Harman International Industries' (HAR) CEO Dinesh Paliwal on Q2 2016 Results - Earnings Call Transcript

| About: Harman International (HAR)

Harman International Industries Inc. (NYSE:HAR)

Q2 2016 Earnings Conference Call

January 28, 2016 11:00 ET


Yijing Brentano - Vice President, Strategy and Investor Relations

Dinesh Paliwal - Chairman, President and Chief Executive Officer

Sandy Rowland - Chief Financial Officer


Ryan Brinkman - JPMorgan

David Leiker - Baird

Brian Johnson - Barclays

Adam Jonas - Morgan Stanley

Joseph Spak - RBC Capital Markets

Brad Erickson - Pacific Crest Securities

Tavis McCourt - Raymond James

Chris McNally - Evercore ISI

David Lim - Wells Fargo Securities

Nate Brochmann - William Blair


Ladies and gentlemen, thank you for standing by. Welcome to the Harman Fiscal 2016 Second Quarter Earnings Call. [Operator Instructions] As a reminder, this conference is being recorded Thursday, January 28, 2016. I would now like to turn the conference over to Yijing Brentano, Vice President, Strategy and Investor Relations. Please go ahead.

Yijing Brentano

Thanks, Dmitry. Good morning and thank you for joining our second quarter fiscal year 2016 investor call. I am joined in Stanford today by Dinesh Paliwal, our Chairman, President and Chief Executive Officer and by Sandy Rowland, our Chief Financial Officer.

If you haven’t done so already, I invite you to visit our newly redesigned Investors section of our website where you can download copies of our earnings release and the supporting slide presentation that we will be referencing today. Before Dinesh and Sandy provide their remarks on the quarter, let me remind you that certain statements during this conference call and question-and-answer session maybe forward-looking in nature as defined in the United States Private Securities Litigation Reform Act of 1995. These forward-looking statements are based on management’s beliefs, assumptions and current expectations, but are subject to a number of important risk factors and uncertainties, which have been fully described in the press release that we issued this morning.

Now, let me turn the call over to Dinesh.

Dinesh Paliwal

Thank you, Yijing and good morning, ladies and gentlemen. I am very pleased to report that earlier this morning we released solid results for the second quarter. Excluding the impact of foreign exchange, net sales increased 19% to $1.8 billion. Our performance on the top line again resulted in double-digit EBITDA growth. We expanded our operating margins and generated $225 million in EBITDA and reported earnings per share of $1.84. On a constant currency basis, EBITDA was up 20% and earnings per share, was up 9% compared to the prior year. This is now our 11th consecutive quarter of top and bottom line growth.

Let me give you some additional color specifically on Connected Car division. Q1 came in 19% top line on constant currency; Q2, 9%; first half, 14%. You may recall, we guided you for 13% on constant currency and we are up already ahead of our guidance and we feel pretty good about our second half. It further gets validated, in fiscal ‘15, you may recall, we booked $6.2 billion worth of automotive orders. Year-to-date, we booked $2 billion, that is $8.2 billion of orders in the last 18 months. We never had any momentum like that and I don’t think anybody else has in the industry. Take rates are expanding, continue to expand and to expedite nonlinear take rate expansion, which we all are hoping and waiting to see soon. We have done some big moves transformation.

We acquired Symphony Teleca for end-to-end connectivity services in the car. We acquired Redbend. We acquired TowerSec for cyber security, because there is no autonomous or connected cars without cyber security. You should be asking that question to other people. No one is thinking about it, but we got strong word of confidence from our automakers at CES, everyone validated and we have tremendous enthusiasm. So, I don’t know what market’s mood is. I am feeling damn good.

So with that, let me just go on to talk about other divisions. In our consumer business, we had a very strong holiday season as a result of the growing consumer demand for our family of portable speakers, including the recently launched JBL Xtreme, JBL Flip 3, JBL Pulse 2, our expanded global distribution channels together with prime shelf space and marketing initiatives are paying huge dividends. In addition, our partnership with Media Markt in Germany and Fnac in France delivered very strong sales growth. You may recall we became the leading audio partner in Media Markt stores a year ago.

In the automotive business, OEMs are rapidly investing in connected and autonomous car technology along with smart audio solutions. We are well-positioned to capitalize on this demand. Take rates for connected car and car audio solutions continue to rise. At the end of fiscal ‘15, we had an industry leading backlog of $23 billion. Since then, we have secured another $2 billion of new automotive awards year-to-date and I remind this is a double-digit operating margin business.

So, before I dive into the details of the division, let me recap some of the headlines we made at CES earlier this month. As some of you know firsthand, our exhibit hall was packed and this is a high-quality audience strictly by invitation only with our current and potential customers, the entire 4 days of the show. It was great seeing so many of you at the investor event. Harman’s innovations were standouts, earning a company best and industry best 13 CES Innovation awards, America’s Choice award for our new co-branded JBL Under Armour headphones, which I will talk about in a minute, and a Best of CES award for voice audio. Harman is partnering with the most innovative companies in the world. Our announcements with Google, Microsoft and Under Armour gained broad attention, and I will go into the detail in a second.

We also demonstrated Harman’s newest technology for the connected and intelligent car, Life-Enhancing Intelligent Vehicle Solutions. We call it LIVS, L-I-V-S. Harman has integrated the industry’s most complete end-to-end system to provide drivers intelligent, adaptable and personalized solution in the car. We have built a suite of integrated technologies encompassing not only infotainment, which includes navigation, multimedia and radio and television tuners, to now include telematics, safety and cyber security features on one compute platform. This compute platform is scalable and modular to allow OEMs and consumers maximum flexibility. Again, this is very forward-looking and strong validation from leading automakers.

This is what we call LIVS. On top of that, we are the only supplier who can provide a full suite of connected services that leverage cloud and data analytics increasingly becoming important for auto industry. We are all aware of the benefits of the connected car. At the same time, we cannot sacrifice security for functionality. To complete Harman’s 5+1 security network, which is already the most comprehensive in the industry, we announced acquisition of TowerSec. TowerSec is a global automotive cyber security company specializing in network protection for connected vehicles. TowerSec’s technology will be integrated into Harman’s 5+1 security architecture aimed at protecting the critical points of vulnerability in the connected and autonomous car. We expect to close this transaction shortly. This will be our second Israeli-based cyber security acquisition. As a reminder, Redbend gave us two of the critical elements of the 5+1 architecture, the hypervisor layer and the over-the-air update technology and now we brought in through TowerSec network protection control.

Let me take a closer look at our divisions and review some recent notable achievements, starting with Connected Car division, which is highlighted on Slide 6 of our investor presentation. Harman launched embedded infotainment solutions on a number of new vehicle models, including the new Genesis luxury brand for Hyundai. The system is now available in Korea, onboard the Genesis EQ900 and will be available in Europe, North America by mid-2016. The Connected Car division also received follow-on business from Subaru. Our first award, if you remember, across car line entry, mid and high worldwide, we received sometime earlier and it is expected to go in SOP mode in fiscal year 2017. Additionally, Harman announced a strategic partnership with Microsoft to bring new mobile and cloud-based services to the automotive market. That’s the first for the industry. The first implementation of this partnership is to integrate key elements of the Microsoft Office 365 productivity suite. Working with Microsoft is a natural fit for Harman as we continue our track record of partnering to integrate the best solutions into cars for consumers.

Now, turning to the Lifestyle Audio division, which is starting to become my second favorite. Some of our recent notable achievements are highlighted on Slide 7 of the investor presentations. We had an extremely strong holiday season in consumer audio. As I mentioned earlier, we are experiencing phenomenal success with our award winning line of portable speakers. On top of that, our headphones are also gaining momentum in the market. You may know Harman is already number one worldwide in the sports headphones. In November, Harman debut the JBL Everest wireless headphones exclusively for the three largest consumer electronics retailers; Best Buy in the United States, Fnac in France and MediaMarkt in Germany. Our strategic partnership with Under Armour, fastest growing apparel and health and wellness and fitness company will bring to market new and meaningful innovations in the fast growing connected health and connected fitness space. It’s all about connectivity. At CES, we introduced our first two co-branded products, wireless headphones and the new JBL Under Armour Bluetooth headphones with heart rate monitoring. The heart rate headphones won a CES 2016 Editor’s Choice Award.

And now turning to car audio, audio is an essential part of the connected car experience. It’s no more just having a great music experience, you need it for connectivity. Award winning car audio solutions and powerful portfolio of brands continue to resonate with drivers, leading to another strong quarter of growth. It isn’t hard to have a 20-plus percent EBIT margin business going up on a top line basis. Harman secured new car audio awards from Audi, BMW, Geely and Volvo among others. In addition, Harman secured the first customer award for industry-first Individual Sound Zones technology. You might have seen that last year at our CES booth and we have secured an order from a European OEM. That’s a strong proof point of Harman’s excellence in car audio engineering and product design.

Our car audio solutions continue to expand across car lines globally. The branded audio solutions that launched during the quarter included Harley-Davidson Road Glide with Harman Kardon, Toyota Prius with JBL, Lexus GS with Mark Levinson and Hyundai Equus with Lexicon. As you may recall, last year we acquired Bang & Olufsen’s automotive audio business. And we have now integrated Harman technologies into the Bang & Olufsen product line. As a result, we are winning new awards and industry recognitions. We are also gaining traction with B&O PLAY, a second brand targeting the mass market. Our Bang & Olufsen’s car audio solutions in the Audi A7 – Q7, forgive me, Audi Q7 won the best sound system Readers’ Choice Award from Auto Bild in Germany.

At CES, we showcased our new Summit Car audio platform, representing the pinnacle of car audio, addressing the growing demand for personalization and adaptability through flexible software solutions. This scalable platform integrates the best of Harman’s sound processing and sound management technologies such as QuantumLogic Surround Sound, Individual Sound Zones and Clari-Fi, along with new features like Connected Jukebox and Virtual Venues to create an unprecedented in-car audio experience for drivers. We also introduced the industry-first Infinity Voyager Drive, which seamlessly integrates Lifestyle Audio for the home, car and on the go. The Voyager Drive won the Best of CES Award, I mean, Best of CES Award. With Summit and Voyager Drive, we now have scalable car audio platform, system-on-chip, total flexibility, modular and scalable that can serve the entire spectrum of the car audio market from high end luxury to entry level.

Now turning to Professional Solutions division highlighted on Slide 8 of the investor presentation, during the quarter we were selected by leading system integrators and installers around the world. Some notable projects include the Dubai Opera House, Newport Naval Station, the USC School of Business and ESPN Studios in Mexico City. Harman’s products also followed a wide range of events including New Year’s Eve in Times Square and the World AIDS Day concert in Carnegie Hall. Division launched 12 new major products during the quarter, several of which were recognized by industry associations.

Now, let me update you on the two important strategic initiatives we are implementing in this division to take the performance to a whole new level. First, our go-to-market approach on October 1, our sales structure was realigned to better capitalize on our unique end-to-end solution including audio, video, lighting and control of enterprise and control systems for enterprise segment and entertainment segments. With this new structure, we are better positioned to bring complete and tailored solutions to different vertical markets. This is happening, it takes a little bit of a time to adjust with our distributors and master dealers and reps, but it’s going very well. And I personally visited many of the customers’ end points.

Second initiative, we are on track to complete our plans to improve our European manufacturing footprint, which will significantly bring our costs down. We are consolidating our professional product manufacturing centers in Denmark and the UK into a single, more cost-efficient Hungarian facility. The first of those – consolidation was completed in December, while the second one is well underway and expected to be fully operational by end of March, that is right on plan. As I have mentioned previously, we expect to realize the full benefit from these strategic initiatives in our fiscal 2017.

Now turning to the Connected Services division, highlighted on Slide 9 of the investor presentation, during the quarter Harman began providing software product development services to new customers, including InterDigital and Reliance Jio. Connected Services also secured follow-on business from Nielsen, Polycom, Renault, Renault car company and Dealertrack, also the major automotive dealer network in the United States, now that is part of Cox Automotive. In addition, we continued building the backlog for our industry leading OTA software update technology, winning awards with Honda in Japan, Jaguar Land Rover, etcetera. Our OTA solutions are not only updating infotainment systems, but also other non- Harman ECUs in the car.

In the case of Jaguar Land Rover, we will be updating the telematics control unit of TCU. As you can see, we are gaining momentum with our OTA business. Building on our success with Daimler and Subaru in automotive and KDDI in mobile in Japan, we now have secured over $100 million worth of OTA business over the last 12 months and expect to continue this momentum. This is again a very pleasant news for us and that’s exactly what we expected.

During the quarter, Connected Services was recognized as a top global R&D services provider by the respected advisory firm, Zinnov. Zinnov placed Harman in the Leadership Zone, the highest category across multiple industry verticals. In addition, several of Harman’s aftermarket products won CES Innovation Awards, including the JBL Legend, Infinity K5, JBL Smartbase and JBL Trip. At CES, we showcased our cloud based end-to-end service delivery platform for the Connected Car. This platform allows automakers and service providers to introduce and easily deploy new enterprise cloud services to connected vehicles. With our service delivery platform, Harman will partner with OEMs to provide a number of new service offerings, including updating existing features and adding new software features after the car is being sold; collecting vehicle data to predict part failures, forecasting for preventative maintenance and enabling OEMs and dealers to address software issues in the field more efficiently without making a major recall. This industry first service delivery platform and I repeat this is the industry’s first service delivery platform, addresses the existing and future demands for scalability, security and flexibility in the provisioning of Connected Car Services for automakers and their customers.

Additionally, Google selected Harman to be the first system integration partner for Brillo, its Android-based IoT developer platform. Google also selected Harman as the first partner for Weave, Google’s communications protocol for IoT devices. This positions Harman as the technology partner of choice for device manufacturers to design and develop products for a range of key IoT applications serving the smart home, consumer, automotive and enterprise segments. Let me remind you, our collaboration with Google spans over a decade, from the development and scaling of Android-based ecosystem across mobile devices and consumer equipment as a member of the Open Handset Alliance to automotive, as a member of Google’s Open Automotive Alliance and now IoT. Our partnership with market leaders like Microsoft and Google will allow us to expand our customer base across automotive, mobile and communications and enterprise.

In summary, I am extremely pleased with our strong financial results for the first half, which are in line with our expectations. As you would expect, we are closely monitoring recent macroeconomic headwinds, but at this point, we are on track to deliver on our full year plan. In addition, we are seeing good momentum in building our backlog. Finally, I am energized by our continued innovation. That has been differentiating Harman from everybody else. In addition, several of Harman’s other initiatives which are in place. Innovation and the strong partnerships that we have formed this year that will drive further growth. All of these factors position Harman for sustainable long-term growth.

Now, I will turn the call over to our Chief Financial Officer, Sandy Rowland, who will give you additional color on our financial results for the quarter.

Sandy Rowland

Thank you, Dinesh and good morning everyone. Let me walk you through our financial highlights for the quarter. As a reminder, most of my financial remarks are provided on an operational basis, which exclude restructuring, non-recurring and acquisition-related items. I want to point out that the majority of the difference between our GAAP and operational results is due to the non-cash amortization of intangible assets recognized as a result of our recent acquisitions. The full reconciliation of our GAAP to operational results is included in the press release that we issued this morning.

This quarter, our revenues were $1.8 billion, an increase of 12% compared to the prior year or 19% excluding the impact of foreign currency translation. Excluding the impact of acquisitions and FX, our net sales increased 12%. Revenue in our Connected Car division increased 2% versus the prior year or 9% excluding the impact of foreign exchange. The increase in net sales was due to higher take rates, stronger automotive production and the expansion of recently launched platforms.

Revenue in our Lifestyle Audio division increased 20% compared to the prior year or 26% excluding foreign exchange. The increase in net sales was primarily due to new product introductions and expanded global distribution channels in consumer audio. In our car audio business, the increase in sales was driven by the acquisition of the Bang & Olufsen car audio business and higher take rates.

Revenue in our Professional Solutions division decreased 7% compared to the prior year or 4% excluding foreign exchange mainly due to weakness in emerging markets, particularly Brazil and Russia. Revenue in our Connected Services division was $170 million in the quarter compared to $74 million a year ago. The increase in revenue was primarily due to the expansion of our services portfolio as a result of the acquisition of Symphony Teleca.

Total company gross margin increased 60 basis points to 30.8%. The improvement was primarily due to improved leverage of fixed costs as a result of higher sales volume as well as the expansion of our services portfolio. Connected Car gross margin increased 60 basis points to 25% primarily due to better leverage of fixed costs and lower warranty costs. Lifestyle Audio gross margin increased 50 basis points to 32.7% primarily due to improved operating leverage as a result of higher sales volume. Professional Solutions gross margin increased 100 basis points to 41.4%, driven by lower manufacturing expenses. And Connected Services gross margins were 33.2%.

Our SG&A expense as a percentage of net sales increased 30 basis points from the prior year to 20.3% due to higher investments in research and development. Connected Car SG&A declined 30 basis points to 13% and Lifestyle Audio SG&A decreased 110 basis points to 18.2%, both due to improved operating leverage on higher sales. SG&A expense in Professional Solutions increased 190 basis points to 29.9% due to lower sales volumes. Connected Services SG&A as a percentage of sales was 22.2%. And finally, corporate SG&A as a percentage of sales remained relatively flat compared to the prior year. Consolidated operating income was $186 million compared to $162 million in the prior year, a 15% increase or 21% excluding the impact of foreign exchange. Our EPS was $1.84 compared to $1.79 in the prior year, up 3% or 9% excluding FX.

Now, let me provide you with a few updates on capital allocation. Fiscal year-to-date, we have repurchased approximately 495,000 shares at a cost of $50 million. We have approximately $450 million remaining on our board authorized share repurchase program. Our liquidity position continues to be strong. We have sufficient cash and access to our revolving credit facility to make the second payment for Symphony Teleca and to close the TowerSec acquisition, which we anticipate closing shortly. In light of current market conditions, we do expect to repurchase additional shares in the second half of this fiscal year.

As Dinesh said earlier, we are on track to deliver on our revenue and earnings targets for our core business. Assuming our acquisition of TowerSec closes as expected over the next few weeks, it will be dilutive to earnings by approximately $0.05 as it is a bolt-on technology investment. Let me also remind you of the traditional seasonality in our businesses. Production tends to be slower in our fiscal third quarter and the annual price reductions in the automotive businesses also occurs in this quarter. We also have higher interest payments as a result of making the second payment on Symphony Teleca and closing the TowerSec acquisition.

Overall, we are very pleased with our strong first half results. Despite the foreign currency headwinds and broad macroeconomic uncertainty, we have performed well and are well-positioned for continued growth in our core businesses.

Thank you for your attention. Dinesh and I are now happy to take your questions.

Yijing Brentano

Dmitry, could you please open the lines for Q&A?

Question-and-Answer Session


Certainly. [Operator Instructions] Our first question comes from the line of Ryan Brinkman with JPMorgan. Please go ahead.

Ryan Brinkman

Hi, good morning. Thanks for taking my questions.

Dinesh Paliwal

Hi, good morning.

Ryan Brinkman

So firstly, just on the growth in Connected Car, I know you started the call explaining that the first half growth rate was very strong. In thinking about that deceleration though in organic growth from 1Q to 2Q, I am curious if you could point to anything that could have caused that? So for example, a customer or segment mix shift that might have impacted you maybe being more exposed to vehicles in China, with over 1.6-liter engines not eligible for government tax incentives or something like that? And then, was that deceleration always contemplated when you issued your full year guidance? I know you don’t guide quarterly, but is there anything we should take into account when thinking about cadence through the rest of the year?

Dinesh Paliwal

Ryan, great question. First of all, we are on plan and our take rates are continuing to expand. And the only difference sequentially, we had unusually strong first quarter as you all know and we had in Q2, China, slight impact, as you had pointed out rightly. China has started to turn the corner and we are seeing the production going up, but that’s affecting positively the very entry level car and we will start to see some pickup for us in the second half most likely I would say third and fourth quarter, more in fourth quarter as mid and high-end cars start to come in. And we will also expect – our second half is more back-loaded for the SOPs and expansion. So, we will also see that. So all-in-all, we guided 13% for the full year. We are running at 14% on a constant currency basis first half. We expect to meet our guidance and we are very comfortable with that.


Our next question comes from the line of David Leiker with Baird. Please go ahead.

David Leiker

Good morning.

Dinesh Paliwal

Good morning, David.

David Leiker

I am trying to figure out, let’s talk about the lifestyle business with automotive, very strong growth there it looks like. Can you talk a little bit about what the launch cadences there and what that looks like the next couple of quarters? And then just one other one on currency, if you could detail what the impact of currency was transactionally and how much of that was offset by hedges? Thanks.

Dinesh Paliwal

So, let me take the first part and I think our CFO will take the hedges part. So, first half for car audio was good. Per plan, we have been beating the plan and second half looks very good as well. I mean, all these new innovations, David, you saw yourself at the CES are truly bringing additional expansion of the SOPs as well as new technologies, so that’s the car audio. And what’s working very well in tandem, as we have been saying for a number of years, that as you build the brand for consumer high end business, portables and others, it is really helping us improve the take rate. So consumer business really performed extremely well. And you know us by now we do not take business sacrificing our bottom line. So consumer business was holding up on expected profitability and still growing the top line. And car audio obviously is a very robust profitable business. It is growing – out of $2 billion, actually $1 billion of that came from car audio, so now we have, as of last year fiscal close, we have $6.2 billion was in car audio backlog, now we have added another $1 billion. So for the revenue of the $1 billion business, we are sitting with $7 plus billion high margin business, I am really excited. So this is how Connected Car will come alive, more and more we are seeing audio, tuner, audio management, connectivity, safety, security and end-to-end services being pulled in. So all means of new awards, they will not be placed based on single point solutions, that you have this with that. Total solutions would really value. So car audio is becoming a very integral part and important part going forward.

Sandy Rowland

And David, I will take the second part of your question on foreign exchange. The hedges that we have put in place are really doing their job and protecting our P&L. I would tell you that this quarter we got a benefit from our hedges from a transactional perspective somewhere in the range between $20 million and $25 million. We do have now over $2.2 billion of hedges in place that will run for the next several years. And for fiscal year ‘17, we also have about the same amount of hedges that we have in place for this year at a very constant rate. So I would say overall, we are very pleased with the performance of our hedges and glad we have put them in on a long-term basis.


Our next question comes from the line of Brian Johnson with Barclays. Please go ahead.

Brian Johnson

Yes. Good morning. Just back to the Connected Car division, since that’s a focus of many, you kind of stated your 30% goal for the year, can you give us some color within that on how your revenue breaks out between what you might call the high end scalable systems versus midrange and as you see more growth in CarPlay and Android Auto, what does that mean for embedded NAV and is embedded NAV really just a pass-through for you, so just maybe if you could address some elements of that debate?

Dinesh Paliwal

So first of all, Brian thank you for your question. We guided the market for 13% growth in fiscal ‘16 over last year on a constant currency basis and we are 14% year-to-date. And as I said, we reiterate that we will meet this and we feel comfortable. In terms of breakdown of embedded infotainment system, if you look around all the cars, about 25% have full blown embedded system and 50% of the cars, let me go straight to the biggest opportunity area, the 50% of the cars are coming out either nothing, just a hole or basic AM/FM radio. That is the business which is turning into an opportunity for us. And either it will grow into a full embedded system or it will grow into – we call it display audio. Display audio would be a smart display unit, but it would allow the smart links like Baidu’s CarLife, Apple’s CarPlay, Google’s Android, Google Link, Automotive Link and many others. So we are seeing the convergence that 50% and moving very fast into fully embedded with everything are into display audio. So you also asked about our revenue, while we don’t break out, majority of our business is mid-segment and high-end. We also do – in all of these cars where customers are asking, we are integrating Android Google Link, CarPlay as well as Baidu’s CarLife. We were actually the first company to integrate Baidu CarLife ever in the industry. So that is just on top of it. It is not in lieu of that. However, when I mentioned earlier to Brian’s question, very many entry-level car in China being produced, they just don’t have anything. So you might see the production from – when you look at IHS or LMC report, production going up, but they don’t have anything. Where we gain, when cars from Japan, Korea, China, United States – I mean, not China, United States or Germany, when they are shipped to China or even produced there, there you will see our systems, whether it’s entry system, mid-system or high end-system.


Our next question comes from the line of Adam Jonas with Morgan Stanley. Please go ahead with your question.

Adam Jonas

Everybody, just a couple of questions, first, so GM showed their electric Chevy Bolt, which they say represents like their car of the future, one of the finest engineering achievements and etcetera and they showed it off to Obama I think a couple of weeks ago. And we – you probably noticed all the content that LG Corp. had on that car, including the contract for infotainment. I am just curious if that was something and were these – are these the kind of products that you are even able to bid on or are you seeing companies like LG or Sony or Panasonic kind of get these types of things and we know they are – and you have recognized they are out there as kind of niche players, but are they stable niche players or do you see them kind of getting bigger chunks that have to be kind of competed against?

Dinesh Paliwal

Adam, first of all thank you for your question. Yes, we saw that. As you know, we are actually working on a very large end-to-end cross car line global contract with this customer and that program is going extremely well. In fact last week, when I was in Detroit opening our brand new facility for 1,000 engineers in Novi, Michigan, we had a very big contingent from this customer visiting and going through further review and came out extremely pleased. This would be first of its kind commercial development based on Android and hybrid, great infotainment integrating the 4G LTE connectivity and everything else you can think of. So we are very happy with that. And the car you mentioned, that’s a showcase and is not out in the production. And when it comes on to production, we are all out there. I mean we had this account and we are very pleased with – we have not had SOP yet, but once the SOP happens, it’s a very good launch plan as well as a SOP expansion plan. And I can’t wait for that to happen.


Our next question comes from the line of Joseph Spak with RBC Capital Markets. Please go ahead.

Joseph Spak

Hi, good morning everyone. Sticking with Connected Car, I was wondering if you are seeing any change in sort of growth rates of sort of mass volume vehicles versus luxury or even within mass, maybe some of the orders for infotainment at the option level changing a little bit just as such a thing we are hearing out there and the economy sort of the bifurcation. And then also, just I am pleased to see – hear you say you are comfortable in sort of the second half, if I look at the margin performance though, in Connected Car, you are running a little bit above what the guidance sort of implied for the year as well, so maybe you can talk a little bit about what’s driving that and is there something that offsets that in the back half or are things just coming in a little bit better?

Dinesh Paliwal

Right. So Joe, great question. Thank you. First of all, on the margin, we are very pleased with the first half performance. Whatever we guided, we are running a little ahead. But we have to – I mean we guided 13.6%, we are running 14% right now. So we are happy. But we also keep in mind that Q3, which we are in traditionally every year gets hit with the annual price reductions, so that’s already built into our guidance. And so that would have an impact, but we will meet or beat. Right now, we are saying we are going to make our guidance for the margins. So that looks good. And the other part of the question was related to – let’s see, I’m just – the trim levels right, how is the development happening. Well, first of all as you know very well, the high end cars where we have very strong position worldwide, that’s pretty high to begin with. So we rely on the production increase. As that grows, we will gain because not so much take rate improvement. The biggest take rate improvement is coming from mid segment where we are very strong player. In fact, majority of our backlog today is in mid segment. Even if it is coming from German automakers, because they also make mid segment cars, like X3 or BMW 3 Series or C-Class or what have you, so that all mid segment. Of course, Hyundai, we have Subaru across car line. We have Fiat Chrysler very strong account and of course the world’s largest automaker who is also in Detroit, that’s also I would say mostly mid-segment. Entry, we are also starting to penetrate either through entry systems or also display audio. So, majority of the take rate improvement I would expect to come from mid-segment where the money is and we will also play in entry if it is part of our existing customers or to together with everybody else like Subaru. Subaru is across car line. We do every single car in every single geography. They are in high. They are in mid. They are in entry. And they also have some display audio type of arrangements. So, we do all. So, majority of the growth, to put it all together, is going to come from mid-segment.


Our next question comes from the line of Brad Erickson with Pacific Crest Securities. Please go ahead.

Brad Erickson

Great, thanks for taking my question. I think you are starting to get some experience now in working with some of the technology players, specifically Apple and Google. Can you talk about sort of your initial impressions of working with them in terms of integrating into some of your platforms? And has this changed or could it change the discussions you are having with your OEM customers in terms of what they are looking for from you in the future?

Dinesh Paliwal

Right. Very good, Brad. Thanks for asking the question. Appreciate it. So, we have been working – in fact, you may recall, Harman was the first Tier 1 to integrate iPod out from Apple, very first in the world. So, we go back to history and we also do business in other parts of our product lines. So, we are partners. And Google, we also go back 10 years either directly Harman systems as well as our services business, Connected Services. They are actually a very strong services partner for product development. And you know we are the member of Open Handset Alliance, we are the member of Open Automotive Alliance, and we are the only company to-date doing a commercial level development of Android-based hybrid infotainment system, which will be future proof. You can personalize it. You can keep it up-to-date, current with 4G LTE built into it. So, we are very happy with that. So experience-wise, I think they are learning a lot something that you might have seen in terms of press release from one of the Bay Area company, who was making a lot of headlines. They just had some headwinds and saw some freeze on hiring in automotive space.

Well, these are all learning. The automotive industry is complex. We had been saying for long time that it will require players like Harman with very comprehensive ecosystem knowledge and investing in innovation of cyber security, connectivity and also end-to-end services plus credibility of delivering projects which have zero bugs unlike the headsets or handsets we launched then with hundreds of bug and we fix them on a weekly basis. You can’t do that. So, with that said, I think automakers have renewed confidence in companies like Harman and our orders speak for it. And as I said, I can just underscore what CES this year was. This was the best CES ever for Harman. We were packed with our customers, with our new customers. Some of them came twice. And there is a lot of activity out there, we are very busy right now and that’s a good thing.


Our next question comes from the line of Tavis McCourt with Raymond James. Please go ahead.

Tavis McCourt

Hey, guys. Thanks for taking my question. I have got a few here. So, I will just – I will list them in order. First, Dinesh, you haven’t talked much about the Connected Services business and we don’t really know the seasonality of this. But to hit the guidance for the year, you would have to have significantly greater revenues in the second half than the first half. So, is that something that we should expect on a seasonal basis? Second one, Sandy, you mentioned a little bit on FX, but can you remind us what the transactional FX headwind is to EBIT or EBITDA this year? And in your comments about a similar amount of hedges next year, does that mean that the headwind next year on FX, all else being equal, should be about the same as the headwind this year or does the headwind get worse or better next year?

And then the last one, more strategic, Dinesh, so in the last few weeks, Ford clearly has gotten very aggressive announcing at CES, they are basically making infotainment standard on every car. And then I guess, AT&T announced a couple of days ago that they are going to embed LTE on every Ford vehicle. So, we are seeing at least Ford take this from an option to something that’s more standard fit. And obviously, that’s not a big customer of your Connected Car business, but you kind of have the other two big U.S. manufacturers who are. So, I am wondering what you are hearing from them in terms of competitive response or kind of anything in the industry that you think maybe Ford could be a tipping point here to move that attach rate up significantly from the smaller increases we have seen the last couple of years? Thanks.

Dinesh Paliwal

Raymond [ph], first of all, very good quality questions. And let me take number one and three and Sandy will take the FX questions. The very first one was Connected Services business seasonality first half versus second half. Yes, this business has seasonality and typically second half in this business is stronger and exactly that’s how we see it. We do carry a little bit of a backlog, but we do not report that. So, the backlog which we report does not have anything to do with – has nothing to do with services, but we track that backlog, we have it. So, second half is stronger and will make the guidance we have given you and we feel good about. It’s growing actually.

Then you mentioned about customers in U.S. You mentioned Ford, you mentioned GM, AT&T, I actually see it very positively to just validate what you said. This is where it’s going and that’s why you might have seen us pushing full integration of telematics and we are investing in telematics as well. And that’s why we acquired Redbend because Redbend – in Honda car actually, we will be – and JLR actually we will be updating ECUs through telematics. And we are investing in telematics, we are doing second-generation telematics solution end-to-end for Daimler cars right now. So, telematics will be big for us. And telematics will drive connectivity and higher penetration whether we do telematics for someone else, but we have an offering and we are investing. So, I see it as a very positive announcement coming from Ford. And by the way, you mentioned GM they have also announced that they have 4G LTE built into every single car. So, I am very pleased that automakers are recognizing and making the right investment to have the connectivity secured upfront. And once you have the secured connectivity in the car with OTA, we will be able to bring latest feature functionality even when the car has left the dealership and keep it current, update the firmware, software applications. Even people like you and I can personalize our experience. We can buy when we want, what we want to buy. A lot of that is happening. So, telematics is a big piece and we are right in the middle of it.

Sandy Rowland

And then Tavis, I will take the second part of your question on foreign exchange. You are right, if you look at fiscal year ‘15 compared to fiscal year ‘16, we are still seeing some headwinds on the transactional FX. We would estimate that, that’s tracking right around 50 basis points across the total company. And when I look forward out on our situation for fiscal year ‘17, yes, we have the same dollar value of hedges in place for both ‘16 and ‘17. So, the variation will be we expect some growth in our business, but we also get productivity out of our suppliers. So, those will be sort of offsetting impacts. And then the uncertainty is around, call it, the 25% that we don’t hedge. This year, we are running right around the $1.10 to euro exchange rate that we had planned. It could be a higher rate next year and then we would see a tailwind. If it dips again, we see a headwind. So, what we don’t know is the un-hedged piece, but still looking like in pretty good shape in that area.


Our next question comes from the line of Chris McNally with Evercore ISI. Please go ahead.

Chris McNally

Good morning, team. Actually, afternoon from London. Two questions on the advanced technology front. The first is around your monetization strategy within cyber security. At CES, you sort of discussed that Redbend and their 5+1 strategy you could begin to offer cyber solutions for competing infotainment providers, what would be a – maybe a true software style licensing model perhaps. Could you give us any more color around the timing, market size for such a Greenfield opportunity? And then I can ask a follow-up question after.

Dinesh Paliwal

Chris, first of all, good afternoon and thank you for joining us, it’s a great one. It is emerging and I will tell you where we are. So, it is true when we acquired Redbend, they were already engaged with multiple Tier 1s like Harman and Harman’s competitors. First thing we did, I myself joined with incoming CEO to talk to various Tier 1s, to tell them that we will keep at arm’s length just like we did many years ago when we used to own QNX because this is an industry solution. We don’t need to monopolize that and we want everybody to benefit. And it’s not just infotainment. It actually will update firmware, software on various other ECUs supplied by many other Tier 1s. And that is already happening and will happen and I hope it will happen because it is by far the best over the air updated technology.

Now coming back to monetization, it is – it goes first of all, as I said I would reiterate we have booked $100 million worth of business, that’s all software. So when it started to go to the bottom – to the revenue conversion, it’s a very high margin business, as you would expect. In terms of how we charge, it is either licensing model. Sometimes it’s a car license to the warranty as OEMs may want to have it all on annual subscription, sometimes it’s a by model. So it’s a different, different packaging as Redbend before we acquired had been doing. Right now, we are trying to streamline and also working with the major automakers when we have bigger opportunity, how do we sort of do create a model. It’s a basically annuity stream, so recurring revenue will come once the Redbend is in there. It’s a server as well as a client, which is in the fitting in the car, so just like anything which needs to be kept always alive and you get paid for. So we see a big opportunity because now you may start to get into a term which no one has talked to yet, it’s called data. Whoever manages the data is the winner. We will manage data through our Connected Services division and Redbend will provide the data exchange. So whether you have AT&T, Verizon, China Mobile, Vodafone, they will provide the plumbing and we are the mechanism for secured data exchange and updates of the data. So we will be having data and that data will go to OEMs, to dealers for the diagnostics, for consumer behavior, to insurance companies, to wellness, health. So we will be doing that data management, so we feel very good about. And that’s where Redbend is part of our Connected Services division, where we have our cloud management applications, we have our Analytics division, very strong analytics engine. Combine that with Redbend, you have got a powerful services business and that’s where our services business is calling on Harman competitors as well as car companies directly.

Chris McNally

And because you probably can’t discuss pricing with too much detail, is there a way to think about as a percentage of the cost of an infotainment system, what cyber security as a software solution could be?

Dinesh Paliwal

So I will try to answer it. Let me try – make an attempt. One attempt – one way we can do is to have a per car basis charge for 5+1 Cyber Security framework we have because we believe that’s a total solution, most comprehensive. So you can price it and car makers will pay for it without a doubt. We are already seeing that or you could do, that we can say, look Harman will start the package Cyber Security 5+1 and including Redbend technology in every single new offering will come out from now on. And that would be priced in as a bundle. But that will be our differentiation. And that’s the way I like to think you maintain price performance ratio. You maintain – going forward, you do not lose the pricing. You maintain the pricing power, but you keep adding the features, feature functionality exponentially. That said, you keep your margins and continue to build margin and leverage will give you the better margin. So we will go probably both ways. Some customers who do not do business with us for infotainment to car audio, they are already using our Redbend and cyber security technology. They will pay us on a license basis. Those who are buying complete system from us, it will be totally embedded, so they will get the whole offering and we will get paid for the system. And one more thing, you might have seen Harman has always commanded better price for our infotainment system in the industry, because we have always been on the cutting edge of technology and this is cutting edge. So when you start to price it in, we will continue to have better pricing.


Our next question comes from the line of David Lim with Wells Fargo Securities. Please go ahead.

David Lim

Hi, good morning Dinesh and Sandy. Thanks for squeezing me in. Just two questions, on that $2 billion order, is that infotainment and audio and it seems like it’s tracking a little behind last year’s number, I know you – I granted there is lumpiness into the orders, can you talk about that a little bit more? And then I have a follow-up.

Dinesh Paliwal

Sure. So David first of all, we don’t have to squeeze you in. You are a very important person who is just randomly coming in, so thank you for taking time to ask the question. As you know very well, auto orders are never smooth on a quarterly basis or even year-over-year basis. Last year was a jumbo year, I call it. We had $4.3 billion worth of infotainment awards and $1 billion – $1.9 billion in car audio. So put it all together, that was like $6.2 billion, phenomenal for a revenue of $4 billion. So we had a bumper year. You don’t expect that every year and we guided this year, that this year may not be because we always have visibility in RFQs and what orders will close. So for this year, we had $2 billion already in the bag. And that’s the 50%, $1 billion came from infotainment and $1 billion came from car audio. And we are not done yet, you know that. So we are very happy with the development this year, it’s actually on plan, slightly ahead of plan, in terms of order bookings.

David Lim

Got it. And then my – thank you for that. The second question I have and I am sort of struggling with this, infotainment revenues, Connected Car went down quarter-over-quarter, it seems like European production was up quarter-over-quarter and North America was flat. And I am sort of piggybacking on Ryan’s question, but is there something unusual, I mean are you guys like gearing the plants up for launches or is there something that you could provide a little bit more detail related to that?

Dinesh Paliwal

So you are right. Obviously, we track, in fact if you look at the global production, we guided what 3.5% for the whole world as a weighted average for all the regions. And we are pretty closely tracking global production. Even some puts and takes, it’s the same. So we have seen, China particularly a slight softening for the high end luxury cars, which is we believe is a temporary shift or actually postponement of the purchases. That’s the view of our car company, our customers. So they will come back. I don’t think it has anything to do with EU production going up or North America flat or declining. It’s just to do with SOP timing, SOP expansion. In Q1 we had pretty strong SOP launches and ramp-ups and that we benefited. Now they are flat or it’s still growing but – so we are seeing some improvement and Q3, Q4, we have a number of SOPs coming in. And that’s why I said earlier that we will deliver on our guidance we gave in spite of some of the headwinds we are seeing in China or Russia in particular.


Our next question comes from the line of Nate Brochmann with William Blair. Please go ahead.

Nate Brochmann

Thanks for taking the question. Going back to the Connected Car segment a little bit and talking about that recurring revenue, if you think out Dinesh, is that kind of business ramps and obviously it should in theory ramp pretty quick, over the next 3 years to 5 years, do you have any like internal thoughts regarding what percentage of kind of recurring revenue you would anticipate that business to kick off. Obviously, that would be one dynamic to kind of make it more of a recurring revenue model than a little bit of the lumpiness quarter-to-quarter on productions or take rates and things like that in terms of your overall business?

Dinesh Paliwal

So first of all thank you for asking the question. I will give you my view as I see. This is by no means a guidance or any expectation, look everybody talks about whether it’s IHS, whether it’s LMC of customers, every research, that’s 65%, 70% take rates in out years, whether it’s going to happen in 3 years or 5 years, but you are right, it’s going to happen in 3 years to 5 years, it’s not going to be beyond 5 years. It’s happening in that period. If that happens, right now industry average this year is supposed to be around 27%, 28% take rates. So if this number goes up to 65%, 70%, guess who is going to benefit most, it’s Harman because we are working with nine, ten of the large OEMs, of the 15 sitting with $23 billion backlog plus $2 billion we have booked this year. That backlog is based on current take rates. So you could double that thing if take rates just double from 27%, 28% to 55% if the number goes up. That’s why I get excited in 3 years to 5 years time, potentially if everything goes well as the industry says, Harman could see our revenue doubling again.

And that’s why I said when I was in – opening our new center, that is not our guidance because we don’t know more than 1 year at a time. We only have visibility 1 year, but 5 years out, is it possible? You bet it’s possible. Plus I think another very important piece, which will drive take rates is Connected Services. The OEM is struggling with one thing. They don’t know or they have not quite figured out how to create the back-end connectivity to servers, the upload of data, the download of data, analytics and make sense out of it. And that Connected Services piece as IHS wrote right after our acquisition that, that was a transformational move we made. And after that, few people have also thought of going in that direction. But there are not too many targets like Symphony Teleca. So, we are very excited about that. So, I remain very optimistic. It’s not my theory. I think it’s the reality, because embedded is here, embedded is winning the day, embedded is not pushing out by the way, Apple and Android phones. They will also be integrated. But the way car industry is going is full embedded and we will gain from that.


There are no further questions registered. I will now turn the call over to the CEO, Mr. Dinesh Paliwal.

Dinesh Paliwal

Well, I will say in closing, first of all, a big thank you for your time for joining us today and thank you to our shareholders, our owners of the company, investors and very importantly, our analyst community for all the hard work you do, it’s a tremendous work, for your support and work you do to communicate the Harman story. And in the last sentence, I would say this is my ninth year. I have seen a lot of ups and downs in our industry. What has differentiated Harman is the innovation and the R&D? And we have clearly shown the last 4, 5 years margin expansion, top line expansion and further growth. Whatever we have said, we have delivered. Our team is solid. We are excited. We have the great customer base. And we have the technology platform in place, especially in all the latest generation compute platform. We call it LIVS. We just launched at CES. It is one of a kind. It’s unique. I am very excited with the future. I cannot control what happens day-to-day on share price, but I do know I can control the direction of our company with my team. So with that, thank you all very much for your time.


Ladies and gentlemen, that does conclude the conference call for today. We thank you for your participation and ask that you please disconnect your lines.

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