Littelfuse, Inc. (LFUS) Earnings Call Transcript & Summary

Hey, everyone. Thanks for joining today's meeting. I'm Karl Ackerman, and I cover semiconductors here at Cowen. I'm pleased to present to you Meenal Sethna, EVP and CFO of Littelfuse. Meenal will give a brief overview of the company, and then we're going to follow with a fireside Q&A format. [Operator Instructions] Meenal, thank you for being here.

Great. Thanks, Karl, and good afternoon, everybody. Thanks for joining us for what may be for some people, a first virtual conference that we've participated in. I was telling Karl, this is our first Zoom virtual conference. So I was looking forward to it, and thanks for joining us today. So let me start -- I'm going to start with an overview of the company. Well, this next slide here, if you want to read more about our disclaimers, you can find these on our website where our presentation is posted. But let me start off with an introduction of Littelfuse. So for those of you who don't know Littelfuse, we've been around for over 90 years now, 90 years strong. We started out in circuit protection products, actually in fuses, expanded our circuit protection portfolio over our first 75 years. And then really in the past decade, decade and a half or so, we've expanded into power control and sensing technologies as well. We finished last year at about $1.5 billion in revenue. Many of you know, we're NASDAQ listed, and there's our ticker there. So what do we do? Our products are really a broad range of circuit protection, power control, which includes power semiconductor products in commercial vehicle technologies; and sensing technologies that we sell across automotive, electronics and industrial end markets. And you can find our products in virtually every end application around the world very -- whether it's a protection technology, a semiconductor or a sensing technology. And ultimately, we sell to 100,000 end customers around the world. You can find our products across a lot of end markets. Our big focus areas are transportation, industrial and electronics end markets. Our strategy is strong organic growth, above-market organic growth, complemented with strategic M&A that further enables our organic growth. And then over the past few years, our best-in-class shareholder returns, when we look across our peer group, 19% shareholder return over the past 7 years. So looking ahead to still a little bit more detail on the overview of the company. One of the questions we get a lot is in response to our COVID actions or are -- what are we doing as it relates to the coronavirus. I think we may have a little bit of an issue here with our slides advancing. I don't know if we're stuck here. I'm going to -- sure. I'm going to keep going and the slides will catch up to us. But for those of you online, we do have our slide deck posted as well. So we've been getting a lot of questions around what are our priorities, and what are the actions we're taking during this time during the COVID pandemic. We've talked a lot about our key priorities, both externally, to our investors. We talked about this at our earnings call. But also internally to our employees. And really, our top three priorities: first of all, our associates, protecting not just the health and safety of our associates and their families but in the number of communities where we operate on a worldwide basis, and we'll talk a little bit about our footprint through these conversations. But also, as we've talked a lot about, during these challenging times, we're working very hard to preserve jobs for our employees, especially where we've seen temporary closes and closures and shutdowns, that's been an important element of our priorities. Our customers. Our customers are critical. They enable our success, we enable their success. And we continue to do everything possible to support their critical needs, especially because we are in some critical industries where we're a critical component, whether that's around energy infrastructure or certain medical products, certain passenger and commercial transportation products, as a few examples. And then lastly, long-term financial health of the company. Everything we're doing today needs to ensure that we continue to operate effectively today, but also looking ahead post pandemic, ensuring that we have the right long-term financial strategy for the company. So there have been a number of actions that we've taken across the company really in support of these key priorities, starting, first and foremost, from global implementation of health and safety protocols at our work sites. We've talked a lot about a numerous set of actions we've taken, ranging from PPE or personal protective equipment that we're supplying to employees as well as their family members as well; making sure we've got the right protocols in place in locations where you cannot work from home, in our factories, in many of our design centers, making sure that we've got the appropriate social distancing; making sure that we can -- where possible, we're working from home. So elements like that. We've continued to look at our cost structure. We spent a lot of time during 2019 where we had some end market demand declines, coupled with channel -- electronics channel inventory reduction. We took $50 million of operating expenses out of our 2019 P&L compared to '18, and we've taken further actions in 2018 to give us another $30 million of operating expense reductions, really to ensure that this is commensurate with our demand levels. But at the same time, making sure we're continuing to invest in our future. And then lastly, preservation of financial flexibility and liquidity. We've got a very strong balance sheet that has resulted in very strong liquidity, quite a bit of cash on our balance sheet. We tend to have a very conservative posture around that. And really, with a net leverage that's well below 1x on a debt-to-EBITDA basis. So feel very good that, that aligns well with the investments we want to make as a company and our long-term financial health. With all that, we expect to come out stronger on the other side of this challenge, and we think we're well positioned to do that as well. So moving along to a little bit more about what are the underpinnings for us in terms of the secular themes that really drive our strategy. Many times we use the moniker safe, green, connected. And we talk a lot about our products have an element of safety. So really thinking about the safety element of circuit protection products. We think about our products as it relates to autonomous driving, where you can find many of our sensor products relate to positioning or seed positioning systems as well as just overall passenger safety as we talk about, say, seat belt buckle sensors. Resource efficiency, whether that's electric vehicles, LED or solar-driven energy opportunities, so a lot of focus around resource efficiency. And then lastly, the increased content we see in connectivity, whether that's in your home, more and more in your office or remote office space, thinking about the number of devices that have our content and the amount of connectivity you expect. It's in automobiles, it's in factories, and you see that everywhere. And so even through these challenging times, we continue to see these long-term growth drivers remain intact for us and really propel us to continue our growth strategy. As I mentioned earlier, we also service a broad range of end markets. We think of those broadly across transportation which includes both passenger and commercial vehicle products that we sell into these end markets. Industrial end markets, a broad range selling into alternative energy and power conversion. Oil and gas, small part of our industrial end market sales, HVAC systems. And then electronics, as we think about communications, both data and telecommunications infrastructure. We think about white goods, we think about building and home automation appliances. So a lot of opportunities for us there across electronics. And then just wanted to finish on that last slide, which is our investment proposition. As we think about Littelfuse, I talked about the secular growth themes, the secular drivers, the safe, green, connected, continue to resonate for us as a company, and they continue to remain strong for us. And we've demonstrated our ability to grow above market organically and supplementing that with the right strategic acquisitions. We worked hard to position ourselves during these challenging times so that we can come out stronger on the other side, both with our strategy intact as well as with our financial foundation that we have. And with that, I'm going to turn it over to Karl because I know Karl has a long list of Q&A for us.

Thanks for the overview, Meenal. That was helpful. Maybe just to kick things off, on your last earnings call, you indicated your electronics segment was -- your book-to-bill within electronics was well above 1. And your electronics segment has trended positively over the last few quarters. I know you reported only a few weeks ago, but the market has been very dynamic. Can you just provide an update on are you seeing any signs of demand improvement yet? And I guess what sort of visibility do you have on your pipeline today versus a few months ago?

Yes. I wouldn't say when we talked at the end of April -- right now, we continue to see the quarter progressing as we had anticipated about a month ago. What we mentioned then was that we were running book-to-bills well over 1. And we also talked about the fact that while demand was strong, our limitation this quarter, especially on the electronics side and even in our industrial, some of our industrial products, the limitation was more from a production perspective. Really because with some of the government directives that have been in place around certain closures of some of our factories or at reduced production levels, we were really limited from a production capacity perspective. Having said that, demand remained strong, but we also talked about the fact that in talking with our electronics channel partners, and talking with EMSs, with end customers, we were seeing that all along the supply chain, these folks are building inventory. They are concerned rightly so from what we've seen in the past few months about supply chain disruptions. So they wanted to ensure that they had sufficient inventory on hand. And that's why we said that we would expect order rates to start slowing down during the quarter, and we were expecting to finish book-to-bill coming down at the end of the quarter.

Got it. That's helpful. You've recently touched upon the supply chain, just in your prepared comments and also just now. I guess just could you give us an update on the production status of your facilities? Specifically within the Philippines and Italy, as I believe that you said were partially -- they were going to have partial capacity through this quarter. And then are your facilities in Mexico still shut down completely? Or just kind of any view on how those particular areas of your business are returning to normal?

Sure. Yes, happy to provide an update. So I am happy to report that all of our facilities are operational today. We had talked about -- we mentioned our facilities in the Philippines and in Italy. And at the time of our earnings call, we were operating at partial capacity. At this point, we're operating at full capacity, really across all of our facilities around the world with the exception of Mexico. But in Mexico, we were expecting to restart our production in the middle of May. We did do that last week, and we're now in the process of ramping up. So things are, I think, progressing as we expected, very happy to see that.

Got it. That's helpful. Maybe just pivoting a bit to China. I think it seems to be kind of top of mind for the electronic supply chain. The U.S. Department of Commerce is scrutinizing exports to military-related applications in China. I guess what sort of exposure do you have to applications that may be unfavorably impacted by these licensing requirements, a? B, do you think you need licensing requirements? And I guess, c, what precautionary measures have you taken to stay ahead of some of these restrictions that perhaps could affect your portfolio?

Sure. So we continue to monitor every time, unfortunately, these rules come out to take a look to see if our products fit into these categories. Thus far, over the past, I'd say, 18 months or so as these rules have come out, including the ones most recently from last week, our products do not fit into those categories. So we've been able to continue shipping to the customers that we do ship to in China, and we've not really had any restrictions on any of our products there, which is good news. I would say as part of our normal operational trade compliance teams, they continue to monitor this very closely.

Got it. That's helpful. Just perhaps double-clicking on the demand outlook you briefly touched on, I wanted to focus on automotive. I was hoping you could maybe give us a little bit of an update on what you're seeing from a demand and/or production standpoint by geography. And I guess, how do you think about that from a visibility standpoint? Any -- Q2 was obviously challenged for the overall industry. But our checks suggest that production is starting to improve modestly in the U.S. I'm curious if you also share that view.

Yes. I would say with automotive, we're not seeing too much that's different than, again, what we projected about a month ago when we had our earnings call. Starting with China, we had commented that really from a production perspective, things have started ramping up in China. We were -- we mentioned our situation was the same, whereby, really by early April, we were back to normal levels of production, including our ability to meet any automotive demand that was out there. From our teams on the ground in China, their comments have been, between our teams saying this, between customers we've talked to, that demand looks better than it did at probably its low point in February. But by no means are we seeing demand levels back to pre pandemic levels. I think as China started releasing some of the stay-at-home restrictions they had throughout the month of March into April, you started to see people come out, go into showrooms, started to see some demand improvement. And I think it's still going to take a few months to see what that trajectory looks like. I think that's a little bit different than the U.S. and Europe. And when we had our earnings call, we also talked about the fact that for the most part, a lot of the OEMs, even many Tier 1s were shut down. Again, a lot of the same restrictions that we were seeing with government directives or various countries where they were shutting down for a period of time or governments were requesting that they shut down for a period of time. What we've generally seen is that OEMs and Tier 1 have started to reopen, I'd say, perhaps a little bit later than we might have originally projected, I'd say, closer to the middle of May, beginning to the middle of May. So as it relates to production, I'd say, it's a bit early right now to see what those trends look like on production. I did see one data point in April that production levels in the United States were down 99% in April. But again, not fully surprising given the number of shutdowns that we have seen across the board at a number of OEMs. As it relates to demand, again, I think it's a little early to tell because you've still got a lot of -- whether it's countries or in the U.S., cities and states that are just emerging from stay-at-home orders. So I think May will start to be the first sign we'll see going into June on demand levels.

Got it. That's helpful. Perhaps shifting gears to your industrial business, which you have a great portfolio. Do you still anticipate a gradual recovery in non-oil and gas subsectors beyond June? You've done a commendable job increasing the profitability of that business over the last few years. It's driving nearly about 1,000 basis point improvement in operating margin from even just 2017. But how do we think about the prolonged demand disruption from COVID-19 on this particular segment? And how do you think about where margins could perhaps inflect higher or lower from here?

Sure. So for our industrial segment, we also did talk about the fact that we expected to see some recovery coming through in the back half of the year, and that's still our current thinking. I think overall, our viewpoint had been, we felt Q2 right now was the trough, and that included for our industrial segment. And talking about the margins and your questions around margins, for us, our incremental or decremental margins are very heavily driven by sales and sales volume. And so we've seen the margin decline as our sales volumes had come down in the second quarter, and we talked about that. But at the same time, as we start to see sales improve and volumes improve, we expect to see the margins improve to our target range of the upper teens for our industrial segment.

Got it. You obviously have -- within your slide, you talked about how you want to balance both organic growth and inorganic growth. And I think you've done a good job about doing that in the past. Your last acquisition of IXYS really kind of propelled you into the power control and power electronics business and augmented your opportunity within circuit protection. I guess what do you view as your largest competitive moat within power electronics? I think in the past, you've referenced that, that's -- that enables you to be earlier in the design process. And how do you think that's resonated with your customers and with IXYS? So if you can just talk about how those -- your largest acquisition has kind of married well with your existing circuit protection business.

Yes. Maybe I'd looked at it from a few different angles. And we have talked about the fact that compared to other parts of our portfolio like circuit protection, having a much bigger presence in the power semiconductor space, especially in a lot of these industrial areas where design-in ends up being very key. And that's one of the reasons we like the industrial end markets that once you're designed in, much stickier from a product perspective. And one of the things that we were expecting to see, and we have started to see some of those is where once you're in the discussions earlier in the design phase, you can also talk to the engineers about some of the other products that we have in our portfolio like the complementary circuit protection products and the high-speed fuse or semiconductor fuse that goes very nicely with some of the semiconductor products. So we have seen that. We've seen our dialogues open up much more with some of the legacy IXYS OEM customers to supplement that with some of our circuit protection products. At the same time, one of the other things we had talked about is one of our strengths, we feel, and one of our competitive advantages is the strategic electronics channel partnerships that we have, a lot of global channel partners that we have as well as regional ones. And the great news is IXYS was selling to some of those. And we were also able to bring in our products into other channel partners as well. So where we have those strong channel relationships we were able to now bring forward a portfolio much broader than it used to be. A lot of our channel partners who knew the products already, were very excited. A lot of other channel partners who didn't have these products in their portfolio, also look at it as really expanding our share with them and vice versa. So those have been -- those 2 have been complementary. And I would -- maybe the last piece, just going back to your competitive moat question, yes, the design-in ends up being very important. But also one of the things that we talked about was, given the size and the scale of the company, we weren't looking to compete with some of the larger competitors that are necessarily in this space. But what we felt was, and we had heard this from many of our customers that there was a good space for us for what they might call smaller wins, which are good size for us in the few hundred million dollar range. And maybe those are too small for some of the bigger competitors in the power semiconductor space. But for us, and for our customers, still a very critical space, still a nice win for us. And that's where we felt there was a nice niche of a high quality, reliable, name brand, very valued technology supplier that we can be in the power semiconductor space, and that's really where we're going after that.

Got it. That's helpful. Maybe as an extension to that, you obviously sell more than just power control products and circuit protection products. You've also moved into the sensor opportunity as well. I guess where do you see yourselves playing in that market going forward? I know -- I think the industry, just in general, has had some fits and starts over the last 2 years, but from here, where do you see your competitive position strengthening? And how do you see yourself playing within this particular area going forward that would augment your circuit protection and power control business?

Sure. So I talk about our sensor products more broadly as a sensor platform because we sell our sensor products in automotive, and I'll come back to that a little bit, but in the automotive space as well as in some of the electronics spaces as well as in industrial end markets. So it's a pretty broad portfolio what we sell. I think the automotive sensor products, we talked about a little bit more recently because we had talked about actions and activities that we have been undergoing to work on improving the profitability. But at the same time, a nice portfolio that focuses on, as I mentioned earlier, seat positioning and seat belt safety systems, which helps not only from a safety perspective, but as you think of autonomous driving, seat position sensors become fairly critical to us. Solar sensors also become very important, and they're now in almost an embedded part of the technology that you would expect in your vehicle where it's helping to manage your HVAC systems, helping to manage when to turn your lights on and off automatically. So we feel we've got a nice base, nice foundation for our automotive sensors. And then across the electronics in industrial markets, the sensor portfolio that we have, many of those products came with "automotive" sensor acquisitions that we made, where we have expanded our presence in areas like white goods, appliances. And you think about the proliferation of sensor applications and appliances that didn't exist 10 years ago, home security systems, sensors end up being vital there. And even in industrials, like in the HVAC space, we've seen some growth opportunities there, and that's a big focus area for us also. So very happy with the sensor portfolio.

Got it. Yes, that's helpful. Maybe just spend the last few minutes of our time here just on financials. With electronic inventories seemingly bottoming out and automotive production, I think, improving, at least on a year-over-year basis throughout the year from Q2, should the June quarter utilization be the trough, assuming no extended impact from COVID-19? And as a result, how do you think about margins improving over the next couple of quarters? I know you perhaps don't want to quantify, but maybe directionally, how do we think about your progression toward that low 40% gross margin that you've been able to realize for quite some time?

Sure. As I mentioned earlier when we were talking about our industrial segment, the fact that really, the pieces that are the biggest driver to our incremental or decremental margins have really been around volume, right? We've done a lot of the work in positioning ourselves from a cost perspective, and now we really need to see the volumes come back. We do believe that Q2 was the trough for us across the company. We'll see different pieces our portfolio over the next few quarters adjust. But if you assume that Q2 was the trough, and we'll start to see volume improvements in volume growth over the next few quarters and continuing that trend, then we would expect margins to improve. The target gross margin, we had set out for the company, was around 40%. So we would absolutely expect to see us trend very quickly with volume improvements back to that. And so that's what we're looking forward to.

Got it. That's helpful. Maybe just a follow-up on that, if I may. How does pricing factor into a longer-term margins? Because I think the industry -- not just yourselves but the industry is saying, well, pricing is becoming more normalized here. And I guess, with respect to cost optimization, how do you -- how do we offset those pricing negotiations, whether it's in the form of perhaps footprint consolidation or manufacturing automation and new product introductions? Just I guess what focus areas do you see over and above volume growth that should perhaps catalyze you toward that 40% target?

Yes. And we would agree. We made those comments last year about normalized pricing levels. And that -- I think that question was directed more around our electronics segment. And a few years back, we had talked about with the strong demand levels that were out there, we had seen price erosion at lower levels which was helping our margin. But over the course of 2019, as the channels adjusted inventory, we did see pricing get back to normal for electronics channel closer to the 4% to 6% price erosion annually. A lot of what we do, I talked about volume being one but beyond that, we have our -- what we call our Littelfuse operating system, or LFOS. And as part of that, that's really -- the foundation of our operating system is really around lean and lean principles. We've been introducing over the past few years, more Six Sigma techniques as well. But that mindset of continuous improvement is really key for us, whether that's automation. And in some cases, there might be some capital investments in automation, which improve our throughput and improve efficiency. But in many cases, it's a lot of the cells that we have in our production sites, where you've got a group of employees that know best the work they do, and they see every day what improvements can be made, and it's a lot of these little opportunities that, in aggregate, add up to bigger savings. And that's -- those lean programs that we have, these continuous improvement programs that we have, that's really where we see a lot of the savings, couple that with material savings and negotiations and other efficiencies like that.

Got it. Well, I think, Meenal, we're bumping up on time, but maybe just last one, if I may. There was a few more questions I'd like to ask, but pass it over to you. Is there any one last thing that perhaps we didn't address today that you'd like to mention?

Sure. I think really with what I started with originally, which was there are a lot of questions about what are you doing through the pandemic? What does this to do your strategy? How does it change? And fundamentally, I would say the secular themes that I talked about, this idea of safety, resource efficiency, content and connectivity, those secular themes were really the foundation of our strategy that we updated back in 2016, and they remain intact. They remain -- when we look ahead, we're going to be strong. We see the strength of these secular things really propelling us into the future, and that's unchanged for us, and that's what really gives us that trajectory going forward.

Great, Meenal. Well, hey, really appreciate your time today.

Thanks, Karl. Appreciate the invitation. And to everybody listening, I appreciate you taking the time to hear a little bit more about Littelfuse.