Ladies and gentlemen, thank you for standing by and welcome to the Tyco Electronics reports strong fiscal second quarter results conference call. At this time, all participants are in a listen-only mode. (Operator Instructions). As a reminder, this conference is being recorded.
I’d now like to turn the conference over to your host, the Vice President, Investor Relations Mr. John Roselli. Please go ahead.
Thank, [Tasha] and good morning. Thank you for joining our conference call to discuss Tyco Electronics second quarter results for fiscal year 2010 and our outlook for the third quarter and full year. 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’ve 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 addressed 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 tycoelectronics.com.
Also, as we announced this quarter we’ve renamed our Undersea Telecommunications business to (inaudible) Subsea Communications or Sub-Comp in short, you will hear us refer to it that way today.
Now, let me turn the call over to Tom for some opening comments.
Thanks, John, good morning, everyone. Let’s start with slide three. I guess the best opening would be a lot difference the year makes. We really had an outstanding quarter in the second quarter. Our sales were up 27% year-over-year and 2% sequentially. Our operating margin up 13.9% was up 240 basis points sequentially and well ahead of our 12/12 goal.
Our gross margin of 32.4% was the highest since 2007 when the company separated. Our earnings per share of $.64, was up 36% sequentially and significantly exceeded our guidance. If you recall our guidance, the midpoint of our guidance was $0.52 and we were over that by $0.12, $0.08 of that was operational, $0.04 was tax and intangibles, we will be walking you through that in detail. And our free cash flow was strong at $422 million and we are on track to deliver in excess of $1.2 billion of free cash flow for the year.
The performance was due to definitely improving economic environments with strong execution on the company’s part as well. The global economics environment continued to improve this quarter and we were able to capitalize on this trend. Our Electronic Components segment was up 55% year-over-year and 4% sequentially. This growth was broad based across all geographic regions and end markets and our CFO will walk you through each of the markets in detail in a few minutes.
This more than offset the decline on our Subsea Communications segment, as you know we have been foreshadowing and discussing that expected decline for several quarters now. We're really encouraged by the demand strength in most of our electronic components end markets and expect sales to stay at the current level in the second half as continued growth in the industrial markets offsets normal seasonal decline in automotive in the fourth quarter. And it's pretty clear that the environment is much better than three months ago and when we started three months ago significantly better than we expected when we started here six months ago.
During the second quarter we did begin to see a pickup in business levels in our Specialty Products and Network Solutions segment and as a result we expect revenue to increase about 10% in the second half in these segments. As you know these segments turndown later than components and they are recovering about two quarters later. Again this growth will more then offset the further softening in our Subsea business, which is now going to settle in at about 150 million per quarter range.
I’m also really pleased with our continued improvement in execution. Our gross margin increased about three points sequentially to 32.4% and this drove the adjusted operating margin increase to 13.9%. Improving gross margin has clearly been a top priority for the company for several years, the reduction in our footprint coupled with our productivity programs are clearly delivering results.
Our second quarter gross margin also benefited from (inaudible) point of favorable mix about half of which was due to very strong margins in the Subsea business. And those strong margins in Subsea Communications were directly related to excellent execution on the part of that team.
We expect gross margins to be in the 31% range for the balance of the year, which is approximately two points higher than our 2008 levels on about 20% lower revenues. Our operating margin has exceeded our near term goal of 12% and we’re well on our way towards (inaudible) milestone goal of 15%. We now expect to achieve 15% margins at a sales level of around 14 billion.
Timing, we had another very good quarter of free cash flow of $422 million in the quarter. We paid a quarterly dividend of 70 million and repurchased approximately 5.7 million shares during the quarter.
I also want to highlight our strategic progress in a couple of key areas as I typically do each quarter. In China, which is now the largest vehicle producing country in the world and they are on path to do 13 million to 14 million vehicles produced in China this year.
Automotive vehicle production was up 63% year-over-year in the second quarter, our China automotive business grew almost 200% in the quarter and we’re now on track to reach a $0.5 billion of sales through this market this year, so our China automotive business in fiscal year ’10, our current year is going to be about $0.5 billion. We continue to build on our very strong positions with both the multi-national OEMs as well as the local Chinese OEM.
In our Data Comm business, which is almost $1 billion in annual sales, our new high speed Data Comm product platforms continue to gain market acceptance and we have had several strategic win in U.S. and Asia over the last three months. It’s been a high priority business for us and I think in the last year our new platforms are really starting to catch on an increased design wins are coming as a result of that.
We also continued to improve our position in the mobile phone market with sales growth of 34% year-over-year. Over the past year we further strengthened our position with the leading handset makers and expanded our business across the high growth, high content smartphone segment of the market.
As we know this continues to be a growing market, slowed down a bit last year, the smartphone portion of the market is really accelerating and there is significantly more content in smartphones for companies like ourselves and we feel we’re very well positioned to take advantage of this shift in the market in overall growth.
And now I’ll turn it over to Terrence, who’s going to cover our Q2 performance in more details.
Thanks, Tom, and good morning, everyone. I'm going to start by reviewing our sales performance by segment and market and then I’ll get into earnings and cash flow. So if you start with slide four, this shows our overall revenue performance growth by segments both on a year-over-year and on a sequential basis.
Total company sales of just under $3 billion were up 27% year-over-year and the quarter. The growth was driven primarily by Electronic Components segment, which was up 55% with growth across all markets.
Excluding our Subsea Comm business growth was broad-based across all regions at with Asia up 64%, Europe up 29% and the Americas up just shy 20%. We also benefited year-over-year from currency translation which had an impact of about 470 basis points on year-on-year growth or roughly $100 million.
On a sequential basis our sales were up 2% with growth in the Electronic Components, Specialty Products and Subsea Communications segments, which is partially offset by a slight decline in our Network Solutions segment that was driven by typical seasonality.
In our businesses serving the consumer markets which is about half of revenue, our sales increased 73% year-over-year and 2% sequentially. Remember that this quarter last year was the low point in the downturn in these consumer markets. As expected, our Industrial and Infrastructure markets start to show improvement and our sales were up 3% versus the last quarter.
Order rates in the Industrial and Infrastructure markets improved throughout the quarter as evidenced by our three largest segments having book-to-bill ratios of 1.05 or greater. Our orders were up 6% in these markets on a sequential basis and this momentum supports our outlook for the improvement in these markets for the remainder of this year.
Now, let me get into segment performance by markets. When I talk to growth rates, all changes that I’ll discuss will be on an organic basis. So if we can turn to slide five. On the left-hand side of slide, let’s look at the key markets in our Components segments. In the automotive market, our sales versus the prior year increased 78% and sequentially were up 5% with growth in all regions.
Sequentially, automotive production was flat as approximately 17.5 million vehicles. However as expected, we did benefit from continued restocking in the supply chain. Based upon current projections, quarter three auto production is expected to be slightly down to about 17 million vehicles. We expect that our sales in the automotive market will be similar to quarter two levels as the effects of restocking wind down and our sales get back in line with vehicle productions.
And as Tom indicated, we do expect right now we will get normal seasonality beginning in the fourth quarter which typically is about a 5% decline going from quarter three to quarter four. In the Data Comm market, which includes sales to the communications equipment server and storage markets, our sales increased 8% year-over-year and were up 7% sequentially driven by the rebound that's occurring in the enterprise market, we’re spending on broadband infrastructure and data storage equipment has increased.
In the industrial equipment market, our sales were up 29% versus the prior year and up 18% sequentially. And we’re seeing improved end demand overall as capital spending increases and China is leading the way of the demand up turn and we did also benefit in this market from some distributor restocking.
In the appliance market our sales were up 56% versus the prior year and up 14% sequentially and we saw double-digit increases across all regions. In the computer market, our sales increased 19% versus the prior year and were up with 4% sequentially driven by end demand for notebook and netbook products.
And finally, in the consumer device market, which includes our sales to the mobile phone and consumer electronics markets, our sales were up 39% versus the prior year, but sequentially we’re down 8%. And the sequential decline was driven by post holiday declines and the end market demand.
Let me talk about Network Solutions on the right-hand side of the slide, our sales in the segment declined 6% versus the prior year of 1% sequentially. The sales declines were driven by continued capital spending reductions by our customers and a seasonal decline in the energy market.
As mentioned, these markets in segment are later cycle and in 2009 may began to decline approximately two quarters later than our consumer end markets. And we’re seeing a similar lag on the way back up. Order rates have improved in the segment and our book-to-bill ratio for the quarter was 1.05.
On the submarkets in this segment, sales to the energy market were down 7% versus prior year driven by continued lower spending and inventory reductions at the utility customers. Our revenues were down sequentially 5% due to the typical seasonality we get in this business in the winter months.
In the enterprise network markets, our sales increased 8% versus the prior year and were flat sequentially, reflecting improvement in the datacenter, government, and education markets, while the commercial construction markets continue to be weak.
Our sales to the service provider marker declined 15% versus the prior year due to the slow down in wireline capital investment in all regions. Revenues were however up 5%, sequentially due to increasing fiber deployments and international market, specifically Europe.
We expect this up tick to continue as the increasing demand for data any time and any where requires more capacity in both the wired and wireless markets. For our third quarter we expect total segment sales in the Network Solutions segment to increase about 10% sequentially with growth in all of our markets. This will be our first year-on-year increase in this segment since the quarter downturn.
Now let’s move to slide six, to talk about Specially Products and Subsea Communications. On the left hand side starting with Specialty, sales in this segment increased 8% overall versus the prior year and 6%, sequentially. The book-to-bill was 1.08 in quarter two and for quarter three we expect a mid-single digit increase in revenues overall.
Sales to the Aerospace, Defense & Marine market declined 8% versus the prior year, but we’re up 8% sequentially due to improvement that we’re seeing in the commercial aerospace and business jet market. During the quarter we saw a nice increase in our orders and for quarter three, we expect a low single digit increase in revenues sequentially.
In the Touch Systems business, our sales were up 6% versus the prior year and up 5% sequentially. We are benefiting from our sales into the retail market as the capital spending in that area continues to improve during the quarter. For quarter three we expected double digit increase in revenues versus quarter two driven by improving conditions in both the industrial market and the improved capital retail spending trends I just mentioned.
We are also seeing significant early interest in our newer Touch platforms that we talked about last quarter and although we don’t anticipate any revenue from these platforms until next year.
In our circuit protection business, which serves mainly our consumer markets, sales increased 67% versus the prior year and sequentially revenues were down about 1% as expected due to the normal seasonal decline and sales for the consumer mobile device markets.
And lastly, in specialty and our medical products business our sales decreased 5% versus the prior year while revenues were up 8% sequentially driven by improvement in disposable applications.
Looking at the right of the chart in our Sub Comm segments, as expected sales declined 33% versus the prior year, sequentially revenues were up 4%. Our backlog ended the quarter at $616 million and we expect revenue at approximately $150 to $170 million in each of quarter three and quarter four, which would result in full-year sales in the range of $700 million to $750 million, which is down from $1.2 billion last year. Rating and coding activity remained solid, although we didn’t put any large projects in the quarter.
We did win a project for approximately $125 million that would be going into our backlog in quarter three and we have been awarded portions of two other projects in excess of $100 million each that are in the process of obtaining funding. All of these projects will benefit 2011 and our initial view of 2011 sales for the Sub Comm segment is in the range of $600 million to $700 million.
Now let me discuss earnings which start on slide seven. Our GAAP operating income for the quarter was $398 million which includes restructuring and other changes of $12 million. In connection with our manufacturing simplification, we closed another two sites in the quarter and our current site total was 90. Our footprint simplification is on track and we expect to get down to a mid-80 site count by the end of 2011.
We also continue to refine our cost estimates and timing of P&L charges and we expect approximately 30 million of charges in quarter three and for the full-year we now expect charges of approximately $120 million, currently for 2011 we expect approximately a $100 million or less in charges. Overall, we’ve made excellent progress in streamlining the footprint and this has been the major contributor to our margin improvement as Tom mentioned.
Adjusted operating income was $410 million in the quarter with an adjusted operating margin of 13.9%. The pull through on sequential sales and improvement in margin continues to demonstrate our improved operating leverage from our cross actions and our ongoing productivity programs, this was particularly evident in the Electronic Component segment where the adjusted margin was 13.6% compared to a loss last year.
In addition, total company margin did benefit from the completion of certain contracts in the Subsea Communications segment, which positively affected overall margins by approximately 50 basis points in the quarter.
In quarter three we expected our adjusted operating margins to continue to be above 13%. Adjusted EPS for the quarter was $0.64 up $0.36 from the first quarter reflecting a growth in operating income and an approximately $0.04 benefit from a lower tax rate.
Now let’s move to slide eight. Turning at the top half of the slide, our gross margin in the second quarter was 32% and this gross margin is the highest level since our separation in 2007 and there is an increase of over 900 basis points versus the prior year and 300 basis points versus quarter one.
As I mentioned, one-time items in the Sub-Comp segment benefited gross margins by approximately 50 basis points. In addition, gross margin also benefited from volume increases and a slightly favorable sales mix in our component segment. Excluding these beneficial effects gross margin would have been approximately 31% and this is where we expect to be for the remainder of the year.
Looking at the bottom half of the slide, on operating expenses which did include both RD&E and SG&A, they were up $88 million year-on-year driven by the increase in sales as well as increased performance compensation and pension expense which I discussed last quarter.
Operating expenses were up approximately 8% versus the first quarter driven by further increases in performance compensation as the business has strengthened, as well as increased investment in RD&E and some currency transaction losses we had in the quarter versus currency gains that we had in the first quarter.
We expect that our RD&E will continue to be approximately 5% of sales and that our SG&A will decline by approximately $15 million on a sequential basis in quarter three and [applying] on quarter four. As a percentage of sales, our SG&A showed approximately 13% for the rest of the year.
Turning to slide nine; let me discuss items on the P&L below the operating line. Net interest expense was $32 million versus $38 million in the prior year due to lower debt levels. Adjusted other income which relates to our tax sharing agreement was $11 million compared to $3 million in the prior year, for quarter three, we expect this will remain approximately $11 million of income.
The GAAP effective tax was 31% in the quarter and the tax rate on adjusted income was 23%, this lower adjusted tax rate benefited the EPS by approximately $0.04 versus our guidance. In quarter three and for the remainder of fiscal 2010, we expect the tax rate on adjusted income of approximately 26%. We also expect to be able to keep our adjusted tax rate at 26% beyond 2010 based on the planning that we’ve completed.
And you may recall that when we separated from Tyco International, our adjusted tax rate was in the mid 30s and our goal was reduced by 200 to 300 basis points over three years. I’m very pleased with the progress we made to bring the rate down much faster than we originally anticipated.
Now let me talk about cash flow that’s on slide 10. Our free cash flow in quarter two was $422 million compared to $370 million in the prior year quarter and this increase was due to higher income levels and slightly lower capital expenditures.
Our adjusted cash tax rate was 8% in the quarter and continues to be lower than our normal cash tax rate of 20% as we’re utilizing net operating losses incurred in the prior year in certain international locations. We do continue to expect that our full year cash tax rate will be in the low teens.
Turning to our working capital metrics, we continue to have very good performance as business conditions improve. Our quarter two networking capital which is receivables plus inventory minus AP days was 66 days and that compares to 67 days last quarter and represents approximately a 20 plus percent reductions from where our working capital metrics were, create a downturn back in 2008.
When you look at our day sales outstanding of 62 days that was down four days versus prior year and one day sequentially. On inventory days on hand excluding contracts in progress, we were down 20 days year-over-year and five day sequentially to 63 days, which is where we expected to be and we expect to be in the 60s as volumes stay at these levels.
On capital, we spent $81 million on CapEx in quarter two, down slightly from prior year levels. We do expect our capital spending to pickup starting next quarter and we’ll run approximately 4% of sales for the remainder of the year and for the full-year we expect capital spending to be about $400 million.
Cash restructuring in the quarter was $55 million and for the full-year we now expect cash restructuring spending of approximately $200 million. When you take all of this, we expect our 2010 free cash flow will be greater than $1.2 billion and that includes to restructuring cash out flow.
Let's move to slide 11 to talk about our balance sheet. We began this quarter with about $1.7 billion of cash and ended the quarter with $1.8 billion. Uses of cash during the quarter included return of capital to shareholders of $219 million, which included dividends of $72 million and share repurchases of $147 million. Also at our annual meeting that we held in March, shareholders improved four quarterly dividends of $0.16 per share starting with the third fiscal quarter of 2010.
As we discussed on the last call, we plan to increases our share repurchases in quarter two and during the quarter we repurchased approximately 5.7 million share or $150 million. At the end of quarter two, we still have approximately 440 million remaining on the current share repurchase authorization and absent any significant acquisition activity, we would expect to use the reminder of this authorization in this fiscal year.
And finally, as we talked last call, we did complete the acquisition of Sensitive Object during the quarter, which resulted in a net cash outflow of $55 million.
Let me turn the call back over to Tom.
Thanks, Terrence. I will now give the third quarter outlook, talk a little bit about the full year outlook, and recap what we’ve just said and then we will open up the Q&A. For the third quarter, we expect our sales to be in the range of $3 billion to $3.1 billion, which is up 20% to 24% year-over-year and 1% to 5% sequentially.
Excluded the expected decline in our Sub Comm segment, our year-over-year organic growth should be 30% to 34% and 47% sequentially due to the increased strength in our networks solution and specialty products segments.
Adjusted operating income is expected to be in the range of $395 million to $420 million compared to $410 million in Q2. The Q3 operating margin should be in the range of 13.2% to 13.6% and this is a slight decline from where we are in Q2 driven by the Sub Comm margin decline which we would expect was very high, unusually high in Q2.
Our Q3 adjusted earnings per share from continuing operations are expected to be $0.61 to $0.65. At this time we are also reintroducing a full year outlook. Sales are expected to be in the range of $11.8 billion to $12 billion for our full fiscal year ‘10 which is 15% to 17% growth versus the prior year and up 22% to 24% excluding Sub Comm and this translates into full year adjusted EPS from continuing operations which are expected to be in the range of $2.32 to $2.40 compared to $0.83 last year.
So just to wrap up, we really feel we had a good first half, clearly economic conditions improved during the first half and we’re encouraged by our order rates over the last quarter as well as the first month of this quarter, (inaudible) we are equally feeling good about is the strong execution. If you comparer us to when we launched three years ago we have a much more focused business portfolio and much more efficient manufacturing footprint which we reduced by 33% in that time.
And we’re also better in the good old faction area of productivity, this has enabled us to improve gross margins at a 31% plus range and it’s clearly demonstrating better operating leverage in the company, which was of the highest priorities for us as we separated.
Cash flows will continue to be strong as we generate in excess of $1.2 billion this year. Stronger earnings, better management of our capital and continued improvement in working capital management. And then as we talked about a year ago when was business was difficult, we felt the best thing to do is to structure the business, take costs out to structure the business around to $12 billion revenue level that we generate 12% adjusted operating income. I think that’s turned out to work out pretty well for us and we’re now running at about 13% at the $12 million revenue level.
And I feel very confidence that we have line of faith for 15% at a $14 million revenue level. And the way to think about that is, the model would look like this, gross margins in the 32% range R&D in the 5% of sales range, SG&A in the 12% of sales range and I would also translate to net income in the 10 plus percent of sales range and return on invested capital all in including good will at 20% plus. So I think we’ve got to key it up, we have to continue to execute, but we feel like all the work of the past three years has really started to kick in.
And then the last point, I think we’re maintaining the right balance of keeping our strategic option open, options open in returning cash to share holder, as Terrence explained, we turned over 200 million, but I think as we’ve consistently said our priority is to continue to strengthen the company strategically. We took a step to strengthen our Touch business last quarter, and it’s still early -- with that acquisition of course, but we’re excited about the prospects in the next couple of years and we are building an asset pipeline much more active than we’ve been here in the last three years, but then I assure you that we’re very thoughtful about the what we are going to do with that pipeline and how we are going to approach it.
Well, with that, a good quarter and let’s open it up for questions.
(Operator Instructions). And first question will come from the line of Amit Daryanani of RBC Capital Markets. Please go ahead.
Amit Daryanani - RBC Capital Markets
Thanks a lot, good morning, guys. May be just to start off here, given the strength you guys have seen in your Electronic Component and the Specialty Products side, can you just talk about how much of that business is direct versus through the channel and then you see a material delta between your selling rates into the channel versus to the OEMs?
The normal split for our business is about 80% direct, 20% channel and what we considered direct is when we design in with the end customer, so in automotive that could be a product that ultimately goes through a tier 1, but we’re getting design win by the end customer. And I would say to the second part of your question, we’re not seeing any material difference in the buy rates from either category of the market.
Amit Daryanani - RBC Capital Markets
Got it. And then nice to see the full year guide and you guys are pulling in a 15% margin target on 14 million sales now. If I kind of work to math roughly speaking, you guys are looking at about 20% incremental margins from today’s -- the quarter you just reported?
Sorry Matt, when you look at that remember we do get some benefit out of our Sub Comm business being 20 plus percent earnings and as we’ve said all along, when it gets into where we guided that $600 million to $700 million next year, it should be in the lower teens. So you do need to adjust out for that. You would get in off that 13 plus rates that we’ve got for rest of the year, more of a high 20% fall through rates than where you quoted.
Amit Daryanani - RBC Capital Markets
I’ll stop that question there, so maybe a different one then. Can you just talk about what your current utilization rates are and given sort of the phenomenal book-to-bill you guys just reported today. At what data point you need to stop adding more capacity on a CapEx basis and increase your OpEx to meet uptick in demand?
I mean we have been increasing OpEx in our factories in our supply chain, but we’re covering that with productivity. So there is no question that we’re adding more people back to respond to the increase in demand and all the supplies and everything that go with that. So, that is reflected in the current results from a capacity point of view our bricks and mortar we’re planning good, absolute manufacturing capacity, I think we’re fine at the capital investment levels that Terrence talked about in the 4% to 4.5% range. And the most variable part of our capital spending is the tooling that we spend, which is that half of our capital spending related to new program.
So as we win new program that’s the piece that varies the most. But we don’t -- I would say, we don’t feel pinched on capacity, where there's pinch points and there are still some, that is less than a quarter ago, it’s more the expanded supply chain of material. We are not delivering in some cases the (inaudible) of life tends to be the supply chain more that our fewer manufacturing capacity.
I just want to ask everyone limit their questions to one question and one follow-up, we have a lot of folks in the queue and want to make sure we get to every one.
And next question comes from the line of Amitabh Passi of UBS.
Amitabh Passi – UBS
My first question just had to with your expectations for auto. Can you just remind us as you go from September to December, what we should expect in terms of the sequential changes in production? And then I just wanted to confirm as we look at from 2010 to 2012, do you still think to 64 million production number in terms of units for 2010 and 73 for 2012 is still, what you’re sort of planning for or your estimates right now?
Amitabh, it’s Terrence, let me take that. Where we have been is, if you look at quarter one and quarter two, car production including light vehicles that we put in [hours] was around 17.5 million vehicles built on the plan in the past two quarters. We do see a slight sequential down tick into the June quarter down to around 17 million vehicles and then we do expect to get into what is typical automotive seasonality down about 5% in production in quarter four. And as a mentioned on the call, we view that this protocol is when we’ll get hooked completely back again with production is our expectation now.
For the year that equates to those numbers, equate to about $68 million build level and current use of next year is more around low 70s, 71 million is where we see it. So it is coming back faster than where we talked before. Yeah, we certainly, I have said 73 which was the ’08 level more like a 12, it looks like we could be getting it earlier in 12 from a production perspective.
Amitabh Passi – UBS
Got it. And then just one follow-up, I'm just trying to get to the midpoint of your EPS guidance for next quarter. One is, you can give some commentary around OpEx and then the fact that you're going to exhaust the full $40 million in your share buyback plan. Should we assume share count down 6 million, 7 million sequentially, would there be some offset there?
When you look at our guidance, I think the right way to think about from what Tom, and I mentioned is, we did benefit from a lower tax rate this quarter versus the next quarter’s guidance which is about $0.2 difference. SG&A that I talked about going down will add about a penny or two and then the volume benefit really offsets the gross margin coming down a little bit. That's really how you get to the midpoint of our guidance. From a share count perspective just how it works, it will come down little bit probably not to the full amount that you mentioned just due to how the accounting guys make the average. But we are anticipating to use right now the rest of your authorizations through the end of the year.
Your next question comes from the line of Matt Sheerin of Thomas Weisel Partners.
Matt Sheerin - Thomas Weisel Partners
Question regarding the gross margin, sounds like it’s somewhat capped at 32% still pretty high, we’re just trying to figure the components that go into in terms of leverage going forward, and inline with that, could you talk about materials pricing, copper and other cost that maybe headwinds going forward. And then also the ASP environment in terms of your pricing to customers given that demand is good, are you able to keep prices firm or even increase prices in some cases?
Let me, if I forgot one of those, remind me. If you start with the where the gross margin level is, as Terrence pointed out, a few benefits, one related to execution, one related to business mix in the quarter, but the 31% we feel very good about. We have a wide range of businesses and products all related around connectivity and 31% is pretty healthier margins. And think about 31% for the balance of this year, I mean we don’t feel we’re limited 31 or 32 necessarily, but we got to take one step at time to improve them.
In terms of headwinds, baked into our second half is some slight copper headwinds, copper at 335 is slightly higher than what it costs us in the first half of the year where we benefited from fixed purchases we made, but fundamentally the combination of our productive programs and what I would call selective price increases, because on this business really every business close that we have an opportunity to bid on, you have to factor in really we want to be in price. But having said that, pricing has been pretty stable all year, I haven’t seen really much of a material change. We’re looking even where copper is at some selective increasing in the second half to offset that.
Matt Sheerin - Thomas Weisel Partners
Then just as a follow-up, just looking at your guidance for the year, it looks like you’re expecting revenue to sort of flatten up a little bit here. Tom, could you just give us a take on where you see demand playing out, because obviously you’re benefiting and other suppliers are benefiting somewhat from this inventory to restocking that’s been going on and it’s been hit consumer in auto first and now we’re seeing in the industrial markets. So there’s some lag there, but what’s your sense of that whole inventory restocking replenishment. When do you think that starts to end and when do you start to grow more inline with your OEM and EMS customers?
The big one for us of course is automotive, that’s by far the biggest piece of our business that affected by that and we see that getting inline next quarter. What you really start to look at where production and the industry, the industry right now is calling as Terrence mentioned about 68 million vehicles produced around the world and about 68 million sold around the world in our fiscal year 2010.
So we had less inventory related replenishment benefit in Q2 and that pretty much is done by Q3. We have a little dip in automotive in Q4, but that’s the model changeover for lot of the company. So that’s the typical seasonality. If you look at the rest of our consumer businesses, consumer electronics, handset were important to relatively small. I think in PC, largely through that cycle already and industrial wasn’t much of that to begin with and again smaller pieces of market in automotive, but there wasn’t so much, so I’d say, it largely behind of them.
Our next question comes from the line of Jim Suva with Citi.
Jim Suva - Citi
My first question and then the follow-up, I’ll tell you the same time too, but the first question has to do with the outlook of sales, which is $3 billion to $3.1 billion has higher than the reported $2.6 billion this quarter. The EPS guidance is you posted $0.64, but you’re guiding $0.61 to $0.65. I understand maybe a penny of tax, but it just seems like you have more sales, you have restructuring doing traction. Why wouldn't the guidance of EPS to be higher? Is there some conservatism built in there or kind of what disconnect between higher sales and not higher EPS?
Then the follow-up question has to do with the Undersea business. I think like it's been several quarters in a row discussions bidding on projects and I'm just wondering is this more of funding issues that the different entities are having to fund some of these contracts or there’s just a little bit of uncertainty in the demand environment has causing the economic reasons to call some of these companies not to build out some more, or we just kind of had a structural lower level that we should think about here or potentially there’s a buildup of additional contracts that should really help at some point in the future? Thank you.
Let me take your outlook question and then I’ll ask Tom to talk about Sub Comm. When you look at it sequentially, the tax impact having a 23% tax rate, which we had a quarter 2 to the 26 is actually a $0.02 differential Jim. So when you look at that that is an element that is a drag.
The other element that we had that we talked about was the Subsea over earning from a gross margin what it did on the rates, so with the gross margin coming from 32 to 31 that is about $0.04 negative. Offsetting those negatives, when you think about it is the volume impact that you talk about, which would have offsets the gross margin slight down draft and then the other benefit we have is SG&A coming down by $15 million, which is a couple of cents. So when you look at those, there’s two negatives, gross margin coming down, tax going up slightly and then the positives are the volumes as well as the SG&A benefit that we talk will also be coming down. Tom will talk about Sub Comm.
On Sub Comm, as you know we came off with a couple of really big years $1 billion plus years, which had several two really large contract, one over a $0.5 billion and one over $300 million. There continues to be a fair amount of activity, I think there are some that are taking longer because of funding. I think we’re confident that eventually happen that the projects tend to be more in the $100 million to $200 million range.
I think in a sense the wildcard is the visibility out beyond six months. I mean we know what our backlog is, but typically the way the business works as the folks are deciding to build a network, while they’re in that process of deciding and gathering their funding in their business plan that is very little bit visibility around that for their competitive reasons.
Once they decide, they want to go forward that’s when they pull companies like ourselves and to give them a bit on how to do it. So these are big major strategic investments, we don’t typically have year or two year visibility to a pipeline. We tend to see it when our folks have decided. They’re going to do something for sure and then they start to bidding process with us.
If you go back over the last three years, I think generally there’s been more activity than we have expected. Again due to the visibility and I think we all know that’s really due to sort of the data anytime, anywhere and data rich transmissions, more video, YouTube, et cetera. So our focus is to make sure we have the right balance of capacity and that we can capitalize on most of the upside and that we ensure in the event of significant downside. We’re still profitable and better than cost of capital and that model has been working pretty well for us for the last four years.
Thank you. Next question comes from the line of Shawn Harrison with Longbow Research; please go ahead.
Shawn Harrison - Longbow Research
First question just ask to deal with the revised against sales range for the 15% EBIT margin. If you could talk to maybe what's change versus one to two quarters ago, where you’re looking at $14 billion to $15 billion in terms of maybe what's more profitable or maybe how the mix of businesses changed a little bit, I think you’ve told into target on the lower sales level?
I think the main thing is the execution is happening. We were confident that we would get through things like the restructuring, but when you’re taking that much off line and moving in someplace also it’s a bit of risk, a clean up of the portfolio has certainly been a major contributor. I think we’re better at pricing from values than we were towards the years ago and we’re getting the leverage in the Electronic Components segment.
I think if I’d have to pick one thing, the business is there really done an excellent job of getting the cost out and as the business comes back and the revenue ramps managing extremely effectively through productivity that these groups have been working on for a three years now. We’re much more protective than we were. So I think that’s the combination of those things, but I had to say hey, which exceeded your expectation Shawn, and most if it’s the productivity we’re getting in the day-to-day running of the business. That contributes most of that point improvement, the 13 and 12 that’s now given up the confidence to talk about 15 and 14.
Shawn Harrison - Longbow Research
Then just to be follow-up question is your different global automotive sales run rate you’re looking to get to that $14 billion and then my follow-up question is just on the later cycle businesses, the specialty products and network solutions. Just maybe if you could characterizing what you’re seeing over the next six months and kind of what inning you believe you’re in, in terms of the recovery there? Thanks.
Shawn, we talked about a different automotive run rate, I assume in the different growth rates in the region.
Shawn Harrison - Longbow Research
Either growth rates of the region have a global production number, I think previously that 15% EBIT margin target you are using kind of a mid 70s global production number?
I‘d say it’s still in that 73, 74 million unit range. So that’s a little bit, that’s a little bit better, I mean that’s happening faster as Terrence said and plus our operating leverages is a little bit better in that business then where we start we would be six months ago, so that’s a combination and then we’re doing extremely well in the emerging markets and automotive and there’s nice leverage there as well.
In terms of the late cycle businesses, I’m not counting on anything extraordinary, but accounting on them getting back to a growth our profile in second half of the year that’s 10% second half versus first half and then getting into their portion of the recovery for SPGA network, but I would say that what’s really given up the confidence to go between $14 billion and $15 billion revenue say it’s going to be around $14 billion, as we’re getting the productivity and we’re especially getting it in Electronic Components.
Thank you. Next question comes from the line of Brian White of Ticonderoga.
Brian White - Ticonderoga
I’m wondering, if you talk about a little bit about the trends that you’re seeing by geography and specifically for auto?
Sure, I would say starting with Asia, as we alluded to this incredible growth in China, two weeks ago I’ve visited one of the local Chinese OEMs in a small town of 3.5 million people, four hours from Shanghai and 12 years ago they were starting their business and now they are. If they were producing in the U.S. that be number three. So its happening the infrastructure is being built quickly over there that drive, that four hour drive was on a six-lane divided highway, so it’s moving quickly and people want to own cars.
Japan not as a consuming country for say, but as a manufacturer of mobiles, is picking up again, so the experts are picking up as well as pent up demand in Japan. So Asia as a whole is really solid up 25% solid double-digit growth for us right now. Europe has been solid growth for us and I think we expect that especially Europe and U.S. to go more into the seasonal slowdown in Q4, but I think you’ve heard the numbers recently as companies like Todd, where sales were strong, and most folks are attributing it so there is it. People are feeling better and there is pent up demand, so I’d say, we fell things are going to start leveling off around this 17 million for the next couple of quarters, but that’s a pretty robust level compared to where we thought would be six months ago.
Brian, to give you may be to add to what Tom said, if you look at the 68 million vehicles we quoted, that’s up about 20% versus ‘09 and certainly Asia overall is up almost 30% in that, but China certainly out earning Japan and Korea. Certainly, we have the rebound in North America from our production, we see North America production to be up 30% this year, and then EMEA is up low double-digits it’s around 12% from a production levels, just sort of pitch into some of the numbers.
Brian White - Ticonderoga
If we look at this recovery, so they started restocking, there were some incentives, people thought auto sales will drop off after the incentives they haven’t. Do you believe the auto market has entered a new cycle and how would you compare this cycle versus other cycles?
Well, I wish I knew. I hope they are, but I think it’s still too early to tell. I would say, the indicators are positive that you wouldn’t be unrealistic to think about a normal growth profile next year for vehicle production and for our business in relation to that, but we don’t have any unique view beyond the next two quarters.
Yes Brian, there’s been no cycle like this in the automotive industry history, so typically and then we talked about it before. The auto typically gets to pre-recessionary bills. We talked that about four years after. So we never had anything as deep as what we went through last year. So certainly every thing that we’re seeing does feel quicker, but to Tom’s point there’s never been a cycle where we seen, what we went through last year, but it is trending quicker based upon what we see in the short-term.
We also didn’t have China, like we do today and we also didn’t have to move to hybrid electric automobiles probably
To that point, I think if you get away from what do we think the numbers are going to be in the next year is hard to call, we love the fundamental. I mean we love the fundamental that half the world have been driving for a few years really and electronics is going to continue proliferate and you look at these cards that have been made by the Chinese OEMs.
I mean they are not low content cars, they are not European car content average, but content moving up, people like features and they decided to buy a car they typically want a several of the features then you lay in on top of that hybrid vehicle, electric vehicle, electronic content goes up, that benefits us. So we think the fundamental in the business are really, really good overtime and of course they’re good right now as we’re in the recovery page.
Next question comes from the line of William Stein, Credit Suisse; please go ahead.
William Stein - Credit Suisse
Guys, I’m wondering if you can talk inventory a little bit. It was up about 6% in dollars and six days in the quarter. Can you give us an idea for what we should expect going forward, and also can you quantify the impact on our profitability in the quarter from the inventory built?
When you look at, the impact on the quarter was nil, I mean, we’ll just take that first. Secondly when you look at it, we have been saying that, as the business came back and as we wanted to make sure we were serving our customer, we would be getting back into that. As you model it, I think you have to model about where that from a metric perspective, certainly I’ll move with volumes we do expected to say and where is that right now.
William Stein - Credit Suisse
One more, if I can on the restructuring side, it sounds like you’re talking about new charges coming in that might not have been formally announced as kind of a new restructuring program to have that right, and can you give us an idea for how big this one is going to be and what the impact on kind of standalone basis excluding the leverage?
If we love anybody without impression, we loved you with a wrong impression. I would say just the opposite. Last year, as I think we told everybody was the peak of the restructuring it’s comedown, and we executed that plan a little ahead of plan, so we’re getting close so where think we need to be given where the outlook of the businesses that’s always going to be fine-tuning in the business like this. I think about this well passed the peak of restructuring and no big new restructuring programs to be announced.
What I’ve mentioned during the call is consistent with what we’ve been talking about us the part of the major program volumes down, there’s nothing new…
William Stein - Credit Suisse
So the charge that’s going to happen next quarter and I think there’s a little bit more in Q4 that you imply that just holdover from stuff that’s already been announced, is that right?
As we show (inaudible) we will take one more question.
Okay. And the final question comes from the line of Craig Hettenbach of Goldman Sachs.
Craig Hettenbach - Goldman Sachs
Nice to see the buyback activity, a lot of other companies have been slow to do that, but what does that say just about the M&A environment and potential pipeline out there and how should we think about capital allocation going forward?
I think sure the way to think about our capital allocation is the dividend first, at least to say the debt level first, but that's behind us. The dividend first, strategic moves to strengthen the company and not that we are ruling anything out, but as we’ve said often I believe that for the right opportunities we’d like to do that in networks in our specialty products business. And then to the extent that those opportunities don't present themselves or they don't percent themselves on a timely basis. We would return capital to shareholders.
We have about 440 million left on the current buyback and so as Terrence said, absent anything that we’ll take priority over that, you can expect that to happen over the balance of the year. But clearly, we have been spending a lot more focus over the last year building the pipeline for two years before that, no question on priority was to get the business focused and the structure very sound, so that we could grow faster organically. I am very encouraged about the organic opportunities in the company. And I mentioned one big one I mentioned in China automotive, but we fell there's a number of allowance there that remains our top priority. But with the cash level we have we're clearly looking at opportunities in our pipeline. I think we would also be fair to say that we’ll probably going to be around the current cash level, we wouldn't build that much more. So that in conjunction with 440 less on the buyback authorization from last year. How I would model at [inaudible] for now.
Craig Hettenbach - Goldman Sachs
Okay. And then on the follow-up, the strength you're seeing in the industrial market is that really just the broad macro recovery is there anything specific to Tyco from a design win perspective that's driving some of that strength as well?
I think it's more, it's definitely more strength in the market and any particular design win I mean we’re having success there, but that’s the very fragmented business. So that's very customized its not a business were you introduced a platform and you'll get hundreds and millions of dollars of revenue from it, it tends to be kind of the one of customized business and its coming back as people are buying capital equipment again. So that's the big driver.
Craig Hettenbach - Goldman Sachs
Got it, thank you.
Thank you very much. Thanks everyone for calling in. And we’ll talk to you soon.
Thank you. Thanks, everyone.
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