TE Connectivity Ltd

Ladies and gentlemen, thank you for standing by and welcome to the TE Connectivity third quarter earnings call for fiscal year 2019. 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 this time, simply press star, then the number one on your telephone keypad. If you would like to withdraw your question, press the pound key. 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, Sue Jill Shaw. Please go ahead.

Good morning, and thank you for joining our conference call to discuss TE Connectivity's third quarter results. With me today are Chief Executive Officer Terrence Curtin and Chief Financial Officer Heath Mitz. 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 are 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. Thank you, Susana, and also I appreciate everyone joining us today as we go through our third quarter results. and our revised outlook for 2019. You know, before I get into the slides, let me frame out a few key points that we're going to talk about in today's call. You know, first off, you know, I'm very pleased with our execution in the third quarter. We delivered adjusted earnings per share, seven cents above the midpoint of guidance, despite sales being $60 million below the midpoint. And what continues to be an uncertain market backdrop, that weakened since our call with you just 90 days ago. Despite this weaker market backdrop, I want to stress that, you know, we continue to be focused on executing our strategy and the multiple levers in our business model. And as we've been sharing with you, you know, started at our investor day, there's three areas of key focus within our business model, which include top-line growth, number one, secondly, margin expansion, and thirdly, capital deployment. And when we think about these three areas, and starting with the growth one, growth is around positioning our portfolio in markets with long-term secular trends that enable organic outperformance from content growth through the cycle, as well as expansion of our portfolio inorganically. When we think about the second lever of margin, it is looking at structural cost improvement through both footprint rationalization, as well as selling general goods and administrative expense initiatives that give us scale advantage. And on the third, when we think about capital deployment, it starts with our strong cash flow generation model and how we balance the capital return as well as expanding our portfolio that I think we've been pretty clear on in our experience that you've had with us has been pretty consistent. When we think about this year, and really driven by the market environment backdrop, The organic growth lever is being challenged after two years where it was the key pillar of our performance. And in 2019, you know, we have been focused on executing on the other levers to protect margin and earnings performance. You know, as we look forward, you know, we are reducing our full year guidance for both sales and adjusted earnings per share to entirely to the incremental market weakness that we're experiencing. During last quarter's earnings announcement, We indicated that we were seeing stabilization in key end markets, and that was reflected by sequential order growth that we were experiencing. Now, since that time, we have seen this trend reverse and have seen a sequential decline in orders. Order patterns, when you take it into the two big buckets of this decline, the first one is a further drop in auto production in China. And then the second is broad inventory to stocking of electronic components in the distribution channel. And both of these are really why we've adjusted our outlook. The other thing that I want to stress before I get into slides is that, you know, the proof on the execution against our levers in our model, you know, in this challenging market is really illustrated not only by our third quarter performance where we grew earnings per share on a sales decline. but also the change in our guidance since the start of the year. Our original fiscal year guidance last November was for sales of $14.1 billion and adjusted earnings per share of $5.70. Our current guide is for sales of $13.4 billion and adjusted earnings per share of $5.50. Current guidance represents a $700 million drop in sales, but only a $0.20 drop in adjusted earnings per share versus our guidance at the start of the year. And what I would tell you, I think this is proof of execution versus the levers in our model, as well as the improvement we've made in this portfolio to enable margin and earnings resiliency through a cycle. So let me now get into the slides, and Heath and I'll go through them and get into more details. And let's start with slide three, and I'll review the highlights in the quarter. From a top-line perspective, sales were $3.4 billion. And this was down 5% year over year on a reported basis and down 3% organically. The difference between reported and organic is primarily due to a headwind of approximately $125 million, which is due to currency translation. In our transportation segment, our sales were down 4% organically due to a greater than expected decline in auto production. That was at 10% globally, and this was driven by China. Our industrial segment grew 2% organically in line with our guidance, driven by strong performance and growth in our commercial aerospace, defense, and medical markets. And our communication segment declined 11% on an organic basis, which was lower than we expected due to inventory, to stocking, and the distribution channel. From an earnings perspective, our third quarter adjusted operating margins were 17.6%, up 20 basis points year over year, as well as up 60 basis points sequentially. You know, this is really due to our team's execution of the cost levers I mentioned earlier, and operating margins are up both year over year and sequentially, despite revenue declines. From an earnings per share perspective, our adjusted earnings per share was $1.50 and exceeded the high end of the guidance, despite the lower sales, and was driven by the strong operational execution that I mentioned. In addition to the earnings, our strong cash generation is a key enabler of our business model, and our free cash flow was $515 million in the third quarter. Year-to-date, our free cash flow is $928 million and is up approximately 27% versus the prior year. During the quarter, we returned $307 million to shareholders through buybacks and dividends. And in addition to return a capital, our capital deployment strategy continues to include building out our portfolio inorganically to further capitalize on the secular trends to drive future growth. In the quarter, we completed bolt-on acquisitions of the Kissling Group that will benefit our commercial transportation business, as well as Alpha Technics, a provider of temperature sensing technology into the medical market. In addition, we also announced our intent to acquire First Sensor, which is a German public sensor company that serves auto, industrial, and medical markets, and just how that process works. That will be further out and won't close immediately. So now let me talk more about the change in guidance. And as I mentioned earlier, it's based solely upon the weaker market conditions. And we're reducing the full sales outlook by $250 million to $13.4 billion today. and the midpoint of adjusted earnings per share guidance by $0.10 to $5.50. Of the $250 million reduction from our prior view, approximately two-thirds is in transportation, which is primarily driven by China Auto, and approximately one-third is in communications, which is primarily driven by lower demand in the distribution channel as a result of the stocking by our partners. As a result of market conditions, we are also further increasing the scope of our restructuring to $375 million this year, which is an increase of $125 million from our prior review, and Heath will get into more details later. So, I appreciate if you could turn to slide four and let me get into the order trends by our segments. In the third quarter, our organic orders were down 10% year-over-year and 4% sequentially. reflecting end markets and inventory trends that I mentioned. Our book-to-bill was 0.98, and our orders declined in each region and in each segment. My segment, transportation, was down 10% organically year over year, reflecting further declines in auto production, primarily in China. The sequential order increases we saw in China in the second quarter reversed in the third quarter, as both auto sales and production figures weakened further. By region, we saw year-over-year declines in the double digits in China, as well as in Europe, and mid-single-digit decline in the Americas. In the industrial segment, industrial orders were down 5% organically driven by industrial equipment, partially offset by growth in aerospace and defense, as well as in energy. I do want to highlight that in our industrial equipment business, it does have a high ratio of sales through the distribution channel. In our communication segment, orders were down 17% organically year over year, driven by broad-based weaknesses across all regions. So, let me talk a little bit about what we're seeing in the distribution channel. And as I mentioned earlier, we are being impacted by the stocking by our partners. You know, at the total TE level this fiscal year, approximately 20% of our sales are through our distribution partners. And we have higher levels of concentration in the industrial and communications segment. You know, we've seen a large reduction in orders by our distributors as a result of broader inventory trends that go beyond our products, and it goes into other component areas. Based on the order patterns, we are expecting a substantial reduction in distribution revenue in our fourth quarter, which we have reflected in our guidance. So, please turn to slide five, and I'll discuss our segment results in the quarter. And as always, I'll start with transportation. Transportation sales were down 4% organically year over year. Our auto sales were down 4% organically versus auto production declines of 10% in the quarter that I mentioned earlier. Our outperformance versus auto production continues to be driven by content growth from the secular trends we've positioned around, including electric vehicles and increased autonomous features. For the full year, we continue to expect content growth to partially buffer auto production declines consistent with the content growth targets we've laid out for you. In commercial transportation, sales were down 5% organically, reflecting broad market weakness, both across markets and regions. And our sensors business grew 1% organically year on year, with growth driven by industrial applications. From an earnings perspective for the segment, adjusted operating margins were 18.6%, and they grew 110 basis points sequentially as a result of the accelerated cost actions we talked to you about. In light of market conditions, we expect to take additional cost actions, which is reflected in the increased restructuring charges I mentioned earlier. So please turn to slide six, and I'll discuss our industrial solutions segment. The segment sales grew 2% organically year over year in line with our expectations, with growth in aerospace, defense, and medical really being the growth drivers. Our aerospace, defense, and marine business delivered a very strong quarter of 17% organic growth, driven by both new program ramps and commercial aerospace, as well as the defense side. In industrial equipment, sales were down 6% organically, driven by inventory to stocking, partially offset by strength and medical applications. Also, our energy business was flat on an organic basis, with growth in North America offsetting declines in Europe. From an earnings perspective, industrial solutions adjusted operating margins expanded 220 basis points over the prior year to 16.6%, driven by strong operational execution by our team. I'm pleased that we can still generate strong performance in this core despite a challenging market environment, and our plans remain on track to expand adjusted operating margins into the high teams over time for this segment. So, let me turn to communication solutions, and if Flip to page seven, please. Communication sales were down 11% organically, well below our expectations. And it goes back to what I talked about earlier. This segment has the highest percentage of business going through the distribution channel. So there is a greater impact from inventory to stocking in this segment. Adjusted operating margins were 14.9%. They declined 70 basis points over the prior year due to volume. So with that, I'll turn it over to Heath to cover the financials for Q3, and then I'll come back and cover guidance.

Thank you, Terrence, and good morning, everyone. Please turn to slide 8 where I will provide more details on the Q3 financials. Adjusted operating income was $596 million with an adjusted operating margin of 17.6%. GAAP operating income was $520 million and included $67 million of restructuring and other charges, and $9 million of acquisition charges. Last quarter, we mentioned that we were broadening the scope of our cost initiatives to better align the cost structure of the organization with the market environment. Given the market conditions, we are taking further advantage of the current lull in demand to reduce our fixed costs and better align our footprint with our customer supply chain. Hence, we are increasing our estimate of restructuring charges to $375 million for the full year. This represents an increase of $125 million versus our prior view. The additional actions are primarily in our transportation and communications segments. Now, I'm confident that the initiatives we've taken so far this year have enabled margin and EPS resiliency despite weaker markets. We are now further accelerating cost actions to ensure that we can preserve margin and EPS performance during this part of the cycle. As we have shown in the past, this will enable us to realize improved margin as demand returns. Adjusted EPS was $1.50, up 6% year-over-year. We were able to grow adjusted EPS year-over-year despite a reduction of revenue, which demonstrates our ability to execute on multiple levers to drive earnings performance. GAAP EPS was $2.24 for the quarter and included a $0.91 tax benefit primarily related to Swiss tax reform. This benefit was partially offset by restructuring acquisitions and other charges of 17 cents. The adjusted effective tax rate in Q3 was 13.6%, and for the full year, we expect the adjusted effective tax rate to be roughly 16.5%. Swiss tax reform results in a one-time tax benefit in Q3, but increases our effective tax rate going forward, so you should continue to expect the tax rate for TE to be in the high teens as we move beyond this year. However, importantly, we expect our cash tax rate to stay well below our reported ETR. Now, if I can get you to turn to slide 9. Sales of $3.4 billion were down 5% year-over-year on a reported basis and down 3% organically. Currency exchange rates negatively impacted sales by $123 million versus the prior year. Adjusted operating margins were 17.6%, and our strong margin performance despite lower sales is a result of the benefits we are seeing from proactive cost actions we initiated earlier this year, as well as the progress we have made in profitability across all of the segments, particularly the industrial segment. In the quarter, cash from continuing operations was $692 million, and our free cash flow was $515 million. With $166 million of net capital expenditures, We returned $307 million to shareholders through dividends and share repurchases in the quarter, and year-to-date 2019 free cash flow is $928 million, which is an increase of 27% versus the prior year. We expect that our free cash flow will exceed the prior year, even with the increased level of restructuring investment related to our cost initiatives. It's a powerful story there. Our balance sheet is healthy, and we expect cash flow to remain strong. which provides us the flexibility to utilize cash in support of organic growth investments to drive long-term sustainable growth while also allowing us to return capital to shareholders and continue to pursue both acquisitions. Now, I'm pleased that our team reacted quickly to pull the levers in our business model earlier in the year to help mitigate the impacts of weaker sales on our margin and EPS performance. But as you should expect, we will continue to balance our structural cost actions with our long-term growth investments investments to ensure sustainability of our business model going forward. So with that, I'll turn it back over to Terrence to cover guidance before we get into questions.

Thanks, Steve. And let me get into guidance. I'll start with the fourth quarter, which is on slide 10. Now, based on what we laid out and we're seeing in the end markets and the order trends, fourth quarter revenue is expected to be $3.2 to $3.3 billion, with adjusted earnings per share of $1.27 to $1.33. At the midpoint, this represents lower year-over-year reported inorganic sales of 7%. Even with this sales decline, we're only expecting year-over-year reduction of 5 cents in adjusted EPS on $250 million of lower revenue, which is evidence of the multiple levers we're pulling in our business model, including the accelerated cost actions Heath just talked about. Looking at it by segment, We expect transportation solutions to be down mid-single digits organically, and this is based upon a global auto production environment, which we expect to be down 6% in the quarter, with our revenue being impacted by supply chain adjustments in light of further weakening in production trends. In industrial solutions, we expect to be down low single digits organically, with declines in industrial equipment from the inventory to stocking being partially offset by growth momentum and aerospace and defense and medical applications. And in communications, we expect to be down approximately in the high teens as the inventory, the stocking we mentioned works its way through, and it will impact that segment more than the others. Now, turn to slide 11, and I'll get into the full year guidance for 19. For the full year, we expect sales in a range of $13.35 to $13.45 billion. As I mentioned earlier, this is a reduction of $250 million from our prior review due to lower auto production driven by China and inventory to stocking in the distribution channel. Our guidance represents declines of 2% on an organic basis and 4% on a reported basis with currency translation headwinds of $400 million on a full year basis. Adjusted earnings per share is expected to be in the range of $5.47 to $5.53, and this is a 10-cent reduction from our prior review. On a year-over-year basis, we are expecting adjusted EPS to be up low single digits, excluding currency exchange headwinds of 16 cents. Similar to quarter four, let me get into some color on their segments for the full year guide. We expect transportation solutions to be down low single digits organically, and we now expect global auto production to be down approximately 7% versus our prior view of being down 5% with the reduction primarily driven by China, and certainly this is all on our fiscal period. Year-to-date, our revenue growth has exceeded auto production. by the content growth range that we've told you in the range of 4% to 6%. So, our content position is very strong. In industrial solutions, we continue to expect sales to be up low single digits organically with growth driven by aerospace defense as well as medical applications. And lastly, in communications, we do expect to be down high single digits organically driven by the Asia market weakness that we've been talking about before this quarter, as well as the inventory, the stocking, and the distribution channel that we're seeing that's impacting us here late in the year. So with that, before we go into questions, let me just recap some key takeaways that I hope we conveyed during the call. First, we've seen a weakening in the market since the last call, and this is driving the reduction in our guidance. It's driven by two main areas, drop in auto production in China and as well as what we're experiencing through our distribution partners as they're stocking their inventories. Secondly, we have positioned TE to benefit from secular trends, such as electric vehicles, autonomous driving, next-generation airframes, as well as interventional medical applications and cloud infrastructure growth, which are enabling us to outperform weaker markets. Thirdly, despite this market backdrop, we are successfully executing on our strategy, driving the multiple levers that we have in our business model to protect our margin and earnings performance through the cycle. And, you know, lastly, goes without saying, you know, I think we've proven this. When we've seen markets that are weaker in the past, we're going to take advantage of these lows as an opportunity to aggressively go after cost reduction and footprint consolidation activities, and we're following the same approach. and expect to emerge with increased earnings power when these markets return to growth. So before I close, I do want to also thank our employees across the world for their execution and cordiality in what continues to be a mixed market backdrop, as well as their commitment to our customers and a future that is safer, sustainable, productive, and connected. So with that, Sujal, let's open it up for questions. All right. Thank you, Lisa. Can you please give the instructions for the Q&A session?

At this time, I would like to remind everyone, in order to ask a question, press star, then the number 1 on your telephone keypad. In order to have time for all questions, each participant is limited to one question. If you would like to ask a follow-up question, please press star 1 to return to the queue. Your first question comes from Craig Hettenbach from Morgan Stanley. Your line is open.

Yes, thank you. Question for Terrence, just given the backdrop that we're in, just want to get your thoughts kind of as you manage internally. You have a number of restructuring programs going on, but also externally you're still looking to kind of pursue and execute on M&A and how you kind of balance those things and what's kind of a difficult cycle.

No, I mean, a couple of things. I think... First of all, it goes back to we're very fortunate that we have a very strong cash generation model that you see with the free cash flow we've generated. So I don't think as we manage through both of these, as well as we return capital to owners, I don't think it's one versus the other. I think what's really nice about what we've done with our portfolio, you see how the content trends where we position ourselves well, and you see it even how automotive content is buffering, you know, a recession in automotive production that, you know, We got a little bit of a head fake last quarter in China that made it a little bit worse here. But I do think when we look at what sensors and medical, which are platforms we want to build on, as well as areas like hisling that we talked about, that's an area where electric and how do we get into high power and commercial transportation, we're going to continue to look for M&A opportunities that continue to build on where we have a very strong position. So I don't think it's one versus the other. And I also believe when we get into our cost structure, I'm pretty pleased that, you know, we got after it early in the year. You know, we've been sort of – auto production has gotten worse, so we've had to expand some things to make sure we take the cost out during the loan. And even with what Heath talked about, you know, what we're talking about in some of the expanded is also, you know, making sure we're looking at maybe some opportunities in communications that – You know, at higher volumes, we probably couldn't take advantage of. The only other thing I would add is, you know, I'm also very pleased that when you think about the adjustments we're making to market, there's also things we teed up last year and the year before that we talked about, about the industrial segment. And, you know, you're really seeing how we continue to improve the performance of that segment, how it's contributing. And, you know, there's still things that aren't from some of the investments we've made aren't having a payback yet. So I think it provides... you know, future leverage as we fix the fixed cost structure of TE and get it better aligned and also a little bit more agile. So I think you're going to continue to see us balancing both of them. And, you know, I think this quarter is a great example of it. All right. Thank you, Craig. We have the next question, please.

The next question comes from David Laker from Baird. Your line is open.

Good morning, everyone.

Hey, David. Good morning.

I wanted to dig through a little bit of some of these headwinds you're seeing in the channel. It seems to be impacting you a little bit later than some other people. I want to understand, if we can, how your business going through that channel is different than other people and how long for your products as we go through those corrections in that channel, how long does it last for you to kind of work through that? Thanks.

Okay. So, you know, David, I don't know what, other products that you're talking about, when you think through us, of our $13.4 billion of revenue, there's a little bit over $2 billion that goes through channel partners, and it's really around the medium to small customers that we can't serve directly, and we do leverage our channel partners for that. When you look at it and you sort of take that $2 billion, our transportation business is a very direct business, so The channel impact is pretty small when it deals with our transportation segment. As you deal with the markets that have more fragmented customer bases, you know, you get that in our industrial equipment area. That's being impacted by it. You're also seeing it in our communications segment. And, you know, what we were seeing was actually our business through our channel partners have been staying pretty stable at around the orders were running around $500 million per quarter. About the last six quarters, and, you know, this past quarter and the June quarter, it stepped down, and we expected it to step down even further, and there's been some announcements out there. Typically, that's getting aligned more with, you know, the slowness of the market, as well as I think we're also being impacted that some of the channel partners, due to lead times and other product categories and certain semi-categories and passives, probably got a little bit ahead of themselves in making sure they had enough supply. That all being said, you know, these types of supply chain adjustments, you know, while ahead when now, typically take four to six months to sort of work through. You know, clearly we're in the middle of it. And I think, you know, they are temporary effects. So they are something, you know, we're going to have to work through here over the next couple of quarters. And, you know, that will be a tailwind at some point. depending upon where markets are, and we're in the middle of it. So while it may be later versus other categories, we start to see it in the orders in quarter three. It'll be with us for a little bit, and then it'll be a tailwind at some point when it corrects and gets normalized. Thank you. Okay. Thank you, David. Thanks, David. We have the next question, please.

Our next question comes from the line of Sean Harrison from Longbow Research. Your line is open.

Morning, Terrence.

Hey, Sean.

Good morning. Hey. The auto sector in terms of the step down here, particularly led by China, are there any leading indicators that you're looking to track, be it inventory, be it other factors within China or globally that will tell you we've reached the bottom? And I'm not looking for you to guide the December quarter, but just to speak about it in some sense of whether we could reach the bottom in the December quarter and calendar 20 could represent a more positive environment.

Sure. So, you know, as everybody heard us talk last quarter, we sort of knew we were getting to stabilization and auto production, and I think Ivan said on this call or in some conversations at conferences, we sort of thought we were running around 22 million units of cars being produced per quarter, and we thought we were stabilizing. And to the comments I made on the call, what we actually saw, you know, in sort of After earnings, you saw China car sales were down mid-teens, and certainly that has impacted China auto production. And I would tell you right now, global automotive is running around 21 million units versus the 22 million units. So that's impacted us by about 2 million units coming out. That all being said, we are looking at inventories in China, inventory days on hand in China. in addition to the sales, they're around 50 days on hand. That's a little heavy. I wouldn't say it's horribly heavy, but they're the types of things both on the car sales as well as the inventories we're looking at. And, you know, right now I would tell you we're sort of assuming we're running around that 21 million unit rate. China typically has a step up in the first quarter in production. You know, I guess that's the real uncertainty. I would say we have to continue to watch where the car sales and inventory levels are before we would tell you where we should be. But right now our mental model is sort of thinking they're saying, how do we plan the business around 21 million units globally per quarter in automotives, how we're thinking about it, and also how we're adjusting our cost structure and some of the things Heath talked about.

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

Our next question comes from the line of Wamsi Mohan from Bank of America. Merrill Lynch, your line is open.

Yes, thank you. Terrence, you opened the call talking about revenue growth and sort of some of the headwinds here in 2019. As we think about adjusting to these lower organic growth levels in fiscal 19, can you maybe give us some sense of how we should think about, you know, heading into fiscal 20 first quarter and how we should think about seasonality off of these lower fiscal 4Q levels, and how do you view the odds of continued headwinds going into fiscal 20?

Thank you for the question, Wamsi. There's part of this you know I'm going to not answer because we're not guiding the 20 yet. And certainly, as we get more intelligence, we will. I think there are some things that I would highlight, though, to your question. I think, you know, there will be things like auto production that has been fluid. I think we're going to have to continue to keep fluid. But I would also say when you think about that, you know, off this point I sort of talked around under 21 million units is, you know, we're still positioned ourselves around that 4% to 6% content element. So you've seen it this year, even while the market's been worse. I think you're going to continue to see that. So as we pick production points and you do your analysis, I do think you're going to see those benefits around transportation. Certainly you're going to see it in aerospace. You're seeing it in medical. So I think that's first off, I would say, as you work your miles is important. I'll go second things, probably going back to what David said. Channel to stocking is a temporary item. And I think there's going to be a lot of data points, not only by us, but there's some out there. This will normalize. So what is the headwind that we have in quarter four that will go into early next year? You know, certainly that will turn like it typically does. And the other thing I would just say as we go into next year and it's less revenue is, you know, there's lots of levers that we're pulling. And, you know, where they hit in the year from a cost perspective will be at different points depending upon we initiate them. But I do think as we try to manage through this, we have many cost levers that we're working on. that I think no different as we displayed in quarter three and quarter four. We're going to continue to be working from an earnings perspective. Now, that being said, you know, there is a sub-point in your question around how do we see seasonality? Let's face it. This year's seasonality was not normal. You know, quarter three and quarter four are typically our strongest quarters of the year, and quarter four, you know, is arguably going to be our weakest. So, I don't think you can take the normal seasonal patterns that we have and say, you know, take quarter one is going to be down mid to high single digits into quarter four. I think you have to adjust for some of these facts as you look at that, and certainly we'll guide more as we talk to you in 90 days, but I would just not say go blind seasonality because these markets aren't typical either. So a longer answer than probably you wanted, but hopefully that gives you some insights as you think about things, and we'll give you more input in 90 days. Okay, thank you, Wamsi. Can we have the next question, please?

Our next question comes from the line of Scott Davis from Malleus Research. Your line is open.

Hey, good morning, guys. Hi, Scott. I know this might be hard to answer, and I know you're not giving 20-20 guidance, but can you help us give a little granularity on the restructuring, you know, as far as kind of payback is concerned? Sometimes you do restructuring in Europe and it takes a few years to see an impact, but you do it in the U.S. and it's immediate. Can you just help us understand either directionally or an actual kind of tailwind for 2020 would be helpful, or at least some color around where the restructuring is?

Super.

Scott, I think you're right on in terms of that. Some of the non-U.S. restructuring does have a longer cash-on-cash return in addition to just the length of time when you're taking factories offline from the point of initiation until when you realize the savings. I think it's fair to say of that 375, there's a blend, but on average it's about a three- to four-year payback. So that would kind of steer you towards a number of annualized savings as part of that and steer you towards jurisdictionally where a lot of this activity is taking place.

Thank you, guys. Thanks, Scott. Thanks, Scott. Can we have the next question, please?

Our next question comes from the line of Mark Delaney from Goldman Sachs. Your line is open.

Good morning. Thanks for taking the question. Hey, Mark. I was hoping you could drill a little bit more into China region specifically, you know, the decline in orders that you saw there and the reversal compared to what you've been seeing. last quarter. Is that all just macro and weakness, or do you think any of this is due to the trade environment and potentially a more difficult region for U.S. companies to do business now? Thanks.

So a couple of things. Certainly, the global trade environment, I think, just creates an overlay around economic conditions, period. I don't think it's only one or two countries. It impacts everything. So I do think that has some impact on the slower economic conditions. because places like Europe shifts into China and so forth, and that impacts us in many places. You know, and, Mark, back to the question that you had, you know, when we were sitting here last quarter, you know, we saw a nice increase in our China business totally. You know, our orders, you know, went up, you know, almost 10% going from our first quarter to second quarter. And, you know, it was primarily driven by transportation. And, you know, it did revert back. I would say in our industrial businesses, it has stayed steady at a constant rate. I wouldn't say it's accelerating, but it's sideways. So in those – our industrial businesses, it's staying steady. And, you know, it's more flat year on year. But auto has been the bigger piece for us as that production has declined. I don't think when it comes to automotive and our position we have in automotive, I don't think it is impacted by – or U.S. attachment. The other thing I would say, the places that I would say have gotten, you know, a little bit weaker is around the communication equipment. That's an area. And also in appliances and CS, we've been talking about that all year. They've been environments where they have been slow. So, you know, in the industrial space, it's been more stable and sideways. But really, the slowing we saw versus last quarter is really in our transportation and communication segments, not as much our industrial space. Okay. Thank you, Mark. We have the next question, please.

Our next question comes from the line of Joe Giordano from Cowan. Your line is open.

Hey, guys. Good morning. Hey, Joe. I know it's hard to do for you guys, but is there any way to kind of at least triangulate how much you think on the communications jam up on the supply side is due to, like, very specific temporary issues with, like, Huawei and restrictions on certain entities?

I would tell you when we think about the supply side of that, I don't think channel has anything to do with that. You know, our channel business, you know, large customers we service directly. So when you sit there And the portfolio set in our communications segment is a portfolio set that goes into a lot of different applications, not just high-speed, and it's why it does have a big part that goes to the channel. In both our appliance business and our D&D business, they're basic building blocks that can be used in a lot of different areas. So to try to tie what's going on with the channel to telecom, China, I think that would be a leap too far. We're also seeing it in industrial markets as well. I'm sorry. I'm sorry, Joe.

Yes, obviously, it's like an indirect route. I was just curious if there was any way to kind of like close that loop there.

No, I mean, I think the other thing that you have, I don't think you can close that loop there. There has been some slowness by certain other telecom equipment makers, and certainly cloud spending, which was very strong growth last year. It's still growing, but at a lower rate. There's lots of those other factors that I would also say impact that, but I wouldn't tie it completely back to Huawei. Okay.

Thank you, Joe. Thanks, Joe. We have the next question, please.

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

Yeah, thanks. Good morning. You know, the headline China numbers are one story, but maybe electric vehicles, a little different story. I think it's up about 50% year-to-date. Just wondering if that aligns with, you know, your thinking. Do you expect that penetration to accelerate? What are you learning along that curve from your kind of specification cycles with the customers there?

Certainly, while China auto production is down, electrical vehicle penetration, you know, you're exactly right. If you look at it, if you take full electric plus any hybrid, you know, it continues to accelerate even though China car production is down. So that is not changing. Certainly, it's growing while overall production is down. And our design wins around those electric vehicles. continue to be very strong. And let's face it, it is something when we think about electric vehicles, electric vehicles are going to be driven in the world by both China and Asia, as well as the CO2 requirements that you have in Europe as well. So when we think about electric vehicles, the place you need to be positioned, and we are positioned very strongly, is in Europe. It is in China, as well as in Japan. And what's really good is we're positioned well with our customers. And, you know, the one thing that we always watch in slow markets is where is our project momentum? Do we see project momentum slowing? We are not seeing any change in the number of projects we have with our customers in any of our businesses. And certainly in the automotive space, there continues to be the march between electric vehicles and autonomous features by all our customers that serve those markets. So we don't see any change in that. Certainly, the global production is impacted, that's more impacting combustion engines.

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

Our next question comes from the line of Jim Sula from Citigroup Investment. Your line is open.

Thank you very much. You've been very clear on the automotive side, which is good, but the communication side, you know, started with a few questions, and when we think about that, If my memory is correct, you're really not a smartphone supplier or component to smartphones. So I assume this is more like on base stations, routers, switches, those type of bigger box, bigger devices. And with 5G build-out, I guess it's a little surprise to see this type of slowdown. So can you help us? Did you see an older build-up like last quarter in excess? of end demand, or was it just a trade war where people overstocked and now they're destocking, or was it truly an end market demand slowdown in the communications segment? Thank you.

Hey, Jim, twofold, and you're breaking up a little bit on yourself. First off, I would say when you think about our communications segment, there's a chunk of it which is that and devices, and then there's another chunk, that appliance. So certainly we need to look, to your question, at that and devices. You're right. We do not plan smartphones. So our products go into base station equipment, goes into traditional switches like you mentioned. And when you look at it, what we've seen is we have seen some of the cloud spending not growing as fast as it grew last year. So when you're talking about something that grew you know, 20%, 30% of spending, and then it grows 10%, you will have adjustments in supply chain. I do think that is working through. On 5G, 5G, when you think about it, certainly we're designed in, and, you know, China's granting licenses, and, you know, we're positioned very well there, but that is still early stages of how much does that contribute to TE's revenue. So their typical gross revenue we're going to get the benefit from So both around cloud and 5G, we're in good shape. The other thing I would just say around our D&D, and it goes back to the channel comment I made, you know, typically our products in D&D are very much next to semiconductors and passives. I do think some of our partners and also other tier ones in the supply chain probably got a little bit ahead of themselves, as you said, and they're correcting to get the more normalized to end demand. This is not a content or share element. It's more of, you know, we're going to get hurt here a little bit with the inventory to stocking, but that will normalize. And I feel very good about where we're positioned in cloud and 5G, but certainly we don't play on the cell phones. Okay, thank you, Jim. Can we have the next question, please?

Our next question comes from the line of David Kelly from Jefferies. Your line is open.

Thanks. I just have a quick follow-up on your earlier comments on China vehicle inventory levels. If we were to see some hypothetical vehicle demand injection in China, can you talk about your ability to ramp back up to support production growth given you are presumably running leaner with ongoing cost actions? I think clearly no one's ready to call for a rebound yet, but we're just trying to get a feel for if there might be an operational lag and impact on short-term margins when production does ultimately rebound.

Clearly, as we do the actions that Heath talked to you about, we are also being very focused on how in those core areas that we keep production flexibility. And, you know, what we had was, in some cases, we were playing catch-up as the volume was going very strong. We talked about last year, we feel we have enough capacity, you know, if we do get a jump back, It might be a little bit of a lag, but we feel very good with how not only what we do, but also our extended supply chain can do. So that is not something we worry about. And certainly if it came back stronger than we thought, you know, we would also have to look at how we time some of the restructuring actions that Heath talked about.

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

Our next question comes from the line of Deepa Regavan from Wells Fargo Securities. Your line is open.

Good morning, all.

Good morning, Deepa.

I think it's a question for you. How do we think about contribution margins, given that the weakness in markets will be offset by some of the cost actions? You seem to be, you know, taking new actions, you know, every few quarters now. What should we expect the average contribution margin to net out on the corporate average line broadly, and how does it compare across segments like above, below corporate average? I think that will help us reset some of our expectations. Thank you.

Well, thanks for the question, Deepa. Let's take a bigger view of this first, right? I mean, we've seen demand tick down pretty considerably throughout the year on auto production, and Terrence said it's kind of settled in around – you know, 21 million vehicles a quarter, which is, you know, in a run rate that's pretty significantly less than what we've been around in prior years. That avails us the opportunity to get after some things on the cost structure or transportation, maybe in jurisdictions that we can better align with new locations, lower cost locations, and so forth, closer to where our customer supply chain exists. So that's a real opportunity for us on that front. And then communications is the other area that we have begun to do some restructuring in. As you'll recall, transportation for the first half of our fiscal year was running quite strong. We've seen, based on all the comments made earlier in this call, as that's ticked down, it's pulled forward some things that we would have done maybe in future years anyway. And so as we're starting to look at those types of actions, you'll start to see closer margin flow through. You know, our normal margin flow through is between 25% and 30%. I will tell you that when you see the types of numbers, specifically within communications, drop at that rate, it's going to take a little while to get back to those types of contribution margins I just mentioned because you're still having to cover fixed costs and so forth. Having said that, I don't want to get too hung up on percentages here because being CS, being our smallest segment, we could be talking about a few million dollars could swing a percentage more dramatically than really what the real material impact is to TE. So I think we've got to be careful with that. Now, industrial is, and we've talked pretty openly about industrial being on a multi-year journey to come out of this, to work its way towards the high teens. I would tell you that we're probably a little ahead of plan than what we went into the year with. We went into the year assuming that our industrial margins would be roughly flat while we execute on some footprint moves that have been announced and we're actively working through. But the team has done a really good job of getting some of those savings out a little bit faster than planned in addition to just kind of normal savings. belt tightening. And so I feel good about that in terms of that. I'd say industrial still has a couple of years left of things, of activity that's doing based on the timing of some footprint moves. And so we're continuing on that journey in terms of that. So, I mean, if you kind of back up from all of that, we're really using this opportunity in this part of the cycle to get out fixed costs. That's why we've lowered the overall restructuring and come out of this when market demand does improve, we'll have a leaner structure, and obviously, you know, it's harder to do this when we're in periods of higher growth. So hopefully that answers your question, but happy to take any follow-up.

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

Our next question comes from the line of Stephen Fox from Cross Research. Your line is open.

Thanks. Good morning. I'd like to follow up. Hey, Steve. Hi. I guess the confusion I have in terms of all the charges you've taken, say, over the even year, last year or two, last five years, is trying to discern tactical from strategic. You made a good case for why industrial is strategic. But in the case of some of these latest charges, how do we know that you're not sort of cutting into the bone a little bit too much as opposed to fat? And how do we see an end to sort of the charges if demand stays sort of at these levels? Thanks.

I think, Stephen, first of all, I think it's a fair question. And we have, you know, as the business has evolved, we have continued the journey on the footprint side of things. As you mentioned, I think industrial is pretty clear in terms of what we laid out here in the last 18 to 24 months and where we are in that journey. You've seen those in the numbers. Certainly, there's some... tactical things that we will be doing within the CS business. But again, it's the smaller segment, and I don't want to get too hung up on a margin rate there in terms of what the target is. We've performed very well in that segment, but a couple million dollars can swing you from mid-teens to low-teens or the other direction to high-teens. So I want to be careful in terms of that. What we're doing on the transportation side, it more mirrors what we're looking at from industrial perspective. which is taking advantage of this. These are locations that, you know, on a clean piece of paper, we would probably not have in those jurisdictions anyway. So this is more of a couple-year journey in terms of that process to get the operating footprint where it needs to be. I'm not worried about cutting into the bone. And I say that because it's a long-term business model of all the trends that we enjoy, whether it's On the auto side with hybrid and electric or the overall factory automation side with an industrial and everything, all the great stuff that's going on in medical or aerospace and defense, there's nothing that we're going into in terms of cutting that we don't have redundant capabilities or opportunities to move into existing locations. We are not having to go do a bunch of greenfield to do this. and we're not taking a lot of cost out of higher growth areas through a cycle like places in Asia and so forth where we do expect, for instance, hybrid and electric to be a more prominent piece there. So as I look at it, I'm not worried about cutting into that. I view this as more of an opportunity to get some things done that would be harder to do if we're in a higher growth environment because in those cases you're just trying to keep up with customer demand.

Great. That's very helpful. Thank you very much. Thanks, Steve. Can we have the next question, please?

Our next question comes from the line of William Stein from SunTrust. Your line is open.

Great. Thanks for taking my question. If we think about the below seasonal trend that we're seeing guided for in Q3 overall, I wonder if we could hear your take on the trends if you were to allocate them to the direct business versus the channel trends. how much of the weakness in the channel, how much of the direct business might have been much closer to seasonal if we were to look at it carved up that way? Thank you.

Well, let me talk directionally. So a couple of things. You know, I highlighted our book to Bill overall as a company with 0.98. In our channel, it was 0.85. So I do think, you know, channel has been a steeper impact, and we've talked about it. But you do sit there and, you know, there has been slowness. You know, auto production slowness has nothing to do with the channel. So I think when we talk about how we frame the reduction in guidance, you know, two-thirds was driven by transportation and a slower China. And certainly seasonally, you know, I do think that's abnormal that China would have weakened in the quarter we're in. But The other one-third is truly the channel, that 250 decline. So it's different by market, but I would say, you know, channel correction happens due to them adjusting to end markets that are happening. And, you know, clearly they're seeing some slowness. So, you know, it is deeper in the channel. Certainly that's an impact we're going to have here, like I said, not only in quarter four, it'll probably go into early next year. But, yeah, certainly we've seen a slowness in our direct customers as well, but not to the expense channel. Thank you.

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

Again, if you'd like to ask a question, press star, then the number one on your telephone keypad. Our next question comes from the line of Matt Sheeran from Stiefel. Your line is open.

Yes, thank you. Another question on the industrial solutions platform. segments, specifically the strong growth that you're seeing in the military, aerospace, marine sector, which has been up double digits. What are the drivers there, Terrence, and what's the outlook? I know we've heard from other suppliers that the defense and aerospace market continues to be strong. I know there's also some distribution exposure there, too. It doesn't sound like there's inventory issues there. And then just on the margins, Heath, you did talk about the drivers of that really strong margin expansion year over year. So I guess one question is the mix of business, the stronger mill arrow, is that a contributor to margins, or is it mostly the cost-cutting actions that you talked about?

So let me take the first half, and I'll let Heath take the second half. So one of the things that we've talked to you all about for a long time, is how we position ourselves very well from around commercial airspace and certainly the content opportunity we have there. And we've laid that out for you both on what happens in dual aisles, single aisles, and also regional jet. And, you know, while airframe production has been pretty steady, not a little bit, I think you're really seeing the benefit in the commercial airspace side from this content momentum that we've had very broadly across the industry. And it's really a credit to our team because that's a very long cycle. In addition, you know, this year we're getting a kicker about defense spending. And I think similarly, while defense, and I think it's pretty obvious when you look at defense companies, you know, they are in a good cycle. But it's also an area that we do have a nice position. Our position between commercial aerospace and defense is pretty balanced. And we're getting benefit on both sides. And, you know, defense is also driven by government spendings. And we're benefiting from that. But that is also a content play as well. When you think about communications, you think about power distribution and all the next generation hardware that's going on the fence. We benefit from that as well, and that's a content play. So those two are very important. To your point, Matt, you know, part of that business does go through the channel. That is not CND stocking. You know, that is a market that's, you know, still staying very good there. And, you know, it's one of the things that's buffering in the industrial segment, the slowness that we have to do the stocking or industrial equipment business in the channel. So I'll let Heath talk about the margin side of it. Yeah, Matt, I appreciate the question.

So on the margin side, you know, when I think about industrial and when we're internally going through our processes, there's not a tremendous amount of mix that plays into it. There's certainly... some pieces that have a little bit better flow through in terms of particular product lines and so forth within each individual business unit. But I think it's pretty well balanced in terms of we make a little bit more money in certain areas and a little bit less in others, but it's not a wide swing there. In terms of, as you can imagine, obviously, you know, I think part of your question was, you know, the aerospace and defense. We're obviously, when you're growing the type of organic numbers that we're seeing out of our aerospace and defense business, you would expect nice flow through, and we are certainly seeing that. And the business is converting the revenue into profits nicely, as you would expect them as they blow past some of their fixed cost base. But there's other areas as well that are showing some resiliency on the margins, particularly our energy business, as they have initiated and nearly concluded some facility restructuring. So there's a lot of different moving parts there. It's a balance between where the growth is as well as some of the footprint consolidations. We had talked some earlier in the year about this being a year where they're not going to be as much. I'd say we're a little ahead of ourselves, as I mentioned earlier in the call. And we'll still see some periods from time to time, a quarter or two, where you'll see it jump down a little bit as you have duplicative costs, meaning you're moving out of one facility into another, and you might have duplicative costs for a period of a quarter or so during any particular facility rationalization period. So that will happen from time to time, but we're very pleased with the progress that the team is doing and what their current outlook is as they move forward.

Okay, thank you, Matt. And I'd like to thank everybody for joining us this morning for our call.

If you have any additional questions, please contact Investor Relations at TE. Thank you and have a nice day.

Ladies and gentlemen, your conference will be made available for replay beginning at 10.30 a.m. Eastern Time today, July 24, 2019, on the Investor Relations portion of the TE Connectivity's website. That will conclude your conference for today.