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Tyco Electronics Ltd (NYSE:TEL)

Q3 2010 Earnings Call

October 28, 2010 03:00 pm ET

Executives

Keith Kolstrom - IR

Tom Lynch - CEO

Terrence Curtin - EVP & CFO

Analysts

Matt Sheerin

Amitabh Passi

Amit Daryanani

Steven Fox

Craig Hettenbach

Shawn Harrison - Longbow Research

Steve O'Brien - JP Morgan

William Stien - Credit Suisse

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the Tyco Electronics Report Strong Fiscal Fourth Quarter for year 2010 results conference call. At this time, all participants are in a listen only mode. later, we will conduct a question and answer session. Instructions will be given at that time. (Operator Instructions) As a remainder, this conference is being recorded. I would like to now turn the conference over to our host, Mr. Keith Kolstrom, Senior Director of Investor Relation. Please go ahead.

Keith Kolstrom

Thank you for joining our conference call to discuss Tyco Electronics fourth quarter results for fiscal year 2010 and our outlook for the first fiscal quarter at full year 2011. With me today are Chief Executive Officer Tom Lynch and Chief Financial Officer Terrence Curtin. During the course of this call, we will be providing certain forward looking information. We ask to review the forward looking cautionary statements included in today’s press release. In addition, we will use certain non GAAP measures in our discussion this morning and we ask you to review the section of our press release in the accompanied slide presentation that address the use of these items.

The press release and related tables along with the slide presentation can be found on the investor relations portion of our website at te.com. finally, for participants on the Q&A portion of today’s call, I would like to remind everyone to limit themselves to one follow question to make sure we are able to cover all questions during the allotted time. Now let me turn the call over to Tom for some opening comments.

Tom Lynch

If you could please turn to slide number three. Q4 was another strong quarter for the company. A revenue of just over $3.1 billion was up 16% year-over-year and was at the high end of our guidance range and our adjusted earnings per share was $0.72 which was up $0.42 versus last year and was also at the high end of our range. Our adjusted operating margins were above 14% again this quarter and I think that’s a clear indication we’ve really strengthened the company’s operating leverage and our consistently delivering about 14% margin at the $12 billion sale level which was an important objective for us. And we are on track to achieve 15% plus operating margin at the $14 billion sales level.

Free cash flow was very strong at $443 million in the quarter as a result of increased earnings and continued solid working capital management. So a pretty solid quarter for us in Q4. now, I'll do a quick recap of the full year. We also felt 2010 was the year very good performance for the company. Sales were up, sales were at $12.1 billion, up 18% and adjusted operating margins improved to 13.7% which was up almost 800 basis points from the prior year. we exceeded the target of 12% margin at $12 billion in revenue that we planned the business around during the downturn, about impacting our strategic investments cause I'm sure you recall 18 months ago and the business was pretty difficult, the 12 at 12 scene is what we embarked on in the company and drove through the company and we’re pleased that we’re able to exceed that and now be delivering 14% at 12.

The key to achieving that through the improved margin were driven by the strong flow through on the volume growth, the benefits of our restructuring program which is now substantially complete and improved productivity. We also made several moves in the past year to strengthen our strategic position. In July, we announced an agreement to acquire ADC which will significantly enhance our position in the broadband connectivity market. We also made some small technology acquisition through the year to strengthen our position in the data communication and touch markets. We had another year of very strong cash flow generating $1.4 billion, up approximately $180 million versus last year. We returned approximately 60% of this cash to shareholders almost $800 million in the form of dividend and share repurchases.

Last month, we announced our board of directors approved the $750 million increase to our share repurchase program and we also planned to request shareholder approval for dividend increase of 12.5% as part of our annual meeting in March. This increase would be effective in June 2011 quarter when approved. So we’re happy with the fourth quarter. I think we finished the year strong, had a year of really good progress in a number of areas and not just for 2010. and now, I’ll turn it over to Terrence who is going to review our Q4 results in more detail.

Terrence Curtin

Let me start by reviewing the sales performance and then I’ll get into earnings as well as cash flow. If you could return to slide four please. In the fourth quarter, we had both year-over-year and sequential sales growth in all of our segments excluding sub communications. Total company sales are just over $3.1 billion were up 16% year-over-year with growth primarily driven by the electronic components segment. Excluding the SubCom segment, growth was broad based across all the regions with Asia up 29%, the Americas up 25% and Europe up 16%. Currency translation did decrease our overall growth on a year-on-year basis by approximately 250 basis points.

On a sequential basis, sales were up 2%. Solid mid single digit growth and our network solutions and specialty product segments were partially offset by the expected decline in SubCom and lower growth in the component segment primarily due to typical seasonal declines in the auto business. Currency translation benefited overall company growth by approximately 80 basis points on a sequential basis as well as compared to our guidance. The currency translation above our guidance really drove our sales being involved the mid point of our guidance range. Now, let me get in some highlights of key markets in each of our segments and unless otherwise indicated, all changes that I’ll discuss will be on an organic basis. So please turn to slide five.

Starting with the component segment on the left side of the slide. In the automotive market, our sales increased 26% versus the prior year and were down 3% sequentially. Year-over-year, sales were up 34% in the Americas, 25% in Europe and 22% in Asia. Sequentially, our sales declined as a result of the expected production declines in Europe and in China. Global vehicle production was in line with expectation at about 17 million units in the quarter and based upon current projections, we expect quarter one auto production expected to remain consistent with the quarter four levels. The increase in production in Europe will be slightly offset by production declines in Japan. Turning to the Datacomm market which includes sales of the communication equipment, server and storage markets, our sales increased 51% year-over-year and were up 9% sequentially, driven by both new customer program launches and continued spending on broadband infrastructure and data storage equipment.

In the industrial equipment market, sales were up 56% versus the prior year and 5% sequentially driven by increased capital spending and factory automation particularly in Asia. When you look at the segment overall, we do expect quarter one sales to be similar to quarter four at levels. We expect sequential growth in the automotive market to be offset by declines in Datacomm and the industrial markets due to inventory adjustments and distribution channel that we believe will work through in the first quarter. now turning to our network solution segment on the right side of the slide. Sales in the segment were up 15% versus the prior year and 6% sequentially due to increased capital spending in all of the end markets.

Sales in the energy market were up 11% versus the prior year with growth in all regions. Revenues were also up 9% sequentially due to the continued recovery by European utilities and normal seasonality. Sales to the service provider market were up 28% versus the prior year. sales were up 4% on a sequential basis with growth in Asia and the Americas while Europe remained at the strong levels we saw in quarter three. We continue see steady improvement in fiber optic network investment in most regions. And the enterprise networks market, our sales increased 12% versus the prior year and were up 3% sequentially, reflecting growth both in Asia and the Americas. In quarter one, we expected sales in the network segment to be down approximately 5% versus quarter four due to typical weather related seasonality.

And turning to slide six to cover specialty products and SubCom. Sales in our specialty products segment increased 18% versus the prior year and 5% sequentially. Sales to the aerospace, defense and marine market were up 16% versus the prior year and up 3% sequentially due primarily to an improved commercial aerospace market. In our touch systems business, sales were up 30% versus the prior year and 10% sequentially driven by additional retail and industrial business applications. In quarter one, we expected segments to be down approximately 5% sequentially primarily due to expected decline in the retail portion of our touch systems business. if you look at the right hand side of the slide, let me cover sub sea communications.

As expected, our sales decline 46% versus the prior year and 14% sequential. Booking is the quarter were $37 million and we ended the quarter with $475 million in backlog. As we covered on the last call, we have been awarded two contracts for about $300 million combined which are currently in the process of securing funding and we expect to have them backlog by the end of the calendar year. we expect revenue of approximately $150 million in quarter one and for the full year 2011, sales expectations remained in the range of $600 to 700 million. now let me discuss earnings which showed on slide seven. Our GAAP operating income of the quarter was $382 million which includes a non cash loss of $41 million on the previously disclosed sales of mechatronics business, $14 million of restructuring charges and $8 million of cost related to the pending ADC acquisition.

As I’ve discussed in prior quarters, the restructuring program we started in 2007 will be completed in 2011 and in quarter one, we expect approximately $10 million of charges and about $30 million of charges for the full year. Adjusted operating income was $446 million in the quarter and the adjusted margin rate was 14.2%. margins were up 600 basis points versus the prior year due to the volume increases and the operating leverage from the prior cost actions as well as our ongoing productivity programs. Sequentially, margins were down slightly as expected. As I discussed on our last call, margins did benefit in the third quarter by approximately 80 basis points from favorable project execution in the SubCom segment and currency gains. Adjusted earning per share for the quarter was $0.72, up from $0.30 in the fourth quarter last year, reflecting the growth in volumes, a significant improvement in our operating margins driven by our gross margin expansion, a lower effected tax rate and as well as the benefit of share repurchases executed during the year.

So let me turn to slide eight to talk about gross margin and operating expenses. Starting at the top half of the slide, our gross margin in the fourth quarter was 31.7%. This improved 600 basis from the prior year gross margin at 25.6% due to the strong operating leverage we achieved on the incremental volumes. Sequentially, gross margin was down slightly due to the Q3 SubCom margin benefit that we did not expect to re-incur in the current quarter. As I covered previously depending on the end market mix and currency rate, we would expect gross margins to remain in the 31 to 32% range at the current sales levels of $3 to 3.2 billion. Looking at the bottom half of the slide, operating expenses were in line with the guidance I gave on the last earnings call of approximately 5% for RD&E and approximately 12.5% for SG&A.

Expenses were up $78 million year-on-year, driven by the increase in sales and up versus quarter three due primarily to currency exchange effects. In quarter one, we continued to expect that our RD&E will round about 5% of sales and that our SG&A will remain approximately 12.5% of sales. turning to slide nine, let me cover items on the P&L below the operating line. Net interest expense was $34 million in the quarter compared to $36 million in the prior year. it was slightly higher than we guided but we do expect a similar level for quarter one. Adjusted other income which relates to our tax sharing agreement was $12 million compared to $9 million in the prior year. for quarter one, I expect this will be approximately $14 million of income. The GAAP affected tax rate was 36% in the quarter and the tax rate on an adjusted income basis was 23%.

The GAAP to tax rate was impacted primarily by a settlement of a pre-separation share tax matter. The impact of this was approximately $0.05 per share. The adjusted tax rate of 23% was slightly lower than our guidance due to the favorable tax and income mix at the end of the year. this had a positive effect of approximately $0.02 per share compared to our guidance level. In quarter one and for the full year 2011, we expect the tax rate on adjusted income of approximately 26%. Now let me turn to cash flow and the balance sheet that starts on slide 10. our free cash flow in the fourth quarter was $443 million and this compared to $608 million in the prior year. higher earnings levels in the current year were partially offset by increases in the capital spending and working capital due to the higher volumes.

Our free cash flow for the year was a record at $1.4 billion, an accomplishment we’re very proud. Our performance to the last two years continue to show our resiliency of our company’s cash during and certainly some economic turmoil. Our adjusted cash tax rate in the quarter was 20% and we expect a mid teens cash tax rate in 2011. Turning to the working capital metrics, our day sales outstanding of 65 days was down one day versus the prior year and flat sequentially. Our inventory base on had excluding contracts from progress of 63 days was flat sequentially and up four days year-over-year. And as I mentioned previously, we expect to be able to maintain inventory days at this level moving forward. Continuing to discuss working capital, over the past two year, we’ve made significant progress improving in this area. And just to highlight this specifically, we’ve been able to reduce our net primary working capital which is AR plus inventory, less AP as a percentage of sales from 24% in 2008 to the current level where we’ve been running around 20% and we expect to be able to keep it down.

In capital spending, we had a $136 million in the quarter, approximately 4.3% of sales which was up from the prior year low levels of $58 million. We expect the capital spending for the full year 2011 to be approximately 4.5% of sales or in line with depreciation levels. Cash restructuring in the quarter was $38 million and we expect about $15 million in quarter one. Certainly, now that the restructuring efforts are winding down, we do have a tail from a cash perspective. This cash will wind down as we go through the year and we do expect about $130 million of cash outlay due to the cash restructuring events we previously completed. We expect 2011 free cash flow will be in excess of $1.2 billion including the restructuring spending I just mentioned and in the first quarter, free cash flow will be approximately $100 million as this is typically our lowest quarter of the year.

Let’s move to slide 11 which get into the balance sheet and our liquidity. Our cash balance increased $175 million in quarter four and we ended the quarter with about $2 billion of cash. The majority of the remaining free cash flow that we generated in this quarter was used to return a $186 million of capital to our shareholders through the dividend payments of $71 million and the repurchase of approximately four million shares. We did also make a $69 million voluntary pension contribution during the quarter. As Tom mentioned earlier, our board of directors approved an increase to the share repurchase authorization by $750 million and we now have approximately $815 million outstanding on the authorization. Since separation, approximately $1.9 billion have been returned to shareholders due to repurchase and about 61 million shares.

And we continue to expect share repurchases in 2011 with the near term rate and pace will be affected by the timing of the funding requirements related to the pending ADC acquisition. We expect to use of the $2 billion, about half or a billion dollars for the acquisition of ADC and we’ll find the remainder of the 1.25 purchase price with that. As mentioned on this morning’s press release, we continue to expect that the ADC acquisition will close in the current quarter and as we perform our integration planning, we continue to validate the strategic merits of the deal and we see no changes to the financial guidance that we previously provided. Before I turn it back to Tom, let me cover page 12 which highlights the change in our segment reporting structure.

Affected with the new fiscal year, we had streamlined our management structure to further alignment of similar businesses. The specialty product segment has been merged with existing businesses and our SubCom business has been aligned wit the infrastructure business and our network solution segments. As a result of these management changes, we will go from four segments to three segments as you can see on the slide and the three segments will be transportation connectivity, communication and industrial solutions and network solutions. When transportation connectivity will include the automotive business from a current component segment and the aerospace defense and marine business from the specialty product segment. Communications and industrial solutions will include the non auto markets of the current component segment and the touch, medical and circuit protection businesses of the specialty product segment.

And finally, the network solution segment will include the current network solutions segment and the SubCom segment and will also include ADC once the acquisition is completed. We will provide a recast financial information for the new segments via 8K and we expect to file this by the end of November. Now let me turn it back to Tom.

Tom Lynch

Thanks Terrence. Why don’t we move to slide 13 which shows an overview of our orders since the fourth quarter of 2009 and I’ll take a little time to describe the trend we’re seeing in the business. In our largest business which is automotive, demand continues to strengthen. The industry is now projecting world wide 74 million units will be produced in our fiscal year 2011 versus 72 million in 2010 and that was recently upped in the last month. World wide production is now back to 2008 levels, well ahead of I think what any of us would have predicted a year ago, driven primarily by growth in the emerging market. And in the two largest markets China and the U.S. we expect the fiscal year 2011 auto production to be up 5% and 4% respectively.

Both those markets had huge growth in fiscal year ’10 with China close to 50% and the U.S. in the high 30’s and we expect that to slow down but to nice healthy level. If you look beyond the one year outlook, we continue to be really very bullish on the long term outlook for this industry as we get around to our customers around the world, it’s clear that the investment and the commitment of hybrid and electric vehicles and building the infrastructures is well underway. So I really believe this is defiantly moved past the if this is going to happen and is now clearly into when this is going to happen and make sure we’re well positioned to take advantage of that transition when it really begins to happen in earnest and as you know when you’re talking a hybrid electric vehicle or a pure electric vehicle, you’re talking a significant increase in our type of content.

In our industrial and infrastructure markets which collectively accounts for about 50% of our business, capital investment did begin to strengthen in the second half of the year and we do expect this to continue in fiscal year 2011, the big drivers underlying this are investments and factory automation, broadband infrastructure and energy infrastructure in both the broadband and energy infrastructure side of our business, investment in general have been relatively low the last few years as our customer cut back and we’re now seeing a pick up and we believe that is sustainable. And then in our non consumer, our non automotive rather consumer markets which accounts for about 15% of our business and includes market such as PCs, mobile devices and consumer electronics, demand has improved from last year but this one hasn’t recovered as much as we would have expected and I'd say, we’re a little less certain about the rate of growth although we do, we would that this will pick up probably in our fiscal second or third quarter of 2011.

Let me turn now to slide 14. Now based on the trends I just described, the following is our guidance for the first quarter in the full year. For the first quarter, we expect our sales to be in the $3.05 to 3.15 billion range, essentially flat with Q4 and up organically by about 10% over last year’s first quarter. The year-over-year increases is broad based across all of our markets offset by the decline in SubCom which we have been fore shadowing for a while. Our Q1 earning per share or adjusted earnings per share are expected to be $0.66 to 0.70, up about 45% from the prior year first quarter and down just slightly versus the quarter we just completed, our fourth quarter of fiscal year ’10 where we generated $0.72. If you take the mid point of the Q1 guidance, $0.02 of the sequential decline is due to taxes and Terrence mentioned that and $0.02 is due to the lower expected volumes and distribution. And the way to think about this quarter is in essence we expect Q1 sales and adjusted EPS to be roughly at the same level of Q3 and Q4 of fiscal year 2010.

So the business has settled in at a nice solid $3 to 3.1 billion revenue level. For the full year, we expect sales to be in the range of $12.8 to 13.2 billion which is up 6 to 9% versus fiscal 2010 and remember fiscal 2011 includes a 53rd week which will occur in the fourth quarter. This additional week adds approximately 200 basis points or $240 million to the year-over-year growth. You take that out and look at it on our purely 52 week to 52 week comparison. We are expecting organic growth to be in the 4 to 7% range and sales to be in the $12.6 to 13 billion range. The key assumption underlying this full year production are that are auto production around the world will be at approximately 74 million vehicles, up above 3% but our SubCom business revenue as we mentioned earlier was going to be in the range of $6 to 700 million. this is down from $720 million our fiscal year ’10 and for the remainder of our businesses, we continue to expect them to be driven by nice growth in the emerging markets and relatively low growth by historical comparisons in the U.S. and Europe.

This all translate into a full year adjusted earnings per share that we expect to be in the range of $2.85 to 3.05 on a 53 week basis compared to $2.54 in 2010 and this would be an increase of 12 to 20%. And again on a 52 week comparison, we have more of an apples to apples EPS would be up 10 to 18% on our organic growth of 4 to 7%. And this guidance assumes current foreign exchange rate and commodity prices. So before we open it up for Q&A, just a quick summary of all that. We thought 2010 was a good year for the company. As you know, the actions we began several years ago and accelerated during the down turn enabled us to significantly improve operating leverage that was really our number priority and we’re now consistently generating 14% operating margins at the $12 billion sales level. And I think an important point to note is we’re able to generate returns per share this year of 254 that was equivalent to the pre-crisis 2008 level when our sales were $14.4 billion. So the net of all that is we feel like we’re operating at a much more flexible way.

We’re also gained strength in many of our end markets by continuing to invest aggressively and engineering during the downturn. We now have about 7000 plus engineers around the globe, close to our customers designing products. We feel that’s our real strength of our company. And in this past year, we did make some strategic acquisitions. One of them, the big one ADC which we talked about earlier but we also made several smaller acquisition and the technology area of fiber optics connectivity, high speed data communications and touch systems which strengthened our portfolio product and technologies in those areas and we believe really all high growth technology driven areas which is where we want to focus any M&A that we do. And of course, we continue to strengthen the balance sheet during the year and we returned almost $800 million capital to shareholders. So all-in-all a good year consciously optimistic as we enter fiscal year ’11 and now let’s open it up to questions.

Question and Answer Session

Operator

(Operator Instructions). One moment please for the first question.

Tom Lynch

Operator? No questions coming?

Operator

All right. Our first question is going to come from Matt Sheerin. Please go ahead.

Matt Sheerin

Yes, thanks and good morning, everyone. So my first question has to do with your guidance for fiscal '11. It looks like you're looking for EPS to grow at about 2X or more than sales given that there's potential headwinds on the margins, gross margin side with rising material cost, where's the leverage in the model on the operating margin side and below the margin line?

Tom Lynch

Nice questions. It’s in both but it’s primarily in the operating margins side. So if you take a 4 to 7% organic growth rate that and we’ve been consistently dropping flow through on revenue of 25 to 30% in that range. So that’s the significant contributor. We would expect in our planning for our operating margins and our gross margins to continue to improve through out the significant contributor. We’re still getting the benefits of the restructuring that we’ve done as well as productivity programs which we believe will largely offset in conjunction with selective pricing the current head winds in that commodity. And then of course, we get some leverage from the cash flow and some lower shares. Terrence you want to?

Terrence Curtin

Yes. Just right now, I think Tom explained up in the operating margin there. Below the operating margin right now, from a tax perspective, its pretty neutral year-on-year with the 26% I guided to. So that’s not there and there is some benefit of both the share purchases we’ve done last year to Tom’s point and as I’ve said on the call, we will continue with the excess capital we generated. There’s nothing strategic to do it. So there will be some benefit but it’s primarily through the operating margin expansion.

Matt Sheerin

Okay. And the operating margin, that's going to come from both some improvements in gross margin and then leverage off the expense line, right?

Terrence Curtin

Yes. It will be improvement in the gross margin and it will also be as we certainly the quarter one guidance is similar to quarter four. We will leverage the SG&A as go and the revenue increases similar to the model that we told you about previously now. RD&E we still expect to be around 5% of sales.

Matt Sheerin

Okay, thanks. And then just for my follow-up, you talked about a correction in distribution in the industrial market and in DataCom. Could you elaborate? It sounds like you're looking for just a one quarter correction. What kind of visibility do you have there?

Tom Lynch

Matt, you’re correct. We do see it as a one quarter correction I think. With a strong rebound in the push out of lead time and folks scrambling for parts in a lot of industry last year, the multiple sources of components, de-stock inventory but the good news was I don’t think in anything that anything got really out of hand. It just had a little bit of a more growth than I think in the channel than any of us kind of would have liked. So, we see that as a one quarter adjustment relatively minor but definitely there’s a little more as we do our channel check and work very closely with our partners. Others are a little more in the channel than I think we both deals as optimum.

Operator

Our next question comes from Amitabh Passi. Please go ahead.

Amitabh Passi

Thank you. Tom, I'm just curious, why go ahead and put out a full year guidance this early? Just if you could elaborate what you're seeing, what gives you sort of the confidence and the conviction that you can do the 4% to 7% growth? I would love to hear just a little more in terms of your thought process.

Tom Lynch

Sure. Yes. Especially after the last couple of years right? Several things. When we look at our last two quarters and the current quarter we’re in, the outlook quarter, we really do see demand pretty broad based stabilizing at the $3 to 3.1 billion level. When we talk to our customer, what are they planning and of course, all these things can change as we know but a pretty consistent thing across customer is about what they’re expecting for the point that I have more confidence that we’d have in a long time but clearly, its still uncertain and when we translate into with the business is going to look like, we felt we had a much stronger like depend on and certainly in the prior six quarter to talk about a year out.

And that’s why we wanted to be clear with the big assumption. Automotive at 74 million units is not a big stretch from 72 where it is at now. You could argue there’s some conservatism in some of those regions and there might be found aggressiveness and other could unbalance that. That looks like a reasonable number to us. If you go to back to last three year in the infrastructure business, there really wasn’t I mean, there was everybody did about as bare minimum as they could, investing in infrastructure in terms of energy and telecom. So we see a lot of activity around the world whether it be fiber or the X sold out or just upgrading the grid, certainly alternative energy has a lot of momentum behind it. And then, probably the most uncertain is our consumer side but that’s only 15% of the business.

But when we take all that in, it seem the better thing to do is to give a full year guidance with a pretty clear set of assumption and we’ll update it every quarter but I'd say we feel it’s pretty balanced right now.

Amitabh Passi

Okay. And then just for my follow-up, you mentioned fiber to the X activity around the world. Could you just update us what you're seeing in the pipeline? And I'm also interested in knowing if there's any update on the Australia NBN project. We've seen a couple of system vendor announcements, Alcatel-Lucent and Nokia-Siemens. So I'm just wondering when you think the passive infrastructure vendors are announced and how you think you're positioned?

Tom Lynch

Yes. I know. I think that there is a lot of activity. NDN is probably one of the ones that’s getting the most which is the big build out in Australia. Latest information we got is sometime, maybe this quarter, early next quarter decisions will be made on who’s going to be awarded it. We feel good about we’re going to have that sizeable participation in that. In Europe, we’re seeing activity pick up for sure across several of the major telecom operators and it’s reflected in our order rates and our business the last couple of quarters. And I think we had a nice product range before the ADC acquisition and once that closes, I think we’re going to have an excellent product range through out the entire network on cyber connectivity as well as copper.

And while copper is a mature piece of it, its still an important part of the network but we’re really excited about the cyber product range that we can bring to our customer literally from beginning to end of the network and customers increasingly are looking for that to simplify their lives. But we’re bullish on broadband. That’s why we did the ADC deal and we wanted to be the leader in broadband connectivity and the past decide. And we feel it’s going to be really good for us.

Terrence Curtin

Just to add to Tom. On NDN, just on the progress, we would expect pretty little revenue in ’11 based upon the work calendar. So for our share that we would hope to get, we probably won't kick in until more into ’12.

Operator

Question comes from Amit Daryanani. Please go ahead.

Amit Daryanani

Just a couple of questions, first off, with your orders being down around 9% and I guess it's down 6% ex the undersea business, can you just talk about what gives you the comfort to guide revenues flat when orders are doing down?

Tom Lynch

Sure. Couple of things. Orders were really robust in Q3. So that backlog has it going away. I think you take the distribution side where there’ adjustment going on, the way that adjustments taking care of is orders are being reduced. So if you look that one chart, I forget which one it is, it shows the book to bill over the course of the year. The book-to-bill was very positive which meant backlog bill. We’re still in 0.99 and historically, this business over in the normal cycle is going to run a little more than one. Then if you take our most recent completed months that we’re in, the order rate definitely supporting. It’s a positive book-to-bill. So it’s affording the revenue level that we’ve guided to in Q1.

So we have a lot of data points there that gives us confidence.

Amit Daryanani

Got it. And just back on the commodity headwinds, can you just talk about if there's any change in your hedging strategy as you go forward? And is there some explicit assumption you have in terms of commodity headwind that you saw in September and the December quarter guidance you're providing?

Terrence Curtin

Yes. Amit, is serious. When you look at it certainly, our risk management process, I've been doing that for many years that has not changed. So we do fix but with gold and copper outnumber numerous months. Typically, the first six months going out. Last quarter, we did have about $10 million of extra costs due to metal net of our hedging program. So that was included in there but when you look at it, next year, we assume current market rates with our hedging program and that is a headwind that we do have growth in next year as part of our guidance. And we have like Tom said, both through pricing and our productivity programs, we feel we can mend.

Amit Daryanani

Got it. And then just finally for me you guys are changing the segments right now. If I remember this I think right at the start of the recession you guys decided to split the specialty products and essentially the take was you were going to focus aggressively to drive better growth on it. And you're just kind of merging that segment into two other segments. What's the mandate to focus on it not successful or not as successful as you thought it was driving you to merge it into other segments now?

Tom Lynch

Yes. If you go back little over two years ago, when we were receiving of that specialty product segment, our top priority there was really to sort through the product pruning that was going on components segment of the divesture or the divesture activities, we had a clean up quite a bit of the portfolio and the restructuring activity was just coming in the full swing. We felt that taken these short smaller business that was kind of worrying that maybe we weren’t getting enough attention with all that going on and putting them into a separate segment. I would help us focus on the bigger challenges in the company while at the same time, not loose focus on those four.

I think that was successful for us but as we went through the last round of strategic planning process and is very much one of the key focus areas and how do we leverage across our business and define opportunities to grow faster and how do we find more synergy in the company, it was pretty clear that the time had frankly, the specialty products sweeper service purpose that there was a lot of commonality in some of the products and some of the environments in both aerospace, defense and marine and automotive harsh environment, high end relay to go into aircraft, same products go in the an electric vehicle and lets get the synergies and those products and then our other businesses.

The really device and equipment connectivity puts them back into the re-organized communications business, communications and consumer business. And that’s why we did it. I think the other point I'd make is we have three segments. Under there, we have about 20 businesses. And those businesses, sort of the integrity of those businesses has been intact pretty much since separation. There’s a medical business, its really how we talk about the business. In Terrence section, there’s a solar business, there’s a general manager, there’s a team that owns that P&L and at this point in time, these three segments we feel is the best way to aggregate and get the most out the synergy of having those businesses together. So it’s actually a pretty much of non event in the company to change it around as I'm slugging the business and slugging it over here to learn any management changes or things like that.

Operator

Our next question comes from Steven Fox. Please go ahead.

Steven Fox

Hi, good morning. A couple questions, just first of all, just to be clear on raw materials, can you just quantify the impact a little bit better in the quarter on what you're thinking is a potential drag as you go into next couple quarters given where copper, gold and plastic prices are?

Tom Lynch

Quarter four that was just ended, it was about $10 million of increased cost sequentially and we do expect an additional $10 million going from quarter one. Before impacts of pricing and productivity, we take all our hedging and it’s about a $50 to 60 million headwind in 2011 versus 2010.

Steven Fox

Okay. And then when you look at just your global trends and what you're outlining, your sales into Europe I would imagine are benefiting from some export demand out of that region. Is it possible to quantify how much that's contributing to growth? Is it more than normal? Is it a big factor? Any color on that would be helpful.

Tom Lynch

Its mainly auto and then industrial equipment and large portion in particularly of the cars made in Germany are going to China and the U.S. China is specially consuming a significant portion of the high end cars of the German manufacturers. So they clearly the biggest impact for us in auto, the secondary impact is a lot of company ourselves included increasing plans to automate what is historically been very labor intensive operations in China and Japan and Germany really I think most consider them the world leaders in its kind of automation. So there’s definitely a lot of export in that segment too.

So we’re here to say take a snapshot about business in Europe. The export piece is very strong. The non export piece is a little tepid, no surprise given with the GDP is over there.

Steven Fox

And is it fair to say you expect that to continue? Is it baked into your full year outlook?

Tom Lynch

Yes. We do expect that to continue.

Operator

Our next question comes from Craig Hettenbach. Please go ahead.

Craig Hettenbach 

Yes, just Tom, following up on the comment on select price increases, given that the industry is now coming back into better balance and is not as tight, do you think there can be any resistance to that from your customers?

Tom Lynch

Definitely. I think there’s always resistance. And that’s why we say it’s a lack. You really can break it down into sort of three types of our businesses. Our infrastructure business which tends to be large projects you negotiate a big project and you have established pricing for several years. And so, you tend to be locked into that. then there’s anything that goes through the channel where we have the opportunity to periodically, typically once a year maybe sometimes twice a year adjust prices and I’d say that’s where you have the highest success rate and then the rest of the business which is the project in ’10 that you’re working with the OEM’s out there.

They are putting out 50 more projects to bid and your bidding on them and really just have to be competitive and that’s where you work on each one of those to optimize your price which often takes the form of a smaller productivity commitment that you give to the customer meaning they’re asking for certain price down every year and we come in and point out, hey, here’s what’s going on with gold and copper and we try t get that price reduction to be a little less. Its operating on different fronts with the way I would say that I think that we would expect customers to as supply-demand continues to give back more balance to be a little more aggressive on price. But that’s what we’ve been used to operating in and that’s why we do things like significant reduction in the foot print, rolling out lean with 2000 and now trained lean practitioners about the company to make sure that we have consistent fundamental productivity improvement across the board cause in electronics, you live in world of price erosion.

Craig Hettenbach

Okay, and in autos you mention high-end German car export for China. Looking out over the next 9 to 12 months, based on just current design pipeline and production plans for your customers, how would you describe just changes in mix within automotive, in terms of dollar content implications?

Tom Lynch

I would say that we’re hearing from our customers what they’re telling us to be prepared to do, we do not see a significant change in mix. It takes a really significant change in mix to move our content off the $62 to 63. So we do not have in this for sure, in this one year outlook or guidance, we don’t have any change in mix of any substance to take in.

Operator

Our next question comes from Shawn Harrison, Longbow Research. Please go ahead.

Shawn Harrison - Longbow Research

Just regarding the channel, now that you're seeing some, I guess [sell-in] pressure could you maybe describe the sell-through environment? Have you seen any adjusting for seasonality change in terms of product sales going through the channel?

Tom Lynch

No. I'd say so though its been pretty stabilized or stable which is encouraging. So we haven’t met the number that’s with our partners. We work very closely cause that’s always a clear indicator of how to sell through the moves. Is there something going on? So sell through is moved, is pretty solid right now. Sell in was a little higher than sell through last quarter. Maybe a little bit at the end of the first quarter. Not drastically higher. We’re thinking that it is a kind of a $15 million adjustment on our sale grow in a quarter going forward. So we’re not looking at anything massive but its enough to notice.

Shawn Harrison - Longbow Research

I guess, too, then I mean, lead times seem to be part of the factor here. Do you think your lead times kind of across the board are back to maybe more normalized levels?

Tom Lynch

Yes. I would say that there’s a few product line, not so much in the inter connect product but still have longer than normal lead times where it is real global capacity constraints but if you look in the bulk of our business, I'd say we see it in our past two backlog going down, all the indicators are that lead times are pretty close to normal.

Shawn Harrison - Longbow Research

Okay, and then just kind of a follow-up for Terrence. In terms of just pension assumptions, liability assumptions for 2011, anything changed versus 2010 that we should be aware of here on the income statement or the cash flow statement?

Terrence Curtin

Not all. I mean we took typically just sits on the cash flow. We typically made $70 to 90 million of normal cash contribution in the year. That’s what we’re planning and our free cash flow guidance. And then on the pension expense, it’s going to go up a little bit but not much. That’s meaningful Shawn. So when we look at it, we’re well funded to begin with. Most of our plans are frozen especially in the United States. We don’t have as much volatility as other.

Operator

Our next question comes from Steve O’ Brien, JP Morgan. Please go ahead.

Steve O'Brien - JP Morgan

Can we talk about the pacing of the 4% to 7% organic growth in fiscal '11, starting the year at 6% to 9% growth? Will there be sort of a settle-in, I think maybe like Tom mentioned here, or is it maybe a modestly slowing year-over-year growth trend for the remaining quarters in terms of or maybe you can put that in context of seasonality as well?

Tom Lynch

Sure Steve. Kind of give you a couple points. You go back to the year we just ended. Revenue builds gradually through the year. So seasonality wasn’t as apparent because of the recovery coming of such a little base. So we don’t. If you take our SubCom business aside, we build, kind of built the revenue a 100 million a quarter. 278, 27, 28, 39, 30 X would be SubCom. So kind of the steady march of recovery with the last two quarters settling in including SubCom around 31, the first quarter 31. So you do have in the first half of fiscal ’11, we’re running at the 31 rival and you compare that to the first half of ’10, you’re going to have a high organic growth in that period. Then we will have a in the second half.

Our current assumption for the second half is that the stronger seasonal period for us slightly improving economic condition but we’ll have growth but it won't be tie as the year-over-year growth we have in the first half because we’re coming of a lower base in the first of ’10. So we kind of see it as steady gradual march through the year. No hockey stick, no hey, all of a sudden, everything gets better and the second half of our fiscal year ’11 which is another reason to the other question why we saw enough confidence to give a full year guidance.

Steve O'Brien - JP Morgan

Great. And I guess on the -- sort of the same token for a follow-up here, we talked, I think, last quarter about the cyclicality of network solutions in specialty products lagging the recovery but so maybe being a little bit later cycle. Should we think about those businesses potentially having another couple quarters of acceleration before the overall moving back to the trend of the overall business?

Terrence Curtin

Steve, when you look at it, as I said and during the call, we do expect network solutions. They had a nice recovery here at the past couple of quarter. They do get impacted so network solutions specifically by win or war, both in the utility energy business as well as in the service provider business where we do actually seasonally slow. So what we do expect coming off quarter four that network solutions will be down about 5%. What that typically says down in that level going into quarter two and then accelerates in quarter three and four, you expect my comp sets seasonal increases later in the year but being a little bit stronger as we some of the initiatives that Tom talked about both in energy infrastructure and broadband kick in.

So we do see network solutions being back to its seasonal pattern but when it comes back in the summer, it will be a little bit stronger.

Tom Lynch

And I think that’s going to net into the high single digits year-over-year growth ’11 versus ’10 that we see every and our assumption is that the recovery continues.

Operator

Our next question comes from William Stein, Credit Suisse. Please go ahead.

William Stien - Credit Suisse

Hi, can you help us understand what happened with the operating margin in network solutions? You saw a good up tick there. It's also the business that you're going to be putting ADC into, and I'm trying to find out if that was related to this commentary around fiber-to-the-node and fiber-to-the-home deployments or if it's something else?

Terrence Curtin

If you look at it, well, its couple of things. Number one is it is the volume coming in across all the segments and it has but not later. So the fact to Steve’s question, it did continue to strengthen through its seasonal strong period and we got very nice follow through as you mentioned and in it. So when you look at it, it continues to improve and its really come in and improvement in that volume across our other 10 markets. So what came through this is pretty balanced. We will step down a little bit going into next quarter, just through the seasonality but the margin improvement we saw last quarter is what we expect our network solutions to march up to as it comes off the low point that’ been there.

William Stien - Credit Suisse

Okay, so less related to mix and more related to volume? Is that right?

Terrence Curtin

Definitely.

William Stien - Credit Suisse

Okay, and then there were some comments in your prepared remarks around the adoption of hybrid electric vehicles. Is there something going on there that kind of is representing a forecast for outsized growth in those types of vehicles relative to traditional that you know about and maybe you can share with us on a region basis?

Tom Lynch

Yes. I would say it’s not in the next couple of year but we’re changed at least from my own personal direct observation of going on particularly in China and visiting with our customers in China. Its their level of investment and developing the vehicle and the government, the level of support and investment in working to, with companies to develop the charging stations and even experimenting now in certain cities in China if you are having electric scooter, you can go to a charging station where that charging station exists, you can go to them and plug in and charge right now, I think it’s no charge because they are trying to get the habits going to adapt to electric vehicle.

So I was with a customer three weeks ago in southern China, OEMs and I mean they are full out working on this and its impressive. And in China, its expected the initial focus so that the government can help it along is going to be in taxis and buses as the first wave. So from difference from two years ago, a lot of talk had to due to extra now lots of company investing and you actually see charging stations. I don’t know how effective they are yet or anything like that but its not on the drawing board anymore, there’s some real product. So I'd say that’s the difference. You certainly see the U.S. company are adjusted with it and as you know, our biggest automotive business is in Europe.

And so we’re right in the middle of working with all of our customers there and what they’re trying to do. So this is in planning or slide ware. I mean we’re seeing the customer spend lots of money, demanding lots of products from us so that they can move the ball forward on this. I don’t think it’s going to be significant business in the next few years but we kind of see this, same happening 2015 and beyond. I meant they’ll be some business before it ended but net of getting position now for that.

William Stien - Credit Suisse

Great, that's helpful. Thank you. One really quick one if I can, there were some comments around lead times and the book-to-bill. To me it seems very related. I mean we can expect when lead times are coming in for book-to-bill to decline, and it has no -- it seems to me to have little to no relation to the forecast. If the lead times are coming in you'd expect orders to slow. Am I thinking about that the right way?

Tom Lynch

I understand your question. I think I do. Well, I think you’re right. When you have demand that far exceeds supply, we do it on our supply as you put lots of orders in, you want to make sure you’re in line. I think less of that happened this time because where everybody would just a year and half ago. and so, we fully expected the book-to-bills there to come down and get to their kind of normal rate. 1.1, 1.2, 0.99 and so, I think that’s there’s no surprise in that in an offense, its another sign of things getting back to normal in terms of lead times, supply demand, synchronization, steadiness of order rates, at least that’s what we hope, that’s what it seems to be pointing to.

And that’s what our assumptions are based around.

Keith Kolstrom

Operator, we have time for one more question.

Operator

Okay. Our last question will come from Jim Suva with Citi. Please go ahead.

Unidentified Analyst

Yes, good morning. This is actually [Samuel Nee]. I'm in on behalf of Jim Suva at Citi. I was wondering if you can provide some details about the longer strategy of the undersea fiber business given the growth of bandwidth consumption? I know you were awarded two contracts recently and expect sales in the range of $600 million to $700 million this year, but if we look out two to three years what does that segment look like as a percentage of total sales? And maybe highlight larger products that you're focusing on?

Tom Lynch

Couple of questions in there. it’s a very important business to us. We have the leading market position there, both front and we have significant strength both in our core fiber transmission capability that was really invented by this group back in the Bell Lab, this day before it was acquired by Tyco International and came with Tyco Electronics and separation. So great technical capability a very capable, fleet capability which is very important to being able to efficiently and make money as laying the cable. Coming of the boom cycle of three year, settling into a what we think for a couple of year will be this kind of $6 to 800 million range.

This year, we’re calling it $6 to 700 million range. And then, we don’t really comment on the big project. There’s only a generally kind of 15 of them at a time and our customers require that because these projects tend to be held very close to the vest by the carrier consortiums that are building them but we would expect them in the next few years for activity to pick in the Atlantic as network area is pretty old and the bandwidth is limited.

Unidentified Analyst

Thank you. I appreciate it.

Tom Lynch

The last three years has really been in Asia, Middle East and Africa which we think there’s still a lot of work to do there but everything we see sometime in the next several years in the Atlantic will get some activity again.

Unidentified Analyst

Thank you. That’s helpful.

Keith Kolstrom

Okay. that wraps our call for today. Please contact the IR team with any questions you might have and thanks and have a great day.

Terrence Curtin

Thanks everybody.

Operator

Ladies and gentlemen, this conference will be made available for replay after 10:30 a.m. today through November 4th. You may access the AT&T Executive Replay System at any time by dialing 800-475-6701 and entering in access code 170757. International participants may dial 320-365-3844. Those numbers again are 800-475-6701 and international participants 320-365-3844 with access code 170757.

 

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