Earnings Call Transcript - TEL Q2 2021

Operator, Operator

Ladies and gentlemen, thank you for standing by and welcome to the TE Connectivity Second Quarter Earnings Call for Fiscal Year 2021. At this time, all lines are in a listen-only mode. Later, we will conduct a question-and-answer session. I would now like to turn the conference over to your host, Vice President of Investor Relations, Sujal Shah. Please go ahead.

Sujal Shah, Vice President of Investor Relations

Good morning and thank you for joining our conference call to discuss TE Connectivity's second quarter 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 R. Curtin, CEO

Thank you, Sujal, and thank you everyone for joining us today to cover our results for the second quarter as well as our expectations for the third quarter of our fiscal 2021. Before I get into the slides, let me give you some perspective on our second quarter. As you will see in our results, we are continuing to demonstrate the strength of our diverse portfolio and the benefit of content growth across our businesses. We are delivering organic growth ahead of our markets as well as strong operational performance and free cash flow generation. This performance occurs in a world with an improving economic backdrop that is dealing with global supply chains trying to keep up with the broader macro recovery. Our execution in the second quarter was impressive. We delivered sales growth of 17% and generated record quarterly adjusted earnings per share of $1.57, representing a growth of 22% year-over-year. Our sales exceeded our expectations across all segments, driven by the continued recovery in most end markets and the benefits of the strategic positioning of TE to capitalize on secular trends. Additionally, our adjusted operating margins expanded 80 basis points year-over-year to 17%, driven by margin expansion in both our transportation and communications segments. Strong cash generation was evident as our year-to-date free cash flow reached approximately $1 billion, which is also a company record for the first half of the fiscal year. As we look into our third quarter, we anticipate our strong performance to continue, with sales and adjusted earnings per share at similar levels to what we just delivered in the second quarter. In our transportation segment, consumer demand in autos continues to remain strong, and auto production is holding stable in the range of 19 million to 20 million units per quarter globally, despite well-documented semiconductor shortages. We've also seen further strength in our commercial transportation end markets. The trend around content growth remains robust as we continue to benefit from increased electronification of vehicles and higher production of electric vehicles, which will enable us to continue outperforming auto production going forward. In our industrial segment, we are witnessing increased momentum in the recovery of industrial equipment markets due to factory automation and rising manufacturing capital expenditure trends. However, commercial aerospace and medical businesses continue to be affected by COVID, though we are seeing some indicators of stability in orders for both sectors. In communication, the market trends we discussed last quarter are continuing. Consumer demand is escalating, and globally, we've noticed an increase in appliance demand. We continue to see strong ongoing capital expenditure trends in cloud applications, as well as acceleration of demand in data centers. As these market trends unfold, the unexpectedly quick recovery has resulted in challenges for industries replenishing their supply chains. While this dynamic has benefitted our orders, which remain strong, it has also created broader supply chain pressures. This is factored into our expectations for the third quarter guidance, which Heath will elaborate on. Lastly, we must remember that we are still navigating the ongoing impacts of COVID. We are continuing to see lockdowns in various countries, which is affecting our customers and their supply chains. While vaccines are being rolled out in some areas, the pace of deployment and availability varies significantly across countries, leaving us with some uncertainty. Our prime focus has been, and will continue to be, on maintaining the safety of our employees while assisting our customers in taking advantage of improving economic conditions. Now, let me get into the slides and I appreciate you turning to Slide 3 for additional details on our second quarter and expectations for the third quarter. Second quarter sales of $3.7 billion were better than our expectations in each segment. They were up 17% on a reported basis and 11% organically year-over-year. We achieved 15% organic growth in our transportation segment with double-digit growth across all businesses. Our communications segment performed strongly with organic growth of 29%. However, sales in our industrial segment were down 4% organically due to ongoing weakness in the commercial aerospace market. In terms of orders, second quarter orders were $4.6 billion, which reflects a 36% year-over-year increase, reflecting an improvement in the markets mentioned along with inventory replenishment by our customers. Our earnings per share was a record at $1.57 for the quarter, up 22% year-over-year, driven entirely by our operational performance. Despite challenges with the supply chain pressures, we managed to achieve margin expansion. Looking ahead, we expect our strong performance to persist in the third quarter, targeting sales of approximately $3.7 billion, up significantly year-over-year.

Heath Mitts, CFO

Well, thank you, Terrence, and good morning everyone. Please turn to Slide 8, where I will provide more details on the Q2 financials. Adjusted operating income was $637 million, up approximately 23% year-over-year with an adjusted operating margin of 17%. GAAP operating income was $612 million and included charges related to restructuring and acquisitions. We continue to optimize our manufacturing footprint as we work toward improving the organization's cost structure. We expect total restructuring charges to be in the ballpark of $200 million for fiscal 2021. Adjusted EPS stood at $1.57, while GAAP EPS was $1.51 for the quarter. In Q2, sales of $3.7 billion were up 17% versus the prior year and 6% sequentially, showcasing the strength of our portfolio. Currency exchange rates positively impacted sales by $150 million. The adjusted EPS of $1.57 reflects a strong operational performance. While we anticipated a higher flow-through from this level of sales growth, supply chain challenges affected that. Free cash flow for the quarter was $477 million, and year-to-date cash flow was approximately $1 billion, a record for the first half of the fiscal year. We remain committed to a disciplined use of cash, with an expectation that two thirds of our free cash flow will be returned to shareholders and one third used for acquisitions. Before we go to questions, I want to reiterate our excitement regarding our market position, organic growth, and margin expansion opportunities ahead. The outlook for many markets remains consistent with our earlier evaluation, alongside an acceleration in commercial transportation, industrial equipment, and communications markets. The economic recovery has been quicker than predicted, leading to increased near-term pressures within the broader supply chain—a dynamic we believe will normalize while our growth and margin expansion expectations remain solid.

Sujal Shah, Vice President of Investor Relations

Okay, thank you Heath. Michelle, could you please give the instructions for the Q&A session?

Operator, Operator

Your first question will come from Craig Hettenbach from Morgan Stanley. Your line is open.

Craig Hettenbach, Analyst

Thank you. Question for Terrence, there were a number of references to replenishment on the call. So can you just talk about the strength you are seeing in the business, when customers think they will catch up on inventory, and importantly, the type of sell-through you're observing?

Terrence R. Curtin, CEO

Sure, thanks Craig. The recovery across the markets is happening at an accelerated pace. Inventory levels are quite low. We see customers not only placing orders for their production needs but also looking to secure additional supply to prevent stresses that might arise from component shortages. Currently, we believe we need a couple of quarters for everything to normalize as stocks were significantly reduced. Our channel partners are also operating with lower-than-normal inventory levels and are trying to replenish them.

Sujal Shah, Vice President of Investor Relations

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

Wamsi Mohan, Analyst

Yes, thank you. Terrence, you referred to a few aspects regarding the communications segment performance. Can you remind us of how much of that is cloud now and whether you expect this growth to sustain?

Terrence R. Curtin, CEO

Thanks, Wamsi. The communications segment was the one least impacted last year, making its current growth more impressive. The growth we see first originates from our Data & Devices segment, primarily due to cloud applications. This is informed by the acceleration in cloud CAPEX and our market share improvements. We expect this segment to perform at higher margins than historically seen.

Sujal Shah, Vice President of Investor Relations

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

Amit Daryanani, Analyst

Yes, good morning, everyone. Terrence, can you elaborate on the difference between the strength we're seeing in both the book-to-bill and the order numbers you put out for the June quarter guidance?

Terrence R. Curtin, CEO

Let me take your last piece first, if that's okay. When observing the trends, as you might expect, orders in the channel were a couple of hundred million higher than our build. The channel sales growth aligned with the total company growth. We're experiencing accelerated orders due to supply chain replenishment after last year’s disruptions. Regarding our book-to-bill of 1.22, this business is not typically a backlog business. Customers aim to replenish and secure supplies in light of market constraints.

Sujal Shah, Vice President of Investor Relations

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

Joseph Spak, Analyst

Thank you very much. If we compare the actual incrementals in the quarter to the lower 30s, is that $50 million what you experienced due to logistical headwinds? Can you discuss margin considerations as we head into your fiscal third quarter?

Heath Mitts, CFO

You’re right regarding your assumptions. We expected higher flow-through on these volumes, but various challenges resulted in a decreased number. Logistics and supply chain issues will persist, but I expect our margins to improve modestly as we proceed into the latter part of the fiscal year.

Sujal Shah, Vice President of Investor Relations

Okay, thank you, Joe. Could we have the next question please?

Chris Snyder, Analyst

Thank you. My question concerns EV wins and the demand pipeline coming to market. Are you seeing better market share relative to ICE in the higher voltage area?

Terrence R. Curtin, CEO

Regarding our share, it’s on par with our leadership position in the industry. The growth rate of electric vehicle adoption is impressive and is expected to rise significantly. We are confident that our content will continue to grow and that we have significant wins in this market.

Sujal Shah, Vice President of Investor Relations

Okay, thank you, Chris. Could we have the next question please?

Samik Chatterjee, Analyst

Thanks for taking my questions. I noticed strong results in automotive despite the ongoing uncertainty. What feedback are you receiving from your automotive customers regarding supply chain management?

Terrence R. Curtin, CEO

OEMs are thrilled with consumer demand. They're prioritizing product delivery amid supply chain pressures, especially with semiconductor shortages impacting production less than a million units in the second quarter. Global auto production is stabilizing at around 19 million to 20 million units. We're all working together to ensure the necessary products reach OEMs during this recovery.

Sujal Shah, Vice President of Investor Relations

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

Mark Delaney, Analyst

Good morning, and thank you for taking the question. Heath, you reiterated that free cash flow conversion should be about 100% of net income. Can you discuss any unusual benefits impacting free cash flow this year?

Heath Mitts, CFO

Mark, thanks for the question. We have benefited from efficient capital expenditures that have been lower relative to prior years. Our strong cash generation has improved our ability to manage working capital effectively. We're not holding back investments and anticipate restructuring support for cash flow improvements moving forward, unless significant restructuring issues arise.

Sujal Shah, Vice President of Investor Relations

Alright, thank you, Mark. Can we have the next question please?

Joseph Giordano, Analyst

Good morning. Terrence, reflecting on last year's second quarter, you had a 40 basis point benefit from supply chain replenishment. If you assume that growth this quarter is particularly strong, how should we think about the continued benefit from supply chain replenishment in the coming quarters?

Terrence R. Curtin, CEO

It’s not advisable to analyze content growth strictly on one quarter. The context of the entire year must be considered. Our position in a recovering market indicates a rise in content. I expect supply chain recovery to improve gradually over the next few quarters.

Sujal Shah, Vice President of Investor Relations

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

Scott Davis, Analyst

Good morning, guys. What’s your approach to contracts when there are excess orders? How do price adjustments occur to alleviate some of the costs?

Terrence R. Curtin, CEO

We do implement price increases every six months, with adjustments made earlier this year to handle inflation pressures. The focus primarily lies on managing our larger customer contracts—pricing adjustments are driven by our operational strategies.

Sujal Shah, Vice President of Investor Relations

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

Christopher Glynn, Analyst

Good morning everyone. Can you discuss the industrial automation cycle and its dynamics. Are we in the midst of an investment super cycle in this sector?

Terrence R. Curtin, CEO

The industrial automation market appears to be accelerating after last year’s slowdown due to COVID. Investments are increasing across semiconductor manufacturing and the EV supply chain. We're seeing strong demand for automation in sectors such as warehousing and logistics, indicating promising prospects for investment.

Sujal Shah, Vice President of Investor Relations

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

David Kelly, Analyst

Thank you and good morning. How are order trends shifting within your distribution channel, especially in communications? Can you remind us of your distribution mix?

Terrence R. Curtin, CEO

Distribution constitutes about 20% of our total company mix, increasing significantly in industrial and communications segments, where we observed robust growth. Our order patterns suggest a strong demand for rebuilding depleted inventories across sectors.

Sujal Shah, Vice President of Investor Relations

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

Jim Suva, Analyst

Thank you. Terrence, you mentioned orders exceeding lead times. Can you elaborate on why customers are placing more orders despite lead times stretching out?

Terrence R. Curtin, CEO

In the automotive sector, the system is largely just-in-time, which makes it different from other businesses. Lead times for most products span four to six weeks, though some areas may extend further. Customers are likely ensuring timely orders to avoid potential shortages, especially with semiconductors. Our current lead times are largely stable, save for specific products facing constraints.

Sujal Shah, Vice President of Investor Relations

Alright, thank you, Jim. Can we have the next question please?

Luke Junk, Analyst

Good morning. Terrence, could you discuss opportunities in your energy business, especially with the push for electric vehicles and grid hardening?

Terrence R. Curtin, CEO

Our energy business is crucial for electrical infrastructure globally. We are positioning our portfolio around renewable energy initiatives. The demand has been consistent. Renewables are a vital growth area primarily associated with solar and wind applications, which will strengthen our market position.

Sujal Shah, Vice President of Investor Relations

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

Nik Todorov, Analyst

Thanks. Good morning, everyone. Terrence, there are reports suggesting some auto OEMs are performing better because they've moved away from just-in-time practices. Are you noticing trends in customer inventory policies with the ongoing supply chain challenges?

Terrence R. Curtin, CEO

Although we’ve not seen significant shifts yet, it's critical to note that OEMs aim to optimize production during this period. They are focused on product delivery while reconciling inventory levels with macro circumstances. It's a collaborative effort for the recovery we're all aiming for.

Sujal Shah, Vice President of Investor Relations

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

William Stein, Analyst

Good morning, Terrence. You mentioned inflation affecting some costs. Could you clarify if this concerns input costs, materials, or labor? And how do you expect to address this moving forward?

Heath Mitts, CFO

William, the main inflationary factor we face currently is on freight, driven by the overall supply chain. Input costs are rising, particularly with resins and metals, due to recent supply constraints. While we are enhancing our pricing strategies to help manage these increases, labor costs are more about availability than inflation at this time.

Sujal Shah, Vice President of Investor Relations

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

Matt Sheerin, Analyst

Thank you, everyone. Regarding the industrial solutions area, how should we anticipate operating margins evolving? You've mentioned targeting high teens, and it seems like a backlash of restructuring might still be expected.

Heath Mitts, CFO

Nothing has changed in our multi-year plan to achieve mid to high teens operating margins. The current decline in margins is based on growth being hampered by the commercial aerospace sector. We are optimistic that improvements will begin to surface soon.

Sujal Shah, Vice President of Investor Relations

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

Steven Fox, Analyst

Hi, thank you. I might have misinterpreted earlier comments about recent market share gains. If so, could you clarify if there's any specific factor driving this trend across your segments?

Heath Mitts, CFO

The recent market share gains and recovery from COVID has strengthened our position across key markets, notably within the transportation and industrial sectors. We’re capitalizing on broader market recovery to enhance our results.

Sujal Shah, Vice President of Investor Relations

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

Shreyas Patil, Analyst

You discussed the content opportunity increasing with BEVs versus ICE. Has the actual content on some of those programs exceeded initial expectations?

Terrence R. Curtin, CEO

Indeed, the content per electric vehicle is often greater than that of internal combustion engines. This expansion opportunities illuminate the scalability that is necessary for making electric vehicles accessible to broader audiences. We're very optimistic about the sustained growth here.

Sujal Shah, Vice President of Investor Relations

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

David Williams, Analyst

Good morning, and thanks for your time. As OEMs pivot to higher-end vehicles, how will the shift back to mid-range or lower-range vehicles affect your revenues and margins?

Terrence R. Curtin, CEO

OEMs are focused on capitalizing on consumer preferences, which leads to higher margins on the vehicles they produce. The increasing options within vehicles may lead to greater content for us, particularly as economies and consumer preferences evolve globally.

Sujal Shah, Vice President of Investor Relations

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

Wamsi Mohan, Analyst

Thanks for discussing the infrastructure plan's impact. Given the investment in EV infrastructure, how could that benefit TE amid potential tax adjustments?

Terrence R. Curtin, CEO

It's quite early to ascertain the exact impacts of the infrastructure plan, but the energy business stands to gain from necessary infrastructure enhancements. With government involvement in EV promotion, our automotive business could see increased demand as well.

Heath Mitts, CFO

As markets evolve, we have to observe potential impacts of tax adjustments on our operations. Previous tax reforms suggested minimal impacts on our revenue streams due to our operational structure and profit segmentation.

Sujal Shah, Vice President of Investor Relations

We have no further questions. Thank you for joining us this morning. If you have additional inquiries, please contact Investor Relations at TE. Thank you and have a great day.

Operator, Operator

Ladies and gentlemen, your conference will be made available for replay beginning at 11:30 AM Eastern time today on the investor relations portion of TE Connectivity’s website. This will conclude your conference for today. You may now disconnect.