively. Given the ongoing strength of the U.S. dollar, we do expect year-over-year currency exchange headwinds of approximately $155 million on the top line and $0.06 to EPS in the second quarter. By segment, we expect Transportation Solutions to be down low single-digits organically. Auto revenue is expected to be down mid-digits organically versus a global decline in auto production of 9%, driven by weakness in both China and Europe. Once again, our top line will outperform versus auto production, showcasing the benefit we derive from content. Industrial solutions are expected to grow low-single digits organically with growth in aerospace, defense and medical applications being partially offset by softness in factory automation applications. We expect the communication segment to be down mid-single digits organically, driven by Asia. If you could please turn to Slide 11, I'll get into more details on the full-year guidance for fiscal 2019. Building on my earlier comments around market and order trends, we expect full-year revenue of $13.45 billion to $13.85 billion. This represents flat sales organically and a reported sales decline of 2% due to foreign currency exchange headwinds of $375 million, which is consistent with our prior view. Adjusted earnings per share is expected to be in the range of $5.35 to $5.55 per share. This guide includes a $0.25 negative impact from both currency exchange rates as well as tax. Excluding these headwinds, adjusted earnings per share would be growing low-single digits at midpoint and a flat organic sales top line. Now let me go through our segments for the full-year. We expect our Transportation Solution segment to be flat organically. We also expect auto sales to be flat organically with content growth enabling outperformance to offset a 4% decline in global auto production. Global auto production is now expected to be down 4%. We expect auto production in China to be down 10% in our fiscal year, Europe to be down mid-single digits, and North America to remain roughly flat. This reflects our assumption that global production and units will remain around quarter one production levels, about 22 million vehicles per quarter. We also expect continued growth in sensors for both industrial and auto applications driven by the ramp of the new auto design wins we've discussed. In Industrial Solutions, our outlook is unchanged from our prior view. We expect sales to be up low-single digits organically with growth driven by aerospace, defense and medical applications, with our 6% order growth in the first quarter supporting this unchanged outlook. In Communications, we expect to be down low-single digits organically, driven by Asia markets in both data and devices, as well as an appliance. As we go to questions, let me summarize some of the key takeaways. In the first quarter, you saw the positive impact of our diverse portfolio with revenue and EPS in line with guidance despite a soft market. Our revised 2019 guidance is driven entirely by weaker markets, primarily in China, and with some weakness in European auto, with approximately two-thirds of the reduction in Transportation and the remaining in Communications. We remain committed to our long-term business model, pulling the non-growth levers to respond to market conditions. In the past, we've taken advantage of weaker markets to aggressively pursue cost reductions and consolidation activities, and we plan to follow that approach to emerge stronger when markets return to growth. We anticipate demonstrating earnings per share performance in our second half that exceeds our exit rate in fiscal 2018, even with our revised sales outlook. Focused on ensuring the company can revert to business model performance when markets bounce back. Lastly, before closing, I want to thank our employees across the world for their execution in the first quarter and their dedication to TE, our customers, and a future that is safer, sustainable, productive, and connected. With that, Sujal, let’s open the floor for questions.

Thank you, Terrence. Craig, could you please give the instructions for the Q&A session?

Just a quick one on Transportation Solutions in autos. If we look at your global vehicle production assumption for the full year, as you sit down 4 to 5, it seems like it’s in line where most are expecting given the recent downturn in China and maybe your September fiscal year-end. How should we think about the regional cadence you're building into the back half of the year? More importantly, has the softer macro changed your customers' approach to electrification and connectivity and the related orders you're seeing there?

Let's take it - I’ll start with the second piece and then I'll get into the regional if that's okay. Thanks for your question, David. First of all, when it comes to electrification and autonomy or connected vehicle, nothing has changed. The amount of car rates we're experiencing and it's one of the things we will balance with the softer environment to ensure we capitalize on these trends. You also see the benefit of these trends even in our first quarter, where our sales were down in a much worse production environment. You're going to continue to see that content growth even in this weaker period where we outperformed production. Now regarding your first part, production is slower than we expected. We guided to what we thought was a flat environment. We thought relatively flat in Asia, relatively flat in North America, and slightly down in Europe. Clearly, car sales in China were weak in the first quarter, and production was adjusted. We now expect China production to be down 10% this year, Europe to be slightly worse than our prior guidance—more mid-single digits down—versus slightly down that we set before. North America is remaining as expected. We actually see production staying constant throughout the year, around 22 million units per quarter. If you consider our discussions, just remember anything we talk about auto production is on our fiscal year basis, which differs from how others talk about it.

Terrence, it looks like even in a 5% production decline environment, you're able to show auto revenues flat organically. Your fiscal 2019 guide implies a 4% to 5% content growth here. Can you talk about what you're seeing within the pipeline that suggests that customers might not be mixing down, or is this assuming that customers do mix down and that's why the content guidance is at 4% to 5%? And just to clarify, Heath, can you talk about the magnitude of that restructuring charge that you are taking and which areas of the segment that will impact since you are already doing some restructuring on industrial?

Sure. Wamsi, thanks for the question. First, let’s revisit how we define content growth. It's been in the 4% to 6% range, and we've had a constructive production environment. We've actually overachieved that 4% to 6% over the past couple of years. There will be some lower value vehicles incorporated, and that's why you see our guidance gravitating towards the lower end of the content growth. On a quarter-by-quarter basis, as supply chains adjust to a slower environment, you may see some separation. Long-term, I believe we will continue to be in the 4% to 6% range. And we see ongoing growth in trends, especially regarding autonomy and electric vehicles, regardless of market fluctuations. I'd also like to note that product cycles and launches usually occur later in our year, which is anticipated in our guidance. Now let me turn it over to Heath.

Wamsi, that's a good question on restructuring. As you mentioned, we had already factored some restructuring into our previous guidance, particularly related to the footprint consolidation opportunities within our industrial segment. We're broadening that now across our other segments, partly because of volume-driven factors and partly taking advantage of a weaker revenue environment to pursue opportunities that we didn't act upon when growth was stronger. In addition, the sale of the SubCom business resulted in submitted costs, which we're addressing. I can't quantify the magnitude yet as we're still finalizing details, but we’ll update you as the quarter progresses.

Just had a question about how much you think you've been able to ring fence or de-risk expectations here. Does it feel stable at a weaker run rate, or is the market still searching for what the lower levels might look like?

I would say order rates are stabilizing around this book-to-bill ratio. Other than China, which was meaningfully weaker in our first quarter, the rest of our market feels stable at a lower rate. Our guidance change was necessary, as we expected orders to stay around $3.5 billion in our first quarter, and we've adjusted based on China's performance. Our early January order rates seem stable at a lower rate. We must continue to focus on the factors within our control.

Terrence, just a question on the broad-based weakness in China which has been evident across the supply chain. Given that your end markets are clearly slowing, are you seeing any inventory management from customers and distributors in response to weaker demand? Where do you think they are in terms of managing their inventory?

In China, our orders were down 22% and auto was weak, leading to supply chain adjustments. Plant adjustments and production reductions are a normal occurrence, and we expect supply chain corrections for the next three to six months. However, in healthy markets like North America, we see no contraction. China's contraction appears to be a localized situation.

When I think about your orders in Asia since the middle of last year, it's gone from rising high-single digits to now down pretty heavily. Since last year, there have been escalating trade tensions and China's underlying economy has slowed. Have you thought about how quickly your business in Asia could recover with a trade resolution or more aggressive fiscal stimulus?

I believe discussing trade resolution is beyond my scope concretely. However, we would prefer a stable environment conducive to growth. We aren't including anticipated stimulus in our guidance, and we're preparing based on current conditions.

A question specifically for Heath on capital return and buyback. The buyback was greater than expected in the first quarter. Some might argue you are under-levered right now. If this is going to be a bottom for your business, will you become more aggressive with buybacks this year? Is there a target number and is that already in the guidance?

First of all, you're right that we've returned $645 million in the quarter, with around $500 million of that being through buyback, partly derived from SubCom proceeds. Our typical practice is using about a third of our free cash flow for buybacks. We expect that to be around $600 million. Overall, this gives a potential total of $900 million based on SubCom proceeds. We'll remain flexible about capital deployment, but I can confirm our guidance assumes the typical return of capital alongside the restructuring implications.

I noted the strength in the data and devices segments, particularly benefiting from data center trends. How significant is this segment exposure to specific data centers? And are you expecting weakness primarily in Asia for data and devices?

The competitiveness of our data and devices segments depends on high-speed connectivity. We've reinforced our positioning in the segment recently, and hyperscale trends are maintaining growth. However, we observed some order conservatism toward the latter part of the quarter. Still, our growth remains strong compared to broad weaknesses in Asia within the segment.

Quick one. Regarding China auto—was the 15% decline orderly? OEMs must have varying strategies to gain market share during this downturn. What are you observing in that context? Additionally, as markets recover, do you anticipate a shift in competitive dynamics favoring local producers?

For our automotive business, we continue to gain share while adjusting our cost base. We’re executing all efforts to capture market interest with our extensive coverage across the 50 OEMs in China. Concurrently, we aim to cement our position with our key competitors while making strategic investments. I believe this environment will ultimately benefit our positioning long-term.

My question pertains to inventories. You seem to have built some inventories during the quarter amid declines. Can you discuss your balance sheet strategy going forward and how this impacted the recent quarter? Additionally, are you witnessing any unusual activity regarding inventory management?

Due to the severity of the slowdown, we’ve seen pressure to increase our inventories in specific areas. Adaptability is in our model, allowing us to reduce inventory levels quickly as we align our revenue and cost structure. I don’t foresee any systemic issues here. You may see some inventory fluctuations if we have facility consolidations in our industrial segment. However, we're managing that, and any increases should drop significantly as we progress.

Regarding your operating margin guidance, if I'm correct, you are projecting margins to increase by 50 to 80 basis points in the back half of the year compared to the first half. What is driving this improvement? I understand you don't want to specify restructuring impacts, but historically these reductions have required more than 12 months to materialize.

When thinking about first half to second half, seasonality plays a part, introducing some natural leverage. We've had restructuring initiatives underway that will positively impact our margins in the second half. You will certainly see the benefits from our industrial segment as well as additional restructuring related to the SubCom divestiture expenses. That said, some of our current restructuring will pave the way for future profitability but will take longer to manifest.

In terms of margin protection during the downside, does your guidance assume that auto margins will reach 20% in the second half, particularly since there are mixed signals in the auto sector in Q1? Additionally, will the SG&A improvements and industrial sales ramp remain on track or be delayed?

It's correct that our Transportation margin is currently around 18%, which is below our target for the segment. We expect sequential improvements in margins as we navigate our cost actions properly. However, we aim to return closer to the 20% target by the end of this fiscal year. For the Industrial segment, we expect margins to remain steady or slightly improve through current initiatives. A more sizable step function in improvement will arrive in subsequent fiscal years.

The weakness in China is well-understood. However, the guidance for industrial appears better than expected. Can you clarify what is propelling this outlook amidst the current environment? Are we discussing aerospace defense contributing or any new programs or technologies coming into play?

Certainly, our Industrial segment is a bit insulated from China's slowdown due to its heavier weighting toward Europe and North America. Our orders show strong segments there and are above 1 in book-to-bill. Aerospace and defense are robust markets for us, both experiencing substantial growth. Our industrial equipment will face challenges, but the growth in our medical business is compensating very well against that.

I have one question regarding your comment about expecting to improve as you exit the year. Was that in reference to operating margins, individual segments, or earnings per share overall?

Jim, I made that comment regarding the total company. We have different levers affecting each segment, but we're expecting overall earnings per share performance to improve as we compare year-over-year.

I have a question regarding your auto guidance. While you're projecting declines in both North America and Asia, shouldn't we expect improving year-over-year comparisons due to the WLTP testing impact in Europe? Can you share your view on the relationship between Europe and exporting into Asia?

The WLTP testing is indeed affecting some of our operations, particularly in Europe. Our outlook factors in extended customer shutdowns affecting vehicle production, which will have an incremental decline in that sector. The production normalization we see in Europe should align more traditionally; auto production typically strengthens in our third fiscal quarter before a slight decrease in the fourth. We expect Europe to slightly improve in the latter half due to improving conditions.

Regarding cash flow dynamics, can you provide insight on your CapEx outlook and how you foresee working capital impacting cash this year?

Our CapEx is expected to be around $850 million for this year. We will likely reduce that given slowing activities. Most of our CapEx is tied to customer programs and remains a priority. You should expect working capital to not be a cash source this year. Inventory and receivables will naturally decline, but we will bolster payables through robust improvement programs.

Regarding aerospace and defense, which performed well this quarter, have there been any changes in program wins or order rates due to the U.S. government shutdown?

Our design work continues to move forward, and we're maintaining steady progress with our prime contractors in that space despite any shutdowns.

Can you discuss the growth trajectories for the sensors side and how you think this impacts transportation margins?

While the sensor business may face headwinds from global macros, the new auto design wins as we progress through the year are expected to support growth and have a favorable impact on margins as production increases.

Could you clarify the updated tax rate assumption and the free cash flow conversion rate?

The expected effective tax rate for the year is between 18% and 19%, down modestly from our original guidance. We also anticipate a free cash flow conversion rate in the 80% to 90% range this year.

Does your new guidance include more cost savings compared to your prior plan or is that help expected mainly in fiscal 2020?

Yes, there are additional restructuring measures that we expect to benefit from in the back half, contributing to our adjusted EPS despite lower revenue growth. Part of our strategy involves addressing the cost structure aggressively in these periods of financial slowdown.

In light of your customers' responses to geopolitical factors, how would you estimate the impact of potential increases in tariffs on your demand outlook?

Given our extensive customer base, perspectives can significantly differ based on location and context. Many customers are adjusting strategies in light of tariff implications, which is leading to more conservative outlooks. We remain alert to these dynamics.

Thank you, Will. It appears there are no further questions. If you have additional inquiries, please reach out to Investor Relations at TE. Thank you for joining us this morning, and have a nice day.