Benchmark Electronics, Inc.

Good day and welcome to the Benchmark Electronics fourth quarter and full year 2018 earnings conference call. All participants will be in listen-only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press star then one on your touch-tone phone. To withdraw your question, please press star then 2. Please note this event is being recorded. I would now like to turn the conference over to Lisa Weeks, Vice President of Strategy and Investor Relations. Please go ahead.

Lisa Weeks Thank you, Operator, and thanks everyone for joining us today for Benchmark's fourth quarter and full year 2018 earnings call. With me this afternoon, I have Paul Tufano, CEO and President, and Rup Lakharaju, CFO. Paul will provide introductory comments and Rup will provide a detailed review of our fourth quarter and full year 2018 results. We will conclude our call with a Q&A session. After the market closed today, we issued an earnings release highlighting our financial performance for the fourth quarter and full year. We have prepared a presentation that we will reference on this call. The press release and presentation are available online under the investor relations section of our website at www.bitch.com. This call is being webcast live and a replay will be available online following the call. Please take a moment to review the forward looking statement advice on slide two in the presentation. During our call, we will discuss forward looking information. As a reminder, any of today's remarks that are not statements of historical fact are forward-looking statements which involve risks and uncertainties described in our press releases and SEC filings. Actual results may differ materially from these statements, and Benchmark undertakes no obligation to update any forward-looking statements. The company has provided a reconciliation of our GAAP to non-GAAP measures in the earnings release as well as in the appendix of the presentation. I will now turn the call over to our CEO, Paul Tufano.

Paul Tufano Thank you, Lisa, and thank you for joining our call. If you turn to slide five, we capped 2018 with strong results in the fourth quarter. Revenue and non-GAAP EPS were both above our guidance. Revenue in Q4 was $657 million, and for the full year was approximately $2.6 billion, which reflects 5% year-over-year revenue growth. This was driven primarily by strength in A&D, telco, and medical. Non-GAAP operating margins improved 30 basis points to 3.2 percent quarter-over-quarter. This is despite continued softening in our test and instrumentation sector, which was down 25 percent year-over-year. Our EPF on a non-GAAP basis was 41 cents and above our guidance. Our cash conversion cycle days were 62 days and for the full year at 68 days, which is at the low end of our target range of 73 to 68 days. Cash from operations was approximately $94 million in the quarter and $7 million for the full year, which is above our expected $30 to $50 million range that we outlined earlier in 2018. We have continued to aggressively buy back our shares. For 2018, we repurchased $212 million of our stock and reduce our outstanding share count by 17%. We continue to prudently repurchase shares, and through yesterday we repurchased $17 million of additional shares. If you turn to slide six, we continue to make excellent progress on bookings, which as you all know are critical to revenue growth. This quarter, We posted solid bookings of $198 million and $721 million for the full year, which is up 23% year over year. If we reflect back to this time period in the fourth quarter of 2016, bookings are up 55%. We had our strongest number of wins in our medical sector, with 34% of total bookings, seven new customers, five linked to design services, with projects ranging from oral image devices to cardiac monitoring to optical sensor manufacturing to in vitro diagnostic devices. In aerospace and defense, which posted 21% of our bookings for the quarter, we won new programs with existing customers for electronic modules for ground-based vehicles for radar systems, and for RF components for space modules. In computing and telco, we had two new customers, one for antenna module manufacturing, the other for advanced cloud storage products. Overall, we had 51 total wins for the quarter and 13 new customer engagements. I'm extremely pleased by the number of joint engineering and manufacturing engagements and it's a testament to our value proposition to customers. If you now turn to slide seven, as we've discussed over the last two quarters, we have a legacy computing contract which has been diluted to our earnings. If you may recall, this is a longstanding contract with a longstanding customer. When this contract was renewed in early 2016, It was assumed that this product line would go end of life and decline substantially by this time. The opposite has happened. Growth has occurred, increasing over 50% from the 2016 period. Margins, which were once acceptable, have deteriorated due to model mix and supply chain changes. We have been working with this customer since the fall of 2017 to attempt to renegotiate this contract. And we notified this customer that we will be not renewing the contract when it expires in December of this year. Consequently, the customers informed us that they will transition this product outside of benchmark. And I anticipate it moving sometime in the middle of this year. The impact of this contract is significant to our numbers. As you look at the box on the left-hand side of the chart, you can see that it comprises $280 to $320 million of revenue in both 2017 and 2018, respectively. But the gross margin impact of that revenue is substantially dilutive. When you exclude that contract from our results, our gross margins increased 80 to 90 basis points in both those years respectively. By removing this contract, we can reflect the true underlying strength of our business, which is at industry-leading margins and continues to grow at 3% on an annual basis. As we go through the transition with this customer, we will continue to report to you our results with and without this contract until it is totally removed from our actual results. If I turn to the next slide, on slide eight, as we traditionally do, I'd like to talk about our milestones to the waypoints we established earlier this year. In the upper right-hand corner, as it relates to bookings, we established a milestone to achieve $200 million of bookings, eggs in the year. As you can see, we delivered $198 million in the fourth quarter, essentially achieving this target. On the upper right-hand corner of the chart, as it relates to high-value market segments, we had set a waypoint of 67%. Our reported results, including this legacy computing contract, have us several basis points below that waypoint. As we exclude that contract, you can see that we are in the mid-70s for the majority of this year. Turning to gross margin was probably the most watched number in the waypoint section. Our waypoint for the end of 2018 was 9.7%. Given the strength of this legacy computing contract, and the decline in our T&I sector, you can see the reported results are 8.4%. When we normalize for the legacy computing contract, that goes to 9.5%. The difference between the weight point of 9.7 and 9.5 is related to the softening of our T&I sector in the second half of the year. If you look at the first quarter of 18, The dynamics of the weight of T&I and the weight of the legacy contract would have been about the same. And had T&I not softened, we would have been above the 9.7% range, closing in on 10%. And finally, on a profit per square foot percentage, or dollar value, which I use as a surrogate for ROIC. Given the lower utilization of our precision machining group because of semi-cap weakness and the high capital intensive nature of that division, we've seen erosion in profit per square foot. In an attempt to reduce the downward sizing of that, we have taken steps to right size capacity and restructure facilities. Now turning to the next slide, slide nine. I want to reemphasize and reiterate our target financial model. Our goal is to get the non-GAAP operating margins in excess of 5.5 percent and ROIC at 12 percent. To do that, we need a target revenue range of $2.8 to $3.2 billion. and a target gross margin range of 9.8 to 10%. With the transitioning of this legacy computing contract out of our base business, our margins begin to approach the threshold of that target range. But it lays bare the fact that we need to continue to grow revenue. Because with the reduction of that computing contract, we're now about $2.2 billion. 600 million shy of the low end of the model. Our business development teams are well aware of this challenge and are focused on driving bookings that will drive revenue growth to get to the low end of that model. If I turn to the next slide, slide 10, as is normally the case this time of year, I'd like to provide some color on 2019. Excluding the legacy computing contract, we expect year-on-year revenue growth of between 3% to 5%. This assumes that our test and instrumentation sector, which is heavily front-end semi-cap, we saw this in the first half of the year with slight growth in the second half. And we are assuming that on a full-year basis, 2019's results will be 10 percent lower than that of 2018. We are targeting gross margins to be in the 9.5 to 9.8 percent range. This will be achieved by focusing on continued process efficiencies and operational margin improvement in all of our sites around the globe. We will aggressively manage cost and expense structure further rationalizing facilities and labor to balance the load. We will examine our SG&A and take proven actions to reduce SG&A over the year. And lastly, we will drive improving mix of services and solutions, especially related to the ramp of our RF and I-speed design center here in Tempe. From a capital allocation standpoint, we will continue to repurchase shares on the outstanding $200 million authorization that we have. And we will continue our quarterly dividend. Combination of both the operating income growth associated with revenue and the actions we talked about and the reduction of our share count should drive EPS acceleration through 2019. Turn to slide 11. As is traditionally the case in our year-end call, we'd like to provide milestones for 2019. For 2019, from a booking standpoint, we are driving the organization to deliver bookings in the range of $800 to $900 million. That allows about $225 million per quarter. And I assume the linearity of that will be a little bit fluctuating as we go through the course of the year. From a high-value market standpoint, we are targeting 72% to 78% of our revenue from high-value markets. From a gross margin standpoint, as I said before, we are targeting 9.5% to 9.8% gross margins. And from SG&A standpoint, we are looking at a range of quarterly SG&A spending of $34 to $36 million, which is down from our previous guidance to you of $37.5 to $36, and represents at the low end a $10 million improvement from what we previously have done. Obviously, these milestones exclude the legacy computing contract. And we'll be tracking them throughout the course of 2019. Finally, turning to slide 12. In a press release earlier today, we announced my intention to retire this year. The board has a search underway to identify my successor. And upon their appointment, I will remain with the company as an advisor through the end of this year. As you know, I joined the Board of Benchmark in March of 2016 and was subsequently asked to come out of retirement to assume the CEO role in September of that year with the goal of improving operational performance, driving revenue growth, and refining and accelerating the company's strategy. At that time, the Board and I contemplated that I would remain in this role for 24 months or less. And last year, we extended my position by another 12 months. It has been a great privilege to lead Benchmark. And I am very proud of the progress that we have made over the past several years. From an operational standpoint, we have made great strides. We have significantly improved working capital management. Cash cycle days, which were almost 100 days at the beginning of 2016, have been reduced by over 30 percent and have remained at an average of 68 days over the past two years. Cash generated from operations over the three-year period is approximately $500 million, with almost 50 percent of that coming from improvements in working capital. We have renegotiated or exited underperforming contracts. We have transformed a federation of sites into a global market sector network, improving overall execution, and more importantly, providing a uniform customer experience around the globe. We have refreshed the leadership team, not only by direct reports, but several levels below, with nearly 50% of the organization new in the past two years. We have consolidated our decentralized corporate teams and other staff functions into our new headquarters in Tempe, driving not only better speed of decision making, but an environment of collaboration and a focus on the deployment and adoption of common processes and tools. From a revenue growth perspective, after a number of years of revenue decline, we have returned to revenue growth in each of the last two years. in our forecasting continued revenue growth in 2019. We've established our market sector business development organization. This team is tasked with acquiring and growing customers that have technically rich, complex product sets that are aligned to our sector strategies that offer the opportunity to utilize the entire breadth of the benchmark capabilities. Over the last two years, we have seen our investment in this organization drive bookings growth to over $700 million, an historic high for this company, and over a 50% increase from levels seen in 2015 and 2016. These bookings will fuel revenue growth in years to come, and we are driving this organization to a billion dollar booking mark in the next 24 months. We have continued to expand our value proposition to customers. making Benchmark more relevant by growing our engineering and solutions offerings. We've expanded our engineering capabilities in a variety of disciplines, such as fluidics, robotics, and optical systems, growing engineering revenue by 50% over 2016 levels. But more importantly, the level of engineering engagements that lead to manufacturing wins now stands at over a third. We have taken a number of unique capabilities, principally acquired with the secure transaction, and transformed them into a powerful set of solutions offerings that will enable customers to go to market faster and more economically. And finally, from a strategy perspective, I am very proud of the fact that we have repositioned Benchmark from principally a contract manufacturer to an engineering and manufacturing services company. position to take advantage of what I believe is the next great technology transition. I've been in the technology sector my entire career. And over the last 40 years, I have been fortunate to witness the evolution of our sector in what I describe as three technology eras. The first is the era of hardware. where advancements in semiconductors enabled computing power that drove the emergence of the mainframe to distributed computing and to PCs. The second is the area of software. First, enterprise software, then application software, and now cloud and SAS software. The third is the area of the network and wireless transmission, which enabled mobility and access not only to voice, but more importantly, voice and video data on any device anywhere. Each of these technology eras built upon the other and provided capabilities to a broader spectrum of end markets and end users driving new products and new offerings. In my opinion, we are at the beginning of the fourth era of technology, which is the evolution to 5G and the associated speed and connectivity improvements, which will enable new applications across even more diverse sets of end markets and industry verticals. For the past two years, we have been developing capabilities that will make Benchmark a key partner for our customers to capture the opportunities that 5G and high-speed gazool afford. These capabilities range from radio architecture to wireless topology to I.O. front-end architecture to high-speed circuit and RF design manufacturing to associated RF components coupled with advanced manufacturing in microelectronics and traditional SMT. We have both the engineering and the manufacturing capabilities that will tie these all together. When I first came to Benchmark in 2016, I told you that the future for the company was bright and that our job was to unleash its potential. Feedback from customers indicate that we are on the right track. They are excited by our offerings, by our level of engagement, and our desire to help them solve problems so they can go to market faster and capture the opportunities that they see. The foundation is set. Our leadership team is aligned. With this backdrop, it's time for a transition in leadership. To a new CEO that has a time horizon to lead this company to achieve its full potential. I am confident in this organization and its ability to execute and make this a reality. I would like to thank not only my leadership team, but the entire benchmark organization for their support over these past several years. I'd now like to turn the call over to Ruth. Thank you, Paul, and good afternoon, everyone.

Before I discuss a recap of our fourth quarter, on behalf of the entire management team and company, We want to thank Paul for his efforts over the last few years. I've had the opportunity to work with Paul at several companies. If there's one word I'd use to describe Paul, it's passionate. Paul is passionate about our people, our customers, our investors, technology, and the success of Benchmark. Through his tireless efforts, Paul has strengthened the foundations of Benchmark, and he leaves the company well-positioned to grow and deliver value. So with that, Paul, I'll just say thank you. We appreciate all that you've done. With that, I'll turn to slide 14 for discussion of our fourth quarter 2018 financial summary. Revenues of $657 million exceeded the high end of our guidance of $610 million to $650 million, but was down 1% year over year. The decline from prior year was due to the continued semi-cap market softness offset by increases in telecommunications and A&E. Our GAAP EPS for the quarter was 64 cents. Our GAAP results also included 3.5 million of restructuring and other costs due in part to the execution of site restructuring actions announced on the Q3 2018 earnings call. 14.5 million of non-recurring tax benefits, primarily related to the finalization of the tax accounting for the 2017 Tax Cuts and Jobs Act, and foreign tax credits generated from our 2018 cash repatriation. Our non-GAAP operating margin was 3.2%, a 30 basis point quarter-over-quarter improvement. Non-GAAP EPS of 41 cents exceeded the high end of our guidance of 32 cents to 40 cents. For the quarter, our ROIC was 9.2%, down 60 basis points sequentially on 110 basis points per year. Please turn to slide 15 for our revenue by market sector for the three months ended December 31. Industrial revenues for the fourth quarter decreased 6% sequentially, but better than our expected 15% decline as a result of demand for infrastructure and transportation customers. Revenues were down 6% year over year from seasonal demand changes and the reduction in revenue from an insolvent customer. ANP revenues for the fourth quarter increased 10% year over year for military and security communication devices and commercial aerospace products. Sequentially, revenues were flat and were lower than expected from custom component delays. Medical revenues increased 4% year over year from increased demand for renal and vascular products and we're up 8% sequentially from demand increases in cardiac products. Test and instrumentation revenues declined 9% in the fourth quarter, and we're down 25% year-over-year in declines in semi-cap customers who utilize our precision technology services. Overall, the higher value markets represented 61% of our fourth quarter revenue, and we're down 2% sequentially and 4% year-over-year, primarily from semi-cap softness. Turning now to our traditional markets, computing was down 1% year-over-year, but up sequentially 18% quarter-over-quarter from storage computing and new program ramps. Telecommunications was up 12% year-over-year from new program ramps with satellite and broadcast products, and down 3% sequentially, which is slightly less than forecasted. Our traditional markets, which represented 39% of fourth quarter revenues, were up 3% from last year and 10% sequentially. Our top 10 customers represented 45% of sales in the fourth quarter. Turning to slide 17 for discussion of non-GAAP business trends. Gross margin for the quarter was 8.4%, a 10 basis point sequential decline, and a year-over-year decline of 70 basis points. Sequentially, Q4 2018 gross margin was down due to continued adverse impacts of semi-cap softness, as well as higher computing revenues from our legacy storage customers. Our non-GAAP SG&A was $34 million, which was down 5% sequentially, driven by continued expense management and resulting non-GAAP operating margin was 3.2%, up 30 basis points sequentially. We had $3.5 million restructuring other costs for Q4. We have completed all the actions announced previously. Savings from the prior restructuring actions are reflected in our Q4 results and in our forward guidance. We expect to incur additional restructuring terms of approximately $500,000 to $1 million in Q1 2019. Turning to slide 18 for an overview of the 2018 financial summary as compared to 17. Revenues were $2.6 billion for 2018 compared to $2.5 billion for 2017, a year-over-year increase of 5% due to 2% growth in our higher value markets and 8% growth in our traditional markets. Gross margin declined 60 basis points year-over-year driven by growth of our legacy computing customer and demand softness and semi-cap. Our non-GAAP SG&A as a percent of revenue increased to 5.5%, a 30 basis point increase as a function of our continued investment and go-to-market capabilities. Non-GAAP operating income declined by 90 basis points year-over-year. Non-GAAP EPS decreased 10% to $1.45, and our ROIC decreased 110 basis points to 9.2%. Turning to slide 19 for our revenue by market sector for the full year. For the full year, higher value markets grew 2%, but still short of our 10% annualized growth rate due to the second half 2018 test instrumentation softness. The A&D sector benefited from increased defense spending for new and existing programs, The medical sector grew on the strength of new programs and increased engineering service engagements. The industrial sector slightly declined as the pace of new customer ramps did not offset declines resulting from program transitions. Revenues in the traditional markets were up 8% from 2017 from stronger than expected demand in computing and security products. As expected, we returned to revenue growth in telecommunications 2018 with a 10% growth from new programs for satellite and broadcast products. IBM was our only greater than 10% customer for fiscal year 2018 at approximately 12.6%. Turning to slide 20 for a few updates on cash flow and working capital highlights. We generated $94 million in cash from operations for the quarter. Free cash flow was $80 million for the fourth quarter after capital expenditures were approximately $14 million. For the full year 2018, we generated $77 million in cash flow from operations, which exceeded the range of $30 to $50 billion discussed previously. Pre-cash flows, $10 million for the full year after cash flow expenditures of approximately $67 million. Our cash balance was $458 million at December 31, with $304 million available in the US. During Q4, we repatriated $38 million of cash from international locations, bringing our total 2018 cash repatriated to $560 million. As we move forward, we'll continue to evaluate further repatriation opportunities. The repatriated funds are used to fund the share repurchases, working capital, capital expenditures, and paying down of our prior term loan aid facility. Our accounts receivable balance is $468 million, an increase of $12 million from September 30th. The increase in accounts receivable is a function of our shipment linearity and mix of customers. Payables were $48 million, quarter over quarter. Contract assets were $140 million at December 31 and $156 million at September 30. Inventory at December 31 was $310 million, a decrease of $11 million from September 30. Turning to slide 21 for a review of our cash conversion cycle. Cash conversion cycle was 62 days for Q4, which is lower than our expectations due to customer demand driving better inventory days. and timing of certain payments. Update on capital allocation on slide 22. Total repurchases through December 31 was approximately $212 million, which exceeded our committed amount of $100 million for the year. We will continue to evaluate further repurchases in 2019 through our OMR program. As of the end of 2018, we had approximately $202 million available under the expanded share repurchase program. In March 2018, we announced a recurring $0.15 per share quarterly cash dividend. Dividends of approximately $7 billion have been paid in April, July, and October of 2018 and January of 2019. Turning to slide 23 for review of our first quarter guidance. And to remind everyone, our guidance continues to include the legacy computing contract. We expect revenue to range from $570 million to $610 million. Our non-GAAP diluted earnings per share are expected to range from $0.29 to $0.37. For sequential modeling for the first quarter, please turn to slide 24. Overall, we expect industrial revenues to be down low singles from seasonally softer demand. A&D expected to be flat in Q1 based on slower program ramps, which are expected to recover in subsequent quarters. We expect medical revenues to be up low single digits, driven by new customer programs. In testing instrumentation, we expect a decline 10% from continuing softness and Semicat. Turning now to the traditional markets, we expect computing revenues to be down greater than 30% due to seasonality, and telco down mostly from new program timing. Implied in our guidance is a 2.7% to 3.2% operating margin range for modeling purposes. The guidance provided does exclude the impact of amortization of intangible assets and estimated restructuring and other costs. Interest expense is expected to be $1.9 million, and the effective tax rate is expected to be 20% due to the expiration of our China tax holiday. We will be reapplying for our China tax holiday in mid-2019 when allowed. If and when we receive the China tax holiday, we expect our effective tax rate would normalize to 18%. The expected weighted average shares for Q1 2019 are $40.7 million. And in closing, on slide 25, we provided for your reference fiscal year 2020 modeling information to reflect the expiration of the legacy computing contract. Operator, please open the call for questions.

Thank you. We will now begin the question and answer session. To ask a question, you may press star, then 1 on your touch-tone phone. If you are using a speakerphone, please pick up your handset before pressing the keys. To withdraw your question, please press star, then 2. At this time, we will pause for a moment to assemble our roster. Our first question today will come from Mitch Steeves of RBC Capital Markets. Please go ahead.

Hey guys, thanks for taking my question. I kind of want to first touch on the end market on the testing and instrumentation side. Are you guys seeing any sort of a bottoming in semi-cap equipment? Because I know that's a pretty large segment for you guys there. What do you guys expect that to kind of be at a run rate of 70 million going forward?

Yeah, Mitch, this is Rup. I'll sort out. We're expected to see, as we said, a 10% overall decline year over year. And we're expected to demand to increase as we go through 2019. with really a second half 2019 kind of accelerated growth.

Got it. And then secondly, on the high-end computer segment for the customer that you guys are moving on from, so how do we think about the profitability from an operating margin standpoint versus a gross margin standpoint? Because I understand that the mix of business will send the gross margins up, but is that something that will flow through to op margins, or should we just assume that the operating margin will be similar?

Yeah, there is an effect on operating margins. So maybe the way I'd ask you to think about it is if you take the range of $280 million to $320 million, that is a very low single-digit type gross margin overall. And so when you do the math, you're looking at operating profit dollars of somewhere around $3 million to maybe $6 million or so. And so you can see that effect. Overall, from an operating margin perspective, it's depending upon exactly where that revenue stream is. maybe 10 basis points to a 30 basis point increase in overall op margin.

Just to be clear here, so 80 to 90 basis point improvement in gross margin, but only 10 to 20 in op margin?

And a 30 basis point in op margin improvement. And that's just a math of how it went through.

Understood. Thank you very much. Thanks, Mitch.

Again, to ask a question, please press star, then 1. Our next question will come from Anja Soderstrom of Sidonian Company. Please go ahead.

Hi, Ruben, Lisa, and Paul. Thank you for taking my question. I had a question about the SG&A for the fourth quarter. It was a little bit lower than expected and the lower end of the guidance range going forward. I just wonder what sort of impacted that and how to think about that going forward.

Yeah, Anya, hi. This is Rup. So good to have you, and thanks for the question. So in terms of the fourth quarter SG&A, obviously, you know, we have been focused on being prudent with our overall cost management structure, and we have put in place actions to normalize that SG&A. It came in around that 34. As we look towards 2019, as Paul pointed out in his comments, we expect it to be in that 34 to 36 million range. There are some investments we still expect to make as we continue moving forward, but we'll be within that range.

Thank you. And then I also just had a question about the semi-cap turnaround in the second half. Are you still seeing the same things that you have been talking about before in terms of that turnaround, or have you gotten any more color you can share with us on that?

Yeah, I mean, we're lucky to have a diversified roster of customers in SEMICAP, and each one is a slightly different story and set of considerations. With that said, what we would kind of aggregate and composite would say we still expect that second half recovery as we see it now and based on our discussions with those customers.

Okay, thank you so much for taking my question.

Thank you.

And again, to ask a question... Please press star and then one. Showing no further questions, this will conclude our question and answer session. At this time, I'd like to turn the conference back over to Rup Lakharaju for any closing remarks.

Thank you, operator. Thank you for everyone for joining our call today. We'll be available after the call to answer any further questions. And we look forward to speaking with you all in 90 days. Have a good rest of your day. Thank you.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.