TE Connectivity plc (TEL) — Q3 2020 Earnings Call Transcript

Good morning, and thank you for joining our conference call to discuss TE Connectivity's third quarter 2020 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 in 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 thank you everyone for joining us today to cover our third quarter results as well as our expectations as we look forward. Before we get into the results of the quarter and the slides, I do want to take a moment to provide our perspective of what is the same and also what is different from the time we spoke just on our last earnings call 90 days ago. So let me first start off with what is the same. First, we continue to be in a challenging market environment that is influenced by COVID, and we continue to prioritize the safety of our employees, while also focusing on meeting the needs of our customers, as they navigate this environment. The second key thing that is the same is that our balance sheet and liquidity were strong coming into the COVID downturn, and they remain strong. We have a strong cash-generative business model with the flexibility to use our cash for investing in growth opportunities and improving our cost structure, while continuing to return good capital to our owners. Another key point that is the same is that we continue to execute on our cost reduction and footprint consolidation plans. These plans will enable higher earnings leverage as we capitalize on content opportunities as the markets return to growth. And the last thing we spoke about last call that is the same is that our manufacturing resilience was a differentiator last quarter, and you’ve seen it again this quarter. It is enabling us to serve our customers through this volatile environment, and our strong operations capability continues to set TE apart from other suppliers, which we believe will enable share gain opportunities during this time. So with that being a backdrop of what’s the same, now let me highlight some of the key differences versus 90 days ago that both Heath and I will cover during today's discussion. Last time when we spoke in April, orders were declining and during that time, our customers were shutting down manufacturing plants in Europe and North America due to COVID, with the biggest impact being in our market-leading automotive business. We have now seen China return to essentially pre-COVID levels, and we continue to see improving order trends in both North America and Europe after the April low point. Another key difference is that in our third quarter we were looking at strong sequential sales declines and margin and EPS compression when we spoke. I'm happy to say that our quarter three results came in better than we expected, and in the fourth quarter, we are now expecting sequential sales growth as our auto customers are ramping production. Along with not only sales increases, we’re going to continue to seek expansion of margins and earnings per share sequentially. We do believe that our third quarter was the low point for our revenue and earnings. To continue to build on auto, another key difference is that auto production was declining to a low point of 12 million vehicles produced in our third fiscal quarter. We are now expecting a 40% increase in auto production sequentially in September, and we are pleased that dealer inventories remain at appropriate levels that support that production. And the last key difference I would say versus last quarter is that while we’re being impacted by market volatility in our Transportation segment, our Industrial and Communications segments performed well in light of market conditions last quarter, and we expect sequential sales to be stable into our fourth quarter for those two segments on a combined basis. So I do hope that just starting off by sharing what's the same and what's different from 90 days ago will help frame our discussion today. One final thing I'd like to cover before we get into the slides is how our employees and teams have completely leaned in and aligned with TE's purpose of creating a safer, more sustainable, productive, and connected world during this crisis. Our teams have been focused on working with our customers to increase production of key elements like respirators and ventilators, where our products are key building blocks in their architecture. I’m proud to say that as part of an employee-led effort, we’ve utilized our 3D printing and molding expertise to supply face shields for healthcare workers around the world. I’m pleased to tell you that we now have produced and donated over 120,000 face shields for frontline healthcare workers in hospitals globally. These are just a few examples of what our teams have done, but they also give me confidence in our focus as well as the opportunities we’re capable of as we come out of this crisis. Overall, we are pleased with our performance considering this challenging, unprecedented environment. We also expect that the recovery will be gradual, more like an endurance race than a sprint. But I can tell you, we remain excited about our content and growth opportunities around which we've positioned TE. So with that laid in, let's jump into the slides, and if you could turn to Slide 3, let me get into the numbers for quarter three as well as how we're thinking about quarter four. For the third quarter, sales of $2.5 billion were better than our expectations. They were down 20% sequentially versus our expectations, where we thought they would be down 25%. Excluding auto, our sequential sales declined 4%, showing the performance of our Industrial and Communications segments, which delivered results in line with our expectations in a challenging market. Transportation sales were down 32% sequentially, better than we anticipated across each of our businesses in the segment, and really the supply chain corrections we thought by our customers were less than we expected in the quarter. In the Industrial segment, sales were down 10% sequentially, with much of the weakness driven by commercial aerospace, while in the Communications segment, our sales were up 14% sequentially, driven by strength related to cloud applications. From an earnings perspective, adjusted operating margins were 9.4%, and I am pleased even with the concentrated drop in our auto sales in our Transportation segment, we managed to control the earnings fall down on sales and achieve the adjusted operating income we reported. Adjusted earnings per share was $0.59; this was ahead of our expectations due to the management of our operations on lower sales. In the third quarter, our free cash flow was $280 million with approximately $240 million being returned to shareholders in the quarter, including approximately $160 million in dividends. Year-to-date free cash flow was approximately $830 million, and we continue to expect to exceed $1 billion of free cash flow for 2020. As we look to the fourth quarter, we expect fourth quarter sales to be up sequentially by approximately 10% from the third quarter with sales growth driven by the Transportation segment as our customers increase auto production. We expect our Industrial and Communications segments to be essentially flat sequentially in the fourth quarter on a combined basis. We continue to expect to improve our earnings power by executing the footprint consolidation plans while also accelerating additional cost reductions considering the weaker demand environment we're experiencing. Looking longer-term, we remain committed to our margin expansion plans and the expectations we’ve shared with you. As we look beyond the current environment, we’re excited about how we've positioned our portfolio to benefit from secular trends, and I'll highlight these as I go through the segment results. So if you could, I'd appreciate it if you could turn to Slide 4, and let's get into the order trends, so we can share what’s on the slide and what we’ve seen as we’ve gone through the quarter as well as what we’ve seen in July. For the third quarter, our orders were $2.4 billion, and that was in line with what we expected. We saw continued monthly trends improve since bottoming in April when our customers shut down. It was a very slow order month that we talked about in our last call. When we look at going into the fourth quarter, we are entering the fourth quarter with a stronger backlog position than we normally have, and our July book-to-bill ratio came in at 1.05. This supports our view of a 10% sequential growth in the fourth quarter, which will be driven by our Transportation segment. I also want to add some color on what we're seeing in orders from a geographic perspective. We've seen improvement in China back to pre-COVID levels, and while our orders contracted in both North America and Europe across all segments during the quarter, we are encouraged that the monthly order trends have been improving in those regions since the low point in April. So I ask that you turn to Slide 5 and let's get into our sales view for the fourth quarter and how we're thinking about it. We expect sales to increase by approximately 10% sequentially into our fourth quarter, primarily driven by a 40% sequential increase in auto production going from roughly 12 million vehicles produced globally in quarter three to nearly 17 million vehicles produced in quarter four. When you factor in our content per vehicle, this will drive approximately $300 million of growth sequentially. While this is a sharp increase, I do want to highlight that auto production is still well below the 21 million vehicles per quarter that we were planning our business around before COVID. Beyond automotive, we do have some puts and takes, both on the positive and the negative side, and we expect sequential growth in some of the other businesses, but this is expected to be offset by the residual impact of supply chain corrections by our auto and other customers. When we think about this growth of 10% sequentially, we expect approximately 20% sequential growth in Transportation, while in Industrial we'll have slight growth, which will be offset by a modest sequential decline in Communications. On this increase in revenue sequentially, we expect roughly 35% incremental adjusted operating margins on the volume growth. Note that these incremental margins do reflect the impact of us working down inventory in the quarter as we continue to drive free cash flow. Now, with that backdrop at the total company level, let me briefly discuss year-on-year segment results in the quarter on Slide 7 through Slide 9 along with some key drivers in each of the segments that we expect will fuel future content growth. In the Transportation segment, sales were down 37% organically year-over-year with declines in each of our businesses, as you can see on the slide. In auto, sales were down 43% organically, which was in line with global auto production declines. Even with the dynamic changes in the auto market due to COVID, our content growth expectations are unchanged, as evidenced by the fact that year-to-date, we are generating 600 basis points of content growth above production, which continues to enable our outperformance versus a weaker production environment. The other thing I want to highlight is, although the production of internal combustion vehicles will drop significantly this year, we expect production of hybrid and electric vehicles to be up approximately 12% in fiscal 2020, which gives us confidence around where we've positioned ourselves around the electric powertrain and the investments we make. Just to bring this to life a little, we continue to innovate with our customers as they move to more sustainable vehicles by providing leading-edge technology and products to enable and improve the performance of both hybrid and full-electric platforms. In fact, we generated approximately $6 billion in design wins for connectors and sensors in hybrid and electric vehicle platforms across every leading OEM. More importantly, our customers' plans remain intact for EV and hybrid electric vehicles. There has even been some acceleration of roadmaps along these platforms as OEMs respond to increased demand and a more stringent regulatory environment in certain parts of the world. What also excites us is, while we talk to you a lot about what's going on in the electrical powertrain in cars, it's also important that we’re taking this technology over to the commercial transportation space as well. A key example of how we're doing that is our applications in working with Nikola. Nikola is using hydro and electric technology in its next generation trucks, and we have partnered with them to enable these designs as we work with them on their architecture. Our products are in various sub-systems within the electrified powertrain of their trucks as well as in the various infotainment and driver convenience systems that use high-speed data connectivity solutions. What's really important about this as we look forward is all these things come together in delivering a class 8 zero-emission truck with equal or better performance of a diesel truck capable of its 750-mile range. I think it just proves that in the markets we've had leadership and we're going to continue to have clear leadership as we help solve next generation electrical powertrains. So with that on Transportation, let me turn over to the Industrial segment. In the Industrial segment, our sales declined 13% organically year-over-year and adjusted operating margins were approximately 13%, certainly impacted by the lower volumes. Importantly, we feel good that we remain on track with our long-term margin expansion plans to drive adjusted operating margins into the higher teens in this segment. During the quarter, commercial aerospace and industrial equipment performed as we expected; however, we did see some declines in our medical business due to the delays in elective procedures caused by COVID-19. We believe this is a short-term dynamic in our medical business that is consistent with what our customers are seeing, and we expect this market to return to strong growth as elective procedures start to increase. To remind you, what we've built in our medical space is a leading position around interventional procedures, and we will come back to strong growth because this is a market that we believe long-term has high single-digit growth. We partner with the leading device makers globally by enabling minimally invasive treatment for heart valve replacement, stroke clot removal, brain aneurysm treatment, and other critical procedures. To bring it to life, on average, 120 patients per minute are treated with medical devices that incorporate our innovations, and we generated over $1 billion of design wins in this business, which will enable strong growth over the long term. Let me turn to Communications and give a recap of that segment in the quarter. In this segment, we grew 4% organically year-over-year, and adjusted operating margins expanded to approximately 16%, that was in line with the business model target of the mid-teens that we've been discussing. Data and devices grew 13% organically year-over-year due to our strong position in high-speed solutions and cloud applications. We continue to benefit from the increasing demand for bandwidth and higher speeds in the data center. Our products and technologies enable 800 gigabit per second performance and the thermal properties required in the next-generation data center for the world’s leading cloud providers. Similar to medical, over the past three years we generated over $1 billion of new design wins in our cloud business, giving us confidence around future growth. With that backdrop, both overall and with the segments, let me turn it over to Heath who'll get into more details on the financials and our expectations going forward.

Well, thank you, Terrence, and good morning everyone. Please turn to Slide 9, where I will provide more details on the Q3 financials. Adjusted operating income was $240 million, with an adjusted operating margin of 9.4%; adjusted EPS was $0.59. GAAP operating income was $134 million and included $98 million of restructuring and other charges and $8 million of acquisition charges. We expect restructuring charges to be approximately $250 million for this fiscal year, similar to last year. GAAP EPS was a loss of $0.18 for the quarter and included a non-cash tax-related charge of $0.51 related to an increase in our valuation allowance for certain non-U.S. deferred tax assets. We also had restructuring and acquisition and other charges of $0.25. The adjusted effective tax rate in Q3 was 15.9%. For Q4, we expect a tax rate of approximately 19.5%. Importantly, we expect our tax rate to continue to stay well below our reported ETR for the full year. Turning to Slide 10; sales of $2.5 billion were down 25% year-over-year on both reported and organic basis. Currency exchange rates negatively impacted sales by $35 million versus the prior year. Adjusted operating margins were 9.4%, and as Terrence mentioned, I am pleased with our overall performance, especially given the over 40% sales drop in our auto business in the quarter. We continue to execute on footprint consolidation plans and pursue additional opportunities to drive cost reduction. We remain committed to our margin expansion goals, and we expect volume growth combined with our restructuring plans to drive adjusted operating margins in transportation to 20%, industrial into the high teens, and communications consistently in the mid-teens. In the quarter, cash from continued operations was $380 million. Free cash flow was $280 million for the quarter and year-to-date free cash flow was $834 million. For this fiscal year, we expect free cash flow to be above $1 billion. In the quarter, we returned $241 million to shareholders through dividends and share repurchases, and just as we noted last quarter, we will continue to thoughtfully evaluate the buyback program as we see market conditions evolve. I now want to give you an update from an operational perspective. We are currently operating all of our factories around the world. As Terrence mentioned, our manufacturing resiliency has enabled us to support our customers' demand through a volatile supply-chain environment. Our inventory position increased in the quarter, which helped us meet customer commitments, but we do expect to reduce our inventory levels going forward, normalizing to the demand environment. Reinforcing our comments from last quarter, we are in a strong liquidity position with approximately $2 billion available to have a strong balance sheet. This allows us to maintain a balanced capital strategy, returning capital to shareholders while continuing to invest to support our growth opportunities. Now please turn to Slide 11 to summarize how we are thinking about the fourth quarter based on everything we've discussed so far today. For Q4, we are expecting sales to grow approximately 10% from Q3, with sequential improvement driven by auto. As we mentioned earlier, we expect approximately 35% fall-through to adjusted operating income on that sequential volume growth. In terms of market, we expect global auto production to increase from approximately 12 million vehicles in our fiscal Q3 to approximately 17 million in our fiscal Q4. We believe this is supported by the production ramps of our customers along with the appropriate levels of dealer inventory in China and North America. As we discussed throughout the call, our portfolio is well balanced to benefit from several secular trends across our businesses, including content growth. While this will be a gradual recovery, as Terrence noted earlier, we do expect revenue growth and margin and EPS expansion as demand returns. So, while the demand environment continues to be dynamic, we are pleased with our operations’ resiliency as well as our ability to keep employees safe while continuing to serve our customers during this challenging time. We have a solid balance sheet, ample liquidity, and solid free cash flow, which enables us to maintain a balanced capital strategy and we will continue to invest in growth opportunities across our business. I'm also very confident that this will enable us to emerge stronger and more profitable when markets do return to growth. So with that, Sujal, let's open it up for questions.

Sure. Jacqueline, could you please give the instructions for the Q&A session?

Yes, thank you. Good morning. Terrence, really impressive performance on the trough operating margins this cycle. For my question, I was wondering if you could provide some additional color on the quarter cadence you're seeing and any early thoughts on how this recovery cadence compares to perhaps, other auto downturns you've seen. Thank you.

Thank you, Wamsi. I want to elaborate further on our orders. One unique aspect of this downturn is that production was halted despite ongoing demand, which sets it apart from previous downturns. In this quarter, our orders totaled $2.4 billion, and our book-to-bill ratio was low due to a significant drop in orders we experienced in April in the western regions. Conversely, orders from Asia and China have rebounded. In markets like Japan and Korea, recovery is ongoing but wasn’t as severe as in Europe and North America. In terms of Transportation, as we anticipated improvements in May and June, our book-to-bill ratio reached 1.05 in July. It's important to note that a book-to-bill ratio has both a numerator and a denominator; the strength of the denominator gives us confidence in our sales projections, despite the volatile environment. Regarding Transportation, we expect production to rise back to 17 million units, which is consistent with the second quarter, but still shy of 21 million units. It's encouraging to see our customers ramping up. In North America and China, dealer inventories appear stable since production was halted abruptly while demand persisted at a lower level. We'll continue monitoring these developments moving forward. Outside of Transportation, we see a mix of strengths and weaknesses in various markets, with recovery in some sectors balancing out weaknesses in areas like commercial aerospace. This indicates how we've improved our portfolio since the last crisis. We are optimistic about the order trends, but it remains a challenging environment affected by COVID, and we anticipate a gradual recovery. I don't expect a quick return to 21 million vehicles; we need to observe how global healing and economic recovery unfold.

Okay. Thank you, Wamsi. Can we have the next question, please?

Perfect. Good morning, guys. Thanks for taking my question. I guess, I had one question on the incremental margins, and it's super early in the West Coast; I'm probably doing the math wrong, but it looks like you did about 43% decremental margins in the June quarter and the guide I think is implying about 35% incremental margins. So I guess, Terrence or Heath, maybe it would be helpful to understand why we're not seeing the same magnitude of margin recovery in the September quarter as we saw the downtick over here. Just some context on this would be really helpful. Thanks.

Thanks, Amit. This is Heath, and good morning. Your math is correct on the decrementals in terms of the magnitude of the sales drop in our fiscal third quarter. It was about $650 million, and clearly the guidance, if you will, here in terms of our directional sequential move up 10% implies something closer to $250 million or so on the way back up sequentially. So part of it is just the magnitude of the revenue drop versus the smaller initial rebound. The other thing is, and keep in mind I mentioned in my prepared comments, that we will be reducing inventory in the quarter, and that does have some effect as we speak about the flow through math on how the handles work through our absorption. Thank you for the question.

Thank you, Amit. Can we have the next question, please?

Yes, thank you. Question for Terrence. Just can you talk about the dollar content that you're seeing in designs for EVs versus combustion? And then just more broadly, I know there's been a lot of supply chain disruptions, but what are you seeing from a new design outside of EV, just in automotive? Are you seeing any sole programs or is things tracking as you'd expect from a new design perspective?

Thank you for the question, Craig. There are a few key points I’d like to share. First, our content is performing well. The strength of our content is evident, particularly with the growth we are seeing in electric vehicles, which have increased by 12%. This growth is reflected in our content year-to-date. I believe our long-term expectation for content remains at 4% to 6%. We are demonstrating this through various cycles, including downturns, affirming the validity of our content growth. Additionally, our perspective on the content opportunity related to electric vehicles versus combustion engines remains unchanged. We estimate that full electric vehicles deliver about twice the content of traditional combustion engines, which is around $60. Hybrid electric vehicles provide about 1.5 times the content. As for customer trends, they are moving forward with electric programs, but are also making strategic choices. We are noticing some delays in areas related to autonomy as they adapt to selling and producing fewer vehicles while navigating pressures stemming from COVID-19. The focus prioritization is clearly on electric powertrains, though we have observed some slowdowns in features and autonomy programs. Electric vehicles typically offer greater content potential for us, and we've been transparent about this. While autonomy remains a future content opportunity, it’s likely to take longer to develop. We have experienced some delays in program launches due to our customers’ adaptations to COVID-19; however, these are temporary and not affecting our overall content. I hope this provides clarity.

Okay. Thank you, Craig. Can we have the next question please?

Hey, guys. Good morning. Just curious about the content discussion here. As you talk about a 40% increase in market production in the next quarter, how do you guys expect to compare to that and just some of your competitors, when they're talking about the market over the next three and six months have been pretty conservative versus third-party estimates and talking about summer shutdowns and some restocking in China over the last month or few months that haven't been directly related to production, so I'm just curious how you think through that?

Yes, Joe. I’d like to share some insights about the production environment before we discuss other topics. We believe our customers have some supply chain challenges to address. We anticipate that 17 million vehicles will be produced in the fourth quarter, with around 4.5 million units in China, indicating a solid recovery in production there. In North America and Western Europe, we are recovering from a significant downturn, but it’s important to note that we maintain strong positions in all markets, including Japan and Korea, not just North America, Europe, and China. Although Japan and Korea haven't faced as severe impacts, auto production in those countries still remains below pre-COVID levels, suggestive of a gradual recovery. Based on our discussions with customers and the insights we’ve gathered, we expect a sequential increase in revenue corresponding to our content relative to production. However, we estimate that our customers need to work through approximately $100 million, as they have significantly reduced production and are now ramping it back up. From a supply chain perspective, this transition must be managed effectively. In considering our outlook, we believe that the $100 million issue, mostly within automotive, needs to be addressed to return operations to normal levels.

Okay. Thank you, Joe. Can we have the next question please?

Hi. Morning, everybody. Terrence, you touched on kind of EV acceleration, but maybe you could speak on kind of what you're seeing coming out of this, maybe an acceleration of programs in other end markets or businesses or things that you’ve seen during COVID that have you excited. Then also just the other side of that, kind of incremental margins on the upside as you get through this restructuring, are they going to be better than kind of what we’ve seen or at least anticipating better than what we've seen over the past couple of years as well?

Yes. Thanks, Shawn, and I think when you say what do I get excited about post-COVID, the first thing will be that we're post-COVID. Certainly, it's been a challenging environment that we're all living in. The first one that I would say, and it’s a little bit different from how we position TE and also the cost actions you highlight in your question is one of the things that we are very excited about in this time is the opportunity to gain market share. During this time, our customers are making choices. They have to make choices as they are dealing with the same reality we are. During the last downturn, we picked up share in some key markets, and I believe this market is an opportunity for that. I think some of the things we talked about upfront, not only how we innovate, but how we're proving them through manufacturing, we’re going to be there for them no matter what market environment we’re in and the stability of TE from our capital structure prior to COVID. That's one thing we do get excited about. The second thing I would tell you that we’re excited about as it goes into some of your cost elements and incremental margins is we’re excited that we didn’t hit this downturn being flat-footed. We talked to you about the work we've had to do in Transportation as we were planning around an 84 million global vehicle environment, and we had cost actions that were starting that will come in as we go forward. Let’s face it; we’ll have to do further adjustments to whatever global auto production comes out to, and also in Industrial, where we were marching up, certainly we have to make some adjustments in some of the areas surrounding commercial aerospace due to the downturn in that market. But I do feel that we did not hit it flat-footed, and our teams are embracing the reality of where the markets have been impacted. We're making those adjustments to ensure we serve both our customers and our owners well. The other thing I would say is you see the benefits of how this portfolio has changed. You see us talking about cloud; you see us meeting our target margins and the other opportunities I highlighted in the script. I feel very good about where this portfolio is positioned. We are being impacted by COVID in our leading business, but we don’t feel we should apologize for it, as it’s a global business with a leading position our customers are going to need us more now than ever while we see opportunity in this time as we come out of it, and we’re going to be there for them. So I do appreciate you asking that question, Shawn; maybe get away from the current a little bit, but I do appreciate the question.

All right. Thank you, Shawn. Can we have the next question please?

Thank you, good morning. I was wondering if you could elaborate on your footprint from two perspectives. First, what advantages do you have compared to other large sensors like Molex, Amphenol, and Hirose, as you mentioned? Secondly, Terrence and Heath, could you provide insight into the endpoint of the industrial business or your manufacturing footprint? Given your previous comments, how should we think about this in relation to the return of auto production to previous levels and your content gains? How much more potential do you see? Thank you.

Sure. So let me take the first part and then I'll ask Heath to take the second part, Steve, and thanks for the question. One of the things when you think about the footprint and it’s a fragmented space and you mentioned a couple of customers; it is very important especially, as people are trying to think about where supply chains need to be post-COVID, certainly post other things going on in the world, and how we’ve continued over the past decade to make sure we are global, while also supporting regional supply chains. You know we’ve done a lot of work, and it’s served us extremely well in this time. As our customers are really working through where their supply chains are going to be post-COVID—certainly, the various strategies we continue to see our global deployment, which is balanced to our revenue and how we continue to shift to be a differentiator. In some cases, we compete against companies that are very regional, and might just be in a single country, where we're able to flex. It’s very important, and I think we proved that during the tariff time, and we're continuing to prove it during COVID. I think you saw that in both last quarter and this quarter’s results. Going forward, we still view that that’s the right strategy, and we will continue to make sure we engineer where innovation is happening in the world and where it occurs is not always aligned with our customer strategy. So it is critical in our business model that the innovation in our engineering nodes or where innovation happens globally, we have not seen change during this period. There has been more discussion around how does the supply chain work, and we’re going to continue to evolve to ensure we serve our customers as they see where they want to innovate and make. And that will continue to evolve; supply chains do not change in a day. I really like how we’re positioned to service our customers especially in this dynamic time. So that’s the first half. Heath, do you want to take the second half around the Industrial?

Yes, I appreciate the question, Steve. Our industrial footprint has remained consistent over the past few years, and we are following our established plan regarding the number and location of our facilities. However, we are still a couple of years away from fully realizing our goals, partly due to delays caused by COVID, especially within the commercial aerospace sector where a recovery is not on the horizon. This situation does provide us the chance to continue refining our footprint. While we are still a few years out, you will notice incremental improvements along the way, which I believe you are already seeing. The next couple of years will remain quite active for both the Transportation and Industrial sectors due to ongoing activities.

Okay, thank you, Steve. Can we have the next question please?

Yes, good morning and thanks very much for taking the question.

Hey, Mark.

Morning. I was hoping to better understand the thought process about reducing the company’s inventory this current quarter and maybe you can frame it relative to the bookings that are improving and also with the footprint consolidation; I think the company would need to carry some extra inventory to enable that. So if you can balance some of those factors with the decision to reduce inventory and provide more clarity on that, it would be helpful. Thanks.

Sure, Mark. This is Heath. We made a decision in some areas of the business when things started to get uncertain back in the spring, focusing on our customers in our inventory discussions. They were still figuring out their production plans. Some considered a short-term shutdown, which then turned into a longer-term shutdown, while others relocated production. We decided to hold more inventory in various locations and markets to support them. Now that we see more stability in order patterns week-to-week, we have the opportunity to normalize. You are correct that there are some inventory increases related to factory moves, but some of that has been planned for a while and is already factored into our strategy. We will manage it based on the demand patterns we observe. I believe there is a chance to reduce inventory this quarter, and we will act on that. However, if we need to make different decisions as the quarter goes on, we will do so, depending on our assessment of our customers' order patterns and the confidence we have in their decisions.

Okay. Thank you, Mark. Can we have the next question please?

Hey, good morning. Just hoping you could remind us of your typical sequential flow-through in a growth macro, and maybe, given your cost actions over the last three years, how are you thinking about potential leverage post-inventory work-down? We're curious particularly if we see a gradual market recovery through '21, how are you thinking about sequential flow-through here?

Our sequential flow-through, in a more normalized environment, would typically be around 25% year-over-year. However, sequential flow-through can vary more because our cost structure doesn't change as quickly in shorter time frames. We have reduced many costs and will continue to do so, which helps decrease our fixed cost base as we consolidate operations. Moving forward, I expect our flow-through to improve compared to past normalized periods, but I can't specify exactly when that will happen since it depends on the recovery of our revenue.

Okay. Thank you, David. Can we have the next question please?

Hi, good morning. Can you talk through how the European automotive vertical is responding to the green stimulus and other incentives provided by countries there? Also, how would you generally rate the sales recovery trend in Europe automotive? Thank you.

The European Union has implemented carbon regulations that have affected our customers, which we discussed extensively before COVID. The situation has become somewhat complicated due to COVID, but a positive development is the growth we are seeing in electric vehicles, with the 12% increase we mentioned being largely driven by Europe. If we look back a couple of years, we would have said that China and Asia would be the main drivers of hybrid and electric vehicles, followed by Europe and North America. However, with the current regulations, European electric vehicle and hybrid sales have surged around 90% year-over-year. This is encouraging as it indicates that these regulations are positively influencing car sales and production levels. Europe is one of our key regions in terms of content and market share, and our investments in electric vehicles globally, particularly in Europe and Asia, have been crucial. We believe these trends will continue to benefit us moving forward. Thank you for your question.

Okay. Thank you, Deepa. Can we have the next question please?

Thank you. Terrence, I believe, if I heard correctly, on your prepared comments you mentioned guidance for transportation to be up around 20%, if I heard that right. And if so...

You are right, Jim.

Yes. And if so, then auto production, I think people are expecting kind of say, from 12 million to 17 million, which is like a 40% or a much bigger increase. What's the reason or rationale to bridge that gap? Is that inventory digestion or timing? And if so, does that kind of getting equilibrium after this quarter?

Sure. Good question, Jim. Really, there are two factors. When we talk about our Transportation segment, no different than our quarter we just ended, auto production was down 40%, and the segment was down 30%. So there are other things outside auto, that's industrial, transportation, certainly sensors. There is an element that won’t voice quarterly, but the other big part is what you articulated. We do, as I said in my prepared comments, expect that's about $100 million of supply chain to work off as our customers have been trying to get their component supply chains lined up, and that's a headwind as we go sequentially, and a lot of that’s in automotive. So if you look at it, it is a 40% production increase from 12 million to 17 million; you also get the $100 million of supply chain work off, and remember these are two other units in that segment that aren’t fully auto. So that’s really how you should think about it.

Okay. Thank you, Jim. Can we have the next question please?

Thank you, Terrence. Could you provide your perspective on the commercial transportation sector? We've been experiencing a cyclical downturn for the past few quarters. What is your forecast for this market? Has it hit the bottom like the passenger vehicle market, or do you think there is still some decline ahead? Additionally, I believe the content opportunities in this market could be as advantageous as those in the passenger vehicle sector.

No. Thanks, Matt. You asked about one of our more complex markets, which has been experiencing a downturn, as we discussed previously. In 2020, globally, construction has been weak, the truck and bus sector has been weak, and agriculture has also been weak. When considering the larger markets, they have all shown weakness, although there are different inflection points based on geography. Emissions play a significant role in this market, in addition to the impact of COVID. In certain regions, it appears to have bottomed out, while in others, due to the benefits from emissions reductions, it may still be weak. The important takeaway is how we have enhanced our content opportunities. We've excelled not only in the U.S. and North America and Europe but also in China. This year, China will be our largest region in the industrial transportation market, which is a significant change from when we made the Deutsche acquisition. Previously, China accounted for about 10% share, and now it’s our largest region, thanks to our market penetration and the infrastructure spending along with emissions evolution. This is both a market and content story. For instance, in the sustainable powertrain within a Class 8 truck, the contents could range from $300 to $400 per vehicle. Electrifying large vehicles can increase content by three times. Our engineers are collaborating with our customers as this becomes a reality, driving content growth. This isn’t just visible in the auto industry but also in the features that are migrating into the truck, bus, and commercial transportation sectors, benefiting us significantly. We maintain a leading position in that market, similar to our automotive business, and it’s crucial how we support our customers in transitioning to next-generation architectures.

Okay. Thank you, Matt. Can we have the next question please?

Hi, good morning. Thanks for taking my question. I just had one longer-term question on automotive. You’ve talked today extensively about the leverage you have to electrification as a theme. Just curious how to think about the portfolio—automotive portfolio and leverage to autonomous vehicles as a theme overall. Even though we are seeing some push outs here, and you mentioned the landscape is good for share gains overall, but how are you thinking about M&A in this landscape? Thanks.

Well, a couple of things. First off, we are exposed. Both what one of the things I think is unique to us is we benefit from both of those trends, and many companies benefit from one or the other. Autonomy though has been one when you think about architecture in a car, it has always been a lower-content opportunity versus EV, and we’ve shared those content charts with you about how much do we get on content about $65, which could break down between safety applications, infotainment, and data stack, as well as production and powertrain stack. Clearly, the powertrain stack is always the biggest content for us, and that’s why we do benefit as the architecture moves more electric. Autonomy is going to be something that drives content; it’s part of our four to six but clearly not the largest piece. The largest piece has always been about powertrain, and we play in all applications. As you look at M&A, I think as we've gone over time, we’re going to look for where we can add value through acquisition as well as to help us solve our customers' problems. We continue to look at M&A, and you see First Sensor; we finally closed after we announced that last year. That’s going to help us from the sensor suite, and we will continue to look at M&A across all our businesses moving forward to see how it strengthens us and improves our portfolio to get returns for our owners.

Okay, thank you, Samik. Can we have the next question please?

Thanks very much. Terrence, maybe you could just be a little bit more explicit about your assumption for North America production on the year-over-year basis in this coming quarter because indications are that July is—you’ve been flat to up year-over-year. So I just want to understand some of your conservatism there, and then maybe you could just clarify, I thought I heard you say 4.5 million units in China, which seems well below trend; I don’t know if that was if I misheard there but could clarify that. Thanks.

A couple of things; you're right, 4 million to 4.5 million for China is right in per quarter. So that's a per quarter number not an annual number, so that is where we view China production was in quarter three, and we expect it to be similar in quarter four. So that is right for China, and when you get to North America, honestly, we expect production in North America to be around 3.5 million units, which is pretty consistent with where it was in quarter one and quarter two of this year. I do want to make the comment earlier at TE; we serve every piece of the world, and North America is our lowest piece of our revenue. So just remember, there are other countries out there that we have very large positions in, like Japan, like Korea, in addition to North America. So North America we expect production to be about 3.5 million units in the fourth quarter.

Okay. Thank you, Joe. Can we have the next question please?

Yes, guys. Thanks, good morning. Given those production numbers, you and your competitors differ from the third-party estimates. I was wondering if you can give us any sense of what is your initial thought on calendar year '21 production. I know we are way too far; visibility is very low, but how do you think about the recovery? I think you mentioned you're expecting a gradual one. Do you see a scenario wherein calendar year '21 production goes back to similar levels to 2019 or are you thinking that's going to take a little bit longer to get there?

I think the one thing you have to think about, and it's the hard thing that we all have to deal with, is how does COVID continue to impact. It’s the same, and how does that go forward. So we can't comment on 2021. I think the key is you look right now, and we are encouraged that production is getting back to 17 million units. We have to see that the consumer demand pull-through on those cars produced. We’d like where inventory levels are right now, but as this is all ramping, I think the first that we have to get there to is how do our customers ramp up to 17 million after being at 12 million and where the consumer demand goes into next year. I think the baseline you would start with is where quarter four production is at as you go into next year, and you can do scenarios. I think point estimates are very dangerous in an environment like this; you have to be thinking in scenarios.

Okay. Thank you, Nick. It looks like there are no further questions. So if you do have further questions, please contact Investor Relations at TE; and we thank you for joining us this morning. Have a great day.