TE Connectivity plc (TEL) — Q1 2024 Earnings Call Transcript

Good morning, and thank you for joining our conference call to discuss TE Connectivity's Q1 2024 results and outlook for our second quarter. 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 te.com. Finally, during the Q&A portion of today's call, due to the number of participants, we're asking everyone to limit themselves to one question and you may 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 we appreciate everybody joining us today. I also want to wish everybody a Happy New Year. As I normally like to do before we get into the slides, I want to take a moment to discuss our performance this quarter along with what we're seeing in our markets versus our last call 90 days ago. We continue to be in a slow global economic environment. Against this backdrop, the performance of our markets is largely consistent with our expectations, and it resulted in our first quarter sales being in line with our guidance of flat revenue growth. Our Transportation segment once again grew year-over-year driven by content growth, and this offset the declines that we saw in our Industrial and Communications segments. Our team’s execution was strong in the quarter with 20% year-over-year adjusted earnings per share growth, driven entirely by adjusted operating margin expansion to 19% on flat sales. This margin performance demonstrates we're successfully executing on a number of structural margin improvement levers across our segments. Those levers drove margin expansion through the second half of last year and are resulting in a further step-up in margin performance, particularly in our Transportation segment. We expect to deliver strong margin expansion this year driven by our Transportation and Communication segments based on what we're currently seeing in our markets. Just as important is the quality of our earnings, and you see this in our record first quarter free cash flow of $570 million which builds on the strong cash performance from last year and that we expect will continue. During the quarter, we deployed approximately $1 billion of capital that included returning $600 million to shareholders and acquiring Schaffner for $350 million. Schaffner expands our product portfolio in factory automation. Our cash generation model continues to give us both confidence and opportunities to return capital to shareholders while supporting ongoing bolt-on M&A activities. Let me now share what we're seeing in our market since our call 90 days ago. Overall, markets are playing out as we expected, and we had orders growth of 4% year-over-year across all three segments. We are seeing sales growth across the majority of our businesses, but we do have a few business units that are continuing to be impacted by inventory destocking by our customers and we'll highlight these during the call. Our view of the Transportation end markets remains unchanged from our prior view with global auto production expected to grow slightly this year. While we're seeing some puts and takes in production by region, China production and EV adoption are stronger, offsetting some weakness in Europe and North America. In our Industrial Solutions segment, three out of our four businesses continue to have growth momentum, and we expect to continue to see sequential growth in each of these three businesses as we go forward. You see our strong positioning in renewable energy in both solar and wind applications. Commercial air sales continue to grow as production increases for both single and twin aisle platforms, and our medical business is benefiting from increases in interventional procedures. When you compare versus 90 days ago, the one market where we've seen incremental weakness is in our Industrial Equipment business. Destocking began a few quarters ago in this business and we now expect it to continue into the second half of this fiscal year. Lastly, in our Communication segment, we continue to see destocking, but it's now just occurring in pockets. We do expect to see growth in the second half of this year in our Communications segment driven by our wins in artificial intelligence programs. As we look forward, our long-term value creation model remains unchanged and is centered around three pillars. The first is our portfolio strategically positioned around secular growth trends including growth in electric vehicles, adoption of renewable energy, and applications for cloud and artificial intelligence. Second, we have operational levers to enable margin expansion despite a slow economic environment. The drivers encompass strong operational execution including footprint consolidation, portfolio optimization benefits, and price actions that we implemented to offset higher input costs. Third, we've established a strong cash generation model to return capital to shareholders while investing in bolt-on M&A opportunities. With that as an overview, let me get into the slides and I'd ask you to turn to slide three, where I'll discuss some of the additional highlights for the first quarter and our outlook for the second quarter, then Heath will provide more details in his section. Our first quarter sales were $3.83 billion, which was in line with our guidance as I mentioned. In Transportation, we saw 5% organic growth driven by content expansion in our auto business. In Industrial, we saw growth in Aerospace, Defense, Marine, Medical, and Energy, which was more than offset by weakness in industrial equipment. Finally, in Communications, it was down as we expected, but we are well-positioned for growth in the second half driven by AI applications. Adjusted earnings per share was ahead of our guidance at $1.84, up 20% versus the prior year. Adjusted operating margins were 19% and these were up 290 basis points year-over-year driven by strong operational performance, and the margin performance was the driver of our EPS being ahead of guidance. As we look forward to the second quarter, we're expecting our second quarter sales to increase over the first quarter to $3.95 billion with the sequential growth being driven by the Industrial segment, partially offset by a slight decline in Transportation. Adjusted earnings per share is expected to be around $1.82, which will be up 10% year-over-year in the second quarter with approximately 200 basis points of adjusted operating margin expansion versus the prior year. Moving away from the financials for a second, and before I get into orders, I want to highlight that we were pleased to be included in the Dow Jones Sustainability Index this quarter for the 12th consecutive year. This designation continues to demonstrate TE's dedication to sustainable business practices that provide value to our customers and align with our commitment to our owners. Now let's talk about orders and ask you to turn to slide four. At the total company level, we had orders of $3.8 billion, which was up 4% year-over-year and consistent with our expectations. This is the first time since after the COVID crisis in 2001 we've seen all three segments experience year-over-year order growth. We continue to see stability in our overall order levels with year-over-year growth in each of the segments, and with backlog remaining at near record levels, this gives us confidence in our second quarter outlook. Transportation orders grew 4% year-over-year and reflect stability in overall global vehicle production. In the first quarter, auto production came in a little over 22 million units with stronger production in China offsetting some of the weakness in Europe and North America. Going forward, we expect global auto production to be roughly 21 million units per quarter as we move through this fiscal year. In our Industrial segment, we saw growth in orders both year-over-year as well as sequentially. The order strength is driven by our AD&M Medical and Energy businesses, and we saw weakness in Industrial Equipment end markets across all regions of the world. In our Communication segment, our orders grew 3% year-over-year, and we do see destocking by our customers now only occurring in pockets in certain applications. With that as an orders overview, let me get into the year-over-year segment results, which we saw in the quarter on slides five through seven of your slide deck, where you can see the details on those slides. Starting with Transportation, the overall segment had sales growth, up 5% organically year-over-year driven by our auto business. Our auto business grew 8% organically with 13% growth in Asia and 7% growth in Europe, more than offsetting a decline in North America. Our performance continues to be driven by content growth from our leading global position in electric vehicles as well as electronification trends within vehicles. Our global outlook for electric vehicle growth is unchanged; it's important to note that over two-thirds of EV production will occur in Asia. We are very well-positioned to capitalize on this growth due to our strong content and share in local Chinese OEM platforms driven by our innovation. Our growth will continue to be driven by content outperformance that leverages our leading global position in the automotive market. In the Commercial Transportation business, we saw 1% organic sales growth driven by Asia, which was partially offset by declines in North America. In our Sensors business, about half of the sales decline was driven by the portfolio optimization efforts, where we're selectively exiting lower margin and lower growth products. The rest of the decline in Sensors was driven by weakness in sensor applications in industrial markets, partially offset by growth in automotive applications. For the Transportation segment, adjusted operating margins were nearly 21%. We expect Transportation segment margins to run around our 20% target margins for the rest of this year. As you know, we've been driving several operational improvements. We have been able to optimize our factory footprint through our restructuring programs and are getting cost savings from these actions. We're also seeing improvement in our EV product margins as volumes increase and in our Sensors business, we have been driving margin expansion through portfolio optimization. Our teams are continuing to effectively manage pricing to offset higher input costs. I’m pleased to report that the team is successfully executing on these initiatives and delivering strong results. Now, moving to the Industrial segment, in this segment, sales were down 5% organically in the first quarter, but we did see growth in three of our four businesses, and we expect to see continued sequential growth in AD&M, Medical, and Energy as we go into quarter two. In the first quarter, our AD&M sales were up 13% organically, driven by increased production of both single and twin aisle platforms in the commercial air market. In Medical, sales in the quarter were up 16% organically, driven by ongoing increases in interventional procedures. In our Energy business, we saw growth in renewable applications, partially offset by slower utility demand in Europe. Finally, you can see on the slide that in the Industrial Equipment business, sales were down 26% organically. In this business, we’re experiencing the destocking that began later in the cycle, so we expect this inventory digestion to continue. This trend is similar to what you've been hearing from other companies. From a margin perspective, for the Industrial segment, adjusted operating margins were 15%, impacted by the volume decline in Industrial Equipment. We expect to continue to see segment margins running in the mid-teens until this destocking environment improves. Now let’s turn to Communications. Organic sales were down 17% year-over-year, and we expect second-quarter sales to be similar to first-quarter levels. Starting in our third quarter, you will begin to see favorable year-on-year growth in this segment. We are well-positioned to grow in our artificial intelligence programs and now expect a $200 million contribution in fiscal '24 from AI applications. In these AI applications, we're focused on providing high speed, low latency connectivity to meet the needs of artificial intelligence workloads. As we mentioned before, we generate 50% more content in an accelerated compute AI platform versus traditional compute servers. We're also continuing to work closely with cloud customers and leading semiconductor companies to ensure reference designs that highlight all our solutions. On the margin front for the segment, adjusted operating margins were 18.7%, up 170 basis points despite the decline in sales. Our teams are executing extremely well, and we believe we will be able to maintain high-teen margins in this segment as we move through this year. So with that overview, let me turn it over to Heath to get into more details on the financials and our expectations going forward.

Thank you, Terrence, and good morning, everyone. Please turn to slide eight, where I will provide more details on the first quarter financials. Adjusted operating income was $731 million with an adjusted operating margin of 19.1%. GAAP operating income was $698 million and included $8 million of acquisition related charges and $25 million of restructuring and other charges. For the full year, our expectations are unchanged, and we continue to expect fiscal '24 restructuring charges to be approximately $100 million, which is well below the levels we've been running in prior years. Going forward, we expect that restructuring charges will be driven by actions to improve efficiency around future bolt-on acquisitions. Adjusted EPS was $1.84, and GAAP EPS was $5.76 for the quarter, which included a benefit of nearly $4 related to a one-time non-cash non-U.S. tax benefit, a change in the Swiss tax rate, and the impact of intercompany transactions. Additionally, we had restructuring, acquisition, and other charges of $0.07. The adjusted effective tax rate was 21.2% in Q1, slightly higher than our guidance due to an increase in the Swiss tax rate that I just mentioned. For the second quarter and for the full year, we now expect our adjusted effective tax rate to be approximately 21%. Importantly, we continue to expect our cash tax rate to stay well below our adjusted effective tax rate for the full year. Now let's turn to slide nine. Sales of $3.83 billion were flat on a reported basis and down 1% on an organic basis year-over-year. Adjusted operating margins were 19.1% in the first quarter, expanding 290 basis points year-over-year despite flat sales. As Terrence mentioned earlier, this was driven by margin expansion in our Transportation and Communications segments. Adjusted earnings per share was $1.84, up roughly 20% year-over-year driven by strong margin expansion. Turning to cash flow. Cash from operations was $719 million. Free cash was a record first-quarter level of $570 million. In the quarter, we deployed roughly $600 million to shareholders through share buybacks and dividends and also utilized roughly $350 million for the Schaffner acquisition. Our long-term capital strategy remains unchanged, which is to return approximately two-thirds of free cash flow to shareholders and use one-third for acquisitions over time. Before I turn it over to questions, let me reinforce some of the key points we discussed today and share how we are thinking about our performance and what we expect to be a slow macro environment. We are continuing to take action on the things we can control to improve our financial performance, and you see this reflected in our strong results for Q1 as well as our expectations going forward. On the top-line, we continue to benefit from secular growth trends, and you see this in the outperformance we are delivering versus some of the key markets we serve. You have been seeing the benefits of our global leadership position in electric vehicles, but other growth applications like artificial intelligence are just getting started. Below the top-line, we are successfully executing on multiple operational levers, as discussed earlier on this call. Moving forward, our focus continues to be on margin expansion and earnings growth despite the slow macro environment. Finally, we remain excited about the opportunities ahead to drive value creation for all stakeholders. With that, let's open up the call for questions.

Thank you. Can you please give the instructions for the Q&A session?

Yes. Good morning, and thanks very much for taking the question. Can you speak in more detail about what is better or worse than you had previously been anticipating with respect to the quarter and outlook? On the broader topic of what areas are changing versus your prior views, do you still think your auto business can outgrow auto production by mid-single digit percent or are shifting EV production plans from auto OEMs impacting that?

Hi, Mark, thanks for the question. Let me start with the first part. As we said on the call, things overall came in as we expected here in the first quarter. When you think of the topline, the two moving parts we saw, one was better and the other was a little worse. The one that was better was we saw auto production was a little stronger, just over 22 million units, driven out of China. We have a great position there and we capitalize on it. The area that was a little bit worse is our Industrial Equipment business. We highlighted back in our September quarter that we started to see some destocking, which got incrementally worse through our channel partners. The overall orders came in where we expected, except for the Industrial Equipment, which was a little weaker. On the bottom line, margin performance by our team was better, driven by Transportation and Communications, and that drove the EPS higher. Regarding auto content outperformance, we do believe EV production will be up about 25% this year, driven largely in Asia, which is our largest region for automotive revenue. We feel good about maintaining the 4% to 6% outperformance we talked about.

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

Yes. Thank you. Good morning. Terrence, maybe just a follow-up on your point about margins. You've really had standout margins at both the gross margin level and at the operating margin level. Can you parse a little about the impact from the actions you have taken, such as restructuring, footprint, EV mix, and so on? What do you think is the sustainability of that and how does that translate into segment margins for the rest of the year? Thank you so much.

Hi, Wamsi, thanks for the question. I'm going to let Heath take that.

Sure. Wamsi, listen, we've talked here for a while about our journey and the outsized restructuring charges we've taken over the past few years. We’re starting to see the benefits of our footprint consolidation come into play, contributing positively to our margins, which, of course, translates into earnings and most of that shows in gross margins. As Terrence mentioned, execution, which includes footprint, is one contributor. We've also made portfolio optimization moves and have been diligent on pricing actions we’ve implemented to recover costs. The key to achieving target margins in the Transportation segment was an increase in volume support, which we are now beginning to see. Despite a few factors impacting Industrial, we feel good about where adjusted operating margins will land across the segments for the year.

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

Thanks a lot. Good morning, everyone. My question is really around the end demand trends. I understand your commentary that things are stable compared to other semiconductor companies. But I'm hoping you can talk about how orders in the December quarter are down sequentially in aggregate while remaining flat for CIS. Is that a concern that perhaps that second derivative is starting to shift negatively? How do you think about orders being down sequentially versus your broader stable commentary?

Yes, sure, Amit. Thank you for the question. First off, our orders were up in all segments year-over-year by 4%. Not only should you look at orders, but we continue to have a backlog around $6 billion. We are not seeing cancellations, which is different from what some semiconductor companies are reporting. Our products are quite different, and the lead times are much shorter. When we look at orders for the quarter, I can tell you they came in as expected, except for Industrial Equipment, which was a little weaker. We think global auto production will drop to about 21 million units per quarter this fiscal year. In Industrial, you will see a sequential order increase led by strong performance in AD&M, Medical, and Energy.

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

Thank you. Good morning. I had a question about some of the channels. With the Industrial Equipment segment declining sharply, could you juxtapose the actual end market for me? Also, any thoughts on inventory levels in the auto sector?

Thanks, Chris, and good morning. Let’s break this apart. In automotive, we do not see destocking of our product at all. Our service levels are 90% plus, and we’re serving our customers directly, which accounts for 80% of what we do. We had low-single-digit organic growth on that 80%. In contrast, the piece that goes through our channel partners, which were down 14% in the quarter, are seeing destocking, particularly in Industrial Equipment and appliances businesses. So, this is where we see the biggest impacts. We experienced some improvements in appliances, but the destocking in Industrial Equipment will take longer to get through.

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

Thank you. I wanted to follow-up on earlier questions around EV penetration and auto outgrowth. Q1 outgrowth came in below target levels despite normalized prices. Is there pressure from softer EV penetration, mix headwinds, or should we not think about this on a one-quarter basis? Lastly, if China took share in global auto production, is it fair to think of that as a headwind due to it typically having lower content than the U.S. and Europe?

A couple of things, Chris. First off, please don't look at outperformance on a quarterly basis. You will see variations like 300 basis points, which was below our expectation. We expect to maintain 4% to 6% outperformance for the year. On EV adoption, we’ve maintained our outlook. Global car production meets our expectations, with about 85 million cars made globally this year, two-thirds of which will be manufactured in Asia, where we see strong EV growth. This is where we have considerable share, and our outlook for EV content has remained strong.

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

Hi, good morning. I was wondering if you could just dig into the Schaffner acquisition a little bit more in terms of what it adds to the industrial portfolio and what kind of sales and margin profile we should expect going forward from it?

Thanks, Steven, good morning. The Schaffner acquisition focuses on factory automation space, where they are a global leader in electromagnetic filter solutions. This acquisition allows us to deepen our portfolio in factory automation, particularly since our existing U.S. product line complements their European presence. Revenue for Schaffner is around $40 million a quarter, and we expect to improve profitability in line with our objectives in the broader market.

No, I think Steve it’s right down the middle of how we view bolt-on deals. While it's contributing $40 million a quarter, our focus is on driving value creation from the acquisition, improving the cost structure, and ensuring cash on cash returns for our shareholders. It won't contribute significantly to EPS in the first year, but we expect it to follow a similar trajectory to our ERNI acquisition with positive outcomes in line with our margin expansion strategy.

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

Hi, guys. Good morning. I just want to ask on the AI side within Communications. You mentioned you have a 50% content lift in AI-type applications. I’m curious how much of what's being built for AI is simply replacing older stuff? Essentially, if you're doing $200 million of AI-related content in 2024, is that replacing like $133 million of content of older types of stuff?

So Joe, your question is about cannibalization regarding capital deployment. We're still deploying servers to support AI. What's crucial is understanding the increased content needed to support the workload. So, it’s not a simple replacement. We believe we will hit $200 million in AI revenue this year, with growth primarily occurring in the second half, driven by program launches.

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

Hi, thanks for taking my question, and Happy New Year as well. I wanted to follow up on your AI contribution, now indicated at $200 million, raised from $150 million. What’s driving this increase? Is it more capacity or demand? Also, you mentioned a $1 billion order booked previously. How has that pipeline expanded? What are the implications on margins for the Communications segment?

Thanks, Samik. The increase in AI revenue is driven solely by demand and winning new projects. Our order pipeline is growing and now exceeds $1.3 billion. Regarding margins, we expect that even with lower revenue, we will maintain high-teen margins in the Communications segment as we move forward.

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

Great. Can you hear me now?

Yes.

Great. Sorry about the technical issues there. Terrence, just hoping you could comment on your ability to hold the line on neutral pricing in Transportation Solutions, especially in automotive this year. It seems some companies are talking about getting back to price downs. For TE, if you could elaborate on the factors helping you maintain that neutral pricing outlook you outlined earlier?

Hi, Luke, thanks for the question. When you look at input costs, we haven't seen massive inflation or deflation. Copper, for example, remains high year-over-year. While freight costs are down, the net phenomenon is quite neutral. As we talked with customers, it's crucial to recover cost us effectively. Pricing is driven by input costs, and we've managed expectations well with our clients to ensure competitiveness.

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

Hi, thanks for taking my question. Following up on the last question. Do you feel if we were to normalize pricing, typically, we see price downs of about 1-2% for TE? Currently, pricing is up about 1%. Given the restructuring and other cost actions undertaken, do you still believe you can sustain that 20% margin moving forward? Also, how should we think about the relative profitability in the auto business between the EV and existing ICE products, particularly if we encounter a slowdown in global EV adoption?

First, if we experience deflation, there may be some price adjustments. In a typical environment, we would strive to return to our target margins, which haven't changed. Notably, roughly half of our content on an electric vehicle overlaps with that of an ICE vehicle, meaning profitability on those products remains essentially the same. We've closed the profitability gap on higher power products significantly, and while growth has slowed in some regions, we believe we’ll manage through.

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

Okay.

Great. Thanks for taking my question. Just one follow-up, you didn't talk about tax. I think you mentioned on the call that the rate is about 21%, which is a bit higher than historically. How should we think about that going forward? Is that a permanent rate? Is that impacting some of the global minimal tax changes, or can we bring that down over time?

Colin, thanks for the question. The change from our originally guided rate of 20% has been increased to 21%, primarily due to the Swiss tax rate adjustments coming sooner than anticipated. As we navigate through various global minimal tax implementations at different times, mitigating the effective tax rate is always a focus for us. I think 21% will be a good rate to work off of for now, but we continue to explore options for mitigation moving forward.

Alright, thank you, Colin. We appreciate everyone joining us this morning. If you have additional questions, please contact Investor Relations at TE. Thanks again, and we hope everyone has a nice day.