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Harman International Industries Inc. (NYSE:HAR)

F2Q08 Earnings Call Transcript

February 5, 2008 4:30 pm ET

Executives

Dinesh Paliwal – CEO

Kevin Brown – CFO

Analysts

Jeffrey Kessler – Lehman Brothers

Peter Barry – Bear Stearns

Scot Ciccarelli – RBC Capital Markets

Chris Ceraso – Credit Suisse

Peter Friedland – Soleil

David Niederman – Pacific Crest Securities

David Leiker – Robert W. Baird

Operator

Ladies and gentlemen, thank you for standing by, good afternoon and welcome to the Harman International Industries second quarter fiscal 2008 earnings release conference call. At this point all of your phone lines are muted or in a listen only mode. However, later during the conference there will be opportunities for questions and those instructions will be given at that time. As a reminder, today’s conference is being recorded. And ladies and gentlemen, if I may have your attention, certain statements made by the company during this call are forward looking statements.

These statements include the company’s beliefs and expectations as to future events and trends affecting the company’s business and are subject to risks and uncertainties. Actual results may differ materially from the statements about the company’s current beliefs and expectations. Persons participating on the call today are advised to review the company’s earnings release issued today and reports filed by Harman International with the Securities and Exchange Commission regarding these risks and uncertainties. With that being said, here with our opening remarks is Harman International Industries’ Chief Executive Officer Dinesh Paliwal. Please go ahead Mr. Paliwal.

Dinesh Paliwal

Thank you Kathy and good afternoon ladies and gentlemen on this wonderful Super Tuesday afternoon and I thank you for joining the Harman second quarter fiscal year 2008 investor and analyst call. The past weeks have been very eventful and our discussion today is intended to reinforce a spirit of decisive action as we strategically address the challenges facing our company. I’m joined today by Kevin Brown, our Chief Financial Officer, Rob Ryan, our Vice President Tresurer and Robert Lardon who recently joined the company as Vice President Strategy and Investor Relations.

Our Chairman Dr. Harman and I have agreed that it is appropriate that I lead the earnings review and discussion with you this afternoon. He has asked me to extend his regards to the many analysts and investors with whom he has worked over the years and I very much appreciate his counsel and support. As reference for our discussion, I’ll call your attention to the company’s press release dated today and to a set of slides which provide an overview of our automotive division landscape and margin outlook for the company. I hope you have had access to these slides as well. Both of these are available on our corporate website at www.harman.com.

Harman results for the quarter ending December 31, 2007 show continued top line growth coupled with some distinct challenges that are impacting profitability. Net sales for the quarter were $1.1 billion, a 14% increase compared to $932 million for the same period last year. Earnings per diluted share in the second quarter were $0.68 compared to $1.22 in the same period last year. Excluding merger related costs, earnings per diluted share were $0.73. Gross profit as a percent of net sales decreased 6% points to 28.3% for the quarter ended December 31.

Operating income for the quarter ended December 31 was $61 million or 5.7% of sales compared to $116 million or 12.4% of sales in the same period last year. Our Chief Financial Officer, Kevin Brown, will take you deeper into the numbers later in the call. As we shared with you in our press release today, we expect to face continuing bottom line pressure through 2008 and well into the next year. This challenge is largely due to factors which I will explain in some detail along with actions we are taking. In January we announced revised earnings guidance for the year which included a decrease in operating profit of more than $100 million.

The primary drivers of this deterioration are P&D, engineering and material cost and I’ll take you through in detail later. The P&D margin outlook for the year has declined by about $60 million, this is divided almost equally across three factors. One-third was driven by a 60% decline in average market prices, another one-third was due to delayed product introductions and lower volume of new generation products for us and the rest of the one-third was the inventory clearance of prior generation models at a loss. Needless to say, we have learned some key lessons and I’ll share later.

Engineering cost will continue to run higher than expected into fiscal 09 to support the 13 new product launches this year and next for which we simply underestimated the magnitude and complexity. We originally planned for a decline in engineering cost in the second half of fiscal 08 but we cannot risk the timely launch of customer programs and therefore will incur about $30 million of additional engineering this year. Material cost will be about $20 million higher than forecast due to delayed implementation of planned material cost improvements.

Once again, we are unwilling to risk such changes amidst an unprecedented concentration of new program launches. Although we continue to view P&D as an important tool for driving future sales of OEM infotainment systems, it is clear that we must sharpen our strategy in this business. However, Harman markets in the past had two lines of P&D, ones sold primarily in the United States under the Harman Kardon brand and the other mostly in Europe under the Becker brand. We are improving our leverage across these two parallel product lines through the creation of a global business unit responsible for all P&D activities worldwide.

An experienced manager has been appointed to lead this business unit and he has full P&L responsibilities. He has been tasked with creating one, one line of Harman P&D, achieving significant synergies in development, supply chain, time to market, distribution channels and of course all for one brand, not two. These experiences also reinforce the need for timely action in raising productivity and optimizing the cost base for our automotive operations globally. We took several additional steps in this process within the past weeks, announcing the closure of our automotive manufacturing facilities in North Ridge, California and Martinsville, Indiana.

These are the first of multiple actions that will improve our cost structure while shifting [some] resources to other sites in both mature and emerging markets. As we evolve our structure, I have made it clear to my senior management team that personal accountability will be a prerequisite going forward and have redesigned our compensation programs accordingly. Beginning this fiscal year, compensation for many senior managers will be based on Harman group wide performance. This will help our businesses to strengthen the mindset of accountability, not only within each division but also across business lines that impact their Harman peers. Ladies and gentlemen, we have a lot of hard work ahead and this work is underway in earnest. I will comment further on significant recent events after first asking our CFO, Kevin Brown, to provide a closer look at the numbers underlying our second quarter results. Kevin.

Kevin Brown

Thank you Dinesh. I will provide certain information on a non GAAP basis, give you a better understanding of our results exclusive of merger related costs. These costs were $9 million and $14 million for the three and six months ending December 31, 2007. A reconciliation of our GAAP to non GAAP results was included in our press release earlier today which is available today on our website. Net sales for the second quarter were $1.1 billion, an increase of 14.4% compared to the same quarter last year.

Gross profit margin was 28.3% compared to 34.3% a year ago. Operating income was $61 million compared to $116 million last year. Excluding merger related costs, second quarter operating income was $70 million. Net income for the second quarter was $43 million and earnings per diluted share were $0.68. Excluding merger related costs, net income for the quarter was $46 million and earnings per diluted share were $0.73. For the six months ended December 31, 2007, net sales were $2.0 billion compared to $1.8 billion for the same period last year, an increase of 14%.

Gross profit margin was 28.1% compared to 34.5% last year. Operating income was $102 million versus $203 million a year ago. Excluding merger related costs, operating income was $116 million, net income for the six month period was $79 million and earnings per diluted share were $1.23. Excluding merger related cost, net income was $87 million and earnings per diluted share were $1.35. In the second quarter, net sales continued to grow across all three divisions. The growth in overall sales was primarily due to increased shipments of infotainment systems to automotive customers and higher sales of consumer and professional products.

Gross profit as a percentage of net sales decreased 6% points to 28.3% for the quarter. The margin decline was in the automotive division which experienced lower margins on P&D products, product mix range change including higher sales of infotainment systems to mid level vehicles and higher than expected material costs. Selling general and administrative expenses were $240 million for the quarter, an increase of $36 million from the second quarter of fiscal 2007. SG&A expenses for the quarter include $9 million of merger related costs.

SG&A was also impacted by higher engineering costs and foreign currency translation. Operating income for the quarter was $61 million or 5.7% of sales compared to $116 million or 12.4% of sales in the same period last year. The decrease in operating income was driven by P&D, product mix, higher engineering material and merger related costs. The effective tax rate for the second quarter was 25.6% compared to 29.5% during the same period last year. The termination of the merger agreement in the second quarter allowed merger costs to be tax deductible, lowering the effective tax rate.

Foreign currency translation positively impacted quarterly results as the Euro strengthened approximately 12% compared to the same quarter last year. The Euro averaged $1.45 in the second quarter compared to $1.29 last year. As a result, foreign currency translation improved sales by approximately $75 million and contributed $0.15 to earnings per share in the quarter. Our December 31 balance sheet was strong with a cash balance of $159 million and total debt of $581 million.

The debt balance includes proceeds from the issuance of $400 million of convertible notes which were used to purchase and retire 4.8 million shares of the company’s stock. We expect to retire an additional 2 million shares of stock in the third quarter as we complete the share repurchase program. During the second quarter we also used cash to make capital expenditures of $35 million and we made tax payments of $17 million. Accounts receivable at December 31 were $541 million and inventory was $435 million.

Compared to our fiscal year end in June, accounts receivable balance was higher primarily due to the holiday selling season. Our inventory balance was lower. I will now provide some additional information regarding the performance of our three divisions, first with automotive. Automotive net sales for the quarter were up 15.5% from the same period last year, excluding currency effects, sales were 5.4% higher. Sales continued to be strong to key automotive customers, including Audi, BMW, Chrysler, Toyota Lexus and Porsche.

Gross profit as a percentage of sales fell by 9.2 points to 26.5%. The gross margin decline was a result of lower margins on P&Ds, product mix and material costs. Operating income as a percentage of sales for the automotive division was down 9.6 points due to the gross margin impacts and higher engineering and SG&A. The majority of the P&D business is in the automotive division. In the second quarter, P&D sales and margin were down about $30 million and $20 million respectively compared to the same quarter last year.

Both P&D sales and margin were significantly lower due to aggressive price reductions by competitors, the sale of older products at substantial discounts and the delay of new product introductions. In the quarter we reduced P&D inventory by over 30% as we sold down prior generation products, but many of those were sold at a loss. Professional division nets sales for the quarter ended December 31 were up 11.2% from the same period a year ago.

Excluding currency effects, second quarter net sales were nearly 9% higher than the same period in 2007. Professional sales grew across a number of the division’s vertical markets, particularly the touring and installed sound markets. Gross profit as a percentage of sales increased by 1.3 points due to more favorable product mix and lower expenses. Operating income as a percentage of sales was up by 0.5 percentage points to 15.2% in the quarter. Consumer division net sales for the quarter increased $21 million or 12.7% compared to the same period last year.

Excluding currency effects, second quarter consumer sales were nearly 6% higher than the same period in fiscal 2007. The sales growth was primarily in international operations where multimedia and home theatre systems continue to be strong. Gross profit as a percentage of sales in consumer was 26.4%, consistent with the same period last year. For the quarter, operating margins were 9.5% of sales, up 0.5 points from the same period a year ago. Dinesh will now offer a closer look at ongoing strategic initiatives.

Dinesh Paliwal

Thank you Kevin. Well ladies and gentlemen, we have been working on a number of strategic actions and initiatives. Let me start with the top, Harman’s Board of Directors has been expanded to eight members, bringing new expertise and global range. Brian Carroll had joined from KKR, bringing strong financial expertise, Dr. Harald Einsmann, a German national who has worked with such industry leaders as Proctor & Gamble, the Wallenberg Group and the Carlson Group, brings international business experience, Gary Steel, a Scottish national brings experience from Europe’s Shell and ABB Groups, including deep expertise in human resources, restructuring and corporate governance. We have also announced several significant additions to our senior management team in recent weeks.

Richard Sorota, an experienced executive with premium consumer brand companies Procter & Gamble and Royal Phillips had joined the company as consumer division president. John Stacey with 20 years of experience in employee and organizational development across the Americas and Europe is joining Harman this month as vice president of human resources worldwide.

Robert Lardon had joined the company as vice president strategy and investor relations. In addition to Robert’s experience as a management consultant at PWC, Accenture and Booz Allen, he was chief strategy officer at Porter Novelli, a global top ten communications agency. Kent Moerk, a Danish national has been appointed to manage the newly established global portable navigation device business which will integrate the company’s two lines of portable navigation devices worldwide with full P&L accountability.

Dr. Wolfgang Ptacek, who has held senior management positions at Deutsche Telecom and Bosch, was appointed chief technology officer for Harman automotive operations worldwide. Bronson Reed, an experienced international finance executive at ABB joined the company as vice president and group controller. In order to strengthen the leadership and to improve common processes across multiple Harman business, we have created the new position of country manager in the United States and Japan and will extend this concept shortly to Germany, China, India and Russia. Blake Augsburger, who leads the global professional division, has taken this additional role in the US. Ken Yasuda, president of Harman consumer group assumes the additional group-wide country role in Japan.

During the fiscal second quarter, we initiated an extensive review of our global footprint and launched a number of key initiatives to improve simplicity and cost. As noted earlier, restructuring our automotive footprint has been accelerated with the decision to close our automotive plants in North Ridge, California and Martinsville, Indiana. We have also decided to close two smaller facilities in Massachusetts, serving the consumer division. These operations will be integrated with other Harman facilities in California and New York.

Closures and consolidations of additional Harman manufacturing and engineering facilities in Europe and Africa are under review. As a matter of fact, I was in Germany last week speaking with [works counsel] and [eagel matel] and our [buld] as well as employees to bring them the reality check and prepare them for the strategic actions to follow. These actions are expected to result in restructuring charges of $25-$30 million in the third quarter and additional $5-$10 million restructuring charge in the fourth quarter of fiscal 2008. About 1,400 jobs will be affected of which 500 jobs will be eliminated in high cost countries and the balance transferred to other Harman facilities in the United States, Germany, China and Mexico. This will generate more than $50 million in sustainable annual savings.

During this period, we have added several hundred new jobs at our plants in Mexico and China and extensive job training is now underway. We have also decided to add capacity to our plant in Hungary in order to expand production of audio electronics and speakers. We have also taken several important steps to optimize our functional processes. Beginning with the launch of a shared financial service center for our units across North America, this step will consolidate accounting people and processes from some 20 plus Harman locations into one functional team for cost efficiency, common practices and more consistent reporting on time.

We expect to complete full integration within the current calendar year. And then we’ll move on to achieve the same synergy in Europe and in Asia. The company is in the final stage of completing an agreement to outsource its information technology back office infrastructure services. This step will blend an outside service provider solution expertise with emerging country resources to bring us significant gains in both agility and most importantly cost for the same or better quality of services. This initiative will also help us take a closer look at alternative resources for projects related software systems and other related cost. In the third quarter we also decided to consolidate corporate resources from Washington DC and North Ridge, California to our new corporate headquarters in Stamford, Connecticut. This will accelerate the speed of decision making and improve coordination across key company functions.

We expect continued growth in sales across our three divisions, although the economic slowdown may impact some of this growth. Fiscal 2008 performance will be adversely affected by lower P&D margin, as I mentioned earlier, product mix and higher engineering and materials cost associated with new platform launches. We anticipated this and we are reiterating the guidance provided on January 14, 2008. Ladies and gentlemen, in the slice distributed today and they have available on Harman website, we have provided a reconciliation of GAAP to non GAAP guidance for fiscal year 2008. We also expect 2009 to be challenging as we complete the launch of this record number of infotainment platforms.

We are currently at an inflection point in our automotive business with a number of high margin platforms reaching the end of their life cycle and about 70% of our 2009 volume will come from new projects launched in 2008 and 2009. That’s the great news, because we will have a brand new portfolio going forward. Now, some of these will be in mixed segment platforms launched at relatively lower margins and at the same time I should remind ourself and to you, we have traditionally seen an improvement of 100-150 basis points annually every year as these new platforms ramp up. [As of essence] for this, I call your attention to slide number five which titled as automotive profitability through 2013. Please make reference to that.

To reach well beyond this traditional margin growth, we are acting decisively with a companywide restructuring program to improve our productivity and cost structure. Our expectation for this series of initiatives are summarized on slide number nine with the title automotive margin improvement beyond 2010. We estimate that improvements in supply chain, engineering, manufacturing and product mix will yield an additional margin improvement of a minimum of 7%. Ladies and gentlemen, as I look around the broader Harman organization, I am encouraged, not only by our response to current challenges but also by the continued spirit of our people to help in raising the bar.

I have launched a series of regular all employee communications to outline key restructuring principles and the high stakes for achieving them. Employees at many levels across the company are responding with suggestions and support. Three weeks ago, I spoke to a group of some 400 global distributors and channel partners from our professional business in Huntington Beach, California. I came away with a new sense of the spirit that has made this division a consistent profit leader.

Harman professional systems were on hand for Sunday’s Super Bowl halftime show and the others will support the 50th annual Grammy Awards in California this coming Sunday. Work is continuing in Beijing, China on equipping more than a dozen key venues for the 2008 summer Olympics, with Harman audio systems. In our automotive division, we have successfully launched our first infotainment platform, one of the seven for this year, for the leading Korean automaker Hyundai and it was introduced at the Detroit International Auto Show last month.

This new Hyundai luxury sports sedan named Genesis features a state of the art navigation system and a 17 speaker surround sound system from our Lexicon brand. It is worth noting that Harman Lexicon supplies a similar system for the Rolls Royce Phantom. JBL and Infinity consumer brands are stepping up the volume beginning this month with new advertising to the home theatre and whole house audio markets. These target both high end audio enthusiasts and dealer installers from the related trades.

To help in capturing this diverse energy, we launched a new corporate website on February 1, this new site is designed for greater interaction with our brand sites from the three divisions and to help stakeholders chart our progress across this rich landscape. I sincerely encourage all of you to visit our new website which I’m very proud of at www.hamran.com and please take a closer look. Thank you for your attention ladies and gentlemen and I must say I want to say this, I know many of you have been asking us to give you greater details, more information.

I hope I’ll pass at least one test that I have fulfilled that request and we have given you, this is a new day, this is a new environment we’re given you a lot more information, lot more details and we hope this will continue based on your advice and as inputs we will receive. Secondly I’ll remind you that restructuring and strategic initiatives which we have begun. I’ve done it more than once in my life at much more complex environment and a much more distributed environment across hundred countries at ABB. I’m ready for it, my team is ready for it. It’s going to be hard work but we are all up to it. With that, once again, I think you for your attention and we will now open up for your comments and questions. Thank you.

Question-and-Answer Session

Operator

Thank you and ladies and gentlemen if you’d like to ask a question please press star then one on your touchtone phone. You’ll hear a tone indicating you have been placed in queue. You may remove yourself from queue at any time by pressing the pound key. If you’re using a speakerphone, please pick up your handset before dialing. Our first question is from the line of Jeffrey Kessler with Lehman Brothers, go ahead please.

Jeffrey Kessler – Lehman Brothers

Thank you very much, can we delve into a little more detail on the P&D issue with regard to number one, because obviously a rather small piece of business inside automotive had a very large effect on the quarter, while it was not the entire effect, it was a good portion of that effect.

Number one, are you in a position now where you feel you know where your market share is, is the competitive environment so tough that it hearts back to let’s say consumer electronics of ten years ago when it was impossible to make any money and is that division, are the products so integral to the brand or identification with Harman automotive that trying to sell as much P&D as you are trying to do now is that the right strategy?

Dinesh Paliwal

Jeffrey, it’s a great question and I’m happy pleased to share my views with you and rest of the colleagues there. You are absolutely right, the P&D is rather small component of our total portfolio. We did have great ambition to grow in 2008 and of course we learned how this market is evolving. With that said, we plan this business to be around $300 million out of about $4 billion sales we will have in this fiscal year and majority of that $300 million was planned in automotive business.

Market did change rather significantly because when we gave you the forecast if I recall correctly in September, we did check with all our employees and sales and distributors bottom up and we found out that they were enough confidence in the marketplace for the new products and functionality we were bringing that we could sustain those volumes. However, word got completely upside down during the month of October, November, December, 60% price decline even more and don’t need to remind that few of our competitors have felt the heat too.

We got burned couple ways, one, we did not introduce some of the newer generation products on time. So we ended up selling the older generation product at heavy discount. Secondly, market had five, six suppliers in this space and if you look at, I still have a German newspaper in my office, 19 suppliers were pushing their products in the month of December. So everybody was going after the same pie so our volumes shrunk and our margins shrunk and inventories started to be also a bit of a challenge.

So second quarter was effected as our CFO mentioned, but we also have seen now what is the market scenario going forward, we have estimated that impact with our external internal auditors so we have taken a $60 million hit on this business which was supposed to be $300 million. Big hit, lot of lessons learn, you reminded me very correctly that this is, reminds us of consumer electronics in the past. I think we have figured out consumer electronics at least in some sense that we are learning where to play and where not to play.

With that said I will say that our strategy going forward in P&D business is be very prudent, very smart, we’re not going to have ambitious targets to grow this business but we will be in this business, very decisively because it’s a business where we will learn the latest technology being deployed which we will be able to integrate in our in dash business and vice versa, we have heck of a lot of confidence in in dash and I must share this because learning in dash business in terms of what components have to go through the testing at minus 40 degrees Celsius. I don’t think my competitors in P&D space have a clue on that, we do.

And what kind of connectivity we need to understand, we’re talking combination from [adation] of thousands of tickets, failure or bugs which you have to debug them when you integrate. So we do bring lot of knowledge, so with that said, Jeffrey, we will run this business from Far East, we will run this business as a single business, on brand. We’ll run this business with one set of distributors, one strategy and very decisive P&L management who has built a great business in the past and now he has been appointed as general manager worldwide.

So I think with that said, I feel comfortable at this point that 2009 when we are making our plan, we would be prudent and yet challenger in this space. And market share wise you also asked, we still hold a respectable position in German market, we are right around number three or number four depending on which model are we looking at. We certainly like to improve on it but we will be selective. We’re not going to go after low end stuff but we will go after high functionality, yeah.

Jeffrey Kessler – Lehman Brothers

So market share will be less important than having the P&D business be integral to the automotive business itself and driving the brand. I mean you’re not going to go for just, you’re not going for revenue at any cost because clearly it has cost you in the last couple quarters.

Dinesh Paliwal

Jeffrey you couldn’t say better. It’s absolute no for the revenue at any price. We will decline business but we will not even plan business based on ambitions, we will have a very clear strategy and right now team is working on together with Dr. Geiger who is our chief technology officer that what can we plan, what components would go in, what software would go in and how do we launch so that come September, October 08 we are ready to go and people will be also held accountable either contract manufacturers or if we are doing something ourself that we launch these things on time. That’s one lesson I’ve learned, can’t allow this to repeat. So you’re right, not revenue but the brand and the learning both ways in dash versus P&D and P&D to in dash.

Jeffrey Kessler – Lehman Brothers

Thank you very much.

Operator

And we’ll go next to Peter Barry with Bear Stearns, please go ahead.

Peter Barry – Bear Stearns

Good afternoon Dinesh, I don’t think any of us on this end of the phone could mistake your sense of urgency and I’d like to ask you a question that directly relates to that. Were you ever in danger of indeed did you lose any infotainment business that was included in that $14 billion of backlog that prompted you to clearly accelerate a great deal of consolidation and integration activity?

Dinesh Paliwal

Peter, let me give a very clear answer. This is a very relevant question and get asked repeatedly. No, we have not lost any customer, we continue to enjoy the great relationship and I’m glad you asked because otherwise somebody else will be thinking of that question. We have defined our backlog and our automotive sales estimate of ours were received and in the past Peter we have taken the line that we wanted to sort of [tuject] the market and the visibility for seven years which has served us very well but I also take this opportunity to bring in a little flavor of my own.

I come from a very large project business myself, a power plant and large industrial plants, while this $13, $14, $15 billion backlog is great and we’ll continue to grow that, I would like to start my team to start think in terms of what percent of revenue they have secured for current year, year after, years to follow, because that sort of a schedule I like to follow as if part of the monthly reviews and the quarterly reviews. What is prompting that thinking and change with frequent technology changes coming in, our OEM customers are also start to look traditionally the life cycle for infotainment platform was five, six years.

That matched the vehicle life cycle. Now, what we are starting to see a new phenomena that if an infotainment award was given to any supplier, in four years time or five years time or sometimes even three and a half years, OEMs are asking can we have a refresh. Of course, once we are in it, we’re likely to get that refresh. But I don’t want to count six years every time once we get award. We have to ask the tough questions from our customers in future, do you have an intention to look for a refresh in four year’s time and if that’s the case, our calculation in future will reflect that. That’s the clarify I wanted to share with you.

Peter Barry – Bear Stearns

Let me take that one step further, were there any performance issues that basically prompted the acceleration if not explosion in R&D and engineering expenses?

Dinesh Paliwal

Can you repeat the first part please?

Peter Barry – Bear Stearns

Any performance issues as it related to the infotainment systems that you were delivering.

Dinesh Paliwal

Well I will turn it around and say we grossly underestimated the effort, so one can say our efficiency and our assessment of complexity and the magnitude of seven very complex infotainment platform was not up to the mark. I remind the slide in the package we have given, if you look at the slide number seven, it shows clearly in 05, we had two infotainment platform, we had zero infotainment platform in 6, we had two in 7 and now here we are for 08 and 09, we have 13 platform. I don’t know any company out there who has undertaken even half of that load.

With that said, Peter, organization at Harman did not comprehend the reality, did not perhaps plan earlier and that’s a lesson learned. We did not do it, we did not leave it because we, we knew that we had to do it, we did not, this is where I said we grossly underestimated the effort in complexity. Therefore, I am forced to say whether I like it or not that I have to continue to keep the higher R&D cost, engineering cost for full fiscal 08 and well into 09.

Last week I was visiting with large OEMs and I promised them that you should be well assured that your SOP, your platforms are my priority and these will be delivered on time within your schedule. We will not cut the resources, as a matter of fact, if I have to I’ll bring in a few more additional external resources to help us. So it’s not a performance issue it is the planning issue, it is the underestimation issue which we have learned a great deal.

Peter Barry – Bear Stearns

So your systems lived up to your expectations even during this very difficult period?

Dinesh Paliwal

Well, Peter, see that’s another topic which I can also elaborate. When the organization is used to delivering one or two or even no platform in a year, and all of the sudden you’ve got seven and six thirteen, you discover the holes in your business processes and inefficiencies built into the system which were not exposed when you had one or two a year.

And with that, why did I say in my introductory comments that I was in front of works counsel in [ega metal], believe me I don’t have any desire to be in front of these people, they’re a feisty group of people but I did because I wanted to prepare them that this organization in Germany needs efficiency gain which means we have to review our consolidation because if you listen to my customers they’re telling me what I should do, which is good. They’re saying Mr. Paliwal, for you to be efficient and deliver large complex projects, you must do it from fewer centers but strong centers of confidence.

Right now we are spreading ourself too thin in Germany, probably ten sites and that’s something as a core determination topic according to German law, I will sit down with my colleagues at the Board as well as works counsel and union to determine what is the right way to consolidate sites and create stronger fewer confidence centers to prepare ourself for better efficiency and gain. That’s the big lesson for Harman International. Nothing new for me, I’ve been through this before.

Peter Barry – Bear Stearns

Last one from me Dinesh and maybe this is for Kevin but your slide nine speaks to margin improvement of 7-10.5%, could you tell me, and this is beyond 2010, so should we, one, could we conclude that margins will be under pressure right through fiscal 2009? And could you tell us where that margin improvement, what the base number is that you’re improving from?

Dinesh Paliwal

Peter, let me try to take shot at it and my CFO can jump in. We worked as a team for several weeks, this is a bottom up approach, it didn’t happen overnight. We did a key strategic initiative this organization must embrace. This is going to be hard. This is going to break some relationships with suppliers, with 50 mile radius sourcing, stuff like that has to be challenged. But what we have done here is, I would say in my view as other conservative approach to three main buckets, global supply chain initiative, global footprint initiative in manufacturing and engineering, I think engineering has lot more to squeeze juice out of than we have shown here and product mix. Let me start backward from product mix.

Product mix is what we’ve got. I have over the holidays, fun holidays, but we worked together to analyze the entire backlog to the Nth decimal. We have done that, entire backlog, spread not just in 12, 13 but for some 35 sublevel SOPs. So we know exactly what the contribution margin we have in our backlog. That can only improve and will improve as we saved 100-150 basis point on each new platform as we ramp up, we’ll see annual gain in contribution margin. So that’s given. Now as we bring these conclusion to these 13 SOPs or platforms, we will not carry the high level of engineering cost and mind that I’m not going to sit quiet. I’m pretty restless right now to get alternative engineering setups in Ukraine, Poland and India and China.

My chief software architect has been in India for two weeks and right now he’s in other parts of Asia talking to people and we’re not going to start from scratch. We’re going to cooperate with some companies who can give us running start fairly soon. So as we bring engineering costs down, simultaneously with the SOPs completion, that is back end of 2009, so in 2010 we would expect margin improvement from contribution margin, product mix is changing, cost is coming down and that is shown actually on slide five Peter if you see.

Our operating income is growing, our contribution margins are deflected what they are. But operating income is the end result of contribution margin and the slide next to which says total functional cost and total engineering. And in addition we have these three big buckets which we’re going to be initiating and we have team coming together who will take on one of these initiatives each. So that’s what I believe that 9 being challenging, more like a transition year. Lot of hard work year. But with the backlogs secured, with quality of backlog well defined, come 2010 we start to see a clear and significant improvement in our operating performance.

Operator

Thank you we’ll now move to the line of Scot Ciccarelli with RBC Capital Markets, go ahead please.

Scot Ciccarelli – RBC Capital Markets

Hi guys, Scot Ciccarelli, I had a question about slide number five. I know it’s not scaled, but it looks like you’re looking for automotive profitability to decline again in 09 from 08 and since that’s really the main profit driver and Dinesh given your cautionary comments about 09 already, should we be assuming at this point full year earnings decline in 09 verse 08?

Dinesh Paliwal

I would not go that far because it has been a single biggest profit driver but I think we are building excellent business in [at pro] which unfortunately we don’t get to talk about much. It’s a great business and we are growing that very nicely, double digit and with a clear market position we have leadership and with certain initiatives we are planning I think this business will become one of the major contributor if not the contributor in near future.

But coming back to automotive I would say we are not giving any guidance for 2009, 2009 we are saying will be a challenging tough year, while we work through, but the good news is we do have the backlog and we know the quality of that backlog and second good news is we have seven plus six, thirteen and many of them are high end infotainment platforms, they are launching, so 70% of the mix will be brand new and as it ramps up every year we will get 100-150 basis point improvement in that, so profitability will grow. So in [at nat] 2009 is going to be challenging year not given any guidance right now.

Scot Ciccarelli – RBC Capital Markets

Okay, fair enough and then another question. You had talked about some of your customers and I know you said you haven’t lost any but Mercedes who’s still your biggest customer, they were conspicuously absent in your list of strong customers and by our math, sales to Mercedes were down about 10-12% after adjusting for currency in the first quarter, can you help us understand what’s going on with that because it’s pretty material to the overall revenue of the company.

Dinesh Paliwal

Absolutely, in fact I was with Daimler last week in Germany. They are, if they are absent from our list then I’ll make sure that they’re not absent anymore in the future because they remain a very strategic and key customer. As a matter of fact we are building on their new S class refresh as we speak and we have ongoing relationship. I do admit that one of the infotainment platform with Mercedes which began perhaps what three, four years ago, that in next couple years would be coming towards end of its life cycle. Having said that, there are other businesses which are starting to happen or will happen with Mercedes. We are well aligned, we have excellent relationship with Daimler and I feel good about that customer for future.

Scot Ciccarelli – RBC Capital Markets

Okay, great, thanks a lot guys.

Operator

We now have a question from Chris Ceraso with CS[ST], please go ahead.

Chris Ceraso – Credit Suisse

Hey, thanks, good evening. I’ve got 25 questions, how much time do you have? Alright, maybe we can start with an update on the Chrysler program. A few points there, can you give us a feel for how far along the way you are on ramping that program, maybe what the customer take rates are on the nav system on the new minivans and then just trying to compare the revenue versus the cost. Are you still losing money on that program and when do you think the revenue will match the cost and eventually do you think you’ll still get back to a 15-16% margin on that program?

Dinesh Paliwal

You mean on Chrysler?

Chris Ceraso – Credit Suisse

Yeah.

Dinesh Paliwal

Alright, Chris let me start, you’ve asked already your 18 questions in one question, but let me try.

Chris Ceraso – Credit Suisse

That’s just one. I’ve had three weeks to stew on this guys.

Dinesh Paliwal

No problem, let me start. First of all, Chrysler relationship is solid and sound. I was with their senior management last Friday in Detroit because not only we are successfully ramped up with the current program but we are also working on new generation very high end infotainment platform which Cerberus the new owners would love to see a differentiation and they have turned to us as a leader in this space and we are very happy with the progress so far. With that said, Chrysler volume in the second quarter was up 50%, five zero, since quarter one of 2008 as the [my gig] infotainment system is now installed on more than a dozen platforms across Chrysler portfolio.

And in fiscal year 2009, we will launch on the Ram truck and Cavalier Compass, the remaining. So when you talk about the take rate, the family oriented vehicles and SUVs, they’re running anywhere from 10-35% depending on the model which is pretty good penetration when you say 35%. And sedans are running 5-20%. But we are satisfied with the development with Chrysler and we expect by fiscal year 2008 end of the year, we would be fairly close to the targeting number of infotainment platforms we will be shipping to them.

Now comes the challenging part of making some money out of Chrysler, I hope they’re listening because we don’t make much money out of them. As a matter of fact, half of our business with Chrysler is slightly profitable and the other half is not profitable. So in net net when you add everything, it’s probably break even, slightly below zero. I can call it maybe just a black zero if not a red zero. So that’s where we are. So taking a zero to 15-16, I think I should not dream of that, it won’t happen in near term. It may happen under different programs where different technology and different feature functionality will be packed, that’s what we’re working on, so this one, the only way we can improve our profitability is to work with Chrysler diligently with their processes and find creative design changes to improve their functionality and take the cost out. That’s the only thing we are doing and we’re working on that’s going to be tough but this is the only way we’ll approach.

Chris Ceraso – Credit Suisse

Was it just bidding inappropriately or why is this unprofitable if you’re up to kind of your full rate now?

Dinesh Paliwal

Well, you know hindsight is always 20/20. When we got into this relationship it was all good intentions and we actually got awarded one mixed segment business and one high end business and high end is profitable for us. It’s the mixed segment business where we thought we would be able to scale it down from the top infotainment and bring it down and fit the mold of the cost of the mixed segment. We failed.

We delivered first class functionality, they love it, but we did not get the cost level we thought. With that said, you’re prompting me to say, I’ve also done a heck of a lot of analysis, the mixed segment infotainment development and entry level development would not be run in Germany, it would effective very near future under the leadership of Dr. Geiger will begin in [Sanjeng] China and in Beijing China. That is the way we’re going to grab the latest technology, the efficiency, the speed and the cost level while take all our competence from Germany and United States in terms of navigation and the debugging, the testing approach, the processes. I think that is going to create a differentiator for us but that doesn’t help immediately in Chrysler.

Chris Ceraso – Credit Suisse

Back to one of your earlier comments in your remarks, you said that in the breakdown of what happened, the $100 plus million hit to EBIT as you went from $4.00 to $3.00, $60 million was P&D. Did you say how much was R&D and engineering and how much [overlay].

Dinesh Paliwal

Yes Chris, I said that $30 million is engineering out of that. $60 was P&D and $20 is in material cost.

Chris Ceraso – Credit Suisse

And when you talk about material cost, it’s not commodities per se, like you said you’ve had your regular price downs but you’ve missed your window or were unable to recapture that through resourcing and other efforts. Is that right?

Dinesh Paliwal

Absolutely right, thanks for guiding yourself the answer. It’s not the commodity driven, not at all. It’s the window missing, number one. Number two, you know these new platforms which we are launching like Genesis, the fantastic Hyundai launch we just had and others to come, we had anticipated that we will have enough time and flexibility to design in a few more substitutions of component.

When we are running so tight and crammed and running with significantly higher load than we expected, you know our organization is not willing to risk by replacing or substituting components and risk the big picture. And so therefore we are also proactively not pushing some of the substitutions. One is the customers window and another one is our own proactive decision to delay it until we have launched them all successfully. As I have said again, this estimation of the complexity and magnitude, that’s what really added up to this $20 million.

Chris Ceraso – Credit Suisse

That’s what’s different from the previous conference call, because you had already highlighted this as an issue, right?

Dinesh Paliwal

We highlighted this issue but we did not until then, this is the December, I can share in the spirit of absolute full openness with all of you guys and that’s what I stand for, if Peter is listening, Peter [Seperstorn] who said that we want you to follow like ABB used to while I’m here and we’re going to do that, that’s how my team will work. You know we highlighted but we had no clue that complexity of these programs when we start to test the full system in December that we will discover that we have quite a bit of testing and debugging, testing and debugging to be done and that’s what is driving us right now, our people didn’t even have proper holidays and we are deploying more resources. During that time, you don’t want to throw one additional element of complexity by substituting the component, that’s what happened here. Lesson learned.

Chris Ceraso – Credit Suisse

Okay.

Operator

We’ll go next to Peter Friedland with Soleil, please go ahead.

Peter Friedland – Soleil

Hi, when you talk about your pipeline going forward like 2011 beyond, how much of that business includes refreshes that you haven’t won yet?

Dinesh Paliwal

Hi, Peter, thank you. Let me start, when you say pipeline for 2013 right? Maybe I should try to use my approach which I was saying, I like to use going forward. Let’s start with fiscal 08 which is of course 100% secured in our backlog. Fiscal 09 I think we are very close to 90%. Fiscal 10 is about 80%. Fiscal 11 is 60 and it goes on into 13 and 14. So when I say fiscal 10 is 80%, so we need to secure additional 20% of the business to deliver in fiscal 10.

So that’s where we are and other part of your question is refresh. If traditionally we had let’s say two or three refresh in three year’s time, we expect now probably double that number going forward because there will be more refresh which I think is exciting for us because we do want to have refreshes and that allows us to not only take advantage of the new technology but also allows us to do the engineering changes, material changes and also keep our customers current with our technology. So that’s what is going to happen, but to answer your question, we have fairly good coverage for our revenues in out years here.

Peter Friedland – Soleil

Great, thank you.

Dinesh Paliwal

Have I answered your question?

Peter Friedland – Soleil

Yup.

Dinesh Paliwal

Excellent, thank you.

Operator

And we’ll go then to David Niederman with Pacific Crest Securities, please go ahead.

David Niederman – Pacific Crest Securities

Thank you, good afternoon, so just a couple of quick clarifications. So when did it become apparent that the challenges in the P&D business were really coming to bear? Was it October?

Dinesh Paliwal

No, it became apparent during holiday periods. Already started, look we had interesting times. I hope those are times will not be repeated at least with us in our company. We sold and then our last distributors like companies in Germany, they could not push the volume out so we had to get some of the products, help them out, either [score] protection, price protection, all of those things which we are aware of that in consumer words you do but we started to discover that market was getting flooded in November, December timeframe and we started to get feedback from our wholesalers or distributors or stores that the take rate from them to the end users was slowing down or there was a glut with the price pressure and we had not issued them instructions to drop the prices significantly.

But then we started to see the volume not clearing up, inventory buildup, then we started to actually take the price hit. Or actually secure one or two wholesalers to take the stock back and resell it at lower prices or at a discount or even at a loss. So this became or started to become apparent in November and in December it was almost very clear that we had a problem with that business, late December. That’s where we started to see that we needed to think about going to the market immediately, we analyzed that, beginning first week of January and we could not even wait for three weeks to come to February 5.

I proposed to the Board and unanimously Board supported that I you already know something go right now, don’t wait for the February 5, which we did. I know a lot of you are unhappy with me that we did not give hell of a lot of information that time. I hope you will forgive me for acting immediately in the spirit, if I know I’m going to share this with you even if I’m not 100% prepared with all the answers. So we knew about it around December timeframe.

David Niederman – Pacific Crest Securities

Great and again I was hoping you could provide maybe a little clarification into the motivation behind the buyback and the timing of the buyback. You know as you look at the stock price in say the low 80’s with the pressures mounting, maybe they weren’t quite apparent in October that the P&D pressures were mounting to the rate they were going to, but still, was it the appropriate thing to do at that time to lever up the balance sheet in this way?

Dinesh Paliwal

Right, I’ll start but I think I may need my CFO’s help. But based on when the program ASI was launched, at that pricing we knew that we were going to get some 4.7 million shares. Of course price has been depressed since then and we know already at this point that we will have surplus cash which will allow us probably additional 2 million shares to be bought. So we will be north of 6 million shares we’ll be acquiring with this current ASI program when it completes. But as such, our current program will be complete around the end of this month.

David Niederman – Pacific Crest Securities

Thank you.

Operator

Thank you our final question will come from David Leiker with Robert W. Baird, please go ahead.

David Leiker – Robert W. Baird

Hi, good evening. Handful of things here. First, a numbers question, Kevin I believe, do you have an R&D number for the quarter?

Dinesh Paliwal

David I can hardly hear you clearly, can you come close to the speaker perhaps?

David Leiker – Robert W. Baird

Do you have an R&D number for the quarter? What the R&D expense was?

Kevin Brown

Yes, David, R&D net R&D expense for the quarter was right at $100 million or about 9.4% of sales.

Dinesh Paliwal

This is for the whole company.

David Leiker – Robert W. Baird

Okay and then, given the discussion you had with Chris on the Chrysler business, the comment had always been that if you moved at a mid level and have lower gross profit that the SG&A cost is lower as operating margins are comparable. Is that no longer the case?

Kevin Brown

Well I think part of that is the cycle and the timing as Dinesh explained that we are in. We’re in the high investment phase right now. In addition, when we initially launched these programs, typically launches the lowest margin point of the cycle of that business. So we’ve not been able to implement all the plan cost initiatives that we’ve had on the mid segment programs given the work load we’ve had. We’re in the early phase of that cycle. So we think and as we showed in the slides, we expect that business to progress as we go forward. I think that answers your question or was there more to that question?

David Leiker – Robert W. Baird

No, I don’t want to put words in your mouth but is it fair to say it’s too early to tell?

Dinesh Paliwal

No, I would not say it’s too early to tell. I think we know the quality of the backlog and we know for sure that what are the levers we have to push and pull and we have started, we’re not just talking. So I think David it’s fair to say that hard work ahead but we’ll start to see improvements as we move forward.

David Leiker – Robert W. Baird

And then I want to reconcile slide six and seven. On slide seven you have a line on there showing R&D engineering, I’m assuming that’s a dollar number?

Dinesh Paliwal

It is a dollar number, that is correct. Well, no, no, let me take back. This is a percent of sales number.

David Leiker – Robert W. Baird

On slide seven?

Dinesh Paliwal

In slide seven, sorry, that is not a dollar number, these are just numbers. These are number of infotainment launches.

David Leiker – Robert W. Baird

What’s the line that’s on there that’s labeled R&D

Dinesh Paliwal

The line is percent R&D of sales. Percent of sales.

David Leiker – Robert W. Baird

Okay so you have your revenues going up because of new business?

Dinesh Paliwal

That is correct.

David Leiker – Robert W. Baird

Your R&D costs in 09 are coming down?

Dinesh Paliwal

09, be careful, this line might not be drawn properly. I would expect this line to start to taper down and really get tapered down in 010, but 09, back end of 09 will start to come down. It will come down because the revenue going up number one but we will be also optimizing R&D both by changing the R&D footprint and also not allowing absolute R&D dollars to grow while revenue grows.

Kevin Brown

Yeah, I think the chart on slide six is the better chart for the R&D line which shows it staying fairly high through 09 as Dinesh said, back half 09 we start to see progress but 010’s where you see real improvement.

Dinesh Paliwal

Right, if you see slide six, Robert, that might be a little better representation in terms of direction.

David Leiker – Robert W. Baird

Great and then if we look at the timeline of things that you have to do Dinesh in terms of identifying things, actions to take, putting actions in place to implement that and realizing the benefits, where, what do you think that timeline looks like as we go through those phases?

Dinesh Paliwal

You know, depending on different actions, like the current restructuring in the Q3 and Q4 we’re announcing, that will happen fast, 12-18 months you start to see annual savings and I have said in the script which I shared with you that we’re going to see north of $50 million annual savings from the restructuring we’re doing, but that’s a very small piece. Then comes the heavy lifting in terms of global manufacturing footprint. Optimizing between high cost and low cost. Right now, Robert, we are close to 80% of our manufacturing is in high cost countries and 20% in low cost.

When it comes to engineering, let me have a little break here, I will say 99% in high cost country and 1% in low cost country, it’s not 100. So moving those competence, takes time, it won’t happen in 12, 18, 24 months because you’re dealing with competence. You move competence, you develop competence in locations in Eastern Europe so those will take some time. They will begin already in calendar year 2008. Some of them have already started the work but by the time you see them complete and you see the net impact, we’re talking 2010 and beyond. That’s why the slide number nine, when we say company wide margin improvement, 2010 and beyond.

David Leiker – Robert W. Baird

Okay and then one last follow up that slide, on slide ten, I don’t, unless that you talked about it, but the base period that you’re using is what level of profitability? What’s the margin number you’re using as a starting point?

Dinesh Paliwal

The base level we are looking at 2008, the guidance we have given you.

David Leiker – Robert W. Baird

Okay and that’s, okay, thank you.

Dinesh Paliwal

Kathy, I would like to say a few concluding comments quickly to our attendees and analysts and other investors.

Operator

Thank you please go ahead.

Dinesh Paliwal

Well ladies and gentlemen it’s been a wonderful session at least a lot of hope and you’re understanding that we’re not sitting idle. We are at work, very aggressively and very decisively. But I hope this detailed review helps to illustrate that we are committed to change. Committed to change, that’s the message I want to get away with and that change is defined as taking the steps necessary to build a strong Harman International. We recognize that a lot of hard work lies ahead to restore our company’s remarkable momentum. And I’m personally committed to timely and decisive action towards this goal. And I truly look forward to continuing our communication and to your support as we work together in helping Harman to achieve its full potential which is out there, we can see it and we’re going to get there. Thank you very much, have a great evening.

Operator

Thank you Mr. Paliwal. Ladies and gentlemen your host is making today’s conference available by digitized replay for two weeks and by web replay for two weeks. The digitized replay is available starting at 6:30 PM Eastern time, February 5, 2008. Simply dial 1-800-475-6701 and at the voice prompt enter today’s conference access code, 908855. You may also go to www.harman.com to listen to the web replay. You will need to enter the access code 908855. That does conclude our earnings release call for this quarter, thank you very much for your participation as well as for using AT&T executive teleconference service. You may now disconnect.

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Source: Harman International Industries Inc. F2Q08 (Qtr End 12/31/07) Earnings Call Transcript
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