Earnings Call Transcript - TEL Q3 2024

Operator, Operator

Everyone, thank you for standing by and welcome to the TE Connectivity Third Quarter Results Call for Fiscal Year 2024. At this time, all lines are in a listen-only mode. Later, we will conduct a question-and-answer session. 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, Vice President of Investor Relations

Good morning, and thank you for joining our conference call to discuss TE Connectivity's third quarter 2024 results and outlook for our fourth 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 be using 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. Finally, during the Q&A portion of today's call, due to the number of participants, we're asking everyone to limit themselves to one question, and you may rejoin the queue if you have a second question. Now, let me turn the call over to Terrence for opening comments.

Terrence Curtin, CEO

Thank you, Sujal. And I also appreciate everybody joining us today for the call. Before we get into the slides and the details, I want to take a moment to provide some performance highlights, along with what we're seeing versus our call just 90 days ago. As we've shared in our calls throughout this year, we continued to be in a dynamic global economic environment. I want to explain what that means when you think about where TE is positioned. First off, in our largest market, Automotive, we're seeing stability on a global basis. In our Industrial Solutions segment, we continue to see growth in three of our core businesses, which are focused on aerospace and defense, energy, and medical applications. In our Communications segment, as we talked about last quarter, we have returned to growth, benefiting from acceleration in Artificial Intelligence applications. Against these growth areas, we're still offset by ongoing weakness in the general industrial markets, and we'll highlight where they are throughout the call and Q&A. Within this backdrop, our sales in the third quarter were in line with our guidance and roughly flat year-over-year. I am pleased that we delivered strong adjusted margin expansion of 200 basis points year-over-year, and adjusted EPS that exceeded our guidance. Our teams have delivered record adjusted operating margins and earnings per share, even in a dynamic market environment, demonstrating our strong operational performance. Our results reflect successful execution against the key initiatives we committed to at the start of this fiscal year. We anticipated a slow demand environment overall, so our focus has been on driving margin and earnings improvement this year. The high quality of our earnings continues to be reflected in our strong cash generation model, and I'm pleased with record free cash flow of $2 billion through the first three quarters of this year, and we expect this to continue into our fourth quarter. Now, in Transportation, our outlook for global auto production is consistent with our view 90 days ago. We continue to see growth in China, offsetting incremental weakness in Europe. In our Industrial Solutions segment, we continue to see three of our core businesses with growth momentum and continued weakness in industrial equipment end markets. As mentioned earlier, in our Communications segment, our markets are back to growth. Finally, before we proceed, I want to reiterate that our long-term value creation model remains unchanged and is centered around three pillars: first, our portfolio is strategically positioned around secular growth trends; second, we have operational levers to drive strong margin performance through economic cycles; and third, we have established a strong cash generation model to return capital to shareholders while investing in bolt-on M&A opportunities. By executing on these pillars, we expect to deliver double-digit earnings growth this fiscal year, driven by a couple of hundred basis points of adjusted operating margin expansion. As we look beyond this year, we anticipate continued benefits from secular growth drivers, alongside improvements in commercial airspace and a normalization of destocking in industrial equipment, leading to further operating earnings growth. Our third quarter sales were $4 billion, which was in line with our guidance and up 2% organically year-over-year. Orders of $4.1 billion were up year-over-year and sequentially driven by momentum in artificial intelligence design wins. Adjusted earnings per share was ahead of our guidance at $1.91, which was up 8% versus the prior year. Adjusted operating margins were 19.3%, up 200 basis points year-over-year, driven by the strong operational performance of our teams. We expect fourth quarter sales of approximately $4 billion, including approximately $60 million of year-over-year currency exchange headwinds. On the margin front, Q4 will show strong year-over-year expansion, and we expect adjusted earnings per share to be approximately $1.94, which will be up 9% year-over-year.

Heath Mitts, CFO

Thank you, Terrence, and good morning everyone. Please turn to Slide 8. Before I get into the details of the financials, I want to reiterate that we are dealing with a slower market environment, but we're focused on improving margins and earnings. I am pleased to report that we have set TE records for quarterly adjusted operating margins and earnings per share in the third quarter. Now, let's look at the details. Adjusted operating income was $766 million with an adjusted operating margin of 19.3%. GAAP operating income was $755 million and included $5 million of acquisition-related charges and $6 million of restructuring and other charges. Year-to-date restructuring charges were $57 million, and we expect restructuring charges for the full year to be approximately $100 million. Adjusted EPS was $1.91 and GAAP EPS was $1.86, including restructuring, acquisition, and other charges of $0.05. The adjusted effective tax rate was 23% in Q3, slightly higher than our guidance due to some jurisdictional rate adjustments. For Q4 and for the full year, we now expect our adjusted effective tax rate to be approximately 22%. And importantly, our cash rates should stay well below our adjusted effective tax rate for the full year. Sales of $4 billion were down 1% on a reported basis and up 2% organically year-over-year, and we continue to experience headwinds from a stronger dollar impacting sales by roughly $80 million in Q3. Adjusted operating margins were 19.3%, expanding 200 basis points year-over-year. This was driven by year-over-year margin expansion in our Transportation and Communications segments. Adjusted earnings per share were $1.91, up 8% year-over-year, despite headwinds of $0.18 from currency exchange and a higher tax rate. Cash from operations was $1 billion, and free cash flow was $867 million in Q3. Year-to-date, we have delivered free cash flow of roughly $2 billion, which is up 36% year-over-year. We expect to deliver another year of free cash flow converging well above 100%. Our cash generation model continues to provide us with confidence and opportunities to return capital to shareholders while supporting bolt-on M&A activities. Our long-term capital strategy remains unchanged, aiming to return approximately two-thirds of free cash flow to shareholders and use one-third for bolt-on acquisitions over time.

Sujal Shah, Vice President of Investor Relations

Thank you, Heath. Brianna, could you please give the instructions for the Q&A session?

Operator, Operator

Thank you. Your first question comes from the line of Amit Daryanani with Evercore ISI. Your line is open.

Amit Daryanani, Analyst

Good morning. Thanks for taking my question. I guess, Terrence, really impressive momentum on the IS side, especially with AI-centric business. This is clearly a big topic for investors. I was wondering if you could just talk about what is driving the expectation for higher growth, both for this year and next year, versus what you had talked about 90 days ago. And perhaps if you could also just touch on what your customer mix looks like on the AI side and where the momentum is coming from?

Terrence Curtin, CEO

Thanks, Amit. I appreciate the question. First off, this starts with the hyperscalers and cloud CapEx. That continues to accelerate, and it's being directed towards AI applications. We've built a strong position with cloud customers previously, and this is translating into a strong position with AI, resulting in design wins across multiple customers. Our order slide showed acceleration in Communications, with orders up about 50% sequentially. The design wins give us confidence to raise our near-term expectations for AI revenue to over $250 million this year, and we expect this to more than double as we move into 2025.

Sujal Shah, Vice President of Investor Relations

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

Operator, Operator

Our next question comes from Wamsi Mohan with Bank of America. Please go ahead, your line is open.

Wamsi Mohan, Analyst

Yes, thank you so much. Clearly, this was very outstanding margin performance in the quarter. I’m just wondering if you could talk about the margin outlook, both for the segment and how incremental margin should trend in communications in light of this AI momentum. Maybe you could also wrap in the rising commodity pricing environment. I know you guys hedge, but if you could share some color on how we can think about the impact from that as we look over the next three to four quarters.

Heath Mitts, CFO

Yes, Wamsi, this is Heath. Our focal point as we entered this year has been on margin expansion, which translates into earnings growth. We have areas of support and areas of weakness on the top line, but net-net we're making progress through the year. We're focusing on non-volume levers such as returns on restructuring actions, ensuring prices are sufficient to offset inflationary pressures, and optimizing the portfolio to improve growth and margins. Our margins in Transportation and Communications are doing well, and we expect both to continue improving. Incremental margins in Communications are expected in the 25% to 30% range with a potential for margin movement as revenue increases.

Sujal Shah, Vice President of Investor Relations

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

Operator, Operator

Your next question comes from Joe Spak with UBS. Please go ahead, your line is open.

Joe Spak, Analyst

Good morning. Thanks for taking the question. I was wondering, back to AI, we've been hearing a little bit more about some cross-licensing deals between interconnect players for AI. I'm just wondering what you can tell us there. How common is that in other areas of the business? Mechanically, how would this actually work if it does occur? If you manufacture some of your license, is that a lower margin profile business or is it relatively even?

Terrence Curtin, CEO

No, Joe, due to the size and ramping that's going to be required, dual sourcing and cross-licensing is very common in these cases where you have IP. We've seen it for a long time in this space, especially in data and devices, and it will be part of how we work with our customers to ensure they get the best solution.

Sujal Shah, Vice President of Investor Relations

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

Operator, Operator

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

Joe Giordano, Analyst

Hey, good morning guys. Terrence, I’m just curious to hear your updated thoughts on the near term and the next 12 to 18 months regarding hybrids versus EVs. GM's talking about not building a plant they were discussing. Where do you think that fits and what do you do from a CE standpoint to adapt and adjust to the changing end market?

Terrence Curtin, CEO

Yeah, thank you, Joe, for the question. Production is stable in automotive. EV production, including battery electric, plug-in hybrids, and hybrids, is expected to rise 20% this year. Last year, we had about 20 million units, and we expect to see that continue despite certain structural challenges. In Asia, battery electrics are up 20%, hybrids are up 20%, and plug-in hybrids are up 50%. There is strong demand for both hybrids and EVs globally, which enhances our market position.

Sujal Shah, Vice President of Investor Relations

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

Operator, Operator

Your next question comes from Mark Delaney with Goldman Sachs. Your line is open.

Mark Delaney, Analyst

Yes, good morning and thanks for taking my question. Following up on the auto end market, I'm hoping to better understand the ability for TE to see revenue benefit in Q4 and into next year from that content growth you were just describing, especially in light of vehicle launch delays or customer inventory corrections. Do you think that TE can actually see the 4 to 6 points of targeted outgrowth in automotive revenue based on customer exposure and that content potential? Thanks.

Terrence Curtin, CEO

Thanks, Mark. The answer is yes, we feel very confident about it. Content growth in automotive is significant, driven by increased data connectivity and features demanded by consumers, which also uplifts our content. Despite challenges, our global position allows us to maintain strong relationships with our customers, ensuring that the 4 to 6 points of growth in content will transpire. Our great global position benefits us significantly.

Sujal Shah, Vice President of Investor Relations

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

Operator, Operator

Your next question comes from Samik Chatterjee with J.P. Morgan. Your line is open.

Samik Chatterjee, Analyst

Hi, thanks for taking my question. I was going to ask about the company’s aggregate revenue level. Throughout the year, your revenues have been in the $3.8 billion to $4 billion range, even as AI revenues ramped, so as we go into next year, when we set AI aside, where do we think we are in the cyclical recovery? What drives your confidence for growth?

Terrence Curtin, CEO

So Samik, we anticipate AI contributing significantly, and while we are planning groth in a flattish environment, we expect recovery in our industrial segment due to destocking. The return to growth is crucial for visibility, and we see that momentum providing a solid basis for revenue growth, considering we also have increased content in automotive.

Sujal Shah, Vice President of Investor Relations

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

Operator, Operator

Your next question comes from Asiya Merchant with Citigroup. Your line is open.

Asiya Merchant, Analyst

Great. Thank you for taking my question. On the cash flow, this has been a great quarter here. As you all think about revenues ramping and especially in the AI segment, can you talk to us about your CapEx commitment as we look into fiscal '25 and the objectives around AI revenues more than doubling? Thank you.

Terrence Curtin, CEO

Sure, our CapEx typically runs at about 5% of revenue, which supports growth areas we've discussed. We are increasing CapEx a bit for AI applications, particularly from our new facility in the Philippines. However, this won't put significant pressure on our financials as trade-offs will balance it.

Sujal Shah, Vice President of Investor Relations

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

Operator, Operator

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

Christopher Glynn, Analyst

Thanks. Good morning, everyone. I wanted to ask about order patterns and any particular insights into markets. The book-to-bill rates look positive in Industrial Solutions, which still face destocking. What kind of visibility do you have?

Terrence Curtin, CEO

What you presume about industrial is correct. We are seeing strength in Communications and appliances as stocking ends. Our backlog remains strong, and service levels are above pre-COVID levels, which is beneficial as we streamline operations. General industrial spaces, however, are still experiencing weakness. Therefore, destocking trends should flatten out more but may take longer to resolve.

Sujal Shah, Vice President of Investor Relations

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

Operator, Operator

Your next question comes from Saree Boroditsky with Jefferies. Your line is open.

Saree Boroditsky, Analyst

Hi, thanks for taking my question. Going back to the AI conversation, you previously mentioned $400 million in sales next year. I believe you just increased that to $500 million. Given this increase, could you give us an update on the $1 billion sales estimate and what's the timeframe for that? Thank you so much.

Terrence Curtin, CEO

As we lay out these design wins, the confidence in our growth trajectory is evident. We feel confident about the $1 billion sales target, but the exact timing will continue to be segmented as we receive further updates and feedback.

Sujal Shah, Vice President of Investor Relations

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

Operator, Operator

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

Luke Junk, Analyst

Good morning. Thanks for taking the questions. Terrence, one of the things you highlighted in your remarks that I thought was interesting around auto investment specifically was miniaturized products for next-gen architectural shifts. Can you elaborate on that trend, especially regarding potential impacts to content? It sounds more engineering-intensive, and perhaps how margins factor into this as well.

Terrence Curtin, CEO

This trend increases our content opportunities. As vehicles increasingly require more complex data and signal transfer systems, the demand for miniaturized products grows. Features that consumers expect, like data connectivity, are tied directly to these architectural shifts and necessitate enhanced engineering solutions, benefiting our operational margins as we solve complex interconnectivity problems.

Sujal Shah, Vice President of Investor Relations

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

Operator, Operator

Your next question comes from Colin Langan with Wells Fargo. Your line is open.

Colin Langan, Analyst

Oh, great. Thanks for taking my question. I'm going to follow up on the zonal architecture question. I understand there's been talk that transitioning to zonal could reduce wires and connectors. However, it sounds like you don't see an impact there. Is it just the wiring that changes, or does the content also reduce as you shift to a zonal architecture?

Terrence Curtin, CEO

Actually, with zonal architecture, you will see wire reductions without a decrease in connector complexity. You will still need complex connectors to handle increased data and signal transmissions. The growth of zonal architecture enhances the complexity—and thus the content—needed despite simplifying the wiring.

Sujal Shah, Vice President of Investor Relations

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

Operator, Operator

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

William Stein, Analyst

Great, thank you for taking my question. In the prepared remarks, Heath mentioned the potential for bolt-on M&A a couple of times. We've seen one of your competitors accelerate M&A investments recently, while your visibility has been limited. Could you remind us of your strategy when it comes to M&A, perhaps highlighting your in-market focus or targets?

Heath Mitts, CFO

Thanks, Will. Our focus on bolt-on M&A isn't new. Bolt-on signifies acquisitions that are similar to our existing capabilities in markets we know. We are looking for opportunities that support operational cohesion and sales synergies. While we are cautious about market conditions, we see a robust pipeline for potential transactions in the industrial space.

Sujal Shah, Vice President of Investor Relations

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

Operator, Operator

Our final question comes from Shreyas Patil with Wolf Research. Your line is open.

Shreyas Patil, Analyst

Hey, thanks for taking my question. Terrence, you talked about transportation and its profitability. I'm trying to think about the drivers for incremental margins and how they might improve from here, especially with commercial transportation improvements and restructuring savings projected for the coming years. What are we missing in terms of margin improvements?

Terrence Curtin, CEO

We’re absolutely seeing wins in new automotive architectures, and the performance of our transportation segment is strong. Incremental margin growth in the future is likely influenced by improved market conditions in commercial transportation, additional restructuring efforts, and margin enhancements in our business lines. We aim to continue leveraging operational efficiencies as we move forward.

Sujal Shah, Vice President of Investor Relations

Alright, thank you, Shreyas. If there are no further questions, I would like to thank everybody for joining us today. If you have additional questions, please contact Investor Relations at TE. Thanks everyone, and have a nice day!

Operator, Operator

Today's conference call will be available for replay beginning at 11:30 a.m. Eastern Time today, July 24th, on the Investor Relations portion of TE Connectivity's website. That will conclude the conference for today. Thank you for your participation. You may now disconnect.