Tyco Electronics F2Q09 (Qtr End 03/27/09) Earnings Call Transcript

| About: TE Connectivity (TEL)

Tyco Electronics Ltd (NYSE:TEL)

F2Q09 (Qtr End 03/27/09) Earnings Call

April 29, 2009 8:30 am ET


Tom Lynch - Chief Executive Officer

Terrence Curtin - Chief Financial Officer

John Roselli - Vice President, Investor Relations


Amit Daryanani - RBC Capital Markets

Brian White - Collins Stewart

Matt Sheerin - Thomas Weisel

Jim Suva - Citi

William Stein - Credit Suisse

Shawn Harrison - Longbow Research

Steven Fox - CLSA

Amitabh Passi - UBS


Ladies and gentlemen, welcome to the Tyco Electronics second quarter earnings call. (Operator Instructions). As a reminder, this conference is being recorded.

I would now like to turn the conference over to your host, Vice President, Investor Relations, Mr. John Roselli. Please go ahead.

John Roselli

Thanks, Rochelle and good morning. Thank you for joining our conference call to discuss Tyco Electronics' second quarter results for fiscal year 2009 and our outlook for the third quarter.

With me today is our Chief Executive Officer, Tom Lynch and our Chief Financial Officer, Terrence Curtin.

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

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

Tom Lynch

Thanks, John and good morning, everyone. Today, we are introducing a slide show to accompany our review here, so hopefully that's helpful for you and if you can move to slide 2, we will get started.

As we expected, the weak global economic conditions did have a significant impact on our business this quarter as our sales declined 28% organically year-over-year and our adjusted operating earnings declined 85%. So it was a tough quarter from that perspective, although what we expected going into the quarter.

Our adjusted earnings per share for the quarter were $0.14 and that does include a $0.07 benefit from a tax rate that was more favorable than our guidance rate. If you were to use our guidance tax rate of 30%, our adjusted earnings per share would have been in the middle of the guidance range we provided last quarter. The tax rate will tend to fluctuate a little bit at these income levels. Terrence will expound on that when he walks you through the financials in more detail in a few minutes.

Our business conditions remain weak and visibility is limited, but we have seen our order rates stabilize over the last two months, last March and April, as compared to the weakening trends we were seeing at the time of our last call.

In our businesses that serve consumer markets, which includes automotive, order rates have picked up over the last couple months. In our industrial markets, orders are still soft and weakening a bit. The good news is we are seeing stabilization in orders, but it is off a much lower base than the prior year, but things do feel a little bit better now than they did three months ago as inventories in the supply chain, particularly in the consumer market and most especially in the automotive markets we serve, have been reduced considerably.

So feeling better; visibility still limited, however, and I think most of what we are seeing is, the inventories getting back in line.

Now I want to spend a few minutes updating you on the progress we are making with the strategy we laid out almost two years ago when we separated the company and then, as today, the strategy has three main elements to it: positioning the company for accelerated growth, improving our operating leverage and focusing the portfolio. Notwithstanding the weak business conditions that are out there, we still have our eye clearly on the ball of positioning this business for growth.

Our strategy there really has four key points: Accelerating new product introductions and better leveraging our technology portfolio, and I'm going to talk about a couple of key new wins for us in a minute; expanding our reach and service levels through the distribution and web channels. We are very strong with the large OEMs. That has always been our strength and we put a lot of resources in front of those customers and have a lot of success there. We want to be as strong and as effective with the other half of our business, which tends to be the smaller customers. So we have a lot in process to improve our ability to reach customers through alternative channels.

Thirdly, as part of our growth, continue to strengthen our position in emerging markets. Naturally, that is where a lot of growth is going to continue to come from. We do have a very strong position in China, Russia, Eastern Europe and India. We are continuing to invest there and most importantly, continuing to build our talent there.

The fourth element of this growth strategy is to broaden our product range through strategic acquisitions. Now we haven't done any of that. We have been much more focused on cleaning up the portfolio that resulted from all the acquisitions that came before to form this business, but we do feel that our platform and infrastructure will lend itself to augmenting our current portfolio of products and technologies when the right opportunities come up at the right time and we are focused on building that pipeline.

So with respect to new products, I'd just like to give you a couple of good examples. The platforms are important. What's really important is broadening the markets we serve with the technology we have. The first one in our aerospace and defense and marine business; we recently won a very key award with Airbus in what is known as the Raceway program. This product provides a solution to protect the aircraft's electrical system from electrical interference and lightning strikes.

There are a couple of very important things about this award. One, these new airliners, that will be rolling out, are made of composite materials. That changes the characteristics of the electrical system a little bit, how it has to deal with interference and lightning strikes. So this was a big win that really highlights the kind of strength we have in electrical and mechanical technology.

This product will initially be deployed on the new A350 and it is more than about $100,000 in content per plane. Really the most exciting piece about this is we have not been a major player in Airbus. This gives us a very strong position there and really positions us as a strategic supplier to them. We have always been strong in Boeing and we're getting stronger there as well.

Another good example is in our energy business and we have about $1 billion of energy business revenue in the company. We serve the biggest part of that is we serve utility. For most of our existence, we've served the low-to-medium voltage part of that market. About three years ago, we began to expand our product line to address the high-voltage market. That is where a lot of the accelerated growth is going to come.

Recently, we introduced a whole new range of porcelain insulators, starting with the North American market. We are starting to see nice traction with that. This was a gap in our product offering and this is going to give us access to a range of new applications.

So two examples of the kind of things we have been doing in the company to better harness the range of technology we have.

In addition to these new product launches, we are seeing increased opportunities to gain market share, especially in automotive. Just in the last six months, we've been on more than $150 million of opportunities in the automotive business that was previously supplied by competitors, in many cases, previously business that we had not won. We are being approached to rebid for these programs, because our customers are increasingly looking for partners like ourselves that have the financial resources to not only get through the current times, but to invest for the future.

So I think the 50 to 60 years we have been in this business, the strength means more than it ever did to our customers.

And then up my last comment on growth, as you know, we talked last quarter about the formation of a new Specialty Products segment and what we did is we broke out four businesses that were previously grouped with our more traditional interconnect business and this is our aerospace, defense and marine; medical; touch systems; and circuit protections. These businesses all have an attractive range of technologies that are broader than just our core interconnect business and it really leverage our material science capability and are well-positioned for growth over the next several years.

The third area or the second key area of our strategy of the three is to improve our operating leverage. As you know, two years ago, we talked about getting, over a three-year period operating margins up to 15%. Now that won't happen by 2010 because of what's going on, but we are making excellent progress on resizing the cost structure to get the operating leverage when the business does come back, and today we are on track to take about $300 million of costs out of the structure. What I mean by this is it is permanent cost savings, it's reduction in facilities, consolidation of comparable businesses, it is reducing spans and layers in organizations.

We have made a lot of progress there and Terrence will take you through the details. About two-thirds of this savings will come from our manufacturing operations and one-third from SG&A. As we went through this program, keep three important things in mind; make sure we size this business to be solidly profitable in the $9.5 billion to $10 billion range. But as part of that, we really preserve our strategic opportunities and there are numerous strategic opportunities and when I say preserve them, I'm really talking about two key things, keep our strength in front of the customer and keep our engineering largely intact to develop a product that supports the customers' increasing needs.

Then the third part of that is, as the business comes back, make sure we have accelerated spring back in our margins.

And then the last part with respect to our strategy is focusing our portfolio. As you know, this has really been key for us to get down to what we consider the core business that we are best at. A couple weeks ago, we announced the sale of our Wireless Systems business for $675 million. We also closed on the sale of a small battery business during the quarter for $14 million and over the last 18 months, we have now divested five non-core businesses, which by the time the wireless sale closes in the June-July timeframe, will generate about $1.3 billion of total proceeds.

And if you now can turn to slide 3, I will talk a little bit about cash flow and liquidity. We did have a very strong free cash flow quarter. We generated $382 million of free cash flow in Q2. This was an increase of 9% over the prior quarter. As you know, reducing our inventory was a very big focus area for us. We did get a bit of a slow start in Q1, but we're moving with great momentum in this area now and we reduced our inventory $326 million in the quarter and without sacrificing customer service levels.

Through the first six months, we have now generated more than $400 million of free cash flow, excluding restructuring and this is putting us on pace to generate about $800 million of free cash flow for the full year before restructuring, consistent with what we said last quarter.

With respect to our capital structure, this remains very solid with over $700 million of cash and another $600 million of net proceeds expected from the wireless sale when that closes.

Then lastly, our plan to reincorporate in Switzerland from Bermuda is on track. This will be brought to our shareholders for approval in late June.

So to recap this section, I feel very good about our progress we are making despite the fact we are in a lousy market. I believe we're strengthening our competitive position in a number of markets, high growth areas where we weren't as strong in the last couple of years; in markets where we are the leader like automotive, we are really focused on capitalizing on share gain opportunities.

We are on track to take out $300 million of structural costs and this will be largely completed by the end of the fourth quarter. This will position us to be solidly profitable even at current business levels and enhances our operating leverage when business improves.

Finally, with the wireless sale, our portfolio is essentially where we want it. So with that, I'll turn it over to Terrence who will walk you through the financials in more detail.

Terrence Curtin

Thanks, Tom and good morning, everyone. Let me start by reviewing our sales performance by segment and market and then I will review our earnings, cash flow and liquidity.

So if you can turn to slide 4, this slide shows our overall revenue performance by segment. Overall, our total company sales were down 33% in the quarter or 28% on an organic basis. As you can see in the lower left hand corner of the slide, our business is serving the consumer markets, most of which are in the Components segment and to a lesser extent in the new Specialty Products segment, decreased 44% on an organic basis and these markets were the most affected by the economic slowdown.

So let me turn to slide 5 and cover segment performance in more detail. Starting with our Electronic Components segment on the left hand side, our sales declined 45% in the quarter or 41% organically. The decline was broad-based across markets and geographies.

On a regional basis, all three regions were down more than 35% year-over-year and we experienced declines in every major end market with the consumer-related markets, which are about 70% of the segment sales, declining 45% while the industrial and infrastructure markets that we serve were down 30%.

Getting into specifics by the major markets in the segment. In the automotive market, our sales declined 49% organically, driven by an estimated 40% decline in global automotive production from 19 million units produced last year to approximately 11 million units in the current year quarter. We were also impacted by inventory corrections throughout the supply chain, which caused our sales decline to be higher than production levels.

Geographically, all regions experienced a similar decline, and for quarter three, we do expect a sequential improvement in our sales driven by increased auto production outside of North America, as well as a reduction in the inventory burn-off in the supply chain.

In the computer market, our sales declined 37% organically. This reflects a steep decline in desktop computers. Inventory levels in the supply chain appear to be clearing out and we expect a slight increase sequentially in our sales to this market.

In the communications equipment market, our sales declined 29%, driven by 42% decline in mobile phones. That was impacted significantly by the supply chain inventory corrections during the quarter. Similar to the computer market, we believe that the supply chain inventory correction is substantially over.

In the industrial equipment markets, our sales were down 37% on an organic basis and this market is being impacted by the global cutbacks in capital spending. We saw a continued weakening of order rates throughout Q2 in this area and we expect sales will be down sequentially in quarter three.

Finally, in the distribution channel, our sales declined 31% organically due to weaknesses in the end-customer demand, as well as inventory reductions by distributors. We do expect a similar decline in the third quarter as distributors further reduce inventory levels.

Looking at the right side of this slide, our Network Solutions segment, sales declined 22% on a reported basis and 11% organically. Sales to the energy market declined 8% organically in the quarter. Double-digit growth in North America was more than offset by declines in EMEA and Asia.

In North America, we continue to gain share as a result of the revamping of our go-to-market structure, coupled with our expanded high-voltage product line. We do continue to see cutbacks in network investment by our utility customers and do not expect to see the typical season increase in sales in quarter three.

Our sales to the service provider market also declined 8% organically. Selective investment in fiber-to-the-home and broadband wireless projects being more than offset by lower spending on upgrades and maintenance of existing networks and especially by the U.S. carriers.

In the enterprise networks market, which we also referred to as building networks, our sales declined 22% organically. This reflects slower commercial construction markets, particularly in the U.S. and also deferred project spending due to IT budget cuts.

Turning to slide 6, sales in the Specialty Products segment declined 21% year-over-year and 19% organically. Sales to the Aerospace, Defense and Marine market declined 12% organically, driven by inventory reductions in the distribution channel, as well as weakening demand in the commercial aerospace market. We do expect a similar decline in quarter three in this area.

In our Touch System business, sales declined 24% due to delays in capital investment by our retail end customers.

In the Medical area, product sales increased 4% due to strength in ultrasound and patient monitoring devices. We do expect lower business levels as hospitals' budgets get reduced, which will impact the sale of the devices in the equipment that our products are designed into.

Finally, Circuit Protection sales declined 49%. Our sales were down due to declines in mobile phones and laptop computers, which were impacted by weak demand and supply chain inventory corrections.

Moving to the right side of the slide, our undersea telecom sales increased 14% driven by progress on several projects underway in the Middle East, Africa and Southeast Asia. We ended the quarter with $1.1 billion of backlog and now expect full year sales to exceed $1 billion compared to prior expectations of $900 million. We do, however, see sales declining sequentially to about $290 million.

Finally, in our Wireless Systems segment, our sales grew 10% organically, driven by increased system deployments. We had very strong orders last quarter and our backlog in this segment grew 19% sequentially to nearly $400 million.

So let me now get into the P&L, which begins on slide 7. Our GAAP operating loss was $3.8 billion and this was impacted by several items. First, we recorded a non-cash goodwill impairment of $3.5 billion and this impairment is due to the impact of the economic downturn on our businesses that serve computer-related markets.

Specifically, $3.4 billion of the charge was in our Electronic Components segment where about 70% of our sales relate to consumer markets. The remaining $112 million impairment occurred in our Specialty Products segment and relates to our Circuit Protection business. We do not expect any further impairments unless business conditions significantly deteriorate further.

Second, we did incur $196 million of restructuring costs during the quarter, which is a bit more than we guided. We initiated more headcount reductions and two additional plant closures. We also incurred a $6 million loss on the sale of the small battery business that Tom mentioned in our Electronic Components segment.

I will cover more detail on the restructuring efforts as part of the cost action update in a minute.

The final item on the slide relates to our separation from Tyco International. As you may recall, Tyco settled its major class action lawsuit about a year ago, but there were several smaller cases that were still outstanding. These cases are being managed by Tyco International, but we share 31% of the liability under the terms of our separation.

During the second quarter, Tyco International settled two of the outstanding cases and established a reserve for the estimated costs to resolve the remaining cases. Our portion of the two settled cases was $19 million and our portion of the reserve for the remaining cases was $116 million. I want to note that this is the estimated cost to cover all remaining shareholder litigation items related to our separation.

Now let's move to slide 8. Starting at the top, I want to talk about manufacturing margins first, and when I talk about manufacturing margins, this is our gross margin, excluding research, development and engineering costs. During the quarter, our manufacturing margin declined 700 basis points from 31% to 24%. The 33% decline in our sales reduced our manufacturing margin by 800 basis points.

While our sales were down 33%, we also reduced production by approximately 50% compared to the prior year as we brought down our inventory levels. This lower level of production negatively impacted our manufacturing margin by 200 basis points. These production cuts will continue to be a drag on margins throughout the third quarter as we continue to reduce inventory. Offsetting these negative effects were our cost reduction efforts.

If you look at the savings from our cost actions in quarter two versus a year ago, it was $110 million of cost savings, which did help our manufacturing margin by about 300 basis points.

Looking at the middle of the slide on operating expenses and this includes both our RD&E expenses and SG&A as shown on the slide, we were down $73 million year on year. I do want to highlight the prior year SG&A amount includes a $36 million real estate gain on the sale that we had last year in the second quarter. If you take out the effects of this real estate gain, as well as currency translation, we reduced our operating expenses by $80 million through a combination of headcount reductions and spending controls.

We have reduced our engineered expense at a slower rate than SG&A as we want to maintain our focus on growth investment. As Tom mentioned, we're seeing more growth opportunities in some end markets and we want to make sure we capitalize on these opportunities. We do expect that our RD&E and SG&A levels will be similar in Q3 as they were in Q2.

Now let me provide you with an update on our cost-reduction efforts. As Tom highlighted earlier, our overall target is to remove approximately $300 million in annualized structural costs from our business. This consists of $200 million in manufacturing costs and another $100 million of SG&A and these actions will position us for solid profitability at the current sales levels and will also provide improved operating leverage as sales growth returns so that we can hit 12% operating margins at the $12 billion sales level.

In addition to these structural reductions, we have also reduced our variable costs, excluding materials, by approximately $500 million on an annualized basis in response to the current demand environment. These reductions consist of a variety of items, which include shortened working weeks, the elimination of temporary workers and a significant reduction in discretionary spending.

If you look at headcount, we have reduced our headcount by 21,000 since year-end and this is a 22% reduction. Sequentially, our headcount is down 13,000 from the first quarter. If you look at our manufacturing footprint, since we began our simplification program in 2007, we have closed 19 manufacturing sites and we have another six closures in process and by the end of the year, we will have less than 100 manufacturing sites.

Overall, we continue to make very good progress on our cost-reduction efforts and with the exception of the plant closures, which do take longer to complete, the majority of our cost-reduction efforts will be completed by the end of the fourth quarter and this will position us for improved profitability in fiscal 2010.

So let me turn to slide 9 and talk about items below operating income. Net interest expense in the quarter was $37 million and this was down slightly from the prior year due to lower debt levels. Favorable adjustments to our expected annual tax rate resulted in tax income of $25 million in the quarter. And as Tom mentioned, the amount and mix of income by jurisdiction have changed considerably since when we entered the year and this has resulted in a lower expected tax expense for the full year. And when you take the half-year adjustment that we have to book and our low income levels in Q2, this magnified the effect on the effective tax rate and actually caused it to go into an income position.

In the Q3, we will also have an unusual tax rate, driven again by the low level of earnings and as you will see on the guidance slide coming up, we estimate that our tax expense will be between $12 million and $18 million, based on our operating income guidance range.

The reason that this is fixed is, please recall that a portion of our tax expense is driven by the interest on our shared tax liabilities that relates to separation.

If you look at other income, which was $3 million in the quarter, this was down from $13 million in the prior year that reflected lower-than-expected interest on the share tax liabilities due to some minor issues being resolved. This line will fluctuate with a corresponding increase or decrease and the interest running through our income tax line.

For Q3, I expect the other income will be approximately $11 million.

Now let me cover free cash flow on slide 10. Q2 free cash flow was $382 million. Lower income levels versus the prior year were more than offset by reductions in working capital and capital expenditures. Our days sales outstanding declined three days year over year and five days sequentially. Our inventory days on hand, excluding construction in process, were up four days year-over-year, but declined six days sequentially to 82 days on hand.

As Tom stated, we reduced our inventory by $326 million in the quarter and we expect to take another $150 million to $200 million out in quarter three.

On capital spending, we continue to manage capital tightly and if you go back, when we exited last year, we were running about $170 million per quarter in CapEx. This quarter was at $95 million, which is a 40% reduction from the prior year levels and we expect similar capital spending in quarter three and approximately $400 million of capital spending for the year.

Cash restructuring in the quarter was $68 million. We expect full-year cash restructuring spending in the range of $300 million, up slightly from the previous guidance.

Cash taxes were $10 million in the quarter and for the full year we continue to expect that our cash tax rate will be approximately 30% of our adjusted pretax income. This is slightly higher than our historical rate and is really due to payments we are making in the current year related to the prior year higher income levels.

Finally, as Tom mentioned, we remain on track to generate approximately $800 million in free cash flow for the year before restructuring cash.

Moving to slide 11, which shows our debt and liquidity position. We began the quarter with $545 million of cash and ended it with $722 million of cash. During the quarter, we paid down just under $100 million on our credit facility and at quarter-end, our debt was $2.9 billion, down from $3.2 billion last year.

Our debt to trailing 12-month EBITDA as measured in our credit facility agreement is now 1.5 times and our liquidity position remains solid with no significant debt due until 2012. Our liquidity position will be further [strengthened] by the proceeds from our Wireless Systems business, which will be about $615 million after tax and transaction costs.

Based upon our cash generation from operations and solid liquidity position, we are committed to the current dividend levels for fiscal 2009. As we do every year, we will review our dividend and payout ratio with our Board as we enter into fiscal 2010.

Now let me turn the call back over to Tom.

Tom Lynch

Thanks, Terrence. I'm now going to move to slide 12, which is our Q3 outlook. And please note that the outlook for Q3 does exclude our Wireless Systems business, as we will now be reporting that as a discontinued operation.

For Q3, we expect our sales will be in the range of $2.35 billion to $2.45 billion, which is flat to slightly higher than Q2, but down 30% to 33% year over year on an organic basis. Last year's third quarter was really the high watermark and after that, that is when the business really began to deteriorate. So it is one of our hardest compares I would say, but business is still weak out there. As I mentioned earlier, in our consumer-related businesses, we expect sequential improvement in the 8% to 10% range while we would expect industrial to be down 5% to 7% and automotive will be low double digits is what we are expecting right now and based on the order rates we are seeing.

We expect our adjusted operating income to be in the range of $40 million to $70 million and this is down a little bit from Q2 due to the continued impact of our inventory reduction efforts on our profitability. Q3 is definitely where the biggest impact of the production cuts is being felt, some impact in Q2, large impacts in Q3. We do expect this will be another 100 to 200 basis points worse impact than it was in Q2, but if sales continue to stabilize or slightly improve, we expect by the end of the third quarter inventory levels will largely be in line with our sales levels although, for sure, we are not taking our foot off the gas on reducing inventory.

We expect our adjusted earnings per share from continuing operations will be in the $0.01 to $0.06 range. Terrence mentioned a little bit of this range, spread is due to the range of the tax rate. Now if you move to slide 13, I will wrap it up before we open it up for Q&A.

To sort of just recap everything we just covered, business is still low. I mean business levels are still low; there is no question about that. But for the first time in a while, we are seeing some signs of improvement and that is largely in our consumer-related markets and importantly in our largest market, automotive. We do feel like we are positioning the Company soundly and solidly for accelerated growth. As Terrence mentioned, we have not reduced our engineering spending that much. We are looking at ways to be efficient and eliminate duplication, but we are very focused there because the leverage on engineering in this Company is very, very high in terms of revenue to engineering dollars and the number of new projects that we do in a business like this.

I feel good about the portfolio and the product with the changes we have made. Terrence took you through the cost program, which has very good traction, good solid second quarter and cash flow and we expect to be solid for the second half of the year as well and generate over $800 million of free cash flow before restructuring. And then finally, we have a very solid capital structure and that is going to get stronger with the closure of the wireless divestiture. So with that, operator, can we please open it up for questions?

Question-and-Answer Session


(Operator Instructions). Our first question comes from the line of Amit Daryanani of RBC Capital Markets.

Amit Daryanani - RBC Capital Markets

Just on the consumer side, right, from your comments and I think from a lot of other component companies, definitely sounds like we are starting to see stability and some inventory build, rebuild. But on the other side, you guys are talking about a 10% sequential growth. Now is that really a reflection of demand getting better or are you just seeing some possible pull-ins due to one-time benefits from the Scrappage Laws in Europe for example?

Tom Lynch

Amit, all of that is in Europe and Asia. None of that is happening in the US yet and it is more from inventory. A lot of governments have a variety of different, say, stimulus programs to encourage people, whether it is the scrapping of the old car, credits for new purchases. I don't think we have seen that really begin to hit in any significant way yet. I mean it remains to be seen how significant that will be, but clearly everybody slams on the brakes in inventory four or five months and that is finally getting to a point where there is just not enough inventory in the pipeline. So I would say it is more inventory right now.

Amit Daryanani - RBC Capital Markets

Then just on the inventory aspect, and you guys actually did a pretty good job I think of lowering it and it was down 20% or so year-over-year. Your sales are still down 30%, so do we still take it that there is actually room for cash generation to be positive as we work down further inventory in the June quarter? Is that reasonable?

Terrence Curtin

It will depend on how much inventory we do take out, but from that viewpoint, if you look at that $200 million, cash could be positive from a free cash flow perspective. We do have our interest payment in this quarter, which are semi-annual, which does create a little bit of a drag, but there definitely is potential for that.

Amit Daryanani - RBC Capital Markets

Then just finally from me, the Electronic Component business, what sort of revenue run rate could we see that business start to break even?

Terrence Curtin

If you look at components, certainly the margin impact of the inventory drag is the largest in components. That is the one that has had the most impact, obviously top line, which is where the inventory actions are there. So, when you look at it, the inventory is creating the loss you have seen there, as well as will create the loss to slightly go up sequentially as we continue to work through inventory.

If you look at the cost actions and so forth, we would have to be higher than the levels are today, but it will depend upon the mix of revenue between the various businesses in there. So, from that viewpoint, the inventory burn is having a big impact there, but it will depend upon where business levels are between the businesses that are in there.

Amit Daryanani - RBC Capital Markets

But it definitely sounds like you need more than just cost savings, right, to drive that and to break even a positive territory.

Terrence Curtin

Between the cost savings and the inventory and a slight improvement in revenue, we would be close to breakeven.


The next question comes from the line of Brian White of Collins Stewart.

Brian White - Collins Stewart

Just on the inventory frontier, if sales were pretty much in line with what you thought, why do we have so much excess inventory going into the June quarter?

Tom Lynch

Can you repeat the last part of that question?

Brian White - Collins Stewart

It seems like sales are what you expected in the March quarter and a little bit of a growth here in the June quarter sequentially, so I'm just wondering why do we have so much excess inventory?

Terrence Curtin

Brian, when you look at it and I'll go back to the last call, when you look at our inventory, we did state that we had higher-than-normal levels and it would take us multiple quarters to work that off as you are aware. Inventory, by the various industries, you can't switch between the industries. So we set a target out to get about $200 million out in quarter two. We drove that at a higher level at $326 million and our goal is to get it behind us by the end of Q3. So our goal has always been that this would be a multi-quarter process to work through and we exceeded the target that we actually set out here for Q2.

John Roselli

And another way to think about that, Brian, this is John, if you look at where we ended last year, we had around $2.1 billion of inventory. If you think about a $10 billion sales run rate, that is down about 30%. So, if you drop our inventory levels by 30%, that is roughly where we need to get our inventory to be in line with our sales run rate and we're not quite there yet.

Brian White - Collins Stewart

Okay, it looks to me, I mean just looking at inventory to revenue throughout '08, you are at a mid-60% type level that maybe you would have more like 350 to 400 excess inventory, but you think it is 150 to 200.

Terrence Curtin

It is slightly above 200, if you look at that. It is not 350 to 400. Right now, if you look at the metric, we are around 82 days. We typically like to be in the 70s. So when you look at it, it is not as big of a number as you have. But to Tom's point, in these uncertain times, we are going to take it down as far as we can basically to make sure we get the most out of cash generation as well.

Tom Lynch

And also, Brian, I would say over time I believe we can run the inventory at less than the 70 days range. We are doing a lot from a process point of view. Probably if you were to say in your reductions this year, 80% is more of in the brute force category, you know, you just stop the press for this kind of thing. But we are making a lot of process improvement and I think one of the real opportunities for this company that we are very focused on is to run the business with less inventory, at the same time improve our delivery rate. So that is a key focus area.

Brian White - Collins Stewart

And just on the auto front, have some of your customers come to you and asked for better pricing in the auto component area?

Tom Lynch

I would say not any more than usual. And what I mean by that is, there is always the pricing negotiations going on. To give you an example though, of that $150 million of additional business we bid on, a fair amount of that business we lost because of the price in the past. We didn't just all of a sudden change our price threshold to get it. Our point has been, we continue to invest. We have dedicated engineers; you can count on us; we are going to keep that. So far we have not seen any real change in price erosion across, and our position has been, volumes are down 30% below when we bid these jobs. So we understand everybody would like lower prices, but so far that is holding the day, and I think it is a good argument for us.


The next question comes from the line of Matt Sheerin of Thomas Weisel.

Matt Sheerin - Thomas Weisel

Back to the gross margin on your expectations past the June quarter, we understand the impact of the inventory reduction on gross margin this quarter. In fact, it sounds like it is going to be down again a little bit. But you also talked about, I think, the 200 basis point improvement when you get back to production levels. So is that what we should be thinking about, about whether it be September or December, the gross margin up a couple of points or so?

Terrence Curtin

Yes. When you look at it, right now certainly the manufacturing margin, I'm going to take out the engineering because that is leverage that is in there. But if you look at the manufacturing margin, you are thinking about it right. At this level, manufacturing margin we would expect to be in the 26%, 27% range, manufacturing margin once we work through all of this, including just the impacts of the cost savings.

Matt Sheerin - Thomas Weisel

Okay. And then on the cash situation, could you just talk about what your short-term plans are for the cash in addition to, obviously, the requirements that you have with the restructuring charges and other things? Do we plan to take down the credit line more than you have now? I think you took it down $100 million this quarter.

Terrence Curtin

Yes. Similar to what we said last quarter, we are not repurchasing shares. Right now, we are going to hold excess capital to provide flexibility around the balance sheet. We do have about $340 million outstanding on the revolver. And really what we will do is right now protect the balance sheet from a liquidity perspective, and there could be further debt reductions, especially when we get into the proceeds off the wireless sale.


The next question comes from Jim Suva of Citi.

Jim Suva - Citi

I believe your financial goals were $12 billion in sales, 12% margins and $2 of EPS, coupled with a dividend payout of 20% to 25% of the EPS. Can you address that because it seems like we are pretty far from that EPS level and the dividend payout of 20% to 25%? I know you are committed for the next quarter or two, but should we expect that payout ratio and that financial goal timeline what we are looking at or do we need to adjust it accordingly now that there are so many acquisition or divestitures that are finished?

Tom Lynch

A couple things I would say. When we talked about the 12 at 12%, it is really to kind of give you a sense of what we are doing with the cost structure to drive the operating leverage. As I mentioned in my comments, when we looked at this program, make sure we draw the right balance, first and foremost, be financially solid at 10, the current run rate.

With all the actions we have largely in place, I feel like we are there. That gives us the leverage then as we go from 10 to 12 to really see the operating leverage come through, which has been something, as you know, as we have talked over the past couple of years, has not been a strong suit of the company. It is something we are extremely focused on up and down in this company to get the operating leverage that I believe is inherent in the company. That would then translate to when $12 billion comes, and I guess that is probably a couple years out based on today's circumstances. But that would translate into roughly a $2 EPS.

And then with respect to the dividend, we think the right level traditionally -- and I'm going back to 25% to 30% based on the kind of company we are, we committed six months ago to a dividend level; we are sticking with it. We have the cash to do it and with our Board, this is always the main topic of our August-September Board meeting, which is, what is your business plan for the next three to five years, let's go through the operating plan for this year and then we work through with the Board's approval what we think the appropriate dividend is.

So that is really where we are. We are committed to the May and August dividend at $0.16 a share and the current rate and then take a look at that, which is our MO for our planning process.

Jim Suva - Citi

And as a quick follow-up on the wireless divestiture, are there any remaining liabilities left from that specifically related to what is remaining or the New York state contract, which didn't go as optimal as planned? How should we think about any residual impact?

Tom Lynch

Well, we clearly retain that liability. As you know, we wrote off about $110 million last quarter, of which $50 million was related to the drawdown by the letter of credit. We have filed affectively suit in the New York Claims Court. We like our position very much. This system that the state decided to discontinue is up and running in other places around the country as advertised.

So I don't believe we have any material exposure beyond what we have recorded. I mean this has to play out, but we're going after this in an aggressive way because we believe that we delivered the system that we signed up to deliver. That would be the major liability.


And the next question comes from the line of William Stein of Credit Suisse. Please go ahead.

William Stein - Credit Suisse

Thanks. First, just a small follow-up on Jim's question. At the $12 billion revenue run rate and 12% operating margin, do you guys have a target operating and free cash flow level?

Terrence Curtin

It would continue to be. As we said historically, we would expect our free cash flow will approximate net income. That has not changed.

William Stein - Credit Suisse

Okay. Then about the plant closures, that's the last of the real restructuring that's still left. I assume the 12%, $12 billion relates to when the plant or the manufacturing restructuring is done. Is that correct and what is the current view on timing of finishing the manufacturing footprint adjustment and what would it look like in terms of number of plants?

Tom Lynch

Yes, you are correct and I will go back in time a couple years when we laid out the plan, which was to get us from about 123 plants, south of 100. We are tracking right to that. I think Terrence mentioned 19 finished, six in progress. If you go back to that original plan, that is really tracking very well to the original plan.

So that is an important part of the $300 million that we talked about $150 million to $175 million annual savings from that, about a three-year payback on the investment. Since then, we have identified some additional fixed costs to take out of manufacturing, plus the $100 million in SG&A. So that is how you get to the $300 million. So we are largely through that. We don't have to start any new plants to hit that number. We have to finish off these six that are well underway now.

William Stein - Credit Suisse

When is the plan to finish those?

Tom Lynch

That will be in early to mid 2010, which is in line with the original plan. We said that program would be finished about then and that is where we are headed.

William Stein - Credit Suisse

Great. And one other one if I can. I was just kind of surprised to hear you talk about new opportunities in automotive. I think you mentioned $150 million new opportunities that you are bidding on. I would imagine that is with one of the big U.S. [ODEs] because it is where you have been less strong. I'm wondering what the strategy is around that. Why is this a new focus?

Tom Lynch

It is more than U.S. Some of the shakeout in the supplier base applies globally and by the way, anything that is US-related is taken with great care, but it is much more than U.S. Clearly, automotive is in tough straits right now and our business is in tough straits, but the dynamics in the business or the characteristics of the business are still fundamentally sound. And if you look at almost any automaker and particularly the European automakers and the Asian automakers, their three fundamental focuses are safe, green and connected. That is all electronics-driven. I mean that is all electronics-enabled I should say.

As we've said before I believe, if you talk about alternative energy engines, whether they be all electric or hybrid vehicles, there is a lot more electronic content in that, which means there is more of our content. So while things are very tough when the production is down 40% in the second quarter of number of vehicles, the trends there aren't changing and we are the leader in the industry and it is not an easy industry to get into because quality, track record, the ability to invest. I mean most of where we spend our engineering dollars today is two to four years out on the next generation of vehicles.

So it's still an important part of our strategy. From the beginning, two years ago, we said the most important part of our restructuring strategy is to significantly reduce our fixed cost base in that business. That is on track. It's being overwhelmed by the volume decline. But keep it as healthy as possible in the short term and take the costs out, be selective on where we want to grow and by the way, we are discontinuing some product lines too. We are phasing out product lines that aren't in our sweet spot.

It's really strengthening the mix of the business within automotive that we're focused on and being very, very selective of chasing North America.


The next question comes from the line of Shawn Harrison of Longbow Research. Please go ahead.

Shawn Harrison - Longbow Research

Just a follow-up on the restructuring question. By my math, it looks like there is about $150 million of fixed costs that have been removed here to date. The remaining of the manufacturing saves I'm guessing are going to be very back-end loaded until the facilities close, if that is correct. Just wondering about the timing of the additional OpEx savings, how we should see those role on?

Terrence Curtin

OpEx savings, for the most part when you say OpEx, I'm talking RD&E and SG&A. They are in, so we were able to execute those quicker, Shawn. So that $100 million structural, that is in place and I think you saw our SG&A this quarter actually came in lower than we guided last quarter based upon executing on those moves quicker.

Footprint, definitely as Tom said, on the six factories that are still in process. Some of those will go into early next year, middle of next year, but the bulk of it is in place.

Tom Lynch

You are in the ballpark on your estimate though there.

Shawn Harrison - Longbow Research

Okay, and then the other side of that, the $500 million in variable costs that have been removed to date, how should we expect those to come back as demand eventually recovers? I'm expecting it to be very gradual, but maybe if you could just kind of give me some idea of how to maybe model that as we look out into 2010 or 2011 if demand comes back, just to think about that dynamic.

Tom Lynch

The way I would think about it is some of it is definitely going to come back because it is in the categories of where there has been a freeze on raises, elimination or in most cases elimination of bonuses, extreme cutbacks on discretionary travel, anything like that. So you swing the pendulum very far as is needed. I would think about it this way, kind of the first billion dollars in revenue back, you would expect a couple hundred million of that to come and then a little bit less because in order to remain competitive in certain areas, you'll need to give some raises and things like that.

I mean we have a very tight fist around that $500 million. Right now, it's managed literally daily across our business. So it would gradually flow back and we want to keep out as much as we can frankly. When we talk around our targets now, we're talking around $300 million permanent, but it wouldn't be at all back in until you get to well north of $12 billion in revenue.

Shawn Harrison - Longbow Research

Okay. And then just I guess two final quick questions. Raw material costs, I know that you're still working through some of the higher priced purchases made back in the latter part of calendar '08. As those roll off, what should we expect to see any P&L benefit in 2010?

Then just on the Network Solutions business, I want to just get a clarification. It sounds like you are saying you are not going to see any type of seasonal uptick here in the June quarter or did I hear that incorrectly?

Terrence Curtin

First, on metals, you are right on how you have it. Inventory reduction that we are in the middle of and on the fixing we did at the end of last year, it is taking us longer to work through the fixing than we anticipated in the first and second quarter. So right now, we are still buying copper in the mid-to high 2s for when we do procure it. We are not buying a lot right now as we work through it.

So as you look at it, as you go into next year, if we stay at these types of levels, we would only probably buy 130 million pounds of copper. You can separate the price on that from mid to high 2s versus a market price and multiply it by the volume. And like we've said, we would anticipate about half of that may have to come back through pricing when we did raise it, but I think that's the way you think about it.

On Network Solutions, typically you are right and in the comments I made. Our utility business where we serve in the energy market, as well as the service provider side, we typically get a summer increase because of weather being better. Right now, with where capital spending are in those markets, we would expect that to really be flat sequentially.

Tom Lynch

Let me just add a little bit to that. I would say that is what we see right now in our order rate. If you take the other two parts of the network, our telecom plant business, the part of that business that is growing is the carriers around the world deploying fiber networks. And as you have seen the last three years, that tends to be lumpy. We really have a very nice product line there and have strengthened our share in the U.S. and our strongest base is in Europe.

That continues to be a little bit of a lumpy business, but it doesn't tie directly to economics. And then I would say thirdly in our enterprise or our building networks business, we are starting to see a little bit of a flattening out of the decline, which we had expected.


And the next question comes from the line of [Steven Fox] of CLSA. Please go ahead.

Steven Fox - CLSA

I guess just going back over the auto business a little, you mentioned the sharp decline in auto production worldwide since a year ago. Were you guys rightsizing the business? If you talked about the 19 million units going down to 11 million, where, in your mind, do you need to get your own production to match up against expected demand over the next few years?

And then just secondly, what is the implications for the margins in the auto business? Is there any permanent impairment that we need to worry about?

Terrence Curtin

First off on production, Steve, we did go down to 11 million units. If you look at that and you annualize that that would be 44 million units of annual car production. We don't believe that that is the right level. So where we have been sizing the business right now is that that comes back to about a 60 million unit level versus the 73 million we had last year.

So when you do look at it, we are sizing it for around a 60 million unit production level. And it is all for us to see when does that come back. Certainly we have lost a little bit of leverage in our automotive business going from 73 million to 60 million, that's why we are taking the costs out. Margin will be slightly less than where we have run historically, but that is built into the 12% at $12 billion model that Tom covered.


Then the final question comes from the line of Amitabh Passi of UBS. Please go ahead.

Amitabh Passi - UBS

Just had a couple of quick ones. My first one had to do with the automotive business too. There's a lot of excitement around the scrappage incentives in Europe and what not. Just wanted to get your perspective. A, do you have any concerns that we are probably seeing some level of demand being pulled in and what do you think the potential ramifications are further down the road?

And B, it seems like most of the increased volumes we have seen have been in smaller model cars. I'm just wondering how you sort of think about that in terms of your dollar content and potentially maybe incremental pricing pressures in these models?

Tom Lynch

Sure. So three things. I think what we are seeing in our business pickup is still more related to inventory correction. Most of the European and Asian automakers are just starting to increase production now or have plans to increase in May. So I don't think we have seen too much impact from a change in demand. We are not counting on it. I mean we are hopeful that it is going to happen, but it is not changing how we run the business.

We are assuming that inventory gets corrected and this is going to last for a while. Our marching orders continue to take the structure down and continue to focus on attractive new programs and be flexible to respond when it comes. I think we are seeing the ability to do that in the third quarter as it evolves.

Could you tell me the second part of your question again?

Amitabh Passi - UBS

The second part was just it seems like most of the incremental volumes have been in what appeared to be smaller makes, smaller model cars.

Tom Lynch

I think that is definitely the case and electronic content is lower in that case, but relatively, it is still on the newer cars that come out of a similar, let's say, category, small car, midsize. There is more content because there is more airbags, there is the move in Asia and U.S. with (inaudible) brakes and I should say vehicle stability systems. There is more entertainment. The entertainment systems are moving from high-end options to more standard in some cases. But no question, a high-end vehicle has more content than a midsize or low end.

So that is a little bit of pressure. We view that as more of a short-term thing because the whole history is people like to move up in cars. So we don't think that dynamic is going to change and it may be this way for a period of time for sure. Like I said, the way we are thinking about and the way we are managing the businesses, not assuming a recovery, being ready for one, but most importantly continuing to lower the cost structure so we can have an attractive business at much lower revenue.

Amitabh Passi - UBS

Then just very quickly on your industrial markets, particularly some of the so-called late cycle markets, including your exposure to non-res construction. Do you have any concerns that we might actually see sort of a prolonged period of weakness in your industrial sort of segment? And then just wondering as the mix shifts, assuming consumer does relatively better, industrial maybe slightly worse, does that have any meaningful impact on your margins?

Tom Lynch

It puts a little pressure on the margins because generally the industrial margins are higher and they are more custom in nature, the products. We are concerned. The industrial markets are definitely lagging and this typically happens in the consumer markets. So I think there will be a lag effect on recovery. As we indicated, we expect industrial to be down in kind of 5% to 7% range sequentially in the third quarter.

Amitabh Passi - UBS

just my final question and maybe this is for Terrence. If we were to normalize for the adverse impact on margins from your inventory work-down, assuming we get back to sort of "more normalized margins". As demand recurs and revenues grow, how do we think about incremental operating margins? I mean is it roughly in the 20%, 25% range as revenues sort of grow?

Terrence Curtin

I think as Tom mentioned, early on, it should be higher because of the cost actions we have had, so I think you will be higher than that rate. I think once you hit the run rate, up above $12 billion, you will probably be in that range both early on because of the temporary actions we have and the suppression we want to keep on these lower levels, it should be higher than that.


Back to you, gentlemen.

John Roselli

Thank you, everyone for taking the time and Keith Kolstrom and myself will be around all day to take any follow-up questions you may have. Thanks, everyone.


Okay, thank you. Ladies and gentlemen, this conference will be made available for replay after 10:30 am today until May 6 at midnight. You may access AT&T executive playback service at any time by dialing 1-800-475-6701, entering the access code 992567. International participants dial 1-320-365-3844. Again, that access code is 992567.

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