Harman International Industries Inc. (NYSE:HAR)
Deutsche Bank Global Auto Industry Conference Call
January 11, 2012 11:45 pm ET
Robert Lardon - VP, IR
Herbert Parker - CFO
Adam Brooks - Sidoti & Company
Chris Ceraso - Credit Suisse
Pat Nolan - Deutsche
Okay we are going to kick off our next presentation which is Harman International. Harman is a global provider of premium audio and infotainment solutions. The company has a $2.8 billion of market cap, expected sales of $4.2 billion to $4.4 billion. The company has one of the most impressive secular growth stories within this sector in part driven by growth in vehicle infotainment premium audio. The company still expects to see margin improvement particularly in its infotainment division as the business moves towards the higher margin scalable systems. In representing Harman today, we are very pleased to welcome Herbert Parker, the company's CFO and Robert Lardon, VP of Investor Relations. And I will hand it over to you.
Good morning or good afternoon. Thanks for coming guys. Just to give you a sense of how we are going to do things. As Rod mentioned this is Herbert Parker to my right here who is our Chief Financial Officer. I run the IR side of things. What I want to do is highlight a few of the recent awards that you may have seen over the last couple of days that we announced and give you a brief history of our transformation and strategy for those of you that are new to the company.
And then I will turn it over to Herbert who will go through the financials and also some of the prospects for the future if that's okay with you. And we will then take time for some questions. So we will bang through this fairly fast. Most of the slides are derivatives from the Analyst Day that I notice some of you had attended on October 26, down in Nashville. So thank you for coming again and for those of you that didn't, that slide which is up on our IR website has some additional slides that I think you will find of help that are not included in this.
So moving on, please advance slowly, so excuse me, okay. So what we did is on Monday, we were down in a New Delhi for the Auto Show there and we announced the formalization of our new, what we call premium entry system. We have talked about this over the last few months that we are working on it. We now have a commercially realizable product. We don’t have an award yet, but hopefully that will be forthcoming and this is part of the transition of our dominance in the high end infotainment luxury sector, systems that cost around say $3500 at dealer retail to the systems in the premium mid level, systems that would run say a $1000 or $1200 to systems in what we would call the premium entry level and premium entry meaning that we will cherry pick those areas of the entry, compact Class A and B markets where we feel we will get the type of margin realization that we require which is essentially 8% to 10% EBIT.
So that was a fairly big news announcement that we had just a couple of days ago and obviously even though it appeals to the Indian high growth market what we call the two wheeler market as the A and B segment, the scalable approach that we had and I will talk about that a little later, allows us to take this and certainly export it to other markets as well. But this is where we first announced a couple of days ago.
We also had four additional awards. So these are actual awards. The first was being with Hyundai for a continuation of our Lexicon premium audio system. I think those of you that have been following the industry know that the Hyundai that won the 2010 with the Genesis Model of the Year for the most advanced technological vehicle, a lot of that was based on the electronic componentry which of course the infotainment and the premium branded audio system comprise.
So we are very pleased with that. That’s a nice follow-on piece of business and it keeps us in the fold with Hyundai with the next generation Genesis for model year 14.
In addition, we have three net new business awards. Premium audio awards with SsangYong as well as with the Smart Car group. They are not huge awards, but they’re important awards because they are net new to us as well as the fact that as you know, premium audio generates very high margins for us in the 15-plus range.
So these are good awards and the last one is Subaru of America has selected our Aha Radio platform, which is really beyond a Pandora internet radio. It really is a platform for aggregating and repurposing content to mobile devices, whether it be radio or a blog or Facebook or Twitter, like a variety of different medium that is coming in to the cars. So that expands that to Subaru’s OEM installation as well. So we’re quite confident in terms of our adoption rates of Aha it’s moving along very, very fast.
This get back to talking about what we got here about five years ago when we first chaired up at Harman. We inherited the company for all of it’s technical prowess and for having created the infotainment category in 1995 with the acquisition of the Harman Becker radio company in Germany was entrepreneurially led and also run that way in the sense of 17 different business cards, different operating units, 17 different presidents, HR groups, et cetera, with very little at the corporate level, other than basically a few lawyers and accountants in Sydney running things.
So what we’ve done as a global company is obviously optimize the global footprint, was one major thing. We took $434 million of cost out. We also positioned the company for growth in the emerging markets which was the other flipside of the cost optimization. We closed five facilities in the US, in the UK as well as in Switzerland, built five new world-class facilities in China to Mexico, in Hungary and opened up four global R&D centers in China and also in India. And also those facilities are scalable and flexible not only in terms of their geographic footprint, but they take a cellular approach in terms of the manufacturing.
So in terms of changeover between different models, depending on how things happen, we can do that as well. We realigned sourcing for our cost and currency and then rebalanced the workforce. In terms of the workforce, our goals in terms of let’s talk about manufacturing. When we started here manufacturing was 86% high cost countries, 14% low cost or what we call best cost countries. We are basically at our targets of about 50:50, so we have made tremendous progress there.
Engineering and research and development in our case, it’s principally application software engineering was virtually a 100% high cost, 98% was actually the number, 2% best cost. We are quickly approaching, not quite there, a couple of points off, a goal of being 60% high cost, 40% best cost and we are very close to that.
In terms of the transformation of Harman, outside of those changes that I talked about, it wasn’t enough just simply to and I shouldn’t simply it was a lot of heavy listing over the last few years to restructure the cost base and position ourselves for growth. We have to reinvent the industry that in fact we created in 95. And when I say reinvent, by that I mean how we build these systems.
The systems were essentially because they never existed before, having a semi-custom custom suite built. So it didn’t happen, no one had them. There was no scale approach to it, so and OEM would give us a set of functional requirements that we would respond to. It would take 2.5 to 3 years over that period of time. You would iterate those functional requirements and you would end up with $50 million to $70 million of R&D cost and a three-year time to market cost.
We reinvented things to take a scalable approach, modularize this so that we can now develop these systems with as much and more functionality than the semi-custom systems had in a 12 to 18 month period at a cost of $10 million to $20 million in R&D and that certainly gives us tremendous flexibility time to market which the OEMs appreciate and it’s evidenced by the fact that 40%, over 40% of our $14.5 billion backlog is scalable in just two years since having announced it.
That's a tremendous takeup rate there or you should say adoption rate of the scalable approach which has really reenergized how we do things and it’s reflected in the operating margins that Herbert will talk about a little later. I talked about the backlog of $14.5 billion, 11.4 of it is infotainment specific. I won't go through the slide and $3.1 billion is premium branded audio and again you can look at that. The pro division, very high margin division, we've guided to 16% to 19% operating margin.
It’s a great business, those of you that had the pleasure or we had the pleasure of having you attend Analyst Day with us, saw a couple of things. An iPad controlled DigiTech guitar signal processor, a lot of fun, everything from Jimi Hendrix playing through a Marshall stack to Eric Clapton playing through a Fender Twin reverb. You've got hundreds and hundreds of things coming out of this box that you can select. Different types of guitarists going through different apps, just a fabulous product for those of you that have to see it, just a demonstration I pointed out and the types of interesting technology that we can do as we look at converging consumer electronics with our other professional audio as well as infotainment and others.
And other thing that’s actually pretty big deal here in terms of potential volume is that expands into transportation audio-video communications market with something that we call IDX. What that is an integrated, full-integrated system of audio-video, paging and actual people movement in large scale transportation facilities around the world. It’s a new thing. We just sold that to the Bogota, Colombia airport.
It comes out of the Pro Division, but again the types of technologies that we have resident in the company. So Herbert, would you like to run us through the financials?
Thank you, Bob. Okay, just to give you a quick highlight. I think most of you know our company is basically a $4 billion company which is pretty close to where we were before the crisis. So we are back at that level, 9% EBITDA just over 12000 employees. You can see it’s broken down into infotainment being about 50% of our business and lifestyle about 30%, professional being the remaining 20%, it’s a general snap shot.
Old slide here, but again we will be reporting in about another month, but for those of you who haven’t seen it, that’s what we did in the first quarter, you could see the significant improvement in the infotainment business going from close to 2% margin to 8% and the rest of them growing, but we had some headwinds rare-earth neodymium which affected the other division, so the margin didn’t increase as like it did in the infotainment division.
The slide I would like to talk about, for some of you that haven’t followed or started to follow us, we like to point out that we have been consistently improving the business year-over-year.
We have simplicity in our business. So, if you follow us on a consecutive basis, you will see a drop off. I repeated many times, to many of you that’s been following us that we get our annual price down, which we call annual price reductions in January.
So our third quarter, which is our fiscal third quarter, typically shows that hit to the margins but if you look at year-over-year, you could see that they’re very consistent. We like to point that out what I talked analysts and investors are going to sometime get the question when we go chopping as you go away because you’re going to have such a large quarter and the next quarters is not as good. I want to point out I don’t call it chopping it. We’ve been very consistent when you go year-over-year.
If you were a company of 6 or 7 billion, then perhaps the drop off wouldn’t be as much. But when you make 50 or 60 million a quarter, 70 million, 5 million changes the margin significantly but sometimes that distorts it.
The slide here is what we call our dashboard, which we like to show every quarter. You can see our targets and our goals there. We like to point out the R&D side, we had a target of 8% of revenues that we set some few years ago and we’re pretty much at that target now. We ended up 8.1% last year. After the quarter, we were at 8.2% and we think 8% is a sustainable number, which means that we don’t plan to reduce our engineering total dollars but we do want to be more efficient at it with our percent of revenues, continue to be the market leader, we will continue to invest in engineering.
I now like to highlight the right side of the bottom is our planned growth in China; 269 million last year versus 35 in ’09, but what's significant is sometime we get the question what happens if there is a big slowdown in China. Yes we have a lot of plans in China but on other hand, looking at those today, it is still not a significant number for us. Only 269 $269 million last year.
Here I would jus like to talk about our capital allocation process. You see that we have very good cash; we don’t have any debt due. I used to say we don’t have any debt due for a while but also with 2012 it’s around the corner now. But you can see we have ample cash to take care of the debt the $400 million of due, we had $690 as of last quarter.
We do our plans as I talked before with a view to look at acquisitions not huge acquisitions, $50 million $200 million. If we find the right target we will above that and or acquisitions are geared at technology, it is geared at getting market access, to get into more of the developing markets, the growth we done already in our Brazil is well as one in the US both less than $100 million.
This slide here we showed at analyst day and in the nest slide is from where we were in the analyst day as well. But I like we talk about this and the key here in takeaway is that our scalable business, which is a higher margin business, that comprises of 40% of our backlog but the real key to this slide is the next one, which I will show you now.
This is the one that we revealed for the first time in our analyst day, in Nashville and the key here is show you that we booked a lot of business under the old traditional business several years ago, customized it and we called it at very low margins.
The good news is through step change that we have we took out more than 400 million dollars of cost, improving our footprint with just that low margin business to around 8% already as it was in our quarter. But on the annual basis we still expect that business to be at around close to 7%, which is the guidance we gave because the 8% we showed in the first quarter was expected to be reduced in our third quarter because of our annual price-downs that come in January.
And we get our savings from our suppliers in July, so we always have a mix year and the problem is normally our first quarter has very low revenues. But this first quarter we had exceptional revenues compared to the prior year, therefore the margins were exceptionally high. So that's when we get those of reductions from our suppliers.
I would like to point out the fact that the backlog mix is shifting with a higher business the green, the scalable business which is 8% to 10% booked margins. So that's just sustain our 7% and 8% going forward where we show over 10% in fiscal year ’16.
So in summary just like to mention that we've had eight conservative quarters of growth top and bottom line. We are doing very well in the BRIC countries we've made an acquisition, but we improved that business by bringing up the market awareness. The EBITDA is high approaching 10%. We've got great liquidity to do ample type of cash for strategic option whether it is acquisition, dividend increase, buyback. We are in a very good position for that.
The scalable systems that we launched about two years ago we already its 40% of our business, that has even exceeded our own expectations. We've got great things of it but its being accepted even better than we had expected. We've increased our marketing campaign. We've informed everyone we expect to spend additional $20 million probably spent in the prior year of marketing. We've never spent very much at all. We probably spent maybe $20 million of that. So really want to increase that.
We have a lot of great products on the consumer side but more importantly on automotive side, with our sound system higher margins, we want to get more of brand awareness and do more things with our dealers and our product development to decide other allocations or which type of systems go into cars.
We continue to drive our footprint, we just opened a new plant in China, the northern China, I like to speak about. We talked a lot of times about two channels. We get the question about the price rising in China, inflation, the wages. We say well. There is another channel. We don’t just go to Shanghai. There is also a Chinese Dandong which is northern China where we opened our new factory which is significantly cheaper than even Suzhou, which is even cheaper than Shanghai. But more importantly there is a fast pace of working in China. So we don’t go to adjust for the cost. That’s why we call it the best cost countries.
And then finally we implemented what we call our scalable manufacturing system as well. In other words, if there is a slowdown we have a significant portion of our manufacturing workforce that are temporary people. So we should be able to reduce them with very minimum cost this time as it as opposed to the crisis time of 2008 and 2009.
Thank you. And now take any questions that you may have. Yes.
[Matt Bloom with Guggenheim] I was wondering if you could just sort of talk about progression of pricing and transition in to the more scalable product and the implications to your margin and on return on capital?
Yes. We know. I shall give you the backlog picture. It already has the price reduction in it and I think a lot of people didn’t understand it, they would ask me what did that mean. My board members have asked. But the numbers we have here, getting soon to 3% to 5% price reduction going forward. So it’s already baked in. So we don’t think there would not be an additional price pressure. The thing we’ve changed over the last few years is that the expected volume is lower is lower than what baked at, then the annual price reductions will be less than what they were. This is something we never had because the automobile industry has gone up for I guess the last five or ten years. It seemed that apparent no one able to put that in to closet because it wasn’t just us. We checked with our competitors. It seems that everyone has the same thing. The annual price reduction was a given and nothing to do with the volume. So we changed that part.
Yes. The margins are should trend that again. The projections we put here for the margin, assumed no price reductions but we also get savings from our suppliers and we also have productivity savings. Also, the scalable system will become a larger part of our backlog. The scalable system has higher margin anyway. So to sustain the margin we roll on the customized business.
The reason that customized business is all bit higher than what we booked it at is, first of all, we took out 400 million of cost. Second, skill plays a big role in infotainment business. We don’t have to hire more sales people to sell more. So there is a higher charge, if there is more of revenues, we automatically get a significant increase in our margins.
Adam Brooks - Sidoti & Company
Adam Brooks Sidoti & Company. Two quick questions. Last quarter you had some spillover from a competitor who couldn't fill customer orders. Did you see anything in this quarter? And two, can you update us on your strategy as far as currency hedging?
Okay. First, I can’t really comment on what we’re seeing in there now as we are in the quite period. But I will repeat what we said in the first quarter, which was the fact that we did have spillover, it was not significant but it was good enough to give a point or two maybe to margins. We expect a little bit, not as much. I guess what we said, we expect a little bit of that to happen in the second quarter.
The question was about currency hedging. Yes what we do, we hedge four quarter out and we don’t get into the game of trying to make profits of it, we try to just take that downside, In order words if we finish the quarter one and the rate as pegged to year old was 1.4 and if the quarter going out for the future year, we are going to hedge that 1.4 to make sure that we don’t get any worse. So when we go down like it did now, we are in pretty good shape with that one. Of course it goes to long-term this was going to have some negative effect. But we also try to do natural hedging in trying to get out customers to give us more in dollars and Euro in Europe as we opposed to Euro and some of them are open to that, because they had their hedging strategy as well. So our main goal is to do natural hedging more than speculation and trying to predict what is going to happen in future.
Chris Ceraso - Credit Suisse
I have two questions first on the Thailand, some of the companies that we have heard from so far telling that the Thailand impact is a little bit worse than the thought. Can you let us know, what kind of impact it had on Harman?
Yes, we have been very fortunate on the supply side. If I go back to the Tsunami as you recall, we had basically no effect from the supply side out of Tsunami. We were affected because one of our top customers Toyota weren’t able to sell as many cars. So that did affect our margins but we were able to supply and that is the reason we are able to take some comparative bids and also with the shortage of our supply.
When it comes to Thailand we seen zero effect. So just again a great credit to our supply management team.
Chris Ceraso - Credit Suisse
And then on M&A front, on the timing, hopefully that the video business is possible area of acquisition?
Well, we will aggressively or I would say we are focused on acquisitions outside of the infotainment area and video would be one, but there are several others that could bump even before that so we will be able to see a focus in that area.
Chris Ceraso - Credit Suisse
I wanted to go back to slide 15; could you just talk a little bit about the range of operating margin for each one of these three categories; it’s pretty obvious that the customized systems you are saying you have 1% margin over the course of the lifecycle and you are obviously you know 2011 at 12%. So what is kind of the sort of low end margin and high end margin over the course of the lifecycle for the saleable contract which you -- that sort of high single digit?
The scalable could go from 8% to 15% even. It depends on the customer and of course the volumes. I think the low-end will be around 8%. The high end will probably be around 15% over the lifetime.
Chris Ceraso - Credit Suisse
And what about the yellow bar?
The yellow bar could go easily double digits. I would say the low-end will be five and the high end would be around 10.
Chris Ceraso - Credit Suisse
And two other questions; how serious are you guys investing in kind of $200 per unit low end infotainment systems?
Yeah. Very seriously looking into that area because the market is what the market is and as there are higher take rates I would like to say that like in the old days there was an option to have a CD in your car, and now a standard infotainment is getting to be that way, every one is going to have a GPS system. So we know we have to be more cost competitive. We are doing a lot with our Indian organization and our Chinese organization and we are getting down to, we believe it would in that range soon.
Chris Ceraso - Credit Suisse
Any thought on when kind of the first contract comes on board, is that three-four years out or….
No. I think you are talking towards 18 months; minimum, maximum I should say sorry, 12 to 18 months maximum.
Chris Ceraso - Credit Suisse
And then last question, you obviously have something very differentiated here on the Scalable systems versus the competitors. What is the competitive landscape looking; and when do you think (inaudible) are all of them still working on the old customized systems or are you seeing any movement where you are trying to catch up on Scalable results?
I think they are working on the customized, but what they are doing same direction as us, is more integration with the connected car. So everyone is working in that area, but they don’t see it down for the Scalable semi standard system, is of course we know. And we obviously, we love to hear back from anything that you guys are hearing, but we still a little bit surprised, on one hand it’s been two and half years. No one has announced anything similar. On other hand, we sometimes wonder because we don’t go compete with the infotainment as the main part of the business, most of them is 2% or 3% of their business, so maybe it’s just not a focus.
Pat Nolan - Deutsche
Hi, Pat Nolan from Deutsche; two questions. First, can you give us an update of where we stand with rare earth cost; I know the price for most of it, but what would it be going to be this year?
I’ll be very careful again and I’ll state what I have said in the first quarter, because when I say in the prior period so I really can’t say much. But we had a gross amount increased from what we’ve said earlier, because our volume increased. However, our savings and the amount that we recoup from our customers increased, so our net exposure went down and so things have been progressing well and so we have been very pleased in that area.
Pat Nolan - Deutsche
Yeah, so it’s got a price tag that is negotiated, and most of the OEMs, here is what's taking us so long. When it’s first announced that would all say, yes, we agree. But as a CFO, I would only like to report numbers that I can touch, I wouldn’t allow us to say we got say X amount just because the customer said, yes. Because they want us to prove to them how much it really increased. We want to just try and get extra amount for them. So we have to go through our ERP systems and show a lot of details to get them finally to size. So when we update our report that we give to the external world, it’s only a possibly sign, not when they stated verbally, we agree with you.
Pat Nolan - Deutsche
For of the suppliers are working for European production down of 5%, you have entered in sort luxury side of the market, much more significantly. What's’ your outlook for European luxury for next year?
Well, I’ll just state what we said, June-July, a lot of people out said that a lot of the top economists in the U.S. were talking double dip and our customers in Europe would say, what are you Americans seeing that we don’t, because we don’t see it, and they were right; nothing happened. So we’re getting the same story right now. They’re not seeing it. It could happen and some one predicts a negative outlook five times in a row they probably be right in one, so I don’t put much credibility to those guys that get to become heroes, that it’s a big double dip every year and get a right one out of four. But right now we’re not seeing it in our field.
Pat Nolan - Deutsche
Two questions; one is just on your comments earlier about how eventually all vehicles will have that system; and I appreciate what you put out in the trajectory of increased Scalable how that should get positive in your margins. But is there sort of been back drop a phenomenon of your existing product portfolio become commoditized overtime and then you are confidently having to put in new point to end technology; is that part of your business as a normal course like other electronic companies?
And then secondly, I was hoping you could may be just comment broadly on how you view other technology companies like Google or Apple; that Google for example specifically extrapolated into financing your automotives base; are they competitors, are they partners, what is that in traditional consumer electronics company and others play very well?
I’ll addressable both, but I think the word safety is the biggest problem of both of those questions. We do the integration and that NAV system controls the entire car. So as a real safety factor in determining who is responsible for that? So as you were talking to the first question of commoditized extended, we’re still adding different technology and different features all the time. We got Facebook and Twitter today we didn’t have five years ago.
What is it going to be another three to five years from now? However, what we do as a management team we don’t ever sit back and rest and sit out as it never happened; that’s why we are making a $200 dollar system. We may even do $100 system another three years from now and as the volumes increase then absolutely our dollars will increase even if the margin go down. So one is, they would be driving for is EPS more than margin; that’s why we gave EPS target now and not margin. So we want to continue to see our business grow at a rapid rate.
And if you talk about Google and all of those companies, again I think the safety factor; who is going to be responsible if something goes wrong? You saw what happened with Toyota and it wasn’t even their fault and they basically took a big down. So I don't know if the Google and everybody else could get in and we know Microsoft has been with Ford for 10 years and I don't think that’s any retraction there. So, but once you get into that I don't know if they get a beginning without absolutely just fine an infotainment company, but then they’ve got a business they want to be in, because they are not going to get to 30% margins from automobile companies they are used to getting.
Okay. Thank you very much.
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