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Edited Transcript of TEL earnings conference call or presentation 26-Jul-17 12:30pm GMT

Thomson Reuters StreetEvents

Q3 2017 TE Connectivity Ltd Earnings Call

SCHAFFHAUSEN Aug 13, 2017 (Thomson StreetEvents) -- Edited Transcript of TE Connectivity Ltd earnings conference call or presentation Wednesday, July 26, 2017 at 12:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Heath A. Mitts

TE Connectivity Ltd. - CFO and EVP

* Sujal Shah

* Terrence R. Curtin

TE Connectivity Ltd. - CEO and Director

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Conference Call Participants

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* Amit Jawaharlaz Daryanani

RBC Capital Markets, LLC, Research Division - Analyst

* Craig Matthew Hettenbach

Morgan Stanley, Research Division - VP

* Jim Suva

Citigroup Inc, Research Division - Director

* Joseph Craig Giordano

Cowen and Company, LLC, Research Division - MD and Senior Analyst

* Mark Trevor Delaney

Goldman Sachs Group Inc., Research Division - Equity Analyst

* Matthew Sheerin

Stifel, Nicolaus & Company, Incorporated, Research Division - MD

* Shawn Matthew Harrison

Longbow Research LLC - Senior Research Analyst

* Sherri Ann Scribner

Deutsche Bank AG, Research Division - Director and Senior Research Analyst

* Wamsi Mohan

BofA Merrill Lynch, Research Division - Director

* William Shalom Stein

SunTrust Robinson Humphrey, Inc., Research Division - MD

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Presentation

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Operator [1]

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Ladies and gentlemen, welcome to the TE Connectivity Q3 2017 Earnings Call. (Operator Instructions) And as a reminder, this conference is being recorded.

I would now like to turn the conference over to our host, Sujal Shah, Vice President of Investor Relations. Please go ahead.

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Sujal Shah, [2]

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Good morning. Thank you for joining our conference call to discuss TE Connectivity's third quarter 2017 results. With me today are Chief Executive Officer, Terrence Curtin; and Chief Financial Officer, Heath Mitts. During the course of this call, we'll 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 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. (Operator Instructions)

Before I turn the call over to Terrence, I'm pleased to announce that we will be hosting an analyst day event in New York City on December 13 for the reception management plan of the evening of December 12, so please hold these days to attend.

Now let me turn the call over to Terrence for opening comments.

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Terrence R. Curtin, TE Connectivity Ltd. - CEO and Director [3]

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Thanks, Sujal, and thank you, everyone, for joining us today. I'm very excited to share our strong results for the third quarter and our increased growth and earnings outlook we're providing for the full year. I believe this quarter's performance continues to demonstrate the strength of our business model with all of our segments contributing. It also reflects the ongoing effective implementation of our strategy to create safer, sustainable, productive and connected solutions for our customers.

To briefly recap the key elements of our strategy that we have been driving, number one, it's about driving above-market growth through our focus on harsh environment applications where we can accelerate content growth. Secondly, it's about leveraging our TEOA continuous improvement system to expand our margin. And lastly, it's delivering consistent execution of our balanced capital allocation strategy, which allows us to further strengthen our position and our markets be a bolt-on M&A while also returning capital back to our owners.

When you look at our third quarter, we delivered sales of $3.4 billion. This represents 8% organic growth year-over-year with growth across all our segments, as well as regions. We delivered 50 basis points of adjusted operating margin expansion year-over-year and adjusted earnings per share of $1.24, which is up 15% over the prior year. This year's growth in EPS year-over-year was entirely driven by our sales and operating income performance. If you want to look at our $1.24 compared to our guidance of $1.16, approximately half was driven by the higher sales growth of 8% with the remainder driven by taxes and a little bit of currency. As a result of our momentum and what we're seeing in our markets and orders, we are raising the midpoint of our revenue and adjusted earnings per share guidance to $12.9 billion and $4.73 in EPS. This represents a 7% organic revenue growth and 20% adjusted EPS growth versus the prior year. With this, we firmly believe that TE is firing on all cylinders with all segments contributing to both the revenue growth and margin expansion this year.

As I think about this year, and to put it in perspective, back when we gave guidance in November, we assumed 3% organic growth and $4.34 of adjusted earnings per share compared to the $3.95 we did in 2016 on a 52-week basis. The increase since the start of the year reflects strong organic growth across our segments and operational improvements across our businesses that now results in the 7% organic growth and 20% adjusted earnings per share growth, driven almost entirely by our strong operations performance. The broad-based growth ahead of the markets we serve continues to reinforce our strategic progress on content growth and having the right products in the right markets.

If you look at our new guidance for the year compared to last quarter, the 7% organic growth outlook is an improvement of 100 basis points and we're raising our earnings per share guidance by $0.11.

I'd appreciate if you could turn to Slide 3 and let me review some additional highlights from the third quarter. Not only do we have growth across all segments and regions, but each of our segments delivered growth ahead of our expectations in the quarter. We delivered 8% organic growth in transportation, with growth across automotive, commercial transportation and sensors. In Industrial Solutions, organic growth of 5% was driven by strength in factory automation and medical applications. And in the Communications Solutions segment, sales increased 14% organically, with growth across each of our 3 business units, demonstrating the progress we have made in transforming this segment to be a contributor to overall TE performance.

Also during the quarter, we had strong free cash flow of over $400 million that we generated, and we returned $324 million back to our owners and we also announced bolt-on acquisitions in the automotive and medical markets that will expand our portfolio and ability to provide integrated highly engineered solutions in these growing markets.

Let me get into the order trends so I'd appreciate it if you could turn to Slide 4. We continue to see broad-based strength in orders across our segments, as well as balanced order growth across regions, which reinforces expectations for our higher growth versus our prior view. Total orders, which excludes SubCom, were $3.3 billion during the quarter, and this is up 12% year-over-year on both a reported and an organic basis. Organically, excluding SubCom, our orders grew evenly with the Americas, Asia and Europe each growing low double digits in the quarter. And if you reflect back at the start of the year when we guided in our first quarter, orders and revenue growth were heavily weighted towards Asia, and we're encouraged by the balance we are now seeing as Europe and the United States continues to strengthen.

In Transportation, orders increased 15% organically with growth in all regions, in particular strength in Europe and Asia. Industrial orders grew 6% organically year-over-year, with growth in all regions and particular strength in Asia. And in communications excluding SubCom, we saw year-over-year organic orders growth to 12%, including 7% growth in Data and Devices from high-speed connectivity ramping in cloud and data center applications; while appliance orders grew 17% year-over-year.

One thing I'd like to highlight that while on a year-over-year basis, orders increased double digits in the third quarter, the guidance that we gave for the fourth quarter reflects mid-single-digit revenue growth. In our customers' broader supply chain, there are supply constraints in certain areas that led to some of our quarter's reorders being placed for delivery outside of our fourth quarter, and we have accounted for this dynamic in our guidance for the fourth quarter.

So let me turn to segment performance and let me start with Transportation. If you could turn to Slide 5, please. The third quarter was another very strong quarter for our Transportation segment, which continued to show our content growth momentum. Sales grew 8% organically year-over-year and operating margins were in line with our expectations. Segment sales exceeded expectations due to strong auto demand across regions and our leading position in the heavy truck market, along with strong Sensors growth, which was 7% organically.

In Auto, our sales were up 6% organically with mid-single-digit growth rate in the Americas, Europe and Asia against a global auto production growth of only 1%. We continue to consistently demonstrate the ability to outperform the market due to content growth, and expect that trend to continue even at these lower production levels. We also expect to benefit from new program ramps as we go forward, which will also continue the outperformance due to content versus market.

For the full year of 2017, we expect high single-digit organic growth in auto on approximately 3% production growth, but clearly, that 3% production growth is driven by the stronger production growth in the first half that we talked about in prior calls.

Turning to Commercial Transportation. Our business continues to outperform the market with organic revenue growth of 23% year-over-year. Growth is driven by continued strength in the global heavy-duty truck market, particularly in China. And while we do expect China growth will moderate over time, we are encouraged to see signs of continued growth in Europe and North America as these markets improve.

In Sensors, during the quarter, our business grew 7% organically year-over-year with growth driven by transportation, as well as an improving industrial backdrop, and we continue to expect mid-single-digit growth for the full year in our Sensors business. Additionally, we're also encouraged by the strong design win momentum that we had in Sensors that was reflected by double-digit order growth year-over-year in the quarter.

Adjusted operating margin were as expected at approximately 19% in the quarter in the segment. But I would say at these year-over-year revenue growth levels, we would normally expect a corresponding expansion of margins versus where we guided. However, demand in the second half of this year has exceeded our expectations and has led to some near-term inefficiencies in our supply chain as we make sure we satisfy our customers. This is a temporary issue as our teams are fully engaged to ensure our customers are not impacted by these supply dynamics and we expect this to be fully remedied in early fiscal 2018.

So let's talk about the Industrial Solutions segment, so I'd appreciate if you could turn to Slide 6. Growth momentum in the Industrial Solutions segment continued with 5% organic growth year-over-year in the quarter. Segment sales did exceed our expectations due to strength in Industrial Equipment with this business growing 10% organically. This growth we saw in the Industrial Equipment side is really due to our position in the factory automation and medical markets, also coupled with the acquisitions that we completed last year. And this is really driving the strong growth ahead of the market on both a reported and on an organic basis. When you think about Intercontec and Creganna, both of these acquisitions are performing exceptionally well and ahead of our expectations.

In Aerospace, Defense, and Marine, we did see a slight organic decline in the quarter in revenue, and this was driven entirely by program timing in commercial aerospace. And we did -- that was partially offset by growth in defense. Our energy business in the quarter grew 2% organically, and that was driven by growth in Europe and Asia.

On the margin side, our adjusted operating margins for the quarter were 12.7%, and this was flat sequentially and down year-over-year due to the near-term softness in commercial aerospace, which does run above segment average margins. We do expect industrial segment margins to resume expansion in our fourth quarter, and this will be both on a sequential and year-over-year basis, driven by a combination of both growth and cost actions. Adjusted EBITDA for the segment were steady year-over-year at 17%.

So if you could please turn to Page 7 and let me cover communications. The Communications segment delivered another outstanding quarter with 14% organic growth and 500 basis points of adjusted operating margin expansion to 16%. Performance was well ahead of the market and included contributions from all 3 of the businesses. Starting with Data & Devices, Data & Devices had 6% organic growth as we continue to benefit from high-speed ramps at cloud infrastructure customers. In addition, because of our multi-year transformation, our D&D business more than doubled its adjusted operating margin from a year ago driving significant improvement at the segment level as the actions that we took to focus the portfolio and optimize our operations are essentially complete.

In Appliances, we had another solid quarter with 14% organic growth year-over-year as demand remains strong, particularly in Asia. And in SubCom, growth was 22% organically in the quarter, reflecting the strong growth cycle of this business.

Earlier this month, we announced the winning of a new regional program which provides high-speed bandwidth between the Caribbean and the United States, and we continue to expect high single-digit growth for the SubCom business in 2017.

Now with that as a backdrop, I'll hand it over to Heath, who will get into the financials in more detail.

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Heath A. Mitts, TE Connectivity Ltd. - CFO and EVP [4]

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Thank you, Terrence, and good morning, everyone. Please turn to Slide 8, where I will provide more details on Q3 financials. Adjusted operating income was $559 million with an adjusted operating margin of 16.6%, leveraging the strong organic growth of 8%. GAAP operating income was $536 million and included $19 million of restructuring charges and $4 million of acquisition-related charges. For the full year, we continue to expect restructuring charges of approximately $150 million driven by footprint consolidation from acquisition and structural improvements. GAAP EPS was $1.21 for the quarter. Adjusted EPS was a new record for the quarter at $1.24, up 15% year-on-year driven entirely by sales growth and operating margin improvement.

The growth above prior year is a result of strong execution of our strategy with harsh applications driving growth, TEOA driving efficiency and balanced capital deployment enabling acquisition and share repurchases. Our EPS performance was above our prior range, driven mostly by revenue growth and the benefit from a lower tax rate due to the mix of profitability by jurisdiction.

For the fourth quarter, I expect an adjusted effective tax rate of approximately 19%, making the full year tax rate approximately 18%, similar to last year. However, as discussed last quarter, please keep in mind the year-over-year dynamics. We received an EPS benefit in the first half of fiscal '17 and have an EPS headwind in the fourth quarter. Going forward, I would expect an adjusted effective tax rate of approximately 19% to 20% and will continue to provide details on that. Page 15 of our slide deck contains a bridge that provide these details for the first half and second half.

Turning to Slide 9. Our strong Q3 results demonstrate that we are performing well against our business model and executing upon multiple levers to drive earnings growth through organic revenue growth, consistent capital strategy for M&A and buybacks and driving margin improvement through TEOA. Adjusted gross margin in the quarter was 33.9%, a 90 basis point improvement from prior year, driven by follow-through on increased volumes, productivity improvements from TEOA programs and restructuring benefits. Adjusted operating margins were 16.6% in the quarter, up 50 basis points year-over-year and in line with our business model. As we've discussed in the past, we continue to invest in growth to support our growing design win pipeline, but are also committed to reducing SG&A as a percentage of revenue over time.

Adjusted EBITDA helps explain the cash earnings of our businesses, and adjusted EBITDA margins in Q3 were 21.2%, up 50 basis points year-on-year. Cash from continued operations was $524 million and free cash flow was $408 million in the quarter. The year-over-year decline in free cash flow was driven by working capital needed to support growth in sales, and as you know, cash flow is not necessarily linear and year-to-date free cash flow is slightly over $1 billion similar to last year's performance. We returned $324 million to shareholders through dividends and share repurchases in the quarter. Year-to-date, we have returned $405 million in dividends and $386 million through share buyback.

Maintaining a strong balance sheet is part of our strategy and -- as it provides us with the competitive advantages in our marketplace, our consistency in converting earnings to cash gives us the ability to support both return of capital and acquisitions while retaining these strong financial positions. We have included a balance sheet and cash flow summary in the appendix for additional details.

And with that, I will turn it back over to Terrence.

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Terrence R. Curtin, TE Connectivity Ltd. - CEO and Director [5]

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Thanks, Heath, and let me get into guidance, and I'll start with the fourth quarter, and if you could turn to Slide 10, please, I'd appreciate it.

For the fourth quarter, we expect fourth quarter revenue of $3.2 billion to $3.3 billion and adjusted earnings per share of $1.14 to $1.16. When you look at this, this represents reported sales growth of 5% and organic sales growth of 4%. And from an operational perspective, this would be adjusted EPS growth of 8% (sic) [$0.08] once you normalize for the unusually low tax rate we had last year that Heath just highlighted.

Looking at it by segment, for the fourth quarter, we expect Transportation Solutions to grow mid-single digits on both a reported and on an organic basis. This is above expected auto production levels of 1% with the outperformance driven by the content growth I mentioned earlier. We also expect growth in Commercial Transportation across all regions in the fourth quarter, and as noted earlier, we do expect to have some lingering effects on margins from supply chain dynamics in the fourth quarter, but expect margin performance to improve as we put these issues behind us in early 2018.

In Industrial Solutions, we expect to grow high single digits on a recorded (sic) [reported] basis and mid-single digits organically, with growth expected across all 3 of our business units, and we also expect as I mentioned operating margins to expand sequentially as well as year-over-year in the fourth quarter. And in Communications, we expect also mid-single-digit growth on both a reported and an organic basis, with growth in each of our 3 businesses.

And while we're not providing guidance beyond this fiscal year, I would ask that as you look at your models, you keep in mind our typical seasonal trends as you think about next year. And while demand continues to be strong, we historically see seasonal declines in the mid-single-digit range from quarter 4 into our first quarter. I'd also ask that you think about adjusted operating margins. Please keep in mind that we're currently running in the mid-16% range and that the first quarter of '17 had an unusually high operating margin level that we covered in detail back in the first quarter call.

Now let's turn to Slide 11 so I can cover full guidance and we'll wrap up and then go to Q&A. We are raising the midpoint of our guidance to represent 7% organic revenue growth and 20% adjusted earnings per share growth for '17. We expect revenue in the range of $12.85 billion to $12.95

billion, and adjusted earnings per share of $4.72 to $4.74. I'm very proud that our 20% EPS growth is driven almost entirely by the strong organic growth performance and operating income expansion that we had in 2017. We did also benefit from using our strong cash flow model, both via adding bolt-on M&A and returning capital to our owners.

When you think about the growth in the margin and the EPS by segment, we expect Transportation Solutions to be up high single digits organically on approximately 3% global auto production growth this year, reflecting continued content growth and share gains. Commercial Transportation is expected to outperform its end markets benefiting from both content expansion and share gain in heavy trucks. And we continue to expect sensors to grow mid-single digits year-over-year, as I previously mentioned. In Industrial Solutions for the year, organic growth guidance of low single digits is consistent with the guidance we've been giving since the start of the year, reflecting continued improvement in industrial markets. And in Communications, we expect it to be up high single digits organically, a further improvement versus our prior view, reflecting continued strength in our appliances and growth in Data & Devices. Our guidance relating to SubCom is being maintained that we're going to grow high single digits in that business.

In summary, I feel very good about our portfolio and execution, and believe we are well-positioned to deliver growth ahead of our markets. As Heath mentioned, we'd established leverage to drive earnings growth and continue to perform well against our business model, and this year's results represent best-in-class performance with 7% organic growth, expanded operating margins and 20% adjusted EPS growth, that these growth results truly demonstrate the execution among all the levers we have in our business model.

Lastly, before I go to Q&A, I want to close by thanking our employees all around the world for their continued strong execution and commitment to our customers. So with that, Sujal, let's open it up for questions.

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Sujal Shah, [6]

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Thank you. Lisa, could you please give the Q&A instructions?

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Questions and Answers

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Operator [1]

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(Operator Instructions)

Our first question comes from the line of Wamsi Mohan with Bank of America.

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Wamsi Mohan, BofA Merrill Lynch, Research Division - Director [2]

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Heath or Terrence, can you address the margins in the Transportation segment? How much of this sort of headwind that you're calling out here in 3 and 4Q were due to factory issues versus expedited shipping or other supply chain reasons? And can you quantify the headwind that you saw in the third quarter? And I have a follow-up.

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Heath A. Mitts, TE Connectivity Ltd. - CFO and EVP [3]

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Good morning, Wamsi, thanks for the question. Certainly, with these growth rates that we're seeing in transportation in both from improved market conditions that have continued throughout the year, as well as our ability to well outperform those and the volume that (inaudible) for us, has created some inefficiencies in terms of our supply chain keeping up with us in that regard. Most all of it is a kind of material constraint and then the higher cost for expedited freight to take care of our customers. So we're working through that. I would say that there's a plan in place to get this remediated, but we do expect to continue to see some of this headwind in our fiscal fourth quarter and into the early part of 2018 albeit as it winds -- as we correct some of those issues it won't be quite as impactful on the numbers. But I would say that it's worth a couple of hundred bases -- it's worth -- not, a couple of 100 basis points. It's worth 10, 20 to 30 basis points if you looked at it overall.

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Wamsi Mohan, BofA Merrill Lynch, Research Division - Director [4]

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Okay, that's helpful, thank you. And Terrence, you've shown some really nice growth here in the transportation segment despite weak auto production concerns and the backdrop remaining somewhat still challenged from an auto production perspective. So as these results look increasingly decoupled from production trends, can you maybe address what you're doing to drive this content growth in the broader transportation segment? And can you talk about the visibility that you have in this content growth?

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Terrence R. Curtin, TE Connectivity Ltd. - CEO and Director [5]

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Yes, thank you, Wamsi, for the question, and let me take it because it is something what we think about our transportation business model, first, it always starts with a global picture, and I think one of the things that we're very fortunate about where we drive growth it's just not in one region in the world, it's across the world. And even as production has slowed down to 1% and pretty much in line with where we are, it does come back to how do we drive across the 3 big trends that are happening in the vehicle. And we've continuously shown content growth and it has been accelerating both from our focus as you think about not only what's happening in the connected car or in safety applications, but also benefiting from everything that happens around the powertrain, whether it's on combustion engine that needs to get more fuel-efficient or to the adoption of electric vehicles that while we talk electric vehicles, when you really think about it, we get very excited around where electric vehicles are going in China. So it is along all 3 dimensions, both where the safety applications go. Certainly, the emission and the green go and also around the connected. And what we feel very proud of as you went back 5 years ago, our content per vehicle in a car was around $50. Today, it's well over $60 and we with the programs that we're winning, we see that content momentum continuing to increase. And when you take the results that we have in a 1% production environment like we've had in quarter 3, as well as what we expect really in quarter 4, growing mid-single-digit shows the content momentum we have. And I just think we continue to demonstrate it and we feel very good about the program ramp will continue to allow us to have that type of separation even as global production stays at a low single-digit to flat environment that we are in.

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Operator [6]

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That comes from Shawn Harrison, Longbow Research.

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Shawn Matthew Harrison, Longbow Research LLC - Senior Research Analyst [7]

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Terrence, wanted to follow-up just on the auto content, particularly in EVs. Maybe if you could just discuss your content per vehicle in light of the fact that U.K. now says they are phasing out combustion engines. But from what I can gather, sounds like you have a high market share in a lot of the connectivity products that go into EVs but maybe discuss the content per vehicle, and how that's been growing over time.

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Terrence R. Curtin, TE Connectivity Ltd. - CEO and Director [8]

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Yes, so let me talk about EV and I always do think, Shawn, it's important to make sure when we talk EV, about close to 90 million cars are made in the world and today, there's about 4 million that are electric vehicles, whether it's pure electric or plug-in, hybrid, et cetera. So what's really -- what we like about that is you do have your emission regulation to drive that increase, but when you sit there, we see the opportunities to that type of level to quadruple of the amount of electric type vehicles over the next 5 years. And when you see that, clearly, that creates higher demand for power and voltage connections, it also gets into things we do from our very high current relay type products, as well as you get into sensing that occurs there. And when you sit there, that really comes down to the energy management that gets into the harsh environment. So the whole environment that you have there really plays to our strength of our engineers and how we have to work with our customers really make this volume grow. When you think about it from a content, on a traditional combustion engine, due to the trends I just talked about, what occurs from that combustion on a model, we typically get about 1.5 multiple of content to a hybrid and then about 2x content increase of pure electric. So if something has $60 today of content on a vehicle, it's an opportunity to get closer to $100 in an hybrid and you could go up to basically $120 on a full electric is the simplest way to think about it. So that's the excitement we have around the content growth, and that comes into the emissions. So we think we're very well-positioned, we think we're positioned globally in all regions of the world around the players in that market and it is part of our content growth story of how we position ourselves and some investments we've been making.

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Shawn Matthew Harrison, Longbow Research LLC - Senior Research Analyst [9]

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Extremely helpful. As a follow-up, I wanted to dig into the comment of -- I think the comment was your orders are being constrained by other issues in the supply chain. And so you're under-shipping true demand right now. Is that the way to read it? Or I guess -- or is the worry that you could see orders canceled if supply of these other products come available? I wasn't exactly sure how to read that comment of...

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Terrence R. Curtin, TE Connectivity Ltd. - CEO and Director [10]

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I would (inaudible) -- it's a fair question. Really, what it is, is what we're seeing is in certain parts of the supply chain, you see them in some [semi] areas and so forth has lead times have expanded, we have seen some customer behavior place orders now that are a little bit more extended. So when we typically think about our orders, our orders are typically pretty current. We typically get orders that are for the current quarter or a quarter out. We've seen some extended placement out. It is not that we're under shipping demand, It's just, I would say, people are making sure their supply chains are lined up for as they're doing production because they've been surprised in certain categories. So it's why when we look at our double-digit order growth, our guidance is more mid-single-digit growth in the fourth quarter because we see orders placed out our first fiscal quarter and into second fiscal quarter. I don't see them being canceled. I just think there will be things that will smooth out over time.

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Shawn Matthew Harrison, Longbow Research LLC - Senior Research Analyst [11]

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Your lead times in this are pretty normal?

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Terrence R. Curtin, TE Connectivity Ltd. - CEO and Director [12]

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I would say when you take our lead times collectively, yes, they're pretty normal. There are some pockets, like Heath talked about on his automotive question, as well as in some of our businesses where you see 14% to 20% growth. They've extended certain product categories but it's very pocketed not broad-based.

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Operator [13]

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Our next question comes from Amit Daryanani with RBC Capital Markets.

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Amit Jawaharlaz Daryanani, RBC Capital Markets, LLC, Research Division - Analyst [14]

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I have 2 questions as well, guys. I guess, first off, just on the auto growth that you guys are seeing this quarter, is there a way to think about how much of that what's the fill in for December quarter versus things that are getting pushed out? I'm trying to get a sense of apples to apples how good is the orders for December versus to your point things getting a little bit more extended over here?

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Terrence R. Curtin, TE Connectivity Ltd. - CEO and Director [15]

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I don't -- I think it's pretty pure actually, Amit. So when you sit there, I think it's pretty pure. Things getting extended, I would not say -- the automotive supply chain stays pretty tight, and that's why we have some of the extra cost to make sure we do not disappoint our customers. But in auto itself, I would say when you look at the growth we've had, it isn't pull-in meaningfully or push-out meaningfully because that's why we've had the extra cost.

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Amit Jawaharlaz Daryanani, RBC Capital Markets, LLC, Research Division - Analyst [16]

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Got it. And then I guess, Heath, I have a question for you on the OpEx and just broadly on how we should think about the OpEx run rate and trends as we go forward? Because you've talked I think a fair amount in middle of the P&L focus, and I think SG&A have actually gone up faster than the revenue growth so far this year. So just talk about the initiatives you have and what's the right way to baseline OpEx as we go forward from here?

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Heath A. Mitts, TE Connectivity Ltd. - CFO and EVP [17]

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Yes, good question, Amit. The year-over-year numbers on our OpEx are driven by a variety of things, including some of the non-acquisitions as they layer into the P&L, with their full cost structures in play. But there are some things that we did specifically in the quarter, and we will continue to do at least in the short term, things that we are investing ahead of our ability to take out some cost. So there's some things that we've done in terms of outsourcing and so forth. We've had to spend a little bit of money ahead of when we'll see those savings, and that's part of the overall strategy to reduce SG&A as a percentage of sales. Sequentially, we made a little bit of improvement on SG&A as a percentage of sales, but we are up year-over-year. And so is the spending ahead of those cost reductions. And then there's also just some performance compensation-related costs given where the results are coming in this year. So there's a variety of things that are in there. I'd say as you look forward, the strategy continues, and it's pretty broad-based across the company to better align our SG&A percentage of sales, but we're also -- some of that is to fund -- reinvested to fund other parts of the company, specifically where we have growth platforms that we have a very strong pipeline and opportunity set there. So we'll continue to refine this and tighten this up, but there was a variety of things that drove the increase to overall OpEx in the quarter.

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Operator [18]

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We have a question from Craig Hettenbach with Morgan Stanley.

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Craig Matthew Hettenbach, Morgan Stanley, Research Division - VP [19]

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I have a 2-part question on automotive and then a follow-up. So in autos, can you talk about just given some of the lingering concerns about North American weakness in that market, just how you guys kind of look at sensitivity to that. I think North America is 20% or less of your auto business but if you could just update on that? And then as a second part of the automotive question, just an update on the timing of the sensor design win pipeline and kind of timing for revenue.

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Heath A. Mitts, TE Connectivity Ltd. - CFO and EVP [20]

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Sure, Craig. Let me take that and I think when you think about North America automotive, I want to take a step back and frame global automotive first. We have to realize there's 90 million cars plus or minus, made on the planet. And 17 million of those cars are made in the United States. So I do think we always have to remember around 50 million of the cars made in the planet are in Asia, and well in the mid-20s are made in Europe. So North America, while we live it every day, as Americans, it is a minor part of production when you think about it globally. But our automotive business in North America when we look at this year, like I said, we have about mid-single-digit growth here in the quarter. So we have the same content trends but to size your sensitivity, it is only about $800 million in total TE. So it's only about 6%. And even if you said, North America automotive production went down 5% and we declined with it. It would be $40 million of revenue and a couple pennies. So I think about it, I think it gets a little bit too much press when you think about TE versus our great global position we have in automotive. And if you correct it by 5% production, it'd be a couple of cents in the big picture. So certainly, we won't want to see that. But it won't be a big thing in the big picture of TE. On Sensors, your second question, when we sit there our (inaudible) momentum that we talked to you about in many quarters of it is continuing. And what we really appreciate is that the programs that we're winning across the Sensor portfolio that we got with (inaudible) is the wins we're getting with our customers are across humidity, pressure, force, position, et cetera. So what's really great is across the whole product set, which is what we were excited about and it's also across all regions of the world. It's not concentrated. So I think it does show the momentum that we really have strength in the automotive with our great sales team and go-to-market resources. From the momentum it hasn't really changed. We are industrializing some of the programs we expect to have revenue in the second half of '18. As we have (inaudible) we'll continue updating you but it continues as we talked about last quarter and previously. So really good momentum.

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Craig Matthew Hettenbach, Morgan Stanley, Research Division - VP [21]

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Great. And then as my follow-up, Heath, wanted to talk on the tuck-in of Hirschmann. I know it's a small sized deal. But I think one of the issues with the investment community has just been kind of the acquisition strategy or multiples paid, in this case it's looks like around 1x sales. And so just wanted you to kind of frame how you're approaching M&A at this point and things we could expect in terms of the process.

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Heath A. Mitts, TE Connectivity Ltd. - CFO and EVP [22]

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Sure. In the deal -- well the deal hasn't closed, we have discussed it as we're getting closer to that. First, it's a nice product line, tuck-in for our auto business, brings some great antenna technology where we see some nice synergies that we will realize as we bring them forward through our channel, our auto channel. So we looked at that as an opportunity both from where does it help us from an overall return profile and where the synergy opportunities and we were able to identify several things, especially on the commercial side. And then on the operations side, there's some things that we'll bring to the table as well. So it aligns really well with the way I would think about bolt on M&A, things that come in that we can get at reasonable valuations and that we bring something to the table that as under our ownership, there's value created for the shareholders. So this is not one that's far afield from what we do today. We understand the technology. We understand where it sits on the car. We understand how it aligns with what we do already in the connector and sensor world. So it was a nice opportunity for the team, and I think our team did a really nice job identifying the opportunities and have plans to execute right out of the gate.

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Operator [23]

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And that comes from Joe Giordano at Cowen.

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Joseph Craig Giordano, Cowen and Company, LLC, Research Division - MD and Senior Analyst [24]

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Just a follow-up on the earlier question on Sensors. As that starts to deploy, can you talk about the margin implications for the auto segment? I know we talked about plus or minus 20% now, but my understanding is that the sensor portfolio is less than half of that right now. So where can that go and what do you think that could do for your more like medium-term outlook for margins in that segment?

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Heath A. Mitts, TE Connectivity Ltd. - CFO and EVP [25]

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Hey, Joe, this is Heath. First of all, good morning. That's a fair question. Listen, our Sensors business is an area that we are investing in, and we are investing out ahead of the growth. But we're very confident because we won several platforms that will see even some kick into production in late 2018 and we're really -- we'll see the benefit of the volume from that in '19, '20 and so on, and that pipeline continues. From a profitability perspective, there is no doubt that it is dilutive to the overall segment average. Now I would -- just to qualify that, we do carry a lot of intangible amortization in that particular BU, the business unit, because of the measurement acquisition that was done almost 3 years ago. So I don't know that we'll ever get on a GAAP basis, I don't know that we'll ever get to the 20% from Sensors. But Sensors' margins have improved significantly year-over-year as we've seen them improve. But we would expect them to ultimately be in the mid-teens from an operating margin perspective given the growth opportunities in some of the investment that is required there. We're not there yet, though, and I think we're still a couple, 3 years away, but we're moving a couple of hundred basis points a year.

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Joseph Craig Giordano, Cowen and Company, LLC, Research Division - MD and Senior Analyst [26]

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Great, and then to follow-up on SubCom, can you maybe frame us the cyclical outlook for this business? I know it's structurally probably in a better position now than it's been like maybe potentially ever giving who your customer base has evolved towards, but given your pipeline here, how long do you think this cycle can extend here and how would you frame out like where a trough level in the current dynamic looks versus where we've seen historically?

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Terrence R. Curtin, TE Connectivity Ltd. - CEO and Director [27]

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Hey, Joe. Thanks for the question. It's Terrence, and great question. I think when you think about SubCom, you're right on. When you think about the customer dynamics versus where they were 5 to 10 years ago, it's clearly a customer dynamic that you actually have the real user related to the business model doing it. So that's always a plus and I feel very good how our team have been executing on getting wins with those important customers. When you think about it, this year, we're going to be a little bit below $1 billion, and I think as you look into next year, I think a fair assumption is sort of keep that flattish because we do get to a level of capacity constraints as well as how orders are coming in and the routes we're building. I think as we sit there, some of the things that we continue to think through is what are the next routes do those customers need, how do we schedule that? So it does not feel to us that you would have the trough cycle we've had in the past when you had customers dry up our customers to be impacted by financing cycle because these customers do have capital and do not need capital markets. So we're still in the middle of what trough is, but it still feels like a business that the trough is much higher. I think it would run, probably in the $700 million to $1 billion range is what we've been telling people but I would say we're still trying to figure that out.

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Joseph Craig Giordano, Cowen and Company, LLC, Research Division - MD and Senior Analyst [28]

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You think trough can be $700 million, is that what you just said?

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Terrence R. Curtin, TE Connectivity Ltd. - CEO and Director [29]

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Yes.

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Joseph Craig Giordano, Cowen and Company, LLC, Research Division - MD and Senior Analyst [30]

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Wow. Versus like half of that last time, right?

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Terrence R. Curtin, TE Connectivity Ltd. - CEO and Director [31]

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Yes.

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Operator [32]

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We have a question from Matt Sheerin with Stifel.

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Matthew Sheerin, Stifel, Nicolaus & Company, Incorporated, Research Division - MD [33]

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Just first question, follow-up Shawn's question, regarding the lead time issues and the fact that you're seeing extended backlog from customers. But as you look at the non-transportation markets this quarter, Terrence, it looks like it's in line to maybe still a little bit better than seasonal. So is there a sense that customers are building any buffer inventory? Can you get a read on those inventories? And probably easier for you to look at the distribution, which is a smaller percentage of your revenue but in terms of what you're seeing there in terms of inventories?

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Terrence R. Curtin, TE Connectivity Ltd. - CEO and Director [34]

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Yes, no, Matt, you're exactly right. So let me take it from what we're seeing through our channel partners because when you go outside of transportation and you're into our communications segment, excluding SubCom, as well as our industrial segment, you do have about 40%, 50% of those businesses go through distribution. So I think that's the right way, just the latter part is how you asked it. What we're seeing, we're seeing right now through our channel partners, they're having point-of-sale out that's pretty much high single digit, and their inventory has been very flat. So we don't see inventory building up in the channels. It's staying very consistent with where it's been. So we don't see creep up there. And the order rates are that we're having from our channel partners are pretty similar to our company average, low double-digit. So the dynamics we're seeing through distribution, I would say, are consistent overall. We're not seeing inventory getting ahead of itself. And I would just say when we look at those markets from a direct customer where we service the larger customers direct, it does feel like it's demand. I mean, we're seeing improving markets, globally, and what we're seeing and how we're seeing it is these are queued to production increases by our customers where we deal with customer directly and not through our channel partners.

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Matthew Sheerin, Stifel, Nicolaus & Company, Incorporated, Research Division - MD [35]

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Okay, great. And just as a follow-up, Terrence, in your closing comments, you talked a little bit about thoughts for fiscal '18 in terms of at least, the seasonal start of to the year. But as you look at your various end markets going into next year, obviously, you're seeing accelerated growth. What are your general thoughts about the sustainability of that growth by end market, if you can?

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Terrence R. Curtin, TE Connectivity Ltd. - CEO and Director [36]

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We'll guide, Matt, when we get to our first quarter call. So I just think some observations I would make as we exit there. I talked about certainly, I think with what we're seeing, we would expect a seasonal coming out of quarter 4 to quarter 1. I think when you take the bigger picture, and I think about next year, number one is the content growth story we have in automotive I think is very evident of the traction we have and I think it's fair to assume that automotive being in this flat to plus 1% production environment where we are right now would continue in next year. And I think we've been very clear that we think we can grow mid-single digit in it. I think when you get into the industrial markets, I see them improving. So I think sort of where we're running right now our strength in the medical markets, certainly what we're seeing along factory automation applications, which is real demand when we see it with servos to drives, the robotics, we're seeing that, we're winning in those applications. And certainly, medical, we talked about being mid- to high single-digit grower. And the communications area, I think, SubCom, back to Joe's question, I think, I would think about that being flat next year. And then in D&D and appliances, I think you would have a things that would be closer to where those markets are after a really hot year. So I think that's the way I would probably think about the growth going in to next year just sitting here today and we'll give you our formal guidance when we talk to you in November. But that's just as you all think about, maybe some ways to frame it based upon what we're saying here without formally guiding.

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Operator [37]

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From Jim Suva with Citi Bank.

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Jim Suva, Citigroup Inc, Research Division - Director [38]

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When we look at the outlook and maybe my math is wrong, are margins going to be down year-over-year in the September quarter and is that due to the extra week, or how should we think about the puts and takes around the margins? And Year-over-year, not sequential but year-over-year.

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Heath A. Mitts, TE Connectivity Ltd. - CFO and EVP [39]

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No, Jim, when we discuss our Q4 and we discuss what we're -- what we -- how we think about when we guided the organic outlook as well as how we will talk about it here in 90 days when we get on a call, it's going to be apples-to-apples year-over-year on a 13-week quarter that we discuss in -- for fiscal -- for Q4 of '16. But we would not expect our -- we do not expect any year-over-year leakage on our operating income margin.

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Jim Suva, Citigroup Inc, Research Division - Director [40]

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Okay, so you're saying year-over-year, operating margins should be up then?

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Heath A. Mitts, TE Connectivity Ltd. - CFO and EVP [41]

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Yes, on an equivalent 13-week to 13-week basis.

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Jim Suva, Citigroup Inc, Research Division - Director [42]

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On an equivalent, got you. And my last question is one thing to note is the margin increase in the Communications Solutions was very big. Is that completely sustainable? Is it due to revenues? Was there anything in there or should we just equate that to kind of (inaudible) go forward improvement in your communications profitability?

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Terrence R. Curtin, TE Connectivity Ltd. - CEO and Director [43]

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Jim, when you look at it, it's Terrence, I think there's 2 pieces to it. The biggest piece is the efforts we've done over the last 3 years to get that business focused on high speed and move away from consumer device based, primarily. So when you look at the big growth, it's really the culmination of cost actions as well as the focus of the portfolio that we did in that segment, mainly around D&D. Secondarily, we also did get benefit. SubCom had a very strong organic growth, 22%. So that's also contributing to the increase. I think longer term, you should think about the segment margin staying around mid-teens, depending on where the businesses are. But that's where I think you can think about it but a lot of that margin improvement was structural impact that we've been driving over the past 3 years that we've talked to you all about.

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Operator [44]

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We have a question from William Stein with SunTrust.

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William Shalom Stein, SunTrust Robinson Humphrey, Inc., Research Division - MD [45]

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Terrence, I think you mentioned that there were supply constraints that were limiting the fiscal Q4 revenue that perhaps if there weren't shortages, for example, I'm imagining that's passives, that revenue could be higher. Any quantification on that?

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Terrence R. Curtin, TE Connectivity Ltd. - CEO and Director [46]

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No, well, just to make sure what I said, maybe I wasn't clear, when we look at that, it's just our orders have been placed on us because people are worried about the extended supply chain and we're impacted by that. Our revenue is going to be pretty pure. I don't see anything impacting, I would say, our revenue in the fourth quarter. It's just our orders were higher. On the items that Heath talked about, maybe around transportation, it's not related to passives. This would be base metals, some plastics, things that we actually use in our manufacturing that because our demand was higher, and certainly a good problem to have. And has created efficiencies not only in the extended supply chain but also bringing in our factories we had to do more changeovers to make sure we didn't disappoint our customers, which we're always going to do. So hopefully, that clarifies it.

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William Shalom Stein, SunTrust Robinson Humphrey, Inc., Research Division - MD [47]

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One more, if I can. You noted or someone noted Hirschmann, I think there was another acquisition that was announced recently. Can you remind us what the total revenue impact is? And then I believe that revenue from those acquisitions is not included in guidance, maybe those deals haven't closed yet. Can you clarify this?

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Terrence R. Curtin, TE Connectivity Ltd. - CEO and Director [48]

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The other deal we close to which was a small tuck in within our medical space, was a business called MicroGroup. I'd say we have not even closed on Hirschmann yet. So the impact in the fourth quarter is going to be very, very small in terms of what the combined impact of the 2 deals are. I think if you're modeling for next year, those 2 deals will probably add about a point of total growth for the company on the top line. And we're still working through what the bottom line impact would be after we get through all the purchase price, accounting and so forth. But not a huge number in the first year as we work through some of the integration plan. It will add about a point of revenue at this point for next year's revenue.

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Operator [49]

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We have a question from Mark Delaney with Goldman Sachs.

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Mark Trevor Delaney, Goldman Sachs Group Inc., Research Division - Equity Analyst [50]

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Two questions from me. The first is I was just hoping if you can elaborate a bit more on China auto. I know that was very robust in the December quarter and it sounds like it's stayed pretty strong throughout the year. I think even in June, China auto was good. So can you maybe talk about how sustainable and what you're thinking about in terms of your views on China auto into next year?

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Terrence R. Curtin, TE Connectivity Ltd. - CEO and Director [51]

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Yes, sure. No, China auto, as we spoke earlier in the year, was extremely strong back in that first quarter as the incentives were benefiting it and you saw it in the registrations, you saw it in their production. What's been nice is China auto sort of has played out as we expected. It was a little stronger in the first half, but as it's worked down post the incentive, it's been in line with what we've expected. And the other thing that's very nice to your point, you're starting to see registrations turn positive and what we've also seen is that dealer inventories are back to normal levels in China, around -- we typically like to see them around 40 days. And that's where they are at. So it doesn't feel like there's a hangover of where production is. And so when we look forward, clearly, we'll have a comparative we'll have to deal with in the first quarter. We see the content story being very strong and I think China will continue to have production growth. So very positive on it, and it's actually nice that it's come in line with how we expected.

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Mark Trevor Delaney, Goldman Sachs Group Inc., Research Division - Equity Analyst [52]

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That's helpful. And a follow-up question on the industrial margins. Can you just better explain what the reasons are that the industrial margins have been soft and is there any qualification of what can kind of benefits we can see from the actions that the company was discussing on the call to improve those for next quarter?

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Heath A. Mitts, TE Connectivity Ltd. - CFO and EVP [53]

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Sure, Mark. The pressure on the industrial margins year-over-year was almost entirely out of the commercial aerospace area where we were down year-over-year. That -- our commercial aerospace margins tend to be pretty profitable and out ahead of the segment average. So when we see a decline in that space, that does have an impact on the segment margins. There were also some things that we're doing that impacted the margins, as I mentioned earlier, some of the spend ahead of the cost reductions that layer into the industrial margins as well. But we're committed to improving the overall segment margins. We see a path towards that. There will be some footprint consolidation pieces that are part of that, and that will take some time and we'll continue to quantify that as we move forward. But we do see our fourth quarter, if we're just looking in the near term, we see the industrial margins year-over-year and sequentially to see a pre-significant improvement based on just where we see the mix and where things are heading right now. But there's a longer journey there for the industrial margins over the next couple of years. We look forward to -- as we get further along in that journey to discussing it more externally.

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Operator [54]

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We have a question from Sherri Scribner with Deutsche Bank.

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Sherri Ann Scribner, Deutsche Bank AG, Research Division - Director and Senior Research Analyst [55]

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I just wanted to dig a bit into the SubC segment where you're having a positive cycle. I think historically, when SubC has been at the bottom in the cycle, that, that's been dilutive to margins and when you're at the top of the cycle, it's been accretive. Now with this new range and a higher trough, do you see the business as being as dilutive in a trough year or is that going to be more similar to typical communications margins as we move forward with this different range? And then my second question would be where should we think about the tax rate this next year given you've had some tax benefits this year?

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Terrence R. Curtin, TE Connectivity Ltd. - CEO and Director [56]

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Thank you for the question. First on SubC and then I'll let Heath do taxes. On SubC, I think when you look at it, when we talked about it historically, it would be positive benefit in an up cycle SubCom, and if you went down the trough, how you at it, it is a very strong business model from an ROIC no matter where you are. I do think it would be slightly dilutive to the communication margins in lower part of the cycle but clearly, not as dilutive if you were much lower like it has been in other parts of the cycle. So I think you can think about it a little bit more linearly. Clearly, an (inaudible) margin comes into it, which of the projects we have going, which projects we won, but I think when you think of it from a volume basis, clearly, it wouldn't be as dilutive as it was before. And Heath I'll let you talk about taxes.

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Heath A. Mitts, TE Connectivity Ltd. - CFO and EVP [57]

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Well, Sherry, forecasting a tax rate is fairly volatile, just given how complex and where we operate in the world and the structure, not to mention what goes on with the world with various tax authorities and the changes that we have to react to. So I would say if you're going to model it, model it around 19% for next year. We said longer term rate is 19% to 20% and we'll continue to give you updates understanding that in any given quarter, there's going to be things that swing it around higher or lower. But I'd say 19% if you're thinking about next year is a pretty good rate to be thinking about.

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Terrence R. Curtin, TE Connectivity Ltd. - CEO and Director [58]

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There's no further questions. I want to thank everybody for joining us on the call this morning. And if anybody does have questions, please contact Investor Relations at TE. Thank you, and have a great day.

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Operator [59]

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Thank you. Ladies and gentlemen, this conference will be made available for replay after 10:30 a.m. today through August 2nd. You may access the AT&T executive replay system at any time by dialing 1 (800) 475-6701 and entering the access code 426345. International participants may dial (320) 365-3844. That does conclude our conference for today. Thank you for your participation, and for using AT&T Executive Teleconference. You may now disconnect.