Benchmark Electronics' (BHE) CEO Gayla Delly on Q2 2016 Results - Earnings Call Transcript

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Benchmark Electronics Inc (NYSE:BHE)

Q2 2016 Earnings Conference Call

July 21, 2016 11:00 AM ET

Executives

Lisa Weeks - VP of Strategy, IR

Gayla Delly - President and CEO

Don Adam - CFO

Analysts

Steven Fox - Cross Research

Mitch Stevens - RBC Capital Markets

Jim Suva - Citigroup

Herve Francois - B.Riley

Sean Hannan - Needham & Company

Presentation

Operator

Good day, ladies and gentlemen, and welcome to the Benchmark Electronics Second Quarter 2016 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions] As a reminder, this call may be recorded.

I would now like to introduce your host for today's conference Lisa Weeks, Vice President of Strategy, Investor Relations. Please go ahead ma’am.

Lisa Weeks

Thank you, operator and thanks everyone for joining us today for Benchmark’s second quarter earnings call. With me this morning are Gayla Delly, President and CEO; Don Adam, CFO. Gayla will provide an update on our near-term outlook and our strategic priorities and Don will provide a detailed review of our financial results followed by a question-and-answer session. Earlier today, we issued an earnings release highlighting our financial performance for the second quarter and we have prepared a presentation that we will reference on this call. The press release and presentation are available online under the Investor Relations section of our website at www.bench.com. This call is being webcast live and a replay will be available online following the call.

Please take a moment to review the forward-looking statements advised on slide 2 in the presentation. During our call, we will discuss forward-looking information. As a reminder, any of today’s remarks that are not statements of historical fact are forward-looking statements which involve risks and uncertainties described in our press releases and SEC filings. Actual results may differ materially from these statements and Benchmark undertakes no obligation to update any forward-looking statements. The Company has provided a reconciliation of our GAAP to non-GAAP measures in the earnings release, as well as in the Appendix 1 of the presentation.

I will turn the call over to our CEO, Gayla Delly.

Gayla Delly

Thank you Lisa and good morning everyone. We are happy to have you with us to review our second quarter successes and challenges and preview our third quarter. Please turn with me to slide 4 in the earnings presentation. Our second quarter results for 2016 were in line with our expectation, revenue of $579 million and non-GAAP EPS of $0.31 were each near the mid-point of our for guidance. The higher value markets grew quarter over quarter led by strong performance in Medical, and Test & Instrumentation where our new bookings have been strong. Industrials lagged a bit as the number of new program ramps in the regulated aerospace and defense markets were delayed. In our traditional markets, revenue increases were lead by stronger than expected demand from some of our top Computing customers. Telco declined as expected sequentially with the completion of legacy products for one customer.

Incorporating these industry dynamics for the second quarter, our year-over-year revenue from higher value markets increased from 53% to 63% reflecting the progress of our portfolio and the Secure acquisition. Our year-over-year gross margin improved to 9.1% as a function of our business mix and productivity improvement. Our recent investments to enhance our sales, marketing and engineering efforts in support of our business strategies are impacting our current and near-term margins. These intentional SG&A investments impact our short-term performance while they lay the foundation for future growth in our targeted markets building a richer margin profile. Including these costs, our second-quarter operating margin was 3.7% in line with our guidance.

Going forward, we have defined cost realignment actions to offset these investments and Don will provide further updates on this in our operating expense outlook. During the quarter, we generated strong free cash flow, our progress on our working capital initiates allowed us to reduce our cash conversion cycle from 99 days last quarter to 83 in the second quarter. I'm encouraged by the solid performance from our teams on these initiatives and the improvement we have made during the past 18 months where we have implemented more efficient demand management and supply chain solutions. Our progress on these initiatives has been strong but we have more work to do in this area. We are on track to achieve our 75 day target as we exit the fourth quarter.

So in the first half of 2016, we generated $141 million in free cash flow which compares to $16 million generated for the same period in 2015. Finally, we returned $15 million of domestic cash to shareholders through our stock repurchase program. The second quarter was our 36th consecutive quarter of stock buybacks and we have returned more than 44% of our free cash flow to shareholders in the past three years. We remain committed to our current programs which has $105 million remaining. Please advance now to slide 5 for a review of our second quarter new bookings. During the second quarter we won 33 new programs and 12 engineering projects and these are expected to result in annualized revenues of $105 million to $130 million when they are fully released to production. Two thirds of these new bookings were in our targeted higher value markets and represented a balance healthy mix of traditional bookings.

Over the last 12 months, bookings in the higher value markets represented 77% of our new program wins, which aligns with our longer term goal of generating greater than 70% of our revenues from these targeted markets. We are in the early stages of transforming our sales and marketing activities under new leadership. I'm encouraged by the progress today in the quality we offer some of these from the design solutions for our higher value markets and complex manufacturing and process development for our traditional market. New program ramps remains a key driver to our business in the near term. So to sum up the quarter, we delivered on our expectations despite seeing some softness across some of our target market and the normal operating inefficiencies associated with program ramps during the second quarter.

Now please turn to our Q3 guidance which is on slide 6. Looking to the third quarter, our revenue is expected to range from $570 million to $600 million. This guidance reflects mixed market performance based on indications from our customers. We expect increased revenues in Industrials and Telco to be offset by seasonally lower demand in Computing. Our medical revenue is expected to be flat to slightly down for the third quarter. As we move to our earnings guidance, to increase reporting consistency with our peers we will separately disclose amortization of intangible assets in the income statement beginning in Q3. In addition, our non-GAAP guidance will exclude the impact of this amortization of $3 million or $0.05 per share. A full reconciliation can be found in the Appendix 2 of the earnings presentation. Our non-GAAP diluted earnings per share are expected to be between $0.33 and $0.38 and implied in this guidance is a 4.1% to 4.4% operating margin range. This guidance reflects the anticipated incremental investment and our go-to market and engineering programs.

Now let me turn the call over to Don Adam, our CFO who will provide more details on our performance for the quarter. Don?

Don Adam

Thank you Gayla, and good morning to everyone. I will start on slide 8 with a second quarter recap of our income statement. Our second quarter revenues of $579 million were within our guidance and up $30 million from the last quarter as each of the market sectors improved excluding Telco which declined as we forecasted. Our year-over-year quarterly revenue declined by 13%, due to lower demand in our traditional markets. Second quarter net income of $13 million and non-GAAP net income of $15 million were both up sequentially. Our GAAP results included approximately $3.6 million of expenses associated with restructuring and other activities including our recent proxy contest. Our GAAP EPS was $0.26 and our non-GAAP EPS was $0.31 for the quarter, which were in the range we expected. Our non-GAAP operating margin improved by 20 basis points from the last quarter to 3.7%. Second quarter non-GAAP effective income tax rate was 21.8% and we expected to be approximately 23% for the next quarter. We increased from Q2 to Q3 as a result of the tax impact of excluding amortization of intangibles from non-GAAP income as Gayla just mentioned. The diluted weighted average shares outstanding for the second quarter were $49.7 million.

Now please turn to slide 9 for a discussion of our quarterly business trends. Gross margins have improved 70 basis points from the prior year as we’ve transitioned our portfolio to a higher mix in our targeted markets. SG&A expenses of $31 million which were in line with our expectations reflect the increased investments in go-to market engineering resources. Again our non-GAAP operating margin was 3.7% in the quarter. In line with our business outlook we will drive further improvement gains as we optimize our manufacturing footprint. In connection with these actions, we expect to incur restructuring charges of $4 million to $5 million in the coming quarters. Starting in 2017, we expect that these actions to result in annual savings of approximately $5 million to $7 million. Our return on invested capital was 8.5% for the second quarter. We are focused on driving return on investment capital above our cost of capital. This includes driving free cash flow which has been off to a good start in the first half of this year.

Now please turn to slide 10 for results and the quarterly outlook by market sector. Industrial revenues were $214 million, up slightly from the first quarter but below our expectations because of product qualification delays primarily in the aerospace and defense market. Overall we expect industrial revenues to be up low to mid single digits for the third quarter. Choppy demand persists for our diverse base of customers for those who have exposure to the currency effects of the strong US dollar and weaker emerging markets. Our medical revenue was $92 million, up 11% sequentially from the first quarter and slightly above our estimates. We expect medical revenues to be flat to down mid single digits in the quarter. Test and instrumentation revenues of $60 million increased sequentially by 13% and were above second-quarter expectations based on stronger demand from our semi-capped [ph] customers. We expect demand to remain stable for the third quarter. In summary, our higher value markets were characterized by stability in our medical, and test and instrumentation customers with pockets of uncertainty in our broader industrial customer base.

Now turning to the traditional markets, computing revenues of $120 million increased sequentially from the first quarter and were above expectation because of higher demand from our top computing customers. We are guiding computing to decline about 15% in the third quarter primarily due to seasonality. Telco revenues of $93 million were down 9% from the first quarter as we expected. We have now completed the production for the maturing and non-reviewing program from our top Telco customer that we discussed last quarter. We are ramping new programs in the broadband and optical markets and expect Telco to be up 20% sequentially in the third quarter. We expect demand from these new programs to remain strong into the fourth quarter. For the quarter and for the full year we expect to have no 10% customers. We have a number of opportunities with new and existing traditional customers and remain committed to our strategy to serve more complex requirements in this space.

Now please turn to slide 11 and I will highlight some balance sheet and cash flow items. Our cash balance at June 30 was $573 million, which is up $54 million from the previous quarter. our US cash balance was $38 million and total debt was $229 million. Our cash cycle days for the second quarter ended at 83, which reflects the effectiveness of our ongoing working capital initiatives. Accounts payable improved sequentially by 8 days to 47, while inventory improved by sequentially by 6 day to 64. In the past 18 months, we have worked to optimize legacy supply chains from outsourcing projects, primarily in our international locations. And for the third quarter, we expect the cash conversion cycle to improve to approximately 80 days and we remain on track to achieve 75 days as we exit the fourth quarter. And the majority of these improvements will benefit outside the US.

Please turn to slide 13. We remain committed to consistently returning value to shareholders. During the second quarter we invested $15 million to repurchase 750,000 shares and we have $105 million remaining for future repurchases. Our capital structure is sound and provides us with a flexibility to support our business. Now I will turn the call back to Gayla for a few closing comments. Oh, excuse me. When I talked about cash flow I skipped that page. We generated $81 million in cash from operations for the quarter, which brings our year-to-date cash flow from operations to $158 million. This quarter, our capital expenditures were $8 million and depreciation and amortization expense was $14 million. For the full year, capital expenditures are expected to range from $35 million to $40 million. Our accounts receivable balance was $422 million, an increase of $8 million from the prior quarter. Inventory at June 30 was $375 million, a decrease from $15 million from the prior quarter.

Now I will turn the call back over to Gayla for some closing comments.

Gayla Delly

Thank it Don. I want to wrap up our prepared remarks by providing an overview of our strategic priorities. The first is our portfolio transition. Over the last few years, Benchmark has moved forward with our business transformation focused on serving higher value markets. We are well positioned to serve these higher value markets which are in the early stages of their outsourcing efforts. Faster growth in these markets serves to reduce our customer concentration and volatility from large customers and programs. Macro pressures have weighed on some of our industrial demand recently but the ramping in several programs has served to somewhat offset that impact. Our year-over-year revenue from the higher value markets increased from 53% to 63% associated with the portfolio transition and the Secure acquisition and we maintained our 10% annual targeted growth rate in these markets over the longer term. We expect our rebalance portfolio to deliver sustainable growth and higher profit margin which will drive returns on invested capital above our cost of capital.

The second focus area for us is our margin expansion. With our reporting change excluding the impact of our amortization and our non-GAAP results, our equivalent non-GAAP operating margin target is now 5.5%. Overall operating margins will improve as we one, leverage productivity and efficiency gains to moderate the near-term investments for sales, marketing and engineering. And second, realign our cost structure including our capacity to align with current outlook. And three, we gain leverage from the expected revenue growth. We will balance our investment, our operational excellence priorities and cost reduction initiatives with the longer term view of supporting margin expansion. We expect margin improvement to accelerate as we move into 2017.

The third focus area is our cash generation and balance capital deployment. We have made excellent progress on our cash conversion cycle this quarter and look forward to continuing to do so through the remainder of this year. For the past 12 months, our cash flow -- free cash flow generation totaled 234 million. We will remain focused on a balanced and prudent capital approach to capital allocation.

To increase shareholder value, we will first continue to invest in organic growth and second, make value enhancing acquisitions aligned with our strategic goals and then third return capital to our shareholders. Looking forward, we like the way we have positioned the business and the directional trend we see heading into 2017 with our diversified revenue base, improving cost structure and focus on increased working capital velocity. And yet, there is more work to be done as we continue to optimize our supply chain, align our cost structure and drive operational excellence.

Operator, let's open the lines for Q&A.

Question-and-Answer Session

Operator

Thank you. [Operator Instructions] Our first question comes from the line of Steven Fox of Cross Research. Your line is open.

Steven Fox

Good morning. I guess my first question is on Secure, can you give us an update on how the business is tracking in the most recent quarter, and in to next quarter, and whether it had an impact good or bad on your results and outlook? And then I had a follow-up?

Gayla Delly

As always, with our acquisitions, we don't segregate those, but as we can see from our overall industry that we are expecting growth in the second half and we have benefited from incorporating both the acquisitions, but importantly the mindset and the approach and the engineering leading focus that we have to accelerate our new bookings. So we’re pleased with opportunities we see in front of us.

Steven Fox

So some of the delays in ramping wouldn't be related to Secure. Can you comment on that at all?

Gayla Delly

No. Actually, good point. Our delays were associated with our new program bookings and associated ramp there and specifically in the defense and aerospace markets, we saw some timing lags there.

Steven Fox

Great. And then just as a follow-up, so you made significant progress on your working capital this quarter. And I understand how the numbers functionally work, but can you talk about exactly what kind of actions you took to reduce your cash cycle by 16 days and then what would be the most important actions you still need to take to get it to 75 days? Thanks.

Don Adam

Yes. We’ve been, as we said in the call, Steve, we have transitioned a number of programs, one of the new programs that has started in low cost geographies. And so with that, we’ve undertaken a lot of actions. So, it’s everything from demand management to localizing the local -- the supply chain and reducing the number of suppliers that you’re dealing with, but given the number of programs that we have ramped and particularly in the higher value market that we’ve done a lot of work on that last year and then in the first half of this year and we saw the benefit. Some of the other things as we go through this process we’ve had to negotiate with the new suppliers as we’ve consolidated the supply base. So, [indiscernible] a lot of hard work to do that and it's an ongoing process, and it's not going to end. We do expect further improvements for the rest of the year, targeting 80 days for the third quarter and down to 75 days by the end of the year.

Steven Fox

Great. So it sounds like a lot of it generally falls under the umbrella of what you’ve done in terms of moving to the low-cost locations and then catching the supply chain up? Is that fair?

Don Adam

That’s fair.

Steven Fox

Okay, great. Thank you very much.

Operator

Thank you. And our next question is from Mitch Stevens of RBC Capital Markets. Your line is open.

Mitch Stevens

Hey, guys. Thanks for taking my question. So I guess first on the telecommunications front, it looks like that's going to be up 20% sequentially in Q3. Can you maybe just walk through what markets are doing better, specifically within there?

Gayla Delly

We see improved markets in the broadband and optical market base primarily.

Mitch Stevens

Got it. So it sounds like it's all optical driven then? And then secondly, I guess just kind of switching topics, with the new directors on board for the board of directors, are you guys seeing any changes in terms of strategy or any update there in terms of what they want to have change going forward?

Gayla Delly

No, again, I don't believe that there was ever any identification through the -- after this process took exception to our strategy. And so I don't believe that there is a strategic change for the indirection for the company. We’re very pleased with the direction that we have and the opportunity to increase our performance there is really what we’re focused on.

Mitch Stevens

Got it. And then just one last one on the margin front, so how should we think about this working back, call it, 4.5% plus going forward?

Gayla Delly

I'm sorry, I don't believe I got that question clearly. Can you repeat that?

Mitch Stevens

Yes. So if we think about the operating margin strategy, how do we think about this ramping up now with the new mix going towards like 4.5% or greater?

Gayla Delly

I believe the word I was stressing was trajectory and what I believe is that, of course, it's never been there. And as we are ramping the new programs and they’re inherently inefficient with the start-up and it really has to do with the mix of business, but we do expect to continue to drive it forward and mix has a great deal of impact on our ability to do that as well as the actions that Don identified. So we expect 2017 to be the biggest beneficiary of the improvements we’re driving currently.

Mitch Stevens

Got it. Thank you.

Operator

Thank you. Our next question is from Jim Suva of Citigroup. Your line is open.

Jim Suva

Thank you very much. You mentioned some aerospace and defense stagnations or delays, was that due to timing production schedule shifts, have they been resolved or how should we kind of think about that?

Gayla Delly

A combination of timing and production ramps associated with supply chain and ongoing qualifications, but none of them are of the nature that we are specifically concerning or push out cancellation there. They are ramped as you recall, these often are longer term in the nature of the products that are being supported as well as the complexity and so we expected them to fall into the second quarter and expect now to be able to do a good bit of those in the third quarter.

Jim Suva

Okay. And then on your new program ramps, you mentioned that there are some delays there, are those related to like BREXIT, because BREXIT happened after your quarter closed or they’re more macro or qualification, a regulatory like with the health healthcare industry with some hurdles there or what's happening while there are some delays in the new program ramps?

Gayla Delly

One of the things on the defense and aerospace is that the defense and aerospace was primarily probably associated with the program ramps. So it was that impact.

Jim Suva

Got you. Okay. And then finally on BREXIT, are you saying any impact to your customers or bookings or things so far, what has progressed through July from BREXIT?

Gayla Delly

We have not seen any customers point to that as having specific impact. It likely causes some caution associated with their forecasting, but nothing specifically has been pointed out to us.

Jim Suva

Great, thanks so much for the details. Much appreciated.

Operator

Thank you. Our next question is from Herve Francois of B.Riley. Your line is open. Please check your mute button.

Herve Francois

Sorry, Gayla. Good morning. Can you just talk about for some of these new program ramps that you are talking about, have the expenses and I think you might have mentioned this earlier, have the expenses been set aside for those new program ramps or you are expecting some impact to your margins because of the expenses associated with those new program ramps?

Gayla Delly

The new program ramps, again, as we expected them to occur in the second quarter, the costs associated with the ramp, the inefficiency associated with the ramp is ongoing through the process, getting to a steady state of production. So it's not to say there is no cost, there are no inefficiencies in the future, but the cost incurred on the initial start-up has already been accounted for.

Herve Francois

Is it more -- can you get a little bit more granular in regards to some of those costs, is it pretty much just lined up with the size of the overall program, or even by the -- if the program is in a particular end market, whether it’s in telco or industrial or anything else like that or is it just overall within your facility?

Gayla Delly

Well, the regulated industries, medical and defense and aerospace typically will have both longer production ramp cycles and higher upfront cost associated with those due to the nature of those programs. But that is the primary differentiator in the type of programs.

Herve Francois

Okay, thanks very much.

Operator

Thank you. Our next question is from Sean Hannan of Needham & Company. Your line is open.

Sean Hannan

Yes, hi. Thanks for taking my question here. So just want to see if I can get back to the margin topic. You guys had some good aspirations for how you’d like to exit the year and just want to see if we can get a little bit more color on that as we think about the trajectory coming out of September and through December, this is something you’ve commented on the past. So I just want to see if we could follow up around that?

Don Adam

Yes. I think, Sean, we had targeted 4.8% on our last call exiting the fourth quarter, given the choppiness that we are seeing in industrials and the overall macro challenges. At this point, certainly, I don't think we’re going to be able to -- we’re going to attain that. But I would say, we should have, depending on what revenue comes up, I mean, we're projecting a positive trajectory as we go into next year and as Gayla indicated, I mean ultimately, we want to drive to the 5.5% if you will, adjusting for the amortization we talked today.

Sean Hannan

Okay. So just want to make sure we address all this on an apples-to-apples, so if we were to think about previous thoughts in trying to achieve a 4.8 by the end of this year, adjusted, that would be kind of a 5.2 the way that we are modeling now. That’s going to be harder to accomplish, however, as we get into ‘17 and based on what you’re winning, do you think that there is a relatively acceptable pathway to get up to 5.5.

Don Adam

Yes. I think coupled with the mix that we have and the actions that I previously mentioned, yes, there is a pathway to get there.

Sean Hannan

Okay. And then, if I could have a follow-up here in terms of the program wins, now, a while back, you guys had redefined how you are quantifying those wins in the criteria, when you do that. I think that we’ve anniversaried that change and approach and now I’m looking at a trailing 12-months scenario that has been consistently ticking down. So just want to see if we can get a little bit more color, because qualitatively I think we’re hearing a lot of optimism, quantitatively, I want to see if I can get better understanding around how that’s being backed up because the trend doesn't seem to be quite as supportive?

Gayla Delly

I believe we will see the bookings begin to tick up. As we indicated, we are, I would call it, seeding the base of our high-growth high-value markets base of customers and as we see those numbers of those opportunities are at the front end and we are trying to continue to move to the point of leading with engineering, and as we do that, those opportunities will differ. So, as expected, and I believe as we’ve talked about over a number of calls, that is exactly what we’re seeing and as we move towards next year and as we continue to focus as well as invest in both sales and marketing and engineering portions of our business, we expect to see those bookings begin to increase. I believe they’ve been more flattish as you likely know any time you’re kind of estimating those, there can be a range and that we do believe that they’ve been pretty much flattish with a good mix of business that we've seen and we want to see those begin to accelerate in 2017.

Sean Hannan

Okay. Thanks very much for the color.

Operator

Thank you. And that concludes our Q&A session for today although the company is taking questions after the call. I would like to turn the call back over to management for any further remarks.

Gayla Delly

Thank you, operator and thank you everyone for joining us this morning. We know it's a very busy day in our industry for earnings calls. We’ll look forward to hearing from you and follow up. Have a great day.

Operator

Ladies and gentlemen, thank you for participating in today's conference. This does conclude today's program. You may all disconnect. Everyone, have a great day.