TE Connectivity - Q3 2023

Transcript

Operator (participant)

Ladies and gentlemen, good morning. Thank you for standing by. Welcome to the TE Connectivity third quarter 2023 earnings call. At this time, all lines are in a listen-only mode. Later, we will conduct a question-and-answer session. If you would like to ask a question during that time, simply press the star key followed by the 1 on your telephone keypad. If you would like to withdraw your question, press star one a second time. As a reminder, today's call is being recorded. I would now like to turn the conference over to our host, Vice President of Investor Relations, Sujal Shah. Please go ahead.

Sujal Shah (VP of Investor Relations)

Good morning, thank you for joining our conference call to discuss TE Connectivity's 3rd quarter 2023 results and outlook for our 4th 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, 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. 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. I also want to remind you that our Q4 results in fiscal 2022 included an extra week.

In this call, year-over-year comparisons for the fourth quarter and fiscal 2023 are made excluding this extra week. Finally, during the Q&A portion of today's call, we are asking everyone to limit themselves to 1 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.

Terrence Curtin (CEO)

Thanks, Sujal. Thank you everyone for joining us today. Before we get into the slides, and as I typically do, I want to take a moment to discuss our performance this quarter within the backdrop of the market environment, along with what we're seeing versus our last call 90 days ago. I am pleased with the execution of our teams in the third quarter, with revenues that were in line and EPS that was ahead of our guidance due to strong performance across all three segments. Our transportation and industrial segments grew year-over-year, which essentially offset the expected declines in our communication segment. Our adjusted operating margins expanded 130 basis points sequentially without the benefit of any volume growth. We delivered on the actions that we've been driving to ensure margin expansion occurred as we move through thisfiscal year.

As important, you're going to continue to see the benefits from the strategic positioning of our portfolio around secular growth trends, including increased global production of electric vehicles, adoption of renewable energy, and applications for cloud and artificial intelligence. In the quarter, our orders of $4 billion are not only indicating stability in transportation and industrial, but also in our communication segment as well. I view the order trends to be a real positive, and they're reflecting the improving supply chains and reinforce our fourth quarter guidance, which I'll get into more details in a moment. As we've been sharing with you, one of the key areas of focus this year has been working capital management as supply chain performance improves. Our strong free cash flow performance reflects our focus both in the quarter as well as you see it at year-to-date.

Cash generation is an important part of our business model, year to date, free cash flow is up 40% versus last year. Our capital strategy continues to remain disciplined, and we've returned roughly $1.2 billion of capital to our owners so far this year. Let me now provide some additional color on our markets and other updates since our last call. On an overall basis, our markets are playing out as we expected. We have most of our key end marks, markets in a growth or recovery trajectory, and we have a few markets that continue to cycle, and these we previously discussed with you. Our view of transportation end markets remain consistent with our prior view, and we continue to expect auto production to remain roughly flat at approximately 20 million units per quarter globally.

Our growth in the transportation area will continue to be driven by content outperformance and our leading global position in electric vehicles. Turning to our industrial segment, we have three businesses that continue to have strong growth momentum. You continue to see our strong positioning in renewable energy, with growth from both wind and solar applications. In commercial air, sales continue to grow as this market recovers, and our medical business is benefiting from increases in interventional procedures. In our communication segment, while sales are down significantly this year versus last year's cyclical peak, our order trends are indicating stabilization at the current levels. Finally, I do want to reinforce that the way we think about long-term value creation remains unchanged.

It's built on the pillars of secular growth trends that will drive increased content in the markets where we position TE, strong free cash flow generation with discipline around how we deploy capital, and leverage to enable margin expansion as we move forward. While our orders are indicating stability, we continue to see strong opportunities to expand sales, margins, and earnings per share as we move forward. At this time, I want to get in the slides, and we'll discuss some additional highlights, and if you could turn to slide 3, I'd appreciate it. Our third quarter sales were $4 billion, and this was in line with our guidance and down slightly year-over-year on a reported and an organic basis. We saw organic growth of 7% in our transportation segment and 2% in our industrial segment.

Our communication segment declined due to the expected market weakness that we've been talking to you about. Adjusted earnings per share was ahead of our guidance at $1.77, with adjusted operating margins of 17.3%. These margins were up 130 basis points sequentially, as I already mentioned. The margin improvement from quarter two to quarter three was driven by our transportation and industrial segments, as we are delivering on our commitment to expand margins from the first half to the second half of this year. Our earnings per share performance that was ahead of guidance was driven primarily by the stronger margin performance. As we look forward, we are expecting our fourth quarter sales to be approximately $4 billion and adjusted earnings per share to be around $1.75, which are both similar to our quarter three levels.

Similarly to our third quarter, we do expect year-over-year sales growth in our transportation and industrial segments and a decline in our communication segment. Moving away from the financials for a moment, I do want to highlight that we issued our corporate responsibility report, which we call Connecting Our World, and, you know, we've issued this report for over a decade. There are a number of initiatives that we're driving internally, and our goals are in line with our purpose as well as expectations from our customers. Key highlights in the report versus prior year includes an over 30% reduction in our absolute Scope 1 and 2 greenhouse gas emissions, and currently, I want to highlight that 50% of the electricity in TE comes from renewable sources.

I also want to note that we communicated our commitment to the Science Based Targets initiative, which enhanced targets for greenhouse gas reductions by 2030 that are inclusive of Scope 3 emissions. With that as a quick background on slide 3, let's move to slide 4, and I want to talk about our order trends. On the slide, you can see the details and the moving pieces, but I do think the key takeaway is that our orders are reflecting stability in all three of our segments. This is nice to say after some of the order patterns we've had over the past couple of years, and these orders reflect and reinforce our guides for the fourth quarter. When you look at our transportation and industrial orders, they're both roughly flat from the second to third quarter.

The real highlight and where you see the changes in our communication segment, where our orders increased 5% sequentially. This is the first sequential increase in our communication segment orders since the first quarter of fiscal 2022. With that quick overview of orders, let me now discuss the year-over-year segment results that are laid out on slides 5 through 7. You can see the details, and I'll just talk about the high points. In our transportation segment, sales growth remained strong, and it was up 7% organically year-over-year with organic growth across all of our businesses. Our auto business grew 9% organically. We had growth in all the regions of the world. The strong performance continues to be driven by our leading position on electric vehicles, as well as electronification trends in cars and positive impacts from pricing.

While auto production is staying flat at about 20 million units per quarter, production of hybrid and electric vehicles are continuing to grow and right now reflect about 25% of total global auto production in our fiscal 2023. As you know, we generate approximately two times the content in electric vehicle platforms versus a combustion vehicle. We expect our content per vehicle to continue to expand as we move forward and the increased adoption of electric vehicles. Elsewhere in this segment, our commercial transportation business, we saw 2% organic growth in the 3rd quarter, and in our sensors business, our 4% organic growth was driven by automotive applications as we see increased volumes from new design wins.

At the margin level, in the segment, adjusted operating margins were 18.6% in the quarter. This was up 130 basis points year-over-year and 200 basis points sequentially as a result of operational performance, including the benefit of price increases. Let me move over to the industrial segment. At the segment level, sales increased 2% organically year-over-year. We had strong organic growth in 3 out of the 4 businesses in the third quarter. Our AD&M business, our sales were up 13% organically. We're benefiting from the ongoing improvement in the commercial air market. In medical, sales in the quarter were up 11% organically, driven by ongoing increases in interventional procedures. Turning to our energy business, we continue to see momentum with 8% organic growth driven by renewable applications.

The addressable market for TE in renewable applications has a double-digit CAGR, and we're helping to enable utility-scale solar and wind farm deployments. Through our broad product portfolio, we are helping our customers reduce installation as well as maintenance costs, and we expect our sales from renewable applications to be up double digits again this year. What's really nice in this business is that the current quarter continues to demonstrate the growth momentum that we've been delivering in this business, which has had an organic sales CAGR of 8% since 2019. Finally, in the industrial segment, in our industrial equipment business, our sales were down 10% organically, and this sales decline was driven by inventory digestion in the distribution channel and is being driven by improvements in the broader supply chain that we're all feeling.

In the industrial segment, adjusted operating margins were 15.8%. These margins reflect the impact of the expected volume declines in the industrial equipment business. I want to highlight that we remain committed to achieving our high-teen margins target for this segment. Now let me turn to the communication segment. In this segment, our sales were down 37% organically to $424 million. It was slightly lower than we expected. Versus last year's cyclical peak, appliances and our data and device businesses are being impacted by market weakness and the ongoing consumption of inventory across our customer supply chain that we previously discussed with you. Despite this weakness in sales, we maintained adjusted operating margins in the mid-teens range at 14.2%.

Based upon the order trends I talked about earlier, we believe communications revenue will be roughly flat to Q3 levels in the Q4, with adjusted operating margins remaining in the mid-teens. With the communication segments, I do want to look beyond the near term for a moment and really talk about what we get excited about, especially in our D&D business, as it continues to have strong design win momentum in next generation AI platforms. Last quarter, we mentioned that we secured $1 billion in design wins for AI and certainly related server applications. I just want to highlight for you, this number continues to grow.

We expect meaningful ramps of AI programs as we move through fiscal 2024, with 50% more content in an accelerated compute AI platform versus a traditional compute server. The other key highlight is we're working closely with cloud customers as well as leading semiconductor companies with reference designs that call out our TE Connectivity solutions. With that, as a wrap-up, let me turn it over to Heath, who will get more details on the financials as well as our expectations going forward.

Heath Mitts (CFO)

Well, thank you, Terrence, good morning, everyone. Please turn to slide 8, where I will provide more details on the third quarter financials. Adjusted operating income was $692 million, with an adjusted operating margin of 17.3%. GAAP operating income was $630 million and included $53 million of restructuring and other charges, and $9 million of acquisition-related charges. Year to date, we have taken $208 million of restructuring charges, and we continue to expect full-year restructuring charges to be approximately $250 million as we continue to optimize our manufacturing footprint and improve the cost structure of the organization. Adjusted EPS was $1.77, and GAAP EPS was $1.67 for the quarter and included restructuring and acquisition and other charges of $0.10.

The adjusted effective tax rate was 18.2% in Q3. For the fourth quarter and for the full year, we now expect our adjusted effective tax rate to be approximately 19%. We continue to expect our cash tax rate to stay well below our adjusted ETR for the full year. If I can get you to turn to slide 9. Sales of $4 billion were down 2% reported and 1% on an organic basis year-over-year. Currency exchange rates negatively impacted sales by $42 million and adjusted EPS by $0.05 versus the prior year. Adjusted operating margins were 17.3% in the third quarter, expanding 130 basis points sequentially, despite lower sales, driven by margin expansion in our Transportation and Industrial segments.

We have continued to drive productivity and cost initiatives and have implemented the price increases that we discussed in prior calls. Our pricing is now fully offsetting the impact of higher input costs. Turning to cash flow. In the quarter, we once again demonstrated strong cash generation model of our business with cash from operations of $779 million. Free cash flow for the quarter was approximately $615 million. Through the first three quarters of the year, free cash flow is approximately $1.5 billion, which is up 40% year-over-year, and then roughly a $1.2 billion return to shareholders through share buybacks and dividends. As you may recall, I indicated that we would look to drive our own inventory levels lower as we saw performance improving in our supply chain.

We have been able to deliver improvements to working capital, which has contributed to our free cash flow performance this year. As a result of our actions and strong profitability, we expect free cash flow conversion to approach 100% this year. We continue to remain disciplined in our use of capital, and our long-term strategy remains consistent, which is to return approximately two-thirds of our free cash flow to shareholders and use about a third for acquisitions over time. Before I turn it over to questions, I want to reinforce that the strategic positioning of our portfolio is enabling us to deliver strong results from secular growth trends. In our transportation segment, we expect to deliver high single-digit organic revenue growth this year. In our industrial segment, we expect double-digit organic revenue growth in three of the four businesses for the year.

In our communication segment, we continue to generate strong design win momentum in AI and cloud applications. We are delivering strong operational performance, including the work we have done on our cost structure and price actions to offset inflation, enabling our first half to second half margin improvement and EPS expansion as we expected. Overall, this sets us up for a strong finish to the fiscal year and a good step-off point as we enter fiscal 2024, which, as you know, begins in October. We remain excited about the opportunities we have ahead of us to drive long-term growth, margin expansion, and value creation for all stakeholders. Now let's open it up for questions.

Sujal Shah (VP of Investor Relations)

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

Operator (participant)

Yes, thank you. At this time, I would like to remind everyone in order to ask a question, press star followed by 1 on your telephone keypad. In order to have time for all questions, each participant is limited to 1 question. If you would like to ask a follow-up question, please press star 1 to return to the queue. We will pause for just a moment to compile the Q&A roster. We will take our first question from Chris Snyder with UBS. Your line is open.

Chris Snyder (Analyst)

Thank you. Q3 top line only met the guide despite a higher level of auto production. Can you just talk about some of the offsetting headwinds there? Also what some more color on what really drove the strong step up in margins. Obviously, a step up was expected, but this was much more significant. Just lastly, any puts and takes into Q4 at the segment or end market levels? Thank you.

Terrence Curtin (CEO)

Sure. Thanks, Chris, and thanks for the question. First off, on the first part of your question, you know, we met our overall guide on the top line, and you're right. In transportation, we were a little stronger, but, you know, communications was a little bit weaker. You know, we've been talking for many quarters now about, hey, as we go through some of the supply chain correction and market weakness around cloud, we thought we'd be in the $450-$500 range, and we thought this past quarter we'd be closer to that $450. You know, our communication segment came in a little bit below that, and our transportation revenue, which was stronger, really made up for that.

On your first part of your question, on really the margin front, you know, let's just move it up a little bit, you know, we knew we had to do margin opportunity as we marched through the year. You know, we had the price cost element that as we talked about in automotive, that was gonna be on a lag basis. We did get those in place. I think you're seeing the benefit of that, and we said we could get our transportation segment back up to where it's at today as we get later in the year, and that's been accomplished. I also think there's been good operating performance in our industrial segment, even in light of, you know, our biggest and, you know, higher profitability business unit, their industrial equipment, you know, has some destocking occurring. I think that was very good performance there.

The other element is, as communications is cycling down here in both businesses, we've been able to maintain the mid-teens margin, even on lighter revenue. I do think, you know, to my prepared comments, I am pleased with the execution that we know we teed up for you all earlier in the year, you know, came through. When we go to next quarter, really, with the order trends that we're seeing, it does look like, you know, the segments will be very similar next quarter to where they were this quarter. You know, auto production is going to be flat. You know, we expect transportation revenue to look similar to quarter three, similar to IS and CS right now with where we see the order patterns, and we expect margin to be similar.

The guide is very consistent with what we just did, and that's some of the stabilization that I talked about. You know, on the EPS side, we're just a little bit lower in quarter four, and that's really due to tax and FX. You know, it's nice to be able to show some of the stabilization, as we wrap up quarter three and go into quarter four.

Sujal Shah (VP of Investor Relations)

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

Operator (participant)

Our next question comes from the line of Wamsi Mohan with Bank of America. Your line is open.

Wamsi Mohan (Senior Equity Research Analyst)

Hi. Yes, thank you. It's really nice to see the operating margin improvement here in transportation that you guys alluded to earlier. I was wondering if you could, Terrence, maybe double-click on some of your inventory comments. How much more inventory digestion do you think is ahead of us, especially in industrial equipment? How much more correction do you think is also left in data devices? Thank you.

Terrence Curtin (CEO)

Yeah, thanks, Wamsi, thanks for the question. I guess the first thing is, you know, I know we talked about destocking, the same benefit we're driving in cash flow as supply chain get better, it is important. We're not in a bubble where not only our supply chains are getting better, but our broader customer supply chains are getting better. I think really where you see it in our results are the three business units we have, two in CS and, you know, one in IS, is where we feel it the most. That's really where, you know, we have distribution channel involved, and certainly things aren't as much of a direct-direct relationship. In transportation, we don't feel there's any supply chain to work off.

We don't see impacts of destocking, you see that in our performance, and you see the growth in all three businesses. You know, in the other businesses, you know, while TE does do about 20% of its revenue through distribution, the businesses you mentioned, Appliance and D&D in CS as well as Industrial, they do about 40%-50% of their revenue through distribution. What we've been seeing is, you know, we do see as broader supply chains improve, we see our distribution channel partners adjusting their inventory levels to get to more normal demand. Let's face it, if lead times, people are hitting lead times, and people don't need to go to distribution to find something to complete a build, they won't have to do that.

It is a natural effect in our business when you have this, but I think we have to realize it is a good sign that supply chains are improving. I think where we are, certainly industrial has gotten to it a little bit later. I think we still have a quarter or two that we need to work through in these businesses, is our best guess, and guess what? That is a guess. I do think there'll be a point in time where our revenue in those businesses, especially go through distribution, will get closer to demand, where right now we're billing less than what demand is as inventory works down.

Sujal Shah (VP of Investor Relations)

Okay, thank you, Wamsi. May we have the next question, please?

Operator (participant)

Our next question comes from the line of Steven Fox with Fox Advisors. Your line is open.

Steven Fox (CEO)

Hi, good morning. I was wondering if you could dig in a little bit more into the cash flow numbers. Like you said, they're up a lot. How sustainable do you see cash flow going forward? Maybe what does it mean, in terms of, you know, your capital allocation? It seems like it's not changing right now, but how does it influence you in a rising rate environment? Then within that, if you could touch on just the M&A environment, that'd be helpful also. Thank you.

Heath Mitts (CFO)

Sure, Steven. This is Heath. I'll take this question. First of all, we're pleased with our cash flow performance this year. Year to date, our free cash flow is $1.5 billion, which, as I mentioned earlier, is up 40% year-over-year, and we've had pretty consistent results each quarter as we've worked through the year. A big chunk of that, to answer your question about, you know, a sustainability of this type of performance, builds on what Terrence just talked about, and that's stability. If you think about, you know, there are times, particularly over the past couple of years, when we've had to flex our working capital, particularly inventory, to handle all of the volatility that's out there in the various supply chains.

Both uncertainty from our suppliers as well as, you know, differing order patterns from our customers. You know, the last thing we're gonna do is be in a position to hold our customers up, so we've had to flex inventory. Now, with the visibility improving, that's tied to some of the supply chain improvement out there, we've had the ability this year, and particularly through the first half of this year, to reduce inventory levels, bring our days on hand back more in line. There's a little bit of work to do in a couple of our businesses, but for the most part, we're getting to a better place. That working capital management has really driven our ability to drive free cash flow improvement year-over-year. We feel good about that.

We feel good in general about our ability to sustain that going forward. In terms of overall capital allocation, which was the second part of your question, listen, we're fully funding capital expenditures. We have not cut that back demonstrably. Most of our CapEx goes towards new products and new applications, and that is still real, and that is still happening, whether that's on the EV side or some of the AI opportunities or things within our industrial segment. That's being fully funded, that is unchanged.

Then when we start thinking about, you know, outside of investing in ourselves, the opportunities out there around the M&A environment, listen, it's, you know, it's always gonna be a bit dynamic in terms of what's coming to market and what's available, and we always take the approach that, are we the right owner for something that fits strategically well for us, and then do the financials work? You know, I feel like I say this just about every quarter, but at any given time, we're looking at about a half a dozen things and, you know, most don't get across the finish line for one reason or another, but we're active in that process. There's been some things that you'll continue to hear us talk about.

Terrence Curtin (CEO)

... you know, over time, I still believe it, that M&A will take up about a third of our free cash flow. It's lumpy. It's not a straight line in terms of the linearity of how that's deployed. Short answer, no change in our capital allocation strategy. We feel good about where we are from a balance sheet perspective, and it allows us to play offense going forward.

Sujal Shah (VP of Investor Relations)

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

Operator (participant)

Yes, our next question comes from the line of Matt Sheerin with Stifel. Your line is open.

Matt Sheerin (Managing Director and Senior Equity Research Analyst)

Yes, thank you, and good morning. Terrence, I wanted to drill down a little bit more on the opportunities in AI in your comments. Sounds like you've got a strong relationships with key customers and the semiconductor suppliers, but could you talk about the competitive landscape and the edge you have over competitors? Could you also size up the market opportunities for us perhaps as a percentage of your overall cloud revenue?

Terrence Curtin (CEO)

Sure, Matt, thanks for the question. You know, let's face it, we like data anywhere, you know, 'cause typically you need a connection to occur. When you think about the core of what we do, whether it's data, power, or some sort of signal, that's where we see opportunities. Anywhere data goes is an opportunity for us. When you think about AI, though, you know, there's one thing to move data, but when you think about the high speeds that this is at, as well as the low latency you need, it's really an extension of what we've been talking about from a cloud perspective.

You know, there's one thing to have a data connector, there's another thing to have a high speed that can handle what these GPUs are throwing off, as well as make sure that you not only have to compute, you also have to move the data, you also have to store the data. How does that all stay in sync? That's really, there is a number of us in the world that do that very well because you're at the cutting edge of technology. You not only need to design with the people that build the architecture, you need to be very close to the semi companies that are making these next generation chips that everybody's all excited about.

When you look at it, I sort of view it's a next step of where cloud went, and you know, we're just taking it up a level of speed. Certainly with the adoption of AI that we all hear about, it's exciting for us. You know, from a product set, when you look at what we do, we have sockets that actually the GPUs and the CPUs go into. You know, you do need something that takes that semiconductor and connects it into the board, or high-speed backplane products that actually make sure how the signal moves around. Then you get into things like DAC cables and so forth, that actually make sure you're connecting different parts of the rack and boxes together. We've had opportunities on all of those, similar to we talked in cloud.

What I really like is our position that our team has built, that is both with the semi customers as well as the ones that are working on the architecture, which are also the cloud guys, really has positioned us well. You know, like I said, we have over $1 billion of wins. They probably will go out over a 4-5-year period as they ramp, so, and the momentum is still building on the win side. Once we work through some of the market correction we're working through in a place like D&D, I think you're gonna continue to see the ramp of these programs probably be more, you know, in the middle of our fiscal 2024. That'll be more visible to you.

You know, some of it's in our revenue already. You know, the launches will be more in 2024 based upon the launch schedules of our customers that do the architecture build-out. You know, we're really excited about the wins we have and also the problems we're trying to solve with our customers, which is really, in essence, what our engineers do.

Sujal Shah (VP of Investor Relations)

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

Operator (participant)

Yes, our next question comes from the line of Mark Delaney with Goldman Sachs. Your line is open.

Mark Delaney (Managing Director and Senior Equity Analyst)

Yes, good morning. Thank you very much for taking my question. I realize the company only formally guides one quarter at a time. Given that we're now in your fiscal fourth quarter, I'm hoping you can provide some early thoughts on fiscal 2024 and how you're currently thinking about trends by end market for next year.

Terrence Curtin (CEO)

Thanks, Mark, I also appreciate you giving a caveat that we only guide for one quarter. Anything I'm gonna give here will be qualitative about what we see and, you know, some insight, which I think I probably talked about some, and Heath talked about some already. First off, start off, it is nice to see the stability that we're starting to see in orders and communications that tick up. I do think the comments start with that sort of as a backbone. It is important that some of the destocking we talk about, you know, in some of our businesses, you know, that'll work off.

I can't tell you the exact date that'll be done, but that, while that's a headwind now, that will be something as we get into next year, will be a tailwind for those businesses. I also think, you know, when you look at transportation specifically, you know, our transportation growth this year is gonna be, you know, driven by automotive, is in the low double digits. That's on pretty low production growth. You know, it has the content that we've always talked to you about, and then a little bit of price on top of that. Really, you should expect on top of what auto production is, will be in that 4%-6% next year, 'cause we won't have the additional price increases unless material would go up more.

You know, in transportation, we still see content being the driver into next year. I think the only thing that we're watching real time is in our commercial transportation business. We see some signs in China and North America, that being a little bit slower. That's one market we're gonna keep an eye on. When you get into the industrial segment, you think about the three units that I talked about on the prepared comments. Commercial airspace is not going to be slowing down in the recovery, and it's one area that we're still playing catch up in. Medical interventional procedures, we feel good about, and you're seeing the strong growth there. You know, renewable applications, we would continue to expect strong growth momentum there.

Once we work through the destock and industrial equipment, you know, we'll get back to some of the growth that we've been showing you. Then in the communication segment, it really is around the destocking and then the AI programs kicking in. You know, having this stability, I think you see the secular content drivers. You know, we still expect it'll be a slow global economy, but really, when you look at these content levers that we've been talking about, will really be the drivers as we get into next year, and hopefully, the inventory destocking winds down.

Sujal Shah (VP of Investor Relations)

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

Operator (participant)

Our next question comes from the line of William Stein with Truist Securities. Your line is open.

William Stein (Managing Director and Senior Analyst)

Great. Thanks for taking my questions. First, sort of a supply chain question. You've given us a pretty good bit of information already about where you're seeing destocking and such. I'd like to draw the comparison to some of the semiconductor suppliers who, in this cycle, were very effective at taking the extended lead time situation as an opportunity to constrain what they were delivering into the channel so that they didn't run into this problem. I wonder if there are any lessons learned from that. I know every cycle is a little bit different, but as you think about this going forward, is that a potential opportunity to improve the business to constrain what you ship into those guys, so you don't wind up in this situation?

Terrence Curtin (CEO)

A couple of things, Will. I just want to give a contrast between semi land and, you know, what we do, because I do think there's an important difference. Semiconductors had some lead times that were well out over a year. I would tell you, when you look at what we do, our lead time, typically, on average, could be 6 weeks to 12 weeks. While we had supply chain challenges, I think the bigger challenge was not us extending lead times, it was meeting lead times. When I think about the service levels we're at today, which our direct customers feel, other than maybe in the aerospace market, our service levels are back to pre-COVID levels from a ship to request element. I do think there's a big difference on lead times.

You know, certainly the semiconductor fab process is very different than the connector process. I do think while we are around the same trends, and we may have stocking and destocking effects, the lead time disconnect between a semiconductor and a connector is very different, and ours is much shorter. We did constrain demand in certain areas where we knew we were ahead. You know, you take our clients business, we did not add capacity for our clients business to be permanently at a billion-dollar run rate. We were trying to manage, you know, through our various channels. I think you're always going to have elements of a little bit of stock and destock where you have more channel activity. Let's face it, we build to orders.

you know, when we're getting orders, we don't say, "Well, this is a real order and this is a fake order." Every order is real because there is a customer that's asking for something someplace. I actually feel pretty good how we managed through it. I'm also pretty proud when you look at our communication segment with where their margins running on how much their revenue is off. I think it also proves we've improved the profitability substantially in that segment when we're at maybe a cyclical low. That really gets us back to where we can take the margin back up to what we talked about when we target for the segment, more like 20%. There are lessons we think about. I'm not sure it relates to the semiconductor processes as much as how what we manufacture.

Sujal Shah (VP of Investor Relations)

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

Operator (participant)

Our next question comes from the line of Christopher Glynn with Oppenheimer. Your line is open.

Christopher Glynn (Managing Director and Senior Analyst)

Thanks. Good morning, guys. Had a question about the TS margin. You have the price fully realized, some wraparound into next year, and you also have called out some operational improvements as well. I'm curious if you could talk about a view of kind of fundamental incremental margin expectations over the next year or two for the TS segment.

Heath Mitts (CFO)

Hey, Chris, this is Heath. Listen, I think TS has done a lot of the Transportation segment in general, but particularly the automotive piece of this, as well as the sensors piece of this, has done a lot of heavy lifting on the cost structure, and that's largely moving production in a meaningful way away from higher cost locations into lower cost jurisdictions. We are starting to see the benefit of that in many cases, we're also following, we're part of a supply chain that's also following that trend. You know, not necessarily unique to us, but following our customers to where we need to be just to support them.

The impact of that on our cost structure is something that has been gradually layering in, catching up on inflation with some of the price increases that we've done over the past couple quarters has certainly benefited us. As I think about as we go into next year, you know, the difficult thing to call on that is what auto production number is going to be. We're not terribly bullish as we go into next year, that auto production globally is going to ramp monstrously. I guess more to come as we all get smarter on that by region. You know the content story, and we do expect the category of EV and hybrid to grow very nicely again, just as it's shown in the past couple of years in our content on that.

I feel good about our ability to outperform the market as we've always done, and that will lead to some margin opportunity for us. When I think about incrementals, you know, we kind of target in normalized times, roughly a 30% incremental. You know, more to come on that as we get through into next year. Obviously, as you mentioned, we'll have some price wraparound for the first half of next year. I appreciate the question.

Sujal Shah (VP of Investor Relations)

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

Operator (participant)

Our next question comes from the line of Joe Giordano with TD Cowen. Your line is open.

Joe Giordano (Managing Director, Research Analyst)

Hey, guys. Good morning. I appreciate all the color on the AI stuff today, but I did have one kind of follow-up there. Now, how do I think about that business as a replacement for business that you would have been doing in the absence of AI? You know, like, if I think about your whole data and device business, you know, what does that business look like on a, on a normalized basis now? Like, it was a $1.5 billion business higher, now it's run rating at, like, $1 billion. You know, where's, like, the right settling?

Terrence Curtin (CEO)

I think there's a couple things. You do have the destocking, certainly, I would say the one area where I know I talk about distribution a lot, there is still a lot of server and semiconductor inventory on the planet that needs to work through. I do think you're going to have us being below that level right now as that clears out. I would also say, just realize, just because AI is happening, doesn't mean every server and cloud application is obsolete. You know, it is different architecture, you're still going to get the benefits of those. I think we're going to get back to normalization in the supply chain, which is driving it, you will see AI add on to some of the cloud element.

It is not a full cannibalization by any means, and you shouldn't think about it as cannibalization. We're in the early innings, really, on AI. I know I talked about the wins we've had, but the engagements we have are still very strong, and you'll start seeing them next year, Joe.

Sujal Shah (VP of Investor Relations)

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

Operator (participant)

Our next question comes from the line of Amit Daryanani with Evercore. Your line is open.

Speaker 16

Hey, guys.

Heath Mitts (CFO)

Hey, Amit.

Speaker 16

This is Abdullah speaking for Amit, and I just wanted to focus on industrial. I think last call, you mentioned industrial would see a 50%-100% margin expansion in the second half, and saw a really nice expansion, I think of 130 this quarter, despite revenues being down, I think, in the segment, $50 million or so. I was just curious what drove it be here and what the way you supposed to takes on?

Heath Mitts (CFO)

Yeah, this is Heath on the margin question for IS. Listen, I mean, you got four very distinct businesses within this, you're always going to have a little bit of noise quarter-to-quarter. I think we talked about last quarter, you know, some of the mix with the downturn in the industrial equipment business, which is our highest margin component of that segment, certainly impacted us. We were able to make up some ground here in our fiscal 3rd quarter with some cost actions, as well as just improved profitability in some of the other businesses. It's a bit of a mix.

As you think forward, I think, listen, at this kind of revenue range and with this current mix of what we're talking about, you know, the operating margins for the segment probably start with a 15%. You know, I don't necessarily know that we would dip back down into the 14% like we were last quarter, as we think forward, I think it's in the 15%. You know, I think the important piece here is that we are still committed to high teens operating margins within this segment. We do have a couple of acquisitions that we need to digest, that we've taken on over the past year or so.

Those have come in with considerably lower margins, but have a really strong opportunity to create value through some of the margin improvement and growth opportunities that we've already identified and are implementing, but still running below segment average. As we get those acquisitions layered in, I think that will also have a meaningful impact. We feel good about our trajectory there, but there's no doubt that we're running a couple of hundred basis points lower than where we want to be longer term.

Sujal Shah (VP of Investor Relations)

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

Operator (participant)

We will take our next question from the line of Samik Chatterjee with J.P. Morgan. Your line is open.

Samik Chatterjee (Managing Director, Equity Research Analyst)

Yep. Hi, thanks for taking my question. I guess I had a question on industrial solutions as well, but more sort of looking at it from a mix perspective. Just wondering how you think about what this business mix looks like in 4 to 5 years, or how do you want it to look like in 4 or 5 years? Because from the outside, it does look like you have secular drivers in AD&M, energy, and medical, whereas industrial equipment, I understand sort of the better margin on it, but doesn't appear from the outside to have the same drivers in terms of secular growth. Is there a way we should think about how this mix transitions in this business by subsegment over time, or where your focus of investment will be as you look at this business?

Terrence Curtin (CEO)

Well, I think when you look at the business, I think it's important to say where you've seen our investment first. You have seen us been very focused on building out the industrial equipment business unit because we like the factory automation trends that are there. You know, even if you went back probably 3, 4 years, you know, that was not always the largest business unit. We have done M&A there. We like the opportunities that are there. We also like the challenges that are there, that what are customers trying to solve? You're typically trying to solve getting data off a factory floor in a very harsh environment and getting it back to the compute that turns that into intelligence.

I think you're gonna continue to see areas in that space where we continue not only to invest, but also thinking continually about where we can do M&A in that spot. You know, in the other areas that you sit there, energy has become much more of a secular driver than we've had, and it's where we've really focused around renewable energy. We actually did a small M&A earlier this year, and I think that's an area that we would also continue to look at on top of the secular drivers we have, there, to say: How do we continue to build out that? In aerospace, I would say we're capitalizing on the recovery. You know, it's a space that I would say, you know, the content is really set because those platforms are one.

I don't see there being big secular changes to the platforms right now. You know, certainly, you have eVTOL and things like that, but they're further out, further out than your horizon to really create value. I think it's really more of an execution story. In medical, I think you see the consistent growth, and I think you're gonna continue to see as we're benefiting from interventional. I think what's nice about this segment is all four of them have growth drivers in them today. We couldn't say that five years ago. I think what you're gonna continue to say, they all give us different options as we continue to build out those businesses.

We'll have times where we do have a little bit of a mix or one has a little bit higher of a margin than the other, but that's just gonna be a factor as we build it out.

Sujal Shah (VP of Investor Relations)

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

Operator (participant)

Our next question comes from the line of Luke Junk with Baird. Your line is open.

Luke Junk (Senior Research Analyst, CFA)

Morning. Thanks for taking the question. Terrence, just wondering if you could comment on the pace of AI-related awards that you're seeing. Just wondering how quickly the $1 billion-plus in awards that you've referenced have come together, how quickly that could get to $1.5 billion or $2 billion? Related to that, in terms of book-to-bill, could you just give us some additional color on overall communications book-to-bill of 0.96, just how that splits between data and devices and appliance, and to what extent AI is impacting the data and devices side? Thank you.

Terrence Curtin (CEO)

Let's take the last question first. Data and devices is above 1, certainly, appliances still below 1. I would tell you on both of those, where the orders go through distribution, the book-to-bill is well below 1, the direct customers are above 1. It sort of shows you some of the dynamics. You know, even in the appliance market, I would say inventory at the OEMs and at our direct relationships seem to be in check where they need to be, where that lower market is. You know, when you look at the wins and with AI, to go back, the wins are coming fast and furious, it's one of the things I have to give our team credit for.

As we were dealing with a market that was turning, how do we really make sure we capitalize on those wins? When you sit there, you know, the pipeline has moved up even since the last time we talked. You know, we're well over $1 billion now. I think it's really gonna be around how these programs ramp and certainly the architecture size. It wouldn't surprise me that we continue on these calls to update you, but there's no pause in the AI platforms. You know, in some cases, similar to the AI, the EV platforms we had in auto. No matter what's happening in the cycle, they're accelerating, and I think we'll be able to give you ongoing updates as they ramp.

Sujal Shah (VP of Investor Relations)

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

Operator (participant)

Our next question comes from the line of Shreyas Patil with Wolfe Research. Your line is open.

Shreyas Patil (VP, Equity Research)

Hey, thanks so much. Maybe just coming back to transportation solutions. If I think about where we are now, you mentioned the price increases are fully offsetting material inflation. You're generating about an 18.5% margin. There is going to be some additional outflow, potentially some benefits from the structuring. How do we think about that bridge to the 20% margin target? Are there other headwinds we should be considering? It does seem that is something that could be achieved potentially at some point next year.

Heath Mitts (CFO)

Look, Shreyas, You know, first of all, I don't wanna commit to anything for 2024 until we, you know, get closer to 2024. I think we've got to be careful with that. Obviously, we're pleased with the improvement from our first half to our second half, both in the third quarter reported results, as well as how we feel about how we're gonna finish the year, you know, in the mid-18s. Our, our target margin for TS is still 20%, and that is unchanged. Obviously, you know, we're approaching 19 now. I want to be careful that we don't commit to something for next year because as I, you know, as I mentioned, on an earlier question, we got to see where revenue comes out as well.

The thing that we have to keep a very close eye on within this segment is commercial transportation, which is an important piece of the segment. We didn't talk about it too much today, but Terrence did mention on an earlier question that, you know, that is our highest margin component of the segment, and we do expect some pressure there next year, particularly in China.

As we think about it's not just an auto story, it's also the combination of commercial transportation, which is a billion-dollar business, as well as our sensors business. More to come on that, but our goal, and I feel comfortable over the next couple of years for sure, getting to sustainable margins closer to target.

Sujal Shah (VP of Investor Relations)

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

Operator (participant)

Our next question comes from the line of Guy Hardwick with Credit Suisse. Your line is open.

Guy Hardwick (Analyst)

Hi, good morning.

Heath Mitts (CFO)

Good morning.

Guy Hardwick (Analyst)

Just wondering if you could differentiate in industrial equipment between sales into distribution, sales to original equipment manufacturers. How sharply different are the trends, or maybe they're not at all? I had a follow-up question as well.

Terrence Curtin (CEO)

Hey, hey, Guy, it's Terrence. If you look at it, to our direct customers, our book-to-bill is running around closer to 1. You know, through distribution, it's probably running more like 0.8. The only color I would add to you, the industrial equipment business in Asia, you know, which includes the Japanese equipment makers for factory automation, who support a lot of things in China and certainly in China, that continues to be weak, both in direct as well as indirect. The backlogs of our OEM customers are strong. I would tell you, in some cases, we see them working off some inventory as they were making sure their supply chain, they were protected. There are different trends between our direct relationship and what we're seeing from in the distribution channel.

In that business, it's close to 50/50 between the channel and what we do direct.

Guy Hardwick (Analyst)

Thank you. Could you give us an update on your Chinese auto business, particularly into electric vehicles?

Terrence Curtin (CEO)

Sure.

Guy Hardwick (Analyst)

I mean, potentially, this market could be 40% NEVs by the end of the year. Can you give us an update on how TE's positioned, particularly versus local competitors and, you know, whether you're fully participating in the growth, particularly one or two very strong domestic players have done very well of late?

Terrence Curtin (CEO)

A couple of things. Thanks for the question. I'm gonna talk, you know, in TE about we have about $3 billion of business in China overall, of which two-thirds of that is automotive. I mean, when you really think about China and TE, the biggest play we have is around EV, and Guy, you're right on. If you want to really participate in EV adoption globally, you have to participate in China or, you know, they're the biggest driver of it. You know, 70% of global fully battery electric vehicles that are adopted on the planet or produced this past year are basically in China.

you know, the thing that I would tell you is, you know, our market share with the local Chinese OEMs versus the multinationals is similar, and, you know, you have to realize today, well over 50% of production in China is local OEMs. you know, the old days of the multinational brands owning the market, you know, that's no longer the case. when you look about our content story, you know, our content story is being driven, you know, not only with the multinationals, with the local Chinese OEMs, and we have a very good share position. Content per vehicle, when you look at it overall in China, it's pretty similar between the two, whether it's a multinational or a local Chinese OEM.

Honestly, the growth we talked about and our CPV growth is really driven by we're positioned well with both of them. I know sometimes people say, "Well, I'm only with the multinationals." That's not true with TE. TE's on essentially every car on the planet, I always say. What's really nice is what our team has done to really make sure they're penetrating both types of OEMs in China, and it's been very important to our growth. You know, our China automotive business, as I said in my prepared comments, all regions in automotive grew this quarter. You know, also for the year, we'll have growth in all regions. Certainly, we see sluggishness in China outside of automotive. We've actually seen, you know, auto production, you know, starting to ramp back up again, and our positioning there is very strong.

Okay, thank you, Guy. I'd like to thank everybody for joining us on the call this morning. If you have any additional questions, please reach out to Investor Relations at TE. Thank you and have a nice morning.

Operator (participant)

ladies and gentlemen, today's conference call will be available for replay beginning at 11:30 A.M. Eastern time today, July 26th, on the Investor Relations portion of TE Connectivity's website. That will conclude the conference for today.