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Edited Transcript of TEL earnings conference call or presentation 24-Jul-19 12:30pm GMT

Q3 2019 TE Connectivity Ltd Earnings Call

SCHAFFHAUSEN Aug 1, 2019 (Thomson StreetEvents) -- Edited Transcript of TE Connectivity Ltd earnings conference call or presentation Wednesday, July 24, 2019 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. - Executive VP & CFO

* Sujal Shah

TE Connectivity Ltd. - VP of IR

* Terrence R. Curtin

TE Connectivity Ltd. - CEO & Director

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Conference Call Participants

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* Christopher D. Glynn

Oppenheimer & Co. Inc., Research Division - MD and Senior Analyst

* Craig Matthew Hettenbach

Morgan Stanley, Research Division - VP

* David Jon Leiker

Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst

* David Lee Kelley

Jefferies LLC, Research Division - Equity Analyst

* Deepa Bhargavi Narasimhapuram Raghavan

Wells Fargo Securities, LLC, Research Division - Associate Analyst

* 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 John Sheerin

Stifel, Nicolaus & Company, Incorporated, Research Division - MD & Senior Equity Research Analyst

* Scott Reed Davis

Melius Research LLC - Founding Partner, Chairman, CEO & Research Analyst of Multi-Industry Research

* Shawn Matthew Harrison

Longbow Research LLC - Senior Research Analyst

* Steven Bryant Fox

Cross Research LLC - MD

* Wamsi Mohan

BofA Merrill Lynch, Research Division - Director

* William 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, thank you for standing by, and welcome to the TE Connectivity Third Quarter Earnings Call for Fiscal Year 2019. (Operator Instructions) As a reminder, today's call is being recorded.

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

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Sujal Shah, TE Connectivity Ltd. - VP of IR [2]

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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 Mitts.

During this call, we will be providing certain forward-looking information, and we ask you to review the forward-looking cautionary statements included in today's press release. In addition, we will use certain non-GAAP measures in our discussion this morning, and we ask you to review the sections of our press release and the accompanying slide presentation that address the use of these items. The press release and related tables along with the slide presentation can be found on the Investor Relations portion of our website at te.com.

(Operator Instructions)

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

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

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Thank you, Sujal. And also, I appreciate everyone joining us today as we go through our third quarter results and our revised outlook for 2019.

Before I get into the slides, let me frame out a few key points that we're going to talk about on today's call. First off, I'm very pleased with our execution in the third quarter. We delivered adjusted earnings per share $0.07 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 we continue to be focused on executing our strategy and the multiple levers in our business model.

And as we've been assuring with you, started at our Investor Day, there's 3 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 3 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 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, and [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 2 years [where] it was the key pillar of our performance. And in 2019, we have been focused on executing on the other levers to protect margin and earnings performance. As we look forward, we are reducing our full year guidance for both sales and adjusted earnings per share due 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 [in the] sequential order growth that we're 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 2 big buckets of this decline, the first one is a further drop in auto production in China, and then the second is broad inventory destocking 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 the proof of the execution against our levers in our model 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. The 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 the cycle.

So let me now get into the slides, and Heath and I will go through them and get into more details. And let's start with Slide 3, 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. Big 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 communications segment declined 11% on an organic basis, which was lower than we expected due to inventory destocking in 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. 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 of 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 acquisition 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've 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 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 2/3 is in Transportation, which is primarily driven by China auto; and approximately 1/3 is in Communications, which is primarily driven by lower demand in the distribution channel as a result of destocking 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 view, and Heath will get into more details later.

So I'd appreciate if you could turn to Slide 4, 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.

By 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, that does have a high ratio of sales through the distribution channel. In our communications 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 destocking by our partners. 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. We've seen a large reduction in orders by our distributors as a result of broader inventory trends that go beyond our products and that 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 5, 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 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've 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 6, 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 in commercial aerospace [space] as well as the defense side. In industrial equipment, sales were down 6% organically driven by inventory destocking partially offset by strength in 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 quarter despite a challenging market environment, and our plans remain on track to expand adjusted operating margins into the high teens over time for this segment.

So let me turn to Communications Solutions, and flip to Page 7, please. Communications 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 destocking 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 quarter 3, and then I'll come back to cover guidance.

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Heath A. Mitts, TE Connectivity Ltd. - Executive VP & CFO [4]

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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 customers' 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. And I'm confident that the initiatives we've taken so far this year have enabled margin and EPS resiliency despite weaker markets, and 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 $0.17.

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 onetime 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.

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've made in profitability across all of the segments, particularly the Industrial segment.

In the quarter, cash from continued 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, so 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 bolt-on acquisitions. I'm pleased with our team reacting 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 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.

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

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Thanks, Heath. And let me get into guidance, and I'll start with the fourth quarter, which is on Slide 10.

Now based on what we laid out and what we're seeing in the end markets and the order trends, fourth quarter revenue is expected to be $3.2 billion 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 and organic sales of 7%. Even with the sales decline, we're only expecting year-over-year reduction of $0.05 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 and 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 destocking being partially offset

(technical difficulty)

growth momentum in aerospace and defense and medical applications. And in Communications, we expect to be down approximately in the high teens as the inventory destocking we've 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 the range of $13.35 billion to $13.45 billion. As I mentioned earlier, this is a reduction of $250 million from our prior view due to lower auto production driven by China and inventory destocking 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 $0.10 reduction from our prior view. On a year-to-year basis, we are expecting adjusted EPS to be up low single digits excluding currency exchange headwinds of $0.16.

Similar to quarter 4, let me get into some color on our 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 destocking in 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 weakening in the market since the last call, and this is driving the reduction in our guidance. It's driven by 2 main areas: drop in auto production in China as well as what we're experiencing through our distribution partners as they are destocking 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 lastly, it goes without saying, 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 lulls 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 in quarter 3 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.

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Sujal Shah, TE Connectivity Ltd. - VP of IR [6]

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All right. Thank you. Lisa, can you please give the instructions for the Q&A session?

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Questions and Answers

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Operator [1]

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(Operator Instructions) Your first question comes from Craig Hettenbach from Morgan Stanley.

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Craig Matthew Hettenbach, Morgan Stanley, Research Division - VP [2]

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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 do you kind of balance those things in what's kind of a difficult cycle?

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

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I mean a couple of things. I think, first off, 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 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 even how automotive content is buffering a recession in automotive production. That -- 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 sensors and medical, which are platforms that we want to build on, as well as areas like Kissling that we talked about, that's an area [where electric] and how do we get into high power in 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 we got after it early in the year. 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 lull. And even with what Heath talked about, what we're talking about in some of the expanded is also making sure we're looking at maybe some opportunities in communications that had higher volumes we probably couldn't take advantage of.

The only other thing I would add is 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're really seeing how we continue to improve the performance of that segment, how it's contributing, and there are still things that aren't -- some of the investments we've made aren't having a payback yet, so I think it provides future leverage as we fix the fixed cost structure at 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 I think this quarter is a great example of it. Thanks, Craig.

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Sujal Shah, TE Connectivity Ltd. - VP of IR [4]

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All right. Thank you, Craig.

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Operator [5]

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Your next question comes from David Leiker from Baird.

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David Jon Leiker, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [6]

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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. But I want to understand, if we can, how your business is going through that channel 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?

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Terrence R. Curtin, TE Connectivity Ltd. - CEO & Director [7]

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Okay. So David, I don't know what other products you're talking about. When you think [through] us, of our $13.4 billion of revenue, there is 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 through the markets that have more fragmented customer basis, you get that in our industrial equipment area, that's being impacted by it. You're also seeing it in our communications segment.

And what we were seeing was actually our business through our channel partners has been staying pretty stable at around -- the orders were running around $500 million per quarter. It'd been up the last 6 quarters, and this past quarter, the June quarter, it stepped down. And we expected a step down even further, and there's been some announcements out there. Typically, that's getting aligned more with 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 in other product categories, certain semi categories and [passives] , probably got a little bit ahead of themselves in making sure they had enough supply.

That all being said, these types of supply chain adjustments, while a headwind now, typically take 4 to 6 months to sort of work through. Clearly, we're in the middle of it, and I think they are temporary effects. So they are something we're going to have to work through here over the next couple of quarters, and 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, it is -- we started to see it in the orders in quarter 3, it will be with us for a little bit, and then it'll be a tailwind at some point when that correction gets normalized.

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Sujal Shah, TE Connectivity Ltd. - VP of IR [8]

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Okay. Thank you, David.

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Operator [9]

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Our next question comes from the line of Shawn Harrison from Longbow Research.

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Shawn Matthew Harrison, Longbow Research LLC - Senior Research Analyst [10]

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The auto sector in terms of this 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 into the December quarter and calendar '20 could represent a more positive environment.

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Terrence R. Curtin, TE Connectivity Ltd. - CEO & Director [11]

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Sure. So as everybody heard us talk last quarter, we sort of knew we were getting to stabilization in auto production. And I think I even 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 felt we were stabilizing. And to the comments I've made on the call, what we actually saw 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 are the types of things, both on the car sales as well as the inventories, we're looking at, and 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. 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 model is sort of [thinking there] and saying how do we plan the business around 21 million units globally per quarter in automotive, how we're thinking about it and also how we're adjusting our cost structure and some of the things Heath talked about.

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Sujal Shah, TE Connectivity Ltd. - VP of IR [12]

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Okay. Thank you, Shawn.

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Operator [13]

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Our next question comes from the line of Wamsi Mohan from Bank of America Merrill Lynch.

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Wamsi Mohan, BofA Merrill Lynch, Research Division - Director [14]

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Terrence, you opened the call talking about revenue growth and 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 heading into fiscal '20 first quarter, 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?

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

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Thank you for the question, Wamsi. There's a part of this I'm going to not answer because we're not guiding to '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 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 off this point I sort of talked around the 21 million units, is we still position ourselves around that 4% to 6% content element. So you've seen it this year even while the market had been worse. I think you're going to continue to see that. So as we peak production [points] and you do your analysis, I do think you're going to continue 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 that I would say, as you work your models, as important.

I'll go -- second thing's probably going back to what David said. Channel destocking is a temporary item, and I think there's going to be a lot of [data points] not only by us, but there are some out there. This will normalize. So a lot of the headwind that we have in quarter 4 that will go into early next year, certainly, that will turn, like it typically does. And the other thing I would just add as we go into next year and [slows] revenue is there's lots of levers that we're pulling. And where they hit in the year from a cost perspective will be at different points depending upon [when] we initiate it, but I do think as we try to manage through this, we have many cost levers that we're working that I think are no different as we displayed in quarter 3 and quarter 4. We're going to continue to be working from an earnings perspective.

Now that being said, 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. Quarter 3 and quarter 4 typically are our strongest quarters of the year, and quarter 4 is already going to be our weakest. So I don't think you can take the normal seasonal patterns that we have and say quarter 1 is going to be down mid to high single digits into quarter 4. 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 [by] 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.

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Sujal Shah, TE Connectivity Ltd. - VP of IR [16]

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Okay. Thank you, Wamsi.

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Operator [17]

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Our next question comes from the line of Scott Davis from Melius Research.

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Scott Reed Davis, Melius Research LLC - Founding Partner, Chairman, CEO & Research Analyst of Multi-Industry Research [18]

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I -- this might be hard to answer, and I know you're not giving 2020 guidance. But can you help us -- give a little granularity on the restructuring as far as kind of payback as 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.

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Terrence R. Curtin, TE Connectivity Ltd. - CEO & Director [19]

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Super. [This one's for Heath.]

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Heath A. Mitts, TE Connectivity Ltd. - Executive VP & CFO [20]

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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 to when you're taking factories offline to -- from the point of initiation until you -- when you're realizing the savings. I think it's fair to say of that $375 million, there's a [blend] but on average, it's about a 3- to 4-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.

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Sujal Shah, TE Connectivity Ltd. - VP of IR [21]

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Thanks, Scott.

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Operator [22]

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

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Mark Trevor Delaney, Goldman Sachs Group Inc., Research Division - Equity Analyst [23]

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So can we go a little -- I was hoping you could drill a little bit more into China region, specifically with 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 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?

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Terrence R. Curtin, TE Connectivity Ltd. - CEO & Director [24]

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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 1 or 2 countries, it impacts everything. So I do think that has some impact on the slower economic conditions because places like Europe ship into China and so forth, and that impacts us in many places.

And Mark, back to the question that you had. When we were sitting here last quarter, we saw a nice increase in our China business totally. Our orders went up almost 10% going from our first quarter to second quarter, and it was primarily driven by Transportation. And 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 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 our U.S. [attachment].

And the other thing I would say, places that I would say have gotten a little bit weaker is around the communications equipment, that's an area, and also in appliances, in CS. We've been talking about that all year. They've been environments where they had been slow. So 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 Communications segments, not as much our Industrial space.

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Sujal Shah, TE Connectivity Ltd. - VP of IR [25]

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Okay. Thank you, Mark.

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Operator [26]

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Our next question comes from the line of Joe Giordano from Cowen.

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Joseph Craig Giordano, Cowen and Company, LLC, Research Division - MD and Senior Analyst [27]

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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 the communications jam up on the supply side is due to like very specific temporary issues with like Huawei and restrictions on certain entities?

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Terrence R. Curtin, TE Connectivity Ltd. - CEO & Director [28]

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I would tell you when we think about the supply side of that, I don't think channel has anything to do with that. Our channel business -- 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 through the channel. They're -- 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 when -- 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, our industrial markets as well. I'm sorry, Joe.

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Joseph Craig Giordano, Cowen and Company, LLC, Research Division - MD and Senior Analyst [29]

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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.

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Terrence R. Curtin, TE Connectivity Ltd. - CEO & Director [30]

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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, is 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.

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Sujal Shah, TE Connectivity Ltd. - VP of IR [31]

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Okay. Thank you, Joe.

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Terrence R. Curtin, TE Connectivity Ltd. - CEO & Director [32]

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Thanks, Joe.

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Operator [33]

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

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Christopher D. Glynn, Oppenheimer & Co. Inc., Research Division - MD and Senior Analyst [34]

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The headline China numbers are one story, but maybe electric vehicle's a little different story that gets up about 50% year-to-date. Just wondering if that aligns with your thinking. Do you expect that penetration to accelerate? What are your learnings along that curve from your kind of specification cycles with the customers there?

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Terrence R. Curtin, TE Connectivity Ltd. - CEO & Director [35]

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Certainly, while China auto production is down, electrical vehicle penetration -- you're exactly right. If you look at it, if you take full electric plus any hybrid, 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 like 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 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 that's impacted, that's more impacting combustion engines.

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Sujal Shah, TE Connectivity Ltd. - VP of IR [36]

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Okay. Thank you, Chris.

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Operator [37]

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Our next question comes from the line of Jim Suva from Citigroup Investment.

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

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Very clear on the automotive side, which is good, but on the communications side, I still have a few questions. And when we think about that, if my memory is correct, you're really not a smartphone supplier or component to smartphone, so I assume this is more like on base stations, routers, which is 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 -- do you see order buildup like last quarter in excess of end demand? Or is it just the trade wars where people overstocked and now they're destocking? Or was it truly an end-market demand slowdown in the communications segment?

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Terrence R. Curtin, TE Connectivity Ltd. - CEO & Director [39]

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Jim, twofold. And you're breaking up a little bit on your cell. So first off, I would say when you think about our communications segment, there's a chunk of it which is data and devices and then there's another chunk. That's appliance. So certainly, we need to look at, to your question, data and devices.

You're right, we do not play in 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 at fast a rate as it grew last year. So when you're talking about something that grew 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 China is granting licenses, and we're positioned very well there. But that is still early stages of how much does that contribute to TE's revenue. So there are typical growth drivers 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, 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 1s in the supply chain probably got a little bit of ahead of themselves, as you said, and they're correcting to get to more normalized end demand. It has -- this is not a content or a share element. It's more of we're going to get hurt here a little bit with the inventory destocking, 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 cellphones.

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Sujal Shah, TE Connectivity Ltd. - VP of IR [40]

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Okay. Thank you, Jim.

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Operator [41]

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Our next question comes from the line of David Kelley from Jefferies.

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David Lee Kelley, Jefferies LLC, Research Division - Equity Analyst [42]

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I just have a quick follow-up on 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're presumably running leaner with ongoing cost actions? And then 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, an impact on short-term margins when production does ultimately rebound.

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

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Clearly, we're -- as we do the actions that Heath talked to you about, we are also being very focused on how in those core areas we keep production flexibility. And 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 if we do get a jump back in there. It might be a little bit of a lag, but we feel very good with how -- not only what we can 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, we would also have to look at how we time some of those restructuring actions that Heath talked about.

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Sujal Shah, TE Connectivity Ltd. - VP of IR [44]

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Okay. Thank you, David.

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Operator [45]

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Our next question comes from the line of Deepa Raghavan from Wells Fargo Securities.

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Deepa Bhargavi Narasimhapuram Raghavan, Wells Fargo Securities, LLC, Research Division - Associate Analyst [46]

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Heath, I think it's a question for you. How do we think about contribution margins, given that the weakness in end markets will be offset by some of the cost actions? You seem to be taking new actions 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.

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Heath A. Mitts, TE Connectivity Ltd. - Executive VP & CFO [47]

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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 21 million vehicles a quarter, which is a run rate that's pretty skimpy, less what we've been running in prior years. That avails us the opportunity to get after some things on the cost structure for 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 through the first half of our fiscal year was running quite strong. We've seen -- based on all the comments made earlier on this call, is that tick down has 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 to] our margin flow-through. 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 can swing percentages more dramatically than really what the real material impact is to TE. So I think we got to be careful with that.

Now Industrial is -- and we've talked pretty openly about Industrial being on a multiyear 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 will 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 belt-tightening. And so I feel good about that.

In terms of that, I'd say Industrial still got -- still has a couple of years left of things -- of activity that it'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, it's harder to do this when time -- when we're in periods of higher growth. So hopefully, that answers your questions, but happy to take any follow-up.

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Sujal Shah, TE Connectivity Ltd. - VP of IR [48]

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Okay. Thank you, Deepa.

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Operator [49]

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Our next question comes from the line of Steven Fox from Cross Research.

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Steven Bryant Fox, Cross Research LLC - MD [50]

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I'd like to follow up on the previous one. I guess the confusion I have in terms of all the charges you've taken, say, over the even year -- last year or 2, last 5 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?

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Heath A. Mitts, TE Connectivity Ltd. - Executive VP & CFO [51]

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I think, Steve, first of all, I think it's a fair question. And we have -- 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've laid out here in the last 18 to 24 months and where we are in that journey, and 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 a 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 performed very well in that segment, but a couple of 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 more mirrors what we're looking at from Industrial, which is taking advantage of -- these are locations that, on a clean piece of paper, we would probably not have in those jurisdictions anyway. So this is more of a couple-of-years' 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 the 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 within Industrial and everything that -- 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 high growth -- higher-growth areas through the 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 then 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.

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Sujal Shah, TE Connectivity Ltd. - VP of IR [52]

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Thanks, Steve.

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Operator [53]

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

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William Stein, SunTrust Robinson Humphrey, Inc., Research Division - MD [54]

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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. How much of the weakness in the channel and how much of the direct business might have been much closer to seasonal if we were to look at it carved up that way?

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Terrence R. Curtin, TE Connectivity Ltd. - CEO & Director [55]

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Well, let me talk directionally. So a couple of things. I highlighted our book-to-bill. Overall as a company, it was 0.98. In our channel, it was 0.85. So I do think channel has been the steeper impact, and we've talked about it. But you do [see] there and there has been slowness -- auto production slowness has nothing to do with the channel. So I think when we talk about how we frame the reduction in guidance, 2/3 was driven by Transportation and a slower China. And certainly, seasonally, I do think that's abnormal that China would have weakened in the quarter we're in. But the other 1/3 is truly the channel, of that $250 million decline.

So it's different by market, but I would say channel correction happens due to them adjusting to end markets that are happening, and clearly, they're seeing some slowness. So it is deeper in the channel. Certainly, that's an impact we're going to have here, like I said, not only in quarter 4. It'll probably go into early next year. But certainly, we've seen a slowness in our direct customers as well, but not to the extent of channel.

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Sujal Shah, TE Connectivity Ltd. - VP of IR [56]

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Thank you, Will.

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Operator [57]

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(Operator Instructions) Our next question comes from the line of Matt Sheerin from Stifel.

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Matthew John Sheerin, Stifel, Nicolaus & Company, Incorporated, Research Division - MD & Senior Equity Research Analyst [58]

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Just had another question on the Industrial Solutions segment, 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. But given -- and so I guess one question is, is the mix of business -- the stronger [mil] , aero, is that a contributor to margins? Or is it mostly the cost-cutting actions that you talked about?

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Terrence R. Curtin, TE Connectivity Ltd. - CEO & Director [59]

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So let me take the first half, and I'll let Heath take the second half. So one of the things that we talked to you all about for a long time is how we position ourselves very well from -- around commercial aerospace 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 while airframe production has been pretty steady and up a little bit, I think you're really seeing the benefit in the commercial aerospace side from those content momentum that we've had very broadly across the industry. And it's really a credit to our team because that's very long cycle.

In addition, this year, we're getting the [kicker] of our defense spend. And I think similarly, while defense -- and I think it's pretty obvious when you looked at defense companies. 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 the benefit on both sides. And 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 in defense, we benefit from that as well, and that's a content play. So those 2 are very important.

To your point, Matt, part of that business does go through the channel. That is not seeing destocking. That is a market that's still staying very good there. And it's one of the things that's buffering, in the Industrial segment, the slowness that we have due to the destocking on our industrial equipment business in the channel. So I'll let Heath talk about the margin side of it.

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Heath A. Mitts, TE Connectivity Ltd. - Executive VP & CFO [60]

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Yes. Matt, I appreciate the question. So on the margin side, when I think about Industrial and 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 -- I think part of your question was the aerospace and defense. 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 businesses is converting the revenue and the profits nicely as you would expect them as they blow past some of their fixed costs 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 there are 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, some -- from time to time, a quarter or 2 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. So that will happen from time to time, but we're very pleased with the progress that the team's doing and what their current outlook is as they move forward.

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Sujal Shah, TE Connectivity Ltd. - VP of IR [61]

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Okay. Thank you, Matt. And I'd like to thank everybody for joining us this morning for our call. If you any additional questions, please contact Investor Relations at TE. Thank you, and have a nice day.

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Operator [62]

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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.