TE Connectivity - Earnings Call - Q3 2020

Transcript

Operator (participant)

Ladies and gentlemen, thank you for standing by, and welcome to the TE Connectivity third-quarter earnings call for fiscal year 2020. At this time, all lines are in a listen-only mode. Later, we will conduct a question-and-answer session. To ask a question during that time, you will need to press star one on your telephone keypad. As a reminder, today's call is being recorded. I would now like to turn the conference over to your host, Vice President of Investor Relations, Sujal Shah. Please go ahead.

Sujal Shah (VP of Investor Relations)

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 on the Q&A portion of today's call, we're asking everyone to limit themselves to one question to make sure we can give everyone an opportunity to ask questions during the allotted time. We are willing to take follow-up questions, but ask that you rejoin the queue if you have a second question. Now, let me turn the call over to Terrence for opening comments.

Terrence Curtin (CEO)

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 do 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 while they are also navigating this environment.

I think the second key thing that is the same is that our balance sheet and liquidity were strong coming into the COVID downturn, and it remained strong. We have a strong cash-generative business model with flexibility to use our cash for investing for growth opportunities and improving our cost structure while continuing to return 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 that we spoke about last call that is the same is that our manufacturing resilience was a differentiator last quarter, and you're seeing 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 that 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'll 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 increase, we're going to continue to see expansion of margins and earnings per share sequentially, and we do believe that our third quarter was a 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 that were produced in our third fiscal quarter.

We are now expecting a 40% increase in auto production sequentially into September, and we're pleased that dealer inventories remain at appropriate levels that support that production, and the last key difference that I would say versus last quarter is, while we're being impacted by market volatility in our transportation segment, our industrial and communication 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 also 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 for respirators and ventilators, where our products are key building blocks in their architecture. And another thing that I'm very proud of, and that was an employee-led effort, is that we've utilized our 3D printing and molding expertise to supply face shields for healthcare workers around the world. And I'm pleased to tell you that we now have produced and donated over 120,000 face shields for frontline healthcare workers and hospitals around the world.

I would tell you these are just a few examples of what our teams have done, but it also gives me confidence in our focus as well as the opportunities of what we're capable of as we come out of this crisis. Overall, we are pleased with our performance considering this challenging and, in many ways, unprecedented environment. We are also expecting that the recovery will be gradual, more like an endurance race than a sprint. But I will tell you, we remain excited about our content and growth opportunities that we position TE around. So with that lead-in, let's jump into slides. And if you could jump to slide three, 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 communication segment, 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. 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 communication segment, our sales were up 14% sequentially, driven by strength related to cloud applications. From an earnings perspective, adjusted operating margins were 9.4%.

I am pleased, even with the concentrated drop in our auto sales in our transportation segment, we were able to manage the earnings fall down on sales and achieve the adjusted OI 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 do 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 communication segments to be essentially flat sequentially in the fourth quarter on a combined basis. We also continue to expect to improve our earnings power by continuing to execute the footprint consolidation plans, while we've also accelerated additional cost reductions considering the weaker demand environment that we're experiencing. Longer term, we remain committed to our margin expansion plans and the expectations that we've shared with you. As we look beyond the current environment, we are 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 four, 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 have seen continued monthly trends improve since the bottoming in April, and April really, as our customer shutdown, was a very slow order month, and 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 105. And 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 have 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'd ask that you turn to slide five, and let's get into our sales view for the fourth quarter and how we're thinking about it. We are expecting sales to increase by approximately 10% sequentially into our fourth quarter, primarily driven by a 40% sequential increase in auto production. We expect auto production to go from roughly 12 million vehicles produced globally in the 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 being produced before COVID. Beyond automotive, we do have some puts and takes, both on the positive and the negative side, and we are expecting sequential growth in some of other businesses, but this is expected to be offset by residual impact of supply chain correction by our auto and other customers. When we think about this growth of 10% sequentially by segment, we are expecting 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 for revenue sequentially, we expect roughly 35% incremental adjusted operating margins on the volume growth.

Note that the 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 as a backdrop at the total company level, let me briefly discuss year-on-year segment results in the quarter on slides seven through nine, along with some key drivers in each of the segments that we expect will fuel future content and growth. So 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 that while the production of internal combustion vehicles will drop significantly this year, we do expect production of hybrid and electric vehicles to be up approximately 12% in fiscal 2020. That gives us confidence around where we've positioned ourselves around the electric power train and the investments we make. And just to bring this to life a little bit on the electric vehicle, 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 performance of both hybrid and full electric platforms.

In fact, we've 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, and there's 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, and what we also get excited about is, while we talk to you a lot about what's going on in the electrical power train in cars, it's also important that we're taking this technology over to the commercial transportation space as well, and a key example of how we're doing that there is the applications in our work with Nikola.

Nikola is using hydrogen 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 subsystems within the electrified power train of their trucks, as well as also the various infotainment and driver convenience systems that use high-speed data connectivity solutions. And 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 and capable of a 750-mile range. And I think it just proves that in these markets, we've had leadership, and we're going to continue to have clear leadership as we help solve next-generation electrical power trains. 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%, and certainly impacted by the lower volumes. It's important that 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 do 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. Just to remind you, what we've built in our medical space is a leading position around interventional procedures.

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 treatments 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 innovation. We've 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 the 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 talking to you about.

Data and Devices grew 13% organically year over year due to our strong position in high-speed solutions and cloud applications. In this business, 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 with that, also the thermal properties that are required in next-generation data centers for the world's leading cloud providers. Similar to medical, in the past three years, we've generated over $1 billion of new design wins in our cloud business, giving us confidence around future growth. So 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.

Heath Mitts (CFO)

Thank you, Terrence. Good morning, everyone. Please turn to slide nine, where I'll 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 of 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 the 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 continuing operations was $380 million. Free cash flow was $280 million for the quarter, and year-to-date free cash flow is $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 and 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 are expecting approximately 35% fall-through to adjusted operating income on that sequential volume growth. In terms of market, we are expecting 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 business, 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.

Sujal Shah (VP of Investor Relations)

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

Operator (participant)

Certainly. At this time, I would like to remind everyone, in order to ask a question, please press star, then the number one on your telephone keypad. In order to have time for all questions, each participant is limited to one question. If you would like to ask a follow-up question, please press star, one to return to the queue. Your first question comes from the line of Wamsi Mohan from Bank of America. Your line is open.

Wamsi Mohan (Senior Equity Research Analyst)

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 order cadence you're seeing and any early thoughts on how this recovery cadence compares to perhaps other auto downturns you've seen? Thank you.

Terrence Curtin (CEO)

No, thanks, Wamsi. So let me spend a little bit more time on orders, expand on what I said. So first off, one of the things that I think has been unique about this downturn has been production was shut off even when there was still demand. And that's very different than any other downturn. And our orders in the quarter, and you can see on the order slide I went through, the $2.4 billion, and even our book to bill was very light in the quarter because of the sharp decline in orders we saw in April in the Western world. And we saw Asia and China orders. In China, they bounced back. In other markets like Japan and Korea, they're still recovering, but didn't go down as deep as certainly Europe and North America did.

So when you think about the shape that we've seen and what we're working with our customers on, especially in transportation, you saw as they were thinking about ramping improvement in May, improvement in June. And as we shared during the call, we had a 105 book-to-bill in July. And I think one of the keys when you think about a book-to-bill, there's a numerator and there's a denominator. And the denominator is also strong. So it gives us the confidence around where we're telling you we think sales are going to be, even though we continue to be in a very volatile environment. I think when you think about, and let's keep it to transportation first, how is production ramping, we do see production getting back to 17 million units, which is pretty consistent with where production was in the second quarter.

But it's still below the 21 million units. So it's nice to see our customers ramp. If you take places like North America and China, dealer inventories look in line because production was shut down so abruptly and demand continued, albeit at a lower level. So they're the things we're going to continue to be watching as we move forward. And what has been nice outside of transportation, while there's puts and takes, like we covered both Heath and I, while there's strength in some markets, it's also offsetting some markets that are weak like commercial air. And I think that demonstrates how we've improved the portfolio over our time since the last crisis.

We are encouraged by where the orders have been tracking to, but certainly it is a challenging environment that's impacted by COVID that I think we do believe will continue to be a gradual recovery, as I said. Don't think it'll be bouncing back to 21 million vehicles immediately, but we have to see how the world heals and how the economy heals.

Sujal Shah (VP of Investor Relations)

Okay. Thank you, Wamsi. We have the next question, please.

Operator (participant)

Your next question comes from Amit Daryanani from Evercore. Your line is open.

Amit Daryanani (Senior Managing Director)

Perfect. Good morning, guys. Thanks for taking my question. I guess I had one question on the incremental margins, and it's super early on the West Coast. I'm probably doing my 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 aren't we 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.

Heath Mitts (CFO)

Thanks. 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 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 think about the flow-through math on how that works through our absorption, so thank you for the question.

Sujal Shah (VP of Investor Relations)

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

Operator (participant)

The next question comes from Craig Hettenbach from Morgan Stanley. Your line is open.

Craig Hettenbach (Executive Director)

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 EVs, just in automotive? Are you seeing any slow programs or are things kind of tracking as you'd expect from a new design perspective?

Terrence Curtin (CEO)

Thanks, Craig, for the question. So a couple of things. One of the things that is a real positive that we talked about in the prepared comments was where our content's holding in. And let's face it, the content's holding in very strong, and we have the separation, and it is due to the progress in EV. And we're getting the benefit of, while electric vehicles are up 12%, you're seeing that in the content, and you see that year to date. When.