TE Connectivity plc (TEL) — Q1 2022 Earnings Call Transcript

Good morning. And thank you for joining our conference call to discuss TE Connectivity's first quarter 2022 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. 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 thank you everyone for joining us today to cover our results for our first quarter, along with our outlook for the second quarter of our fiscal 2022. As I normally do, and before Heath and I take us through the slides, I want to provide some key takeaways that frame our performance relative to the broader environments that we continue to operate in. Our results represent a strong start to our fiscal year in a world that continues to have challenges. Our first quarter builds upon the strong momentum that we demonstrated throughout our fiscal 2021, and things are playing out as we expected, including the outlook for our markets. We also continue to be excited about the growth opportunities where we have positioned TE, along with the strong operational performance of our teams to expand margins and drive earnings and cash flow growth moving forward. In our first quarter, we delivered strong results in each segment. On a year-over-year basis, in quarter one, we delivered sales growth of 8% and adjusted earnings per share growth of 20%, along with operating margins of 18.6%, which are up 90 basis points over last year. From an EPS perspective, our adjusted earnings per share of $1.76 was a record for our first quarter. The demand environment also continues to be strong, as evidenced by the orders that we'll discuss. Our orders remained above $4 billion in the quarter. This reflects strength across many of our end markets and provides a positive indicator of ongoing future growth. What we like about our performance in the first quarter is that it demonstrates the strength and diversity of our portfolio. Our Industrial and Communication segments grew over 20% and 40% respectively, more than offsetting the expected impact from the mid-teen auto production declines in our Transportation segment. You also see in our results the benefits of where we strategically positioned our engineering investments around certain secular trends, generating market outperformance across all segments. The content story growth is real, and we continue to benefit from our leading position in electric vehicles, factory automation, and cloud applications. Twenty percent of our auto sales are now driven by hybrid and electric vehicles, and we continue to see ongoing content growth in auto around electronification across both electric and combustion engine platforms. We also highlight that we're generating content outperformance from automation and the Internet of Things in manufacturing, as well as higher speeds and greater efficiency in the data center. Throughout today's presentation, you will see how our teams continued to execute well in a challenging supply chain environment, which is reflected in both our first quarter results and our second quarter guidance. We are also pleased to see our performance aligning with our long-term business model goals. Our first quarter results, when compared with our second quarter guidance, imply a first half growth of 5% in sales and 13% growth in adjusted EPS versus the first half of last year, along with continued margin expansion. This strong performance is set against a backdrop of global GDP growth and higher demand across most end markets where we've strategically positioned TE. We are witnessing broad strength in capital expenditures related to factory automation, expansion in manufacturing capacity, cloud and data center investment, and investment in renewable energy sources. If we look at the consumer side of the economy, demand for autos remains healthy, with auto production improving sequentially in our first quarter. Moreover, we continue to see content growth driving market outperformance in both our commercial transportation and auto businesses. We are observing continued expansion in our content per vehicle, driven by our leading position on electric vehicles, and ongoing expansion of electronification in both internal combustion and EV platforms. We expect that this trend will persist as we move forward. While this demand environment is positive, we are still navigating challenges related to COVID as well as supply chain issues. The supply chain challenges and inflationary pressures we've been discussing since the onset of COVID are somewhat worse than 90 days ago, but I want to emphasize that I am pleased with how we are handling this and making continued progress towards our business model goals despite these ongoing factors. With healthy demand and the current state of the global supply chains, our ability to produce will be a key factor in our near-term revenue performance. We continue to benefit from our global manufacturing strategy to produce in region, and our teams are actively driving pricing actions and productivity initiatives across all three of our segments. So, with that context, let me now turn to the slides and discuss some additional highlights, starting with slide 3. Our first quarter sales at $3.8 billion were up 8% on both a reported and organic basis, and adjusted earnings per share was $1.76, which is up 20% year-over-year and a record for the first quarter, as I mentioned earlier. Adjusted operating margins were 18.6%, up 90 basis points year-over-year, driven by the strong operational performance in our Industrial and Communication segments. We are seeing a strong demand environment, which is reflected in orders of $4.3 billion. I'll get into more details on the orders in the next slide. Looking at free cash flow, we generated approximately $370 million of free cash flow in the quarter and returned approximately $410 million to shareholders through buybacks and dividends during the quarter. Additionally, I want to draw attention to our recognition for our ESG initiatives. We were named to the Dow Jones Sustainability Index for the 10th consecutive year, and we recently ranked in the top 20 of Investor Business Daily's 100 Best ESG Companies. Importantly, we remain committed to our goal of decreasing Scope 1 and Scope 2 greenhouse gas emissions by over 40% on an absolute basis by 2030, which surpasses the 27% reduction we've already achieved over the past decade. While I've spoken about our team's performance in execution, it is vital to note that to make these sustainability investments, it also hinges on how our employees engage. I am very pleased with the progress we have made in engaging our employees as we drive sustainability initiatives across TE. Let me now turn to guidance for the second quarter. We expect our strong portfolio performance to continue in the second quarter with approximately $3.8 billion in sales, which will be up 2% on a reported basis and 3% organically versus the prior year, despite the year-over-year decline in auto production. We anticipate double-digit growth in both Industrial and Communication segments to drive our second quarter growth, reinforcing the diversity of our portfolio. We expect adjusted EPS of approximately $1.70 in the second quarter, an increase of 8% year-over-year. Now let me delve into the order trends and markets. Please turn to slide 4 to see order progress by our segments. For the first quarter, our orders were $4.3 billion, and our book-to-bill ratio was 1.13, with year-over-year and sequential growth in our Industrial and Communication segments. Our largest segment, Transportation, saw order levels come in as we expected, with a book-to-bill ratio of 1.0, aligning closely with auto production trends. Global auto production in the first quarter was slightly better than we anticipated, at approximately 19 million units. We expect auto production to remain at a similar level in the second quarter, reflecting roughly a 5% year-over-year reduction in auto production. We anticipate auto production will improve in the second half compared to the first half and return to year-over-year growth as we progress through 2022. In addition to production, trends around content remain strong, and we expect outperformance to be on the higher end of our 4% to 6% range for 2022, benefiting from increased electrification and higher global production of electric vehicles, which we expect to rise over 30% this year. There are ongoing challenges with semiconductors and the broader supply chain, which continue to constrain our auto customers' production capabilities. Despite the near-term fluctuations in the auto supply chain, we see a favorable setup for longer-term auto production growth, supported by healthy consumer demand and extremely low dealer inventories. Turning to the Industrial segment orders, we're pleased to note that, for the first time since the onset of COVID, we observed sequential order strength across all businesses in the segment. We face an improving backdrop, with increased capital expenditures for factory automation and investments in renewable energy as well as manufacturing capacity related to electric vehicle infrastructure and semiconductors. This increased capital investment benefits our industrial equipment and energy businesses. We also see improved order trends in our communications and medical businesses. We expect to begin seeing favorable year-over-year revenue comparisons in those sectors later this fiscal year. In our Communications segment, order growth in the first quarter was solely driven by our data and devices business, reflecting an improved outlook for cloud capital expenditures alongside our ongoing share momentum. Our customers in the D&D sector are placing orders for delivery beyond the current quarter due to broader supply chain uncertainties. While we continue to see positive end-market trends in D&D, we are observing a moderation in the appliance market, particularly in China, and expect further softening from the first half to the second half of our fiscal year. With that overview on orders and markets by segment, let me briefly cover the year-over-year segment results, which are illustrated on slides five to seven. In Transportation, our sales decreased 2% organically year-over-year, with declines in auto partially offset by growth in commercial transportation and sensors. Our auto business saw a 6% organic decline in line with the mid-teen auto production declines. Despite the challenges, we have continually demonstrated a separation in our sales performance versus the market due to content growth. TE's technology and products are enabling high-voltage architectures and applications with all leading customers, and 20% of our sales are now driven by hybrid and electric vehicle platforms. In commercial transportation, we achieved an 11% organic growth driven by content growth drivers similar to our auto business. Our sensors segment also grew 5% organically, primarily due to industrial applications and new ramps in transportation applications. Adjusted operating margins for this segment were 18.2%, as anticipated. Moving to the Industrial segment results, our sales increased 18% organically year-over-year. Specifically, in the industrial equipment area, we experienced 40% organic growth, benefiting from increased capital investment across the globe. Our energy business reported 17% organic growth, aided by our deeper penetration of renewable applications. The medical business grew 8% organically as we begin to see recovery in interventional procedures. However, there was a 3% organic decline in our aerospace and defense business due to market dynamics in that space, although orders show a more optimistic outlook going forward. The adjusted operating margins for the Industrial segment grew by 130 basis points year-over-year to 14.8%, propelled by higher volume and robust operational performance by our teams. In the Communications segment, sales grew 40% organically year-over-year, with strong growth across each of our businesses. In data and devices, we experienced strong growth across all regions, driven by content growth and share gains in high-speed cloud applications as our customers move toward 400 gig and next-generation chip platforms, along with growth in server and artificial intelligence applications. We also saw growth in appliances with continued share gains as we differentiate ourselves with our global manufacturing network. Margin performance in this segment was outstanding, with another record in adjusted operating margins of 27%, an increase of 950 basis points year-over-year, building on strong performance in the previous year. Overall, our teams capitalized on growth trends in their end markets, demonstrating the diversity of our portfolio and delivering operational execution with pricing adjustments amid challenging supply chain conditions. Now, I’ll hand it over to Heath to provide more details on the financials and our expectations moving forward.

Thank you, Terrence, and good morning, everyone. Please turn to slide 8, where I will provide more details on the Q1 financials. Adjusted operating income was $712 million, with an adjusted operating margin of 18.6%. GAAP operating income was $672 million and included $24 million of restructuring and $16 million of acquisition-related charges. We continue to expect restructuring charges of approximately $150 million for the full year as we optimize our manufacturing footprint and improve the cost structure of the organization. Adjusted EPS was $1.76 and GAAP EPS was $1.72 for the quarter, including a tax planning-related benefit of $0.05. Additionally, we recorded restructuring, acquisition, and other charges of $0.09. The adjusted effective tax rate in Q1 was approximately 18%. For the second quarter, we expect our tax rate to be very similar to Q1. We anticipate an adjusted effective tax rate for the full year to be around 19%. Importantly, we expect our cash tax rate to stay well below our adjusted effective tax rate for the full year. Moving to slide 9, our results reflect the effective execution of our teams and the diversity of our portfolio. Sales of $3.8 billion were up 8% on both a reported and organic basis year-over-year, while currency exchange rates negatively impacted sales by $45 million compared to the prior year and were worse than expected. We expect currency exchange rates to be a sequential headwind from Q1 to Q2, with a year-over-year headwind of approximately $110 million in the second quarter. If the dollar stays at current levels relative to other currencies, the foreign exchange could impact approximately $300 million to $400 million for our full fiscal year. Adjusted EPS of $1.76 increased by 20% year-over-year, setting a record for the first quarter, as mentioned earlier. Adjusted operating margins were 18.6%, expanding by 90 basis points year-over-year. The incremental flow-through from the adjusted margins and revenue growth was approximately 30% in Q1 on a year-over-year basis. Given the inflationary pressures we encountered and challenges in the broader supply chain, I am pleased with our performance. As Terrence mentioned, we are leaning on pricing measures across the businesses to offset those inflationary effects. Regarding cash flow, during the quarter, cash from operating activities reached $532 million. Free cash flow for the quarter stood at $373 million. The year-over-year trend in free cash flow reflects strategic inventory builds to meet anticipated customer demand, as discussed last quarter. In Q1, we returned approximately $410 million to shareholders through share repurchases and dividends. Notably, in our recent proxy filing, we proposed a 12% increase to our dividend that we expect shareholders to approve in March. We remain committed to our disciplined capital management strategy. Over time, we anticipate returning two-thirds of our free cash flow to shareholders and one-third for bolt-on acquisitions. Before we transition to questions, I want to reiterate that we are executing well, despite the challenges we’ve outlined in the supply chain. Our quarterly results demonstrate the strength and diversity of our portfolio, supported by robust operational performance in each of our three segments. The demand environment remains strong, as evidenced by our orders indicating strength across many of our markets, providing a positive outlook for future growth. We continue to exhibit market outperformance across each segment due to our strategic positioning around secular trends, and we remain enthusiastic about the opportunities for growth and margin expansion moving forward.

Rob, can you please give the instructions for the Q&A session?

Maybe starting with the orders, and appreciate all the color there. Industrials and Communications clearly accelerated, while Transportation softened. Can you just talk about how you're thinking about the order implications for revenues going forward and how we should consider some of the supply chain dynamics affecting those orders?

First off, you're correct. Orders accelerated. As I noted in my comments, we expected the orders in automotive to step down. Even in the last quarter's discussion, we highlighted our extreme content outperformance in the fourth quarter, which we knew would be slightly ahead as some inventory was out there. The orders arriving as expected allows us to maintain a favorable outlook, particularly in Transportation. Where we noticed reacceleration was within Industrial, along with the D&D uptrend I mentioned. This shows a broad revival in industrial spending cycles as we see capital spending accelerate across industrials as well as in com air and medical sectors. On the Communications side, we have a mixed picture — D&D remains robust while cloud CapEx has slightly increased. I would also mention that our teams are winning larger share programs for various applications let's say the order reduction in automotive is more natural. Reaching close to 1 in book-to-bill feels like a stable situation. Auto production improved from 16 million to 19 million units in our first quarter, and as the supply chain stabilizes, it has potential for further growth throughout the year.

The question really revolves around the EPS performance. There are quite a few moving parts here. Could you put some context around the EPS performance that we're seeing? Specifically, what drove the beat in the December quarter? Your perspective would be helpful. As we look at the March quarter, you're suggesting EPS being flat; could you elaborate on the factors at play there?

This is Heath. We are pleased with our results. Remember, our guide for the December quarter showed we beat the top line by more than $100 million, primarily driven by higher auto production numbers that Terrence referenced earlier. We are happy with that and with the follow-through in incremental revenue. In terms of Q2, we're expecting the top line to remain flat sequentially, as we anticipated. We believe auto production will remain stable at around 19 million units. There are challenges from the strengthening dollar that will present headwinds sequentially. Looking at the segments, we anticipate Industrial to improve slightly, while we foresee Communications coming down a bit sequentially due to appliances, as previously noted by Terrence. Non-operational impacts from foreign exchange and tax rates will also serve as headwinds sequentially. Overall, we see similarities in the quarters ahead despite the operational pressures and changes on the top line.

Terrence, you mentioned that the supply chain internally for you was worse than it was 90 days ago. Could you estimate the lost revenue in terms of our missing shipments, and how that compares to recent quarters? What does that embed into the guidance for Q2?

This is Heath. Last quarter, we estimated around $50 million of sales we would like to have shipped if we had the material. That worsened in the current quarter, and we're now just above $100 million in terms of what we would have liked to have shipped if we had the availability of raw materials. This situation took a step back in this quarter, which we expect to remain similar for the second quarter.

My question is on pricing in the quarter and the forward expectations for price-cost dynamics, especially for the transportation segment, where pricing can lag behind other segments. Are there other factors impacting Transportation margins for the rest of the year, as volume potentially rebounds?

Pricing across TE was positive in the first quarter, and we expect it will remain positive this year. In Transportation specifically, pricing often depends on contractual negotiations, which tend to be slightly slower. Later in the year, this should help our margin supplanting some pressures we've previously discussed. One key reminder about pricing — our normal business model in technology generally experiences a 1% to 2% price erosion model. Currently, we're realizing low-single-digit positive gains on pricing. This trend demonstrates strong execution across all segments, and pricing is positive across the board. While certain slow adoption might persist, we aim to counterbalance the inflation and supply chain challenges through effective pricing measures.

Terrence, evaluating the order trajectory in autos normalizing with a book-to-bill closer to 1, how do you foresee that playing out in the June and September quarters? Can you provide qualitative insights on fiscal 2022 and notable headwinds and tailwinds we should consider?

We aren’t providing specific guidance for the year due to the varying market conditions. However, from what we've seen, there’s positive momentum in order trends with some markets, like com air and medical, gaining traction that’s been absent for some time. Auto production is also expected to turn a corner, and although we remain cautious, the outlook from six months ago feels more optimistic. We see solid order trends continuing from sectors like D&D and industrial equipment. As for the second half of the year, Transportation might stabilize while Communications may decrease due to some appliance-related comments I've made. A primary headwind is the strengthening dollar, creating a currency exchange constraint for us year-over-year, with anticipated impacts of about $300 million to $400 million through the full year.

I'm hoping to delve deeper into the dynamics within the automotive end market. Investors may fear that OEMs are shifting towards higher profit-margin models in light of shortages, specifically focusing on premium models. Do you have visibility on whether that trend will persist when supply begins to stabilize? Is this sufficient to shift back toward more economical models? Also, regarding EVs versus internal combustion engine trends, do you anticipate a continuation of the current model, favoring EVs similarly to last year?

When discussing content, we must first look at auto production levels compared to our revenue figures. Auto production is still off by roughly 10% globally, while our revenue exceeds that, reflecting our content outperformance. The supply chain dynamics could affect results – we believe there's natural capability to drive revenue moving forward, and what's more critical is the push on electric vehicles rather than solely the trim mix. Demand for EVs is strong due to regulations that OEMs face across various regions. This aspect remains a significant driver, resulting in doubling the content of electric vehicles compared to internal combustion vehicles. Meanwhile, we're also benefiting from the innovation in combustion vehicles focused on fuel efficiency through enhanced electronic systems. Remember, in addition to EVs, the growing electronic features in combustion engines will continue to support our content growth.

I would like to further understand the dynamics regarding the Transportation segment, specifically bookings. You indicated lower production levels impacted bookings, as well as inventory levels. Can you advise whether you can sustain this level of bookings in Transportation, or is there a chance for bookings to dip, considering any remaining inventory?

I believe you will see a booking level that aligns closely with production metrics. It seems likely that bookings can stabilize closer to the 1 book-to-bill ratio rather than extreme volatility that we saw before, suggesting a stabilizing trend. We anticipate robust order performance, which we've seen at the onset of the second quarter, remaining solid across all regions.

Could we discuss average selling prices? I noticed you mentioned in your prepared remarks and during Q&A that you're up low-single digits relative to the normal decline in pricing trends. Is this an observation that applies specifically to Transportation, or is it across your entire portfolio? Additionally, are these ASP changes tied to long-term contracts where you have visibility, or are they instead based on supply chain cost additions or other factors?

You’re right — price adjustments across TE have been positive in general. As you noted, we've seen low-single-digit increases against traditional downtrends. Pricing pressures are consistent across all three segments; thus, this includes Transportation as well. The pricing adjustments are partly linked to contractual agreements with large clients, affecting their timeline for acceptance. However, pricing in smaller segments is more adaptive, where changes materialize quickly. In aggregate, our pricing reflects supply chain inflationary effects and successful management across our segments. We've accomplished substantial progress overall, and we're witnessing pricing come through the more contractual businesses in the latter part of the year compared to initial adjustments placed in less formal agreements.

Terrence, I do not want to reiterate previously discussed concerns, but I would like to know about order integrity. Many focus on automotive, but how are the non-auto sectors performing? Have you observed notable inventory builds? Are there any customers you foresee being on allocation, particularly in medical, where components are scarce?

Focusing on the IS and CS segments, we don't see significant inventory build-up. A notable aspect is that our distributors are running at roughly 150 days, down from their typical 180 days. They are currently attempting to regain inventory levels, while we have not been able to increase them to pre-COVID highs. From larger customer perspectives, our customers appear to be scheduling much farther ahead due to supply chain tightness, committing to ensuring availability over multiple quarters, particularly seen in data and devices. This ranges to our growth as industrial equipment orders also reflect the positive recovery phase where we aim for consistent alignment with upcoming demand. The medical and com air spaces are showing signs of relief as well.

This is Manmohanpreet Singh on behalf of Samik Chatterjee. Regarding your note that orders were down in Europe, can you help us understand the factors that are driving this trend specifically?

The decline in European orders was primarily linked to the automotive sector, which remains a crucial area for us. Automotive orders were below expectations, but other segments such as industrial and communications also experienced substantial growth. However, the performance lagged in the automotive category driving the overall decline.

I wanted to discuss your strategic inventory build. Is that something you anticipate will work off in the upcoming quarters, or given supply chain uncertainty, do you expect those levels to stay elevated for a while?

This is Heath. Most of our strategic inventory build comes from the transportation side, specifically around automotive and commercial transportation. We built up a significant order base last fiscal year. Even as we return to normalized book-to-bill ratios, a healthy backlog remains for us to exhaust. Whether or not we see moderation in inventory levels will correspond with the recovery of auto production. Consequently, some reduction in inventory levels could occur in the second half of the fiscal year, but this relies on the confidence from our customers and their scheduling patterns. Additionally, the ongoing restructuring may affect some plant operations later in the fiscal year, leading to further builds associated with those changes. This too will play a role in managing our inventory levels.

This could be a question applicable to either Terrence or Heath. I wanted to inquire about your gross margin performance in the first quarter. Following the ongoing discussion about supply chain and inflation affects, could you clarify the company’s gross margin performance in the quarter?

For the quarter, our gross margins on a GAAP basis showed low 32 percentages; however, some non-cash charges from restructuring activities, including a plant closure, influenced that line. We are running closer to the 33% adjusted basis, which aligns with our expectations. As we progress, we anticipate slightly higher margins. The absorption of the ERNI acquisition could weigh on gross margins, but our team is actively engaging in integrating those operations effectively while working through those numbers.

I would like to clarify regarding the 6% content outgrowth you're anticipating for fiscal year 2022 within the automotive sector. Does that account for the impact of foreign exchange, given that you are seeing a more significant impact than expected compared to a quarter ago?

No, that estimate does not include the effects of foreign exchange. That remark pertains strictly to organic growth expectations. Any anticipated changes from the supply chain this year will be categorized differently than currency exchange impacts.

Terrence, I wanted to get a better understanding of the performance you're seeing in devices, particularly cloud computing. Could you describe the customer base there? I understand there is a concentration among large hyperscale players. How diversified is that market? And as you gain market share, are you introducing new players or winning over existing clients?

The customer base in the cloud is indeed dominated by the hyperscalers of the market. While it is a concentrated customer base, we maintain a broad presence among all. Our market share is robust across all players, which is positive. The increasing demand for higher speeds, up to 400 gig, alongside the necessity driven by artificial intelligence, elevates the computing and storage needs that our technology supports. Those wins span an extensive client base, showcasing our adjusted positioning across the high-speed segment we've developed over the years.

Following up on the earlier discussion regarding data and devices, how should we assess the structural growth rate for that segment? Notably, this quarter you've seen almost 50% growth, but strong growth seems to persist. What's the outlook here? For Communications overall, you've referenced high-teens margins previously, so how might we evaluate that in light of the 27% margin achieved this quarter?

From the perspective of D&D performance, I anticipate our business to maintain these high revenue levels throughout the year as we navigate existing challenges. The movements we are witnessing often correspond with scheduled orders made for supply readiness. I foresee a strong sustainable uptick alongside a consistent need for technological enhancements in data centers. As Heath and I discussed concerning margins, while the current data and device sector is performing exceptionally well, expect some moderation particularly in appliances reflected in the second half of our fiscal year due to mix elements. Originally aiming for high-teens margins, we can still consider that as a strong aspiration they still maintain across various segments even with fluctuations.

It looks like we have no further questions. Thank you all for joining us this morning. For any questions, please reach out to Investor Relations. Enjoy the rest of your day.