TE Connectivity plc (TEL) — Q3 2019 Earnings Call Transcript

Good morning, and thank you for joining our conference call to discuss TE Connectivity's third 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. Due to the large 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 are 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.

Thank you, Sujal. And also I appreciate everyone joining us today as we go through our third quarter results and our revised outlook for 2019. Now, before I get into the slides, let me frame out a few key points that we’re going to talk about in today’s call. First off, I’m very pleased with our execution in the third quarter. We delivered adjusted earnings per share $0.07 above the midpoint of guidance, despite sales being $60 million below the midpoint, in what continues to be an uncertain market backdrop that weakened since our call with you just 90 days ago. Despite this weaker market backdrop, I want to stress that we continue to be focused on executing our strategy, and the multiple leverage in our business model. And as we’ve been sharing with you and started at our Investor Day, there is three areas of key focus within our business model, which include top-line growth, number one; secondly, margin expansion; and thirdly, capital deployment. And when we think about these three areas, and starting with the growth one, growth is around positioning our portfolio in markets with long-term secular trends that enable organic outperformance from content growth through the cycle, as well as expansion of our portfolio inorganically. When we think about the second lever of margin, it is looking at structural cost improvement through both footprint rationalization, as well as selling, general and administrative expense initiatives that give us scale advantage. And on the third, when we think about capital deployment, it starts with our strong cash flow generation model, and how we balance the capital return, as well as expanding our portfolio that I think we've been pretty clear on in our experience that you've had with us, it has been pretty consistent. When we think about this year, and really driven by the market environment backdrop, the organic growth lever has been challenged after two years where it was the key pillar of our performance. And in 2019, we have been focused on executing on the other levers to protect margin and earnings performance. Now, as we look forward, we are reducing our full-year guidance for both sales and adjusted earnings per share due entirely to the incremental market weakness that we're experiencing. During last quarter’s earnings announcement, we indicated that we were seeing stabilization in key end markets, and that was reflected by sequential order growth that we were experiencing. Now, since that time, we have seen this trend reverse and have seen a sequential decline in orders. Order patterns, when you take it into the two big buckets of this decline, the first one is a further drop in auto production in China and then, the second is broad inventory destocking of electronic components in the distribution channel. And both of these are really why we've adjusted our outlook. The other thing that I want to stress before I get into slides is that, the proof on the execution against our leverage is our model in this challenging market. It’s really illustrated not only by our third quarter performance where we grew earnings per share on a sales decline, but also the change in our guidance since the start of the year. Our original fiscal year guidance last November was for sales of $14.1 billion and adjusted earnings per share $5.70. Our current guide is for sales of $13.4 billion and adjusted earnings per share $5.50. Current guidance represents a $700 million drop in sales but only a $0.20 drop in adjusted earnings per share versus our guidance at the start of the year. And what I would tell you, I think this is proof of execution versus the levers in our model, as well as the improvement we've made in this portfolio to enable margin and earnings resiliency through a cycle. So, let me now get into the slides, and Heath and I'll go through them and get into more details. And let's start with slide three. And I'll review the highlights in the quarter. From a top-line perspective, sales were $3.4 billion, and this was down 5% year-over-year on a reported basis and down 3% organically. The difference between reported and organic is primarily due to a headwind of approximately $125 million, which is due to currency translation. In our Transportation segment, our sales were down 4% organically due to a greater than expected decline in auto production that was at 10% globally, and this was driven by China. Our Industrial segment grew 2% organically, in line with our guidance, driven by strong performance and growth in our commercial aerospace, defense and medical markets. And our Communication segment declined 11% on an organic basis, which was lower than we expected, due to inventory destocking in the distribution channel. From an earnings perspective, our third quarter adjusted operating margins were 17.6%, up 20 basis points year-over-year, as well as up 60 basis points sequentially. This is really due to our team’s execution of the cost lever, as I mentioned earlier. And operating margins are up both year-over-year and sequentially, despite revenue declines. From an earnings per share perspective, our adjusted earnings per share was $1.50 and exceeded the high end of the guidance, despite the lower sales and was driven by the strong operational execution that I mentioned. In addition to the earnings, our strong cash generation is key enabler of our business model. And our free cash flow was $515 million in the third quarter. Year-to-date, our free cash flow is $928 million and is up approximately 27% versus the prior year. During the quarter, we returned $307 million to shareholders through buybacks and dividends. And in addition to return of capital, our capital deployment strategy continues to include building out our portfolio inorganically to further capitalize on the secular trends to drive future growth. In the quarter, we completed bolt-on acquisitions of the Kissling Group that will benefit our commercial transportation business as well as Alpha Technics, a provider of temperature sensing technology into the medical market. In addition, we also announced our intent to acquire First Sensor, which is a German public sensor company that serves auto, industrial and medical markets, and just how that process works that will be further out and won’t close immediately. So, now, let me talk more about the change in guidance. And as I mentioned earlier, it’s based solely upon the weaker market conditions. And we’re reducing the full sales outlook by $250 million to $13.4 billion, and the midpoint of adjusted earnings per share guidance by $0.10 to $5.50. Of the $250 million reduction from our prior view, approximately two-thirds is in transportation, which is primarily driven by China auto and approximately one-third is in communications, which is primarily driven by lower demand in the distribution channel, as a result of destocking by our partners. As a result of market conditions, we are also further increasing the scope of our restructuring to $375 million this year, which is an increase of $125 million for our prior view, and Heath will get into more details later. So, I appreciate if you could turn to slide four and let me get into the order trends by our segments. In the third quarter, our organic orders were down 10% year-over-year, 4% sequentially, reflecting end markets and inventory trends that I mentioned. Our book to bill was 0.98 and our orders declined in each region and in each segment. By segment, Transportation was down 10% organically year-over-year, reflecting further declines in auto production, primarily in China. The sequential order increases we saw in China in the second quarter reversed in the third quarter as both auto sales and production figures weakened further. By region, we saw year-over-year declines in the double digits in China as well as in Europe and mid single-digit decline in the Americas. In the Industrial segment, industrial orders were down 5% organically, driven by industrial equipment, partially offset by growth in aerospace and defense, as well as in energy. I do want to highlight that in our Industrial Equipment business, it does have a high ratio of sales to the distribution channel. In our Communications segment, orders were down 17% organically year-over-year, driven by broad-based weaknesses across all regions. So, let me talk a little bit about what we're seeing in the distribution channel. And as I mentioned earlier, we are being impacted by destocking by our partners. Now, at the total TE level, this fiscal year, approximately 20% of our sales are through our distribution partners. And we have higher levels of concentration in the Industrial and Communications segments. We've seen a large reduction in orders by our distributors as a result of broader inventory trends that go beyond our products, and it goes into other component areas. Based on the order patterns, we are expecting a substantial reduction in distribution revenue in our fourth quarter, which we have reflected in our guidance. So, please turn to slide five and I'll discuss our segment results in the quarter. And as always, I'll start with Transportation. Transportation sales were down 4% organically year-over-year. Our auto sales were down 4% organically versus auto production declines of 10% in the quarter that I mentioned earlier. Our outperformance versus auto production continues to be driven by content growth from the secular trends we’ve positioned around, including electric vehicles and increased autonomous features. For the full year, we continue to expect content growth to partially buffer auto production declines, consistent with the content growth targets we've laid out for you. In commercial transportation, sales were down 5% organically, reflecting broad market weakness, both across markets and regions. And our sensors business grew 1% organically year-on-year with growth driven by industrial applications. From an earnings perspective for the segment, adjusted operating margins were 18.6%, and they grew 110 basis points sequentially, as a result of the accelerated costs actions we’ve talked to you about. In light of market conditions, we expect to take additional cost actions, which is reflected in the increased restructuring charges I mentioned earlier. So, please turn to slide six, and I'll discuss our Industrial Solutions segment. The segment sales grew 2% organically year-over-year, in line with our expectations with growth in aerospace, defense and medical really being the growth drivers. Our aerospace, defense and marine business delivered a very strong quarter of 17% organic growth, driven by both, new program ramps and commercial aerospace, as well as the defense side. In industrial equipment, sales were down 6% organically, driven by inventory destocking, partially offset by strength in medical applications. Also, our energy business was flat on an organic basis with growth in North America offsetting declines in Europe. From an earnings perspective, Industrial Solutions’ adjusted operating margins expanded 220 basis points over the prior year to 16.6%, driven by strong operational execution by our team. I am pleased that we can still generate strong performance in this quarter, despite a challenging market environment. And our plans remain on track to expand adjusted operating margins into the high teens over time for this segment. So, let me turn to Communications Solutions and flip to page seven, please. Communications sales were down 11% organically, well below our expectations, and it goes back to what I talked about earlier. This segment has the highest percentage of business going through the distribution channel. So, there is a greater impact from inventory destocking in this segment. Adjusted operating margins were 14.9%, they declined 70 basis points over the prior year due to volume. So, with that, I will turn it over to Heath to cover the financials for quarter three, and I will come back and cover guidance.

Thank you, Terrence, and good morning, everyone. Please turn to slide eight, where I’ll provide more details on the Q3 financials. Adjusted operating income was $596 million with an adjusted operating margin of 17.6%. GAAP operating income was $520 million and included $67 million of restructuring and other charges and $9 million of acquisition charges. Last quarter, we mentioned that we were broadening the scope of our cost initiatives to better align the cost structure of the organization with the market environment. Given the market conditions, we are taking further advantage of the current low in demands to reduce our fixed costs and better align our footprint with our customer supply chain. Hence, we are increasing our estimate of restructuring charges to $375 million for the full year. This represents an increase of $125 million versus our prior view. The additional actions are primarily in our Transportation and Communication segments. And I’m confident that the initiatives we've taken so far this year have enabled margin and EPS resiliency, despite weaker markets. We are now further accelerating cost actions to ensure that we can preserve margin and EPS performance during this part of the cycle. As we have shown in the past, this will enable us to realize improved margin as demand returns. Adjusted EPS was $1.50, up 6% year-over-year. We were able to grow adjusted EPS year-over-year, despite a reduction of revenue, which demonstrates our ability to execute on multiple levers to drive earnings performance. GAAP EPS was $2.24 for the quarter and included a $0.91 tax benefit, primarily related to Swiss tax reform. This benefit was partially offset by restructuring, acquisitions and other charges of $0.17. The adjusted effective tax rate in Q3 was 13.6%; and for the full-year, we expect the adjusted effective tax rate to be roughly 16.5%. Swiss tax reform resulted in one-time tax benefit in Q3 but increases our effective tax rate going forward. So, you should continue to expect the tax for TE to be in the high teens as we move beyond this year. However, importantly, we expect our cash tax rate to stay well below our reported ETR. Now, if I can get you to turn to slide nine. Sales of $3.4 billion were down 5% year-over-year on a reported basis and down 3% organically. Currency exchange rates negatively impacted sales by $123 million versus the prior year. Adjusted operating margins were 17.6%. And our strong margin performance despite lower sales is a result of the benefits we're seeing from proactive cost actions we initiated earlier this year, as well as the progress we've made in profitability across all the segments, particularly the Industrial segment. In the quarter, cash from continuing operations was $692 million and our free cash flows was $515 million with $166 million of net capital expenditures. We returned $307 million to shareholders through dividend and share repurchases in the quarter. And year-to-date 2019 free cash flow is $928 million, which is an increase of 27% versus the prior year. We expect that our free cash flow will exceed the prior year, even with the increased level of restructuring investment related to our cost initiatives, so powerful story there. Our balance sheet is healthy, and we expect cash flow to remain strong, which provides us the flexibility to utilize cash for organic growth investments to drive long-term sustainable growth while also allowing us to return capital to shareholders and continue to pursue bolt-on acquisitions. I'm pleased with our team reacting quickly to pull the levers in our business model earlier in the year to help mitigate the impacts of weaker sales on our margin and EPS performance. But as you should expect, we will continue to balance our structural cost actions with our long-term growth investments to ensure sustainability of our business model going forward. So, with that, I'll turn it back over to Terrence to cover guidance before we get into questions.

Thanks, Heath. And, let me get into guidance, and I'll start with the fourth quarter, which is on slide 10. Now, based on what we laid out and we’re seeing in the markets and the order trends, fourth quarter revenue is expected to be $3.2 billion to $3.3 billion with adjusted earnings per share of $1.27 to $1.33. At the midpoint, this represents lower year-over-year reported and organic sales of 7%. Even with the sales decline, we’re only expecting year-over-year reduction of $0.05 in adjusted EPS on $250 million of lower revenue, which is evidence of the multiple levers we're pulling in our business model, including the accelerated cost actions Heath just talked about. Looking at it by segments, we expect Transportation Solutions to be down mid single digits organically. And this is based upon a global auto production environment, which we expect to be down 6% in the quarter with our revenue being impacted by supply chain adjustments, in light of further weakening in production trends. In Industrial Solutions, we expect to be down low single digits organically with declines in industrial equipment from the inventory destocking being partially offset by growth momentum in aerospace and defense and medical applications. And in Communications, we expect to be down approximately in the high teens, as the inventory destocking, we've mentioned, works its way through and it will impact that segment more than the others. Now, turn to slide 11, I'll get into the full year guidance for ‘19. For the full year, we expect sales in the range of $13.35 billion to $13.45 billion. As I mentioned earlier, this is a reduction of $250 million from our prior view, due to lower auto production driven by China and inventory destocking in the distribution channel. Our guidance represents declines of 2% on an organic basis and 4% on a reported basis with currency translation headwinds of $400 million on a full year basis. Adjusted earnings per share is expected to be in the range of $5.47 to $5.53. And this is a $0.10 reduction from our prior view. On a year-over-year basis, we are expecting adjusted EPS to be up low single digits excluding currency exchange headwinds of $0.16. Similar to quarter four, let me get into some color on the segments for the full year guide. We expect Transportation Solutions to be down low single digits organically. And we now expect global auto production to be down approximately 7% versus our prior view of being down 5% with the reduction primarily driven by China, and certainly this is all on our fiscal period. Year-to-date today, our revenue growth has exceeded auto production by the content growth range that we told you that in the range of 4% to 6%. So, our content position is very strong. In Industrial Solutions, we continue to expect sales to be up low single digits organically with growth driven by aerospace, defense as well as medical applications. And lastly, in Communications, we do expect to be down high single digits organically, driven by the Asia market weakness that we've been talking about before this quarter as well as the inventory destocking in the distribution channel that we’re seeing impacting us here late in the year. So, with that, before we go into questions, let me just recap some key takeaways that I thought we convey during the call. First, we’ve seen weakening in the market since the last call, and this is driving the reduction in our guidance. It’s driven by two main areas, drop in auto production in China, as well as what we are experiencing through our distribution partners as they are destocking their inventories. Secondly, we have positioned TE to benefit from secular trends such as electric vehicles, autonomous driving, next-generation airframes as well as interventional medical applications and cloud infrastructure growth, which are enabling us to outperform weaker markets. Thirdly, despite this market backdrop, we are successfully executing on our strategy, driving the multiple levers that we have in our business model to protect our margin and earnings performance through the cycle. And lastly, goes without saying, I think we’ve proven this; when we've seen markets that were weaker in the past, we're going to take advantage of these lows as an opportunity to aggressively go after cost reduction and footprint consolidation activities, and we're following the same approach and expect to emerge with increased earnings power when these markets return to growth. So, before I close, I do want to also thank our employees across the world for their execution in quarter three and what continues to be a mixed market backdrop and as well as their commitment to our customers and a future that is safer, sustainable, productive and connected. So, with that, Sujal, let's open it up for questions.

All right. Thank you, Lisa, can you please give the instructions for the Q&A session?

Yes. Thank you. Question to Terrence, just given the backdrop that we’re in, just wanted to get your thoughts, kind of as you manage internally, you have a number of restructuring programs going on, but also externally you are still looking to kind of pursue and execute on M&A. And then, how you kind of balance those things in what's kind of a difficult cycle?

I think there are a couple of important points to consider. First, we are fortunate to have a strong cash generation model, as demonstrated by the free cash flow we generated. As we navigate both the restructuring internally and returning capital to shareholders, I believe these efforts are not mutually exclusive. Our portfolio positioning has been effective, especially given the trends in content and the automotive sector, which has faced challenges like production declines and setbacks in China last quarter. When we examine our platforms in sensors and medical, as well as opportunities in areas like Kissling, we are focused on electric solutions and exploring high power and commercial transportation. We will continue to seek M&A opportunities that align with our strong market position. Additionally, I'm pleased with the steps we've taken to address our cost structure earlier this year, which has become especially relevant as auto production has worsened. We've proactively taken measures to reduce costs during this downturn. As we expand our operations, particularly in Communications, we are also considering opportunities for higher volumes that we hadn't previously leveraged. Furthermore, it's worth noting the adjustments we've made in the market, particularly in our Industrial segment, which continues to show improved performance and contributes positively. While not all investments have yielded returns yet, they offer potential for future leverage as we refine our fixed cost structure and enhance our agility. I believe we will continue to strike a balance between these efforts, and this quarter exemplifies that well.

I wanted to explore some of the challenges you're facing in the channel. It appears these are affecting you a bit later than others. Can you help me understand how your business operates differently in that channel compared to others? Additionally, as you navigate these corrections, how long does it take for your products to adjust? Thank you.

Okay. David, I'm not sure which products you are referring to. When considering our $13.4 billion in revenue, just over $2 billion comes from channel partners. This mainly involves medium to small customers that we cannot serve directly, so we rely on our channel partners for that. Our transportation business operates quite directly, meaning the channel impact is minimal in that segment. In markets with a more fragmented customer base, such as our industrial equipment and communications segments, we see more impact. Our business through channel partners has remained stable at around $500 million per quarter over the past six quarters. However, in the most recent quarter and the one in June, we saw a decline that we expect to continue. Some of this aligns with the overall market slowdown, and it appears some channel partners may have over-prepared in terms of supply due to lead times in certain product categories. These supply chain adjustments are currently a challenge but usually take four to six months to resolve. We believe these effects are temporary, and while we are currently experiencing them, they should become a tailwind in the future as the situation normalizes. We expect to begin seeing this improvement in orders starting from the third quarter, and it will be with us for a while before it eventually corrects.

The auto sector in terms of the step-down here, particularly lead by China, are there any leading indicators that you’re looking to track the inventory, the other factors within China or globally that will tell you we’ve reached the bottom? And I’m now looking for you to guide the December quarter but just to speak about it in some sense of whether we could reach the bottom in the December quarter, and calendar ‘20 could represent a more positive environment.

Sure. So, as everybody heard us talk last quarter, we sort of knew we were getting the stabilization in auto production. And I think I’ve been said on this call or at some conversations, at conferences, we sort of thought we were running around 22 million units of cars being produced per quarter and we thought we were stabilizing. And to the comments I made on the call, what we actually saw in sort of after our earnings, you saw China car sales were down mid-teens, and certainly that has impacted China auto production. And I would tell you right now, global automotives running around 21 million unites versus 22 million units. So, that's impacted us by about of 2 million units coming out. That all being said, we are looking at inventories in China, inventory days on hand in China in addition to the sales. They are around 59 days on hand. That’s a little heavy. I wouldn’t say it’s horribly heavy. But, they are the types of things both on the car sales as well as the inventories we're looking at. And right now, I would tell you, we’re sort of assuming that we’re running around that 21 million unit rate. China typically has a step up in the first quarter in production. I guess, that’s the real uncertainty. I would say, we have to continue to walk for the car sales and inventory levels are before we would tell you where we should be. But right now, our model is sort of thinking, they’re saying how do we plan the business around 21 million units globally per quarter in automotives, how we're thinking about it and also how we're adjusting our cost structure and some of the things Heath talked about.

Terrance, you opened the call talking about revenue growth and sort of some of the headwinds here in 2019. As we think about adjusting to these lower organic growth levels in fiscal ‘19, can you maybe give us some sense of how we should think about heading into fiscal ‘20 first quarter, how we should think about seasonality and also these lower fiscal 4Q levels? And how do you view the odds of continued headwinds going into fiscal ‘20?

Thank you for your question, Wamsi. I won’t provide a specific answer regarding guidance for ‘20, but we will share more as we gather further insights. However, I want to highlight a few key points. Auto production remains fluid, and we need to keep that in mind. Currently, we are positioning ourselves around 21 million units and a content element of 4% to 6%. Even with a challenging market this year, we expect that trend to continue. As we analyze production and plan accordingly, we anticipate benefits in transportation and industry sectors like aerospace and medical. Additionally, as David mentioned, channel destocking is temporary and will normalize based on various data points available. Although we expect some headwinds in quarter four that will carry into early next year, the situation should shift as expected. Next year, we have multiple cost management strategies in place that will be employed at different points throughout the year. Regarding seasonality, this year has not followed the usual pattern. Typically, quarter three and quarter four are our strongest, but this year quarter four is projected to be our weakest. Therefore, we can’t simply rely on standard seasonal trends for projections, especially with the current market conditions. We will offer more guidance in 90 days, but it's important to account for these anomalies as you analyze the situation. I apologize for the lengthy response, but I hope this provides some clarity on the matters at hand.

I understand this might be difficult to answer, and I know you're not providing guidance for 2020. However, could you give us more detail on the restructuring? For instance, when restructuring in Europe, it can take a few years to see results, while in the U.S., the effects are immediate. Could you help us understand, even if just directionally, what kind of benefits we might expect in 2020, or at least provide some insight into the restructuring process?

Scott, I believe you're correct in noting that some of the non-U.S. restructuring does result in a longer cash-on-cash return, along with the time it takes to take factories offline from the initiation point until the savings are realized. It's reasonable to say that out of the 375, on average, it yields a payback period of about three to four years. This insight would guide you towards understanding annualized savings and where this activity is occurring.

I was hoping you could got a little bit more into China region specifically, with the decline in orders that you saw there and the reversal compared to what you’ve been seen last quarter, is that all just macro and weakness or do you think any of this is due to the trade environment and potentially a more difficult region for U.S. companies to do business now? Thanks.

So, a couple of things. Certainly, the global trade environment, I think, just creates an overlay around economic conditions period. I don't think it’s only one or two countries, it impacts everything. So, I do think that has some impact on the slower economic conditions because places like Europe ships into China and so forth, and that impacts us in many places. And, Mark, back to the question that you had, when we were sitting here last quarter, we saw nice increase in our China business totally. Our orders went up, almost 10% going from our first quarter to second quarter, and it was primarily driven by transportation and it did revert back. I would say, in our industrial businesses, it has stayed steady at a constant rate. I wouldn’t say, it’s accelerating, but it’s sideways. So, in those, our Industrial businesses, it’s staying steady. And it was flat year-over-year. But auto has been the bigger piece for us as that production has declined. I don’t think when it comes to automotive and our position we have in automotive, I don’t think it is impacted by our U.S. attachment. The other thing I would say, the places that I would say have gotten a little bit weaker is around the communication equipment. That’s an area, and also in appliances and CS, we’ve been talking about that all year, they’ve been environments where they have been slow. So, in the industrial space, it’s been more stable and sideways. But really, the slowing we saw versus last quarter is really in our Transportation and Communications segments, not as much our Industrial space.

I know, it’s hard to do for you guys, but is there any way to kind of at least triangulate how much you think on the Communications jam-up on the supply side is due to like very specific temporary issues, that like Huawei and restrictions on certain entities?

When we consider the supply side, the channel isn’t a factor in this situation. We directly service our large customers in the channel business. The portfolio in our Communications segment is utilized in various applications, not solely high speed, which is why a significant portion reaches the channel. This includes both our appliance and D&D businesses, and these components serve as fundamental elements for multiple areas. Therefore, linking the channel's situation to telecom in China seems like an overreach. We are also observing this trend in our Industrial markets as well. I apologize, Joe. No. I mean, I think the other thing that you have, I don’t think you can close that loop there. There has been some slowness by certain other telecom equipment makers and certainly cloud spending, which was very strong growth last year, so growing that at a lower rate. There's lots of those other factors that I would also say impact that. But I wouldn’t tie it completely back to Huawei.

The headline China numbers are one story, but maybe electric vehicles little different story, I think it’s up about 50% year to date. Just wondering if that aligns with your thinking. Do you expect that penetration to accelerate? What are your learnings along that curve from your kind of specification cycles with the customers there?

Certainly, while China auto production is down, electrical vehicle penetration, you're exactly right. If you look at it, if you take full electric plus any hybrid, it continues to accelerate, even though China car production is down. So, that is not changing. Certainly, it's growing, while overall production is down. And our design wins around those electric vehicles continue to be very strong. And let's face, it is something when we think about electric vehicles. Electric vehicles are going to be driven in the world by both China and Asia, as well as the CO2 requirements that you have in Europe as well. So, when we think about electric vehicles, the place you need to be positioned and we are positioned very strongly is in Europe, it is in China, as well as in Japan. And what's really good is, we're positioned well with our customers. And the one thing that we always watch in slow markets is where is our project momentum, do we see project momentum slowing? We are not seeing any change in the number of projects we have with our customers in any of our businesses. And certainly, in the automotive space, there continues to be the march between electric vehicles and autonomous features by all our customers that serve those markets. So, we don't see any change in that. Certainly, the global production is impacted. That's more impacting combustion engines.

Thank you very much. You've provided clarity on the automotive side, which is appreciated. However, I have a few questions regarding the communications segment. If I recall correctly, you're not a supplier or component provider for smartphones. I assume your focus is on larger devices like base stations, routers, or switches. Given the 5G rollout, I was somewhat surprised to see this slowdown. Can you clarify whether we can expect an order buildup similar to last quarter despite the end demand, or is this a situation where overstock from a trade war is leading to destocking, or is it genuinely a slowdown in end-market demand within the Communications segment? Thank you.

Hey, Jim, twofold, and you're breaking up a little bit on yourself. So, first off, I would say, when you think about our Communications segments, there's a chunk of it, which is data and devices, and then there's another chunk that appliance. So, certainly, we need to look at, to your question at data and devices. You're right. We do not plan smartphones. So, our products go into base station equipment, goes into traditional switches, like you mentioned. And when you look at it, what we've seen is, we have seen some of the cloud spending not growing as fast as rate as it grew last year. So, when you are talking about something that grew 20%, 30% of spending and as grows 10, you will have adjustments in supply chain. I do think that is working through. On 5G, 5G, when you think about it, certainly we’re designed in. And China is granting licenses, and we're positioned very well there. But that is still early stages of how much does that contribute to TE’s revenue. So, their typical growth drivers we're going to get the benefit from. So, those around cloud and 5G were in good shape. The other thing I would just say around our D&D and it goes back to the channel comment I made. Typically, our products in D&D are very much next to semiconductors and passives. I do think some of our partners and also other tier 1s in the supply chain probably got a little bit ahead of themselves, as you said, and they are correcting to get to more normalized to end demand. This is not a content or share element, it’s more of we're going to get hurt here a little bit with the inventory destocking but that will normalize. And I feel very good about where we're positioning cloud and 5G. But certainly we don’t plan the cell phones.

I just have a quick follow-up on earlier comments on China vehicle inventory levels. If we were to see some hypothetical vehicle demand injection in China, can you talk about your ability to ramp back up to support production growth, given your presumably running leaner with ongoing cost actions? I think, clearly, no one is ready to call for rebound yet, but we're just trying to get a feel for it. There might be an operational lag and impact on short-term margins when production does ultimately rebound.

Clearly, as we do the actions as Heath talked about, we are also being very-focused on how in those core areas that we keep production flexibility. And what we had was in some cases, we were playing catch-up as the volume was growing very strong, we talked about last year, we feel we have enough capacity if we do get a jump back in there. It might be a little bit of a lag but we feel very good with how not only what we do but also our extended supply chain can do. So, that is not something we worry about. And certainly, if it came back stronger than we thought, we would also have to look at how we time some of those restructuring actions that Heath talked about.

I think, it’s a question for you, how do we think about contribution margins, given that weakness in end markets will be offset by some of the cost actions? You seem to be taking new actions every few quarters now. What should we expect the average contribution margin to net out on the corporate average line, broadly, and how does it compare across segments like above, below, corporate average? I think that will help us reset some of our expectations. Thank you.

Thank you for the question, Deepa. Let’s take a broader perspective on this. We’ve observed a significant decline in demand for auto production throughout the year. As Terrence mentioned, it appears to stabilize around 21 million vehicles per quarter, which is a substantial decrease compared to previous years. This situation allows us to focus on optimizing our transportation cost structure, potentially in regions where we can align better with new, lower-cost locations that are closer to our customer supply chains. This presents a real opportunity for us. Communications is another area where we can implement some restructuring. You may recall that Transportation performed quite well in the first half of our fiscal year, but, as noted earlier in this call, the recent decline has accelerated some initiatives we would have planned for future years. As we move forward with these actions, you can expect to see margin improvement. Our usual margin flow is between 25% and 30%. However, with the recent drop in Communications numbers, it may take time to return to those contribution margins due to the need to cover fixed costs. I want to emphasize that we shouldn't overemphasize percentages, as CS is our smallest segment, and small dollar changes can significantly affect percentage outcomes without having a substantial material impact on TE. We also want to highlight that we have discussed Industrial’s multi-year plan to improve, aiming for high teens margins. I believe we’re currently slightly ahead of our initial expectations. Initially, we anticipated flat margins in Industrial while implementing announced footprint changes, but the team has managed to achieve some savings more quickly than expected, along with standard cost-cutting measures. Overall, I feel positive about this progress. Industrial still has a couple of years of activities linked to the timing of footprint changes, and we are committed to continuing this journey. In summary, we’re taking this opportunity in the current cycle to reduce fixed costs, which is why we’ve lowered our overall restructuring plans. As market demand improves, we’ll be prepared with a more streamlined structure, making it more challenging to execute these changes during periods of higher growth. I hope this answers your questions, and I’m happy to address any follow-ups.

I'd like to follow up. My confusion regarding the charges you've taken over the last year or two, or even the last five years, is about distinguishing between tactical and strategic decisions. You presented a strong argument for why Industrial is strategic. However, with some of these recent charges, how can we be sure you're not cutting too deeply instead of just trimming excess? Additionally, how can we expect the charges to stop if demand remains at these levels? Thank you.

I believe it’s a fair question. As the business has evolved, we have continued to develop our footprint. Industrial has been clearly outlined over the past 18 to 24 months, and we are making progress in that area, as reflected in the numbers. While there are some tactical adjustments in the CS business, it remains a smaller segment, so I don’t want to focus too much on specific margin rates. We have performed well in that segment, but a few million dollars can shift us from mid-teens to low-teens or even high-teens. So, I want to approach that carefully. On the Transportation side, we are basically mirroring what we’re doing in Industrial, taking advantage of opportunities that we might not have considered in those locations. This will be a multi-year process to align our operating footprint effectively. I’m not concerned about cutting too deep because our long-term business model benefits from ongoing trends, such as hybrid and electric vehicles and advancements in factory automation, medical, and aerospace sectors. We have sufficient redundant capabilities and options to transition into our existing locations without needing to develop new sites. We aren't eliminating costs from areas of higher growth, like in Asia, where we expect hybrid and electric to gain more significance. So, I view this more as a chance to implement necessary changes now, which would be more challenging in a high-growth environment where we're mainly trying to meet customer demand.

If we consider the seasonal trends we are seeing in Q3, I would like your perspective on how these trends might be divided between the direct business and the channel. How much of the weakness in the channel could be compared to the direct business, which might align more with seasonal expectations if we analyze it that way? Thank you.

Let me talk directionally. So, couple of things. I highlighted our book to bill overall of the Company was 0.98, and our channel was 0.85. So, I do think channel has been a steeper impact and we’ve talked about it. But you do sit there, and there has been slowness, auto production slowness has nothing to do with channel. So, I think when we talk about how we frame the reduction in guidance, two-thirds was driven by Transportation and the slower China and certainly seasonal I do think that’s normal that china would have weakened in the quarter we’re in. But the other one third is truly the channel; that 250 decline. So, it’s different by markets. But I would say, channel correction happens due to them adjusting to end markets that are happening. And clearly, they’re seeing some slowness. So, it is deeper in the channel. Certainly that’s an impact we're going to have here, like I said, not only into quarter four but probably can go into early next year. But, certainly we’ve seen a slowness in our direct customers as well but not to the extent as channel.

Thank you. I have another question about the Industrial Solutions segment, particularly the strong growth in the military, aerospace, and marine sectors, which has increased by double digits. What are the drivers behind this, Terrence? What's the outlook? I've heard from other suppliers that the defense and aerospace market remains strong, and it seems there is some distribution exposure as well. It appears there are no inventory issues. Also, regarding the margins, Heath, you mentioned the factors contributing to the significant year-over-year margin expansion. One question is whether the mix of business, specifically the stronger MIL-Arrow, plays a role in the margins, or if it is mainly due to the cost-cutting measures you discussed.

Let me start with the first half, and then Heath will cover the second half. We've been discussing how well-positioned we are in commercial aerospace, particularly regarding content opportunities. We've detailed our focus on defense, dual aisle, single aisles, and regional jets. Airframe production has remained steady and has even increased slightly, and we're seeing significant benefits in commercial aerospace from the content momentum we've established across the industry, which is a testament to our team's efforts. This process is a long-term commitment. Additionally, this year we're experiencing a boost from defense spending. It's evident that defense companies are currently thriving, and we have a strong position in this balanced space between commercial aerospace and defense, benefiting from both. The defense sector's growth is driven by government funding, resulting in an additional content opportunity as it pertains to communications, power distribution, and next-generation hardware in defense. Both areas are crucial for us. To your point, Matt, part of our business operates through channels where destocking isn't an issue, demonstrating that the market remains stable. This dynamic helps buffer the slowdown we're experiencing in our Industrial Equipment business due to inventory adjustments. I’ll let Heath address the margin aspect.

Yes, Matt, thank you for the question. Regarding margins in the Industrial sector, there's not a significant amount of mix impacting it. Some product lines do have better flow-through in individual business units, but overall it's quite balanced. We earn a bit more in certain areas and a bit less in others, but the variations are not extreme. As you might expect, in aerospace and defense, with the organic growth we're experiencing, we're seeing favorable flow-through, and the business is effectively converting revenue into profits, especially as they exceed some fixed costs. Additionally, other areas like our energy business are showing margin resilience due to recent and nearly completed facility restructuring. There are various factors at play, balancing growth with footprint consolidations. Earlier in the year, we discussed expecting less activity in this area, but we find ourselves a bit ahead of that. There will still be instances where you might notice a temporary dip in margins due to duplicative costs when moving from one facility to another during rationalizations. This will happen occasionally, but we are very pleased with the team's progress and their outlook moving forward.

Okay. Thank you, Matt. And I would like to thank everybody for joining us this morning for our call. If you have any additional questions, please contact Investor relations at TE. Thank you and have a nice day.