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

Hello, everyone. We're going to get started here. I'm Matt Sheerin, Senior Analyst at Stifel, and we're pleasure to have a Littelfuse, one of the largest component suppliers, both semiconductors and passive components and representing the company's CEO, Dave Heinzmann; and David Kelley from Investor Relations. Thank you, and welcome.

Yes. Thank you.

So Dave is going to start off for just a handful of slides that give you a sense of the company and the strategy, and then we'll go into Q&A. David?

Sure. Thanks, Matt. And so some familiar faces and some new faces, so I thought I'd do just very briefly, a quick -- a couple of slides to kind of show who we are as a company before we go into questions. So of course, the first slide is all the legal disclaimers to keep me honest on things. And so we move forward, this is our attempt at trying to capture the Littelfuse strategy on one page, right? And so this is our 5-year strategy going from 2021 through 2025. So we're kind of going into year 4 here and now. And so our strategy is really built around 3 large structural growth themes of sustainability, connectivity and safety. If you go back and look at our history, a lot of our history is really around safety and products, but it's evolved much more in those 3 categories. And those are all areas with applications and markets that are outgrowing the market and that we're over-indexing to both on an organic and an inorganic standpoint. So we have the opportunity to continue to grow that. We set targets over the cycle. And as much as I'd like to think we are not in a cyclical space. The electronics world is a bit of a cyclical space. So anytime we put strategy together, we talk about through our cycle. And so we expect our strategy delivers double-digit growth through the cycle as well as best-in-class profitability and obviously top-tier shareholder returns. If you look at our specific financial targets and what kind of we expect out of the business from a revenue standpoint, we expect a double digit, somewhere 5% to 7% on average from an organic basis and another 5% to 7% coming from acquisitions that add to our ability to sustain that higher level of organic growth. Earnings, we, of course, always target to have earnings above our top line growth and look to get leverage as we grow, and we've been successful in doing that. We set a range of 17% to 19% from an EBIT margin perspective over the cycles. There are going to be times where at the peak of a cycle, and it's going to be above that, they're going to be times or maybe at the bottom of the cycle, maybe a bit below that. That's the average that we expect from the business. It's a great cash generating business. We've been successful in the last 3 years doing better than 100% cash conversion as we've grown the business. And from an allocation perspective, from a balance sheet, M&A is our first priority, followed by shareholder return with opportunistic shareholder buys. Now this is kind of a look back because we talk about that cyclicality, the strategy that I talked about, the 5-year strategy is really kind of a continuation of a pretty common strategy we've had for the last 8, 10 years. And this is just a look back to, yes, there's cyclicality in the business. But if you look at this over time through the cycles, from a top line perspective, we've been averaging better than 10% growth for 15 years, and we've grown our EPS by more than 18% over that period of time. So we think the markets that we serve, the strategy, the operating model we have is one to really leverage this growth pretty successfully. And we look to continue to go down that path. So hopefully, that gives you just a brief snapshot.

Okay. That's perfect. So first, let's start off with -- you talked about cyclicality. And obviously, we're at the bottom of the cycle, you talked about some data points in the last earnings call where your passives component business is starting to see some more positive book-to-bill, still work to go in semiconductors. So talk us through the dynamics of the market fundamentals now and how you see that recovering?

Sure. Sure. Yes, the electronics portion of our business is obviously the most cyclical portion of the business. We rely pretty heavily on distribution that can tend to exaggerate those cycles on the ups and the downs. So we very clearly look for these cycles and look for inflection points in the cycles as we kind of look forward. A typical peak to trough for us in a typical electronic cycle is about 4 to 5 quarters. This cycle has been a bit elongated. And we believe that's really related to the fact that EMS customers as well as end customers carried a bit heavier inventory out of this cycle than they have in the past. So for the first time, we talked about it in our first quarter earnings that in the first quarter, we actually saw positive book-to-bills in our passives business for the first time in 7 quarters, where we think we've kind of seen the indicators that we hit that inflection point. We know the distribution in our channel partners is approaching that healthy stage. And while there may be a little bit excess left at EMS and another quarter or so to kind of bleed off some of that, we think the inflection point on passives is kind of here. The semiconductor is a little bit behind that, but there's a little less excess inventory in the semiconductor side of things. That's really more of a reflection of slower industrial demand on the semiconductor side?

Yes. I know in some of your semis like MOSFETs, you had very long lead times so there tends to be over ordering. So is there some overhang from that? Or is it mostly just the end demand?

Yes, it's kind of both. It starts with the last couple of years, we had a very large backlog. So we've been working back -- working down the backlog over the last 2 years in our power semiconductor business. As we ended last year, we cleaned up all the backlog. So now our demand versus end market is matching up. So that already is bringing the revenue down because we're not cleaning up backlog. And then the end markets are a bit soft there. So you kind of have a bit of both playing into that space. The challenges we also see behavior by some of our end customers that may lead us right back to where we were again because some of our power semiconductors have pretty long standard lead times. And we have customers that will approach them is like, yes, we don't see you have orders placed in our lead time. Is your demand soften, no, but they're not placing orders. And so it likely is going to create the same challenge again if they don't start ordering again pretty soon.

Yes. And your distribution customers in terms of inventory, I know your biggest distributor, Arrow has taken a lot of inventory down and others are behind that. And so in terms of the channel inventories, how far are we from the bottom?

We're pretty close to healthy levels in the channel inventories. Of course, we have many different technologies and product lines, and it will vary by product line. But it is an overall perspective, we're pretty close to a healthy level kind of across the board. We have some of the high service distributors like a Digi-Key or a Mouser, which always carry a much higher weeks of inventory. There is a certainly higher, but the broad line guys have brought theirs down to pretty close to normalized.

Another metric that we watch is design wins and design registrations like new business. And how is that activity either through distributors or your own sales force?

Yes. So I would say that the design activity continues to be extremely robust, actually. And I think there's been a bit of pent-up demand on that side because if you think back about 2 years ago or even 3 years ago, as there were a lot of semiconductor shortages and other component shortages, a lot of our customers' engineers were spending all their time on respecting and redesigns to get product that they could actually shut. So they were maybe having a shortage on a pick to semiconductor so that they would switch their designs to another semiconductor, took a lot of engineering resources to do that, that's behind them now. And so those same engineers are back working on new projects and new opportunities. So we've seen the activity pick up pretty nicely. We're seeing a maybe a slower pickup on that converting to sales yet. We were having a discussion with some of our distribution partners that they're seeing that the design registrations and things like that are quite strong. There's still a little bit of a hesitation on launch on some of the products.

So the conversion is slow.

Yes. So the conversion is a little slow. So we're looking for that to turn because that will really be a strong indicator.

Yes. Yes. Yes. One issue that come up with investors is concerned from China and the fact that -- concern that local, China OEMs are going to be sourcing more locally versus Western suppliers. And I know you got exposure there, both in electronics and in your transportation, obviously, you sell to China OEMs and EVs. What's your take? Have you seen that? Because you do play a lot of what you do is customer, but you do have some commodity areas in passives and semis, discretes. Are you seeing any pressures there?

We -- I would say -- for the most part, we haven't seen it shift too much at all. So it's remained pretty constant. We have 1 area that I would say has shifted and changed a little bit, and that's in the transportation side. And so let's talk about electronics first. We very much have a China -- for China strategy from a manufacturing perspective. China is a fantastic market, a large market for our products, continues to be pretty robust. There's been an interesting kind of shift in the past. I just recently had a conversation, a guy who runs sales for us in China. And he's trying to adjust because -- in years past, there's a lot of design activity that was taking place here in North America or in Europe, but it was being produced in China. So design here transferred to be sold in China, if you will, or Southeast Asia. Interesting as Chinese OEMs and multinationals are doing more and more design work in China. He's actually now seeing the opposite of that, where he and his team are getting design wins in China but it's actually being sold in Southeast Asia or Mexico because even Chinese OEMs are moving some of their operations out of China into other parts of the world. So it's been kind of an interesting dynamic there. We haven't seen a dramatic shift in competitive space in the electronics side. As we switch to the transport side and our passenger car specifically with electrification of vehicles, EVs, which China is, of course, continues to go ahead, strong with EV adoption. Our core history of low-voltage side on a vehicle, the good news is when you have an EV, the low-voltage system still exists on the vehicle. And we're the #1 player in China in that space from a market share perspective. We continue to be the #1 player, and we really haven't seen the dynamics shifted there, where it has been a bit of a shift is on the high-voltage systems on EV in China, specifically with the Chinese OEMs they've kind of determined the EV drive systems and battery systems are that core technology. So on the high-voltage side on the vehicle, we have more -- there's a preference towards Chinese competitors for that. So therefore, on the high-voltage side, we have seen -- we have a lower market share, and we expect to have a lower market share with Chinese OEMs on the EV side.

Is there an attempt to gain share back there? Or is that just?

We win business with Chinese OEMs because at the end of the day, they need the best products still. And they're advancing things and we win business but where they can, they are giving business to Chinese-backed company that's been backed by central government and a couple of our competitors -- or not our competitors, a couple of the OEMs.

Yes. I'd just add where many of the local Chinese OEMs have global aspirations and certainly see more in the export market out of China that's an intriguing opportunity.

That might be an opportunity to try to reach back and per share as they set up operations in Mexico or in Eastern Europe.

Could you remind us how big China is for your transportation business?

So from a perspective of passenger cars, specifically, our #1 region is Europe, followed by North America and Asia and Asia really -- China is the largest player because just the sheer number of vehicles are being produced in China. So it is approaching the size of our U.S. business.

Because I know that your long-term content within cars has been going up with fuses, but also you're in other parts of the vehicle, too, you've got sensors, et cetera. But does that -- the content sort of tap out in China now because of that -- because of the dynamic of the OEMs locally.

It's been kind of interesting because on the low-voltage side, which we continue to be a leader and don't see a lot of changes in the competitive tensions there. The level of sophistication on Chinese OEM vehicles is growing pretty dramatically. So if you get into a Li Auto, and I had a chance to drive a Li Auto, which is a new company, EV in China, first of all, fantastic $100,000 car. So the content in Chinese OEMs for the low voltage side continues to grow really nicely. So even if you look at our last couple of quarters, you'll see some of the biggest drivers we've had of growth in pass car came out of Chinese OEMs. So the offset there, we continue to see low voltage actually content continue to grow very nicely. And we are winning high-voltage just not at the same rate. So we think there's still content expansion for us in China.

Got it. Okay. Another question -- last question on electronics before we move to the other sectors and that's on your operating margin through the cycle, you had -- you were in, I think, the mid-30s in terms of operating margin well above your target is, I think, around high teens, low 20s. And you have some pricing, obviously, benefits huge demand. And then now margins are down to the low teens below your target. But as you said, there's cyclicality through the business. So how should we think about the margin recovery in sync with the revenue recovery?

Sure. I think, first of all, what's important is to recognize, over the last several years, we've been -- we know our electronics business is cyclical. We've been working to try to manage this in a way and diversify our customer base within the electronics segment to get a healthier mix overall so that when we do go through the cycle, when we hit the bottom of the cycle, we raised the floor on where the margin profile is. So if you look at our first quarter, our EBIT margins in the Electronics segment are about 13%. If you look at the last cycle, when we hit the bottom, they were running a little over 8%. So we've successfully moved up the floor on that is still a painful place to be when you're at 13% and you'd like to be operating at 20%. You referenced a couple of years ago where in my career, it's certainly been the strongest opportunistic pricing opportunity that's existed in the electronic space. Costs were certainly well up, but we're able to pass that along very effectively. So that drove margins pretty high in the peak and demands were really strong as well. But as you know, Matt, the incrementals on our electronics business, particularly the passives business are quite strong. So as soon as we start seeing a return to growth and some expansion of revenue, the drop-through there will be quite meaningful and you'll see that pick back up pretty rapidly.

Great. And does that factor in return to more normal price erosion or cost down from that.

Absolutely. And we're kind of across our segments, we're seeing kind of normal pricing behaviors. And in the electronics world for us, normal is a 3% to 5% price erosion every year. That's kind of the normal. It's been that way for decades. And we do see that, and that's kind of in the return. There's been a lot of questions and a lot of thought that with lower demands, boy, prices are really going to drop off pretty dramatically. We have not seen that much. There are a couple of small pockets in China on a couple of product lines. But other than that, it's really kind of a return to normal.

Okay. Great. So let's turn to the transportation business, which is obviously a big business for you. You've got 3 subsegments passenger car, sensors and commercial vehicles. Commercial vehicles is now a big chunk of that because of acquisitions you've done. Your margins are depressed in that space. So can you talk about what you're seeing across those 3 subsegments?

Yes. We -- so we really kind of manage this primarily to between commercial vehicle and passenger car. We launched sensors into the passenger car because that's where the bulk of the revenues are. So let's first talk about commercial vehicle. The commercial vehicle business, we doubled. Transportation is about a 50-50 split between commercial vehicle and pass car. We doubled the size of our commercial vehicle business 3 years ago with a sizable acquisition called Carling Technologies. That was a business that had a huge backlog when we bought it. So in year 1, we were concentrating on cleaning up the backlog and serving customers that we're screaming. And so we had a 22% growth from the prior owners last year in our first year of ownership. So that was really strong. The unfortunate thing is you get all that backlog cleaned up and then the customers realized, well, most of it went into inventory. So they began to kind of pull that down. So that's lessened than the revenue there, and it dampened and certainly hurt profitability. So we've got a lot of work on the integration activity we've been doing there. We've talked about openly about that we expect this year a headwind in our transport segment of 500 basis points on revenue really primarily driven out of product line and customer rationalization out of that business. So we see that headwind, but we will expect an uptick in the profitability there. And you saw in the first quarter, we saw a nice step up overall in transport and commercial vehicle got up into the high single digits, which is a nice step in the right direction and needs to work its way back up to mid-teens. We think over the next couple of years, we can do that in the commercial vehicle, we still have some plant moves we're doing right now. And then, of course, these product line and customer rationalizations to get there. Now on the passenger car side, that also has had kind of tougher margins in the last year or so. We made the strategic choice that when costs were going up dramatically, we have in the passenger car world, we have multiyear contracts. There's always the opportunity to break the contract and renegotiate pricing and raise prices. And we've done that in some cases. But usually, what happens with the OEMs and the Tier 1s is you can do that as long as you do an open book on your costs and show exactly where the changes are we've made the decision that we prefer not to do open book with our customers there. So we've said, we'll address it with our contracts as they renew. So that means you have a delay and getting your pricing in, but we've been able to start to get that with contracts as we renew them. So we've also seen passenger car improve meaningfully there. The sensor side of it, we started sensors a few years ago. There was a couple of segments or end applications, particularly in Asia, in transmission sensing, where margins degraded pretty rapidly because of competition. We've been pulling back from that and stepping back from that, and we've been launching organically some sensors that are used in hybrids, plug-in hybrids and EVs and current sensing capability. And so our spend on R&D has been pretty high, as we've organically been developing that and winning new business there. Just literally in the last month, started shipping to our first customers there, and that will start ramping over the next couple of years. So that will continue to drive improvements there also in the margin profile there. So transport overall, we were kind of in the 9% range. And it will probably bounce around a little bit around that range, but we should exit the year in the double digits and continue to see the journey back.

And how are you feeling about production outlook for auto, which is obviously flattish, basically, but the content story. And for you, is there a big difference? Or it doesn't matter whether it's hybrid, EV or ICE in terms of content.

For us, the low-voltage systems on ICE, we average about globally about $5 of content for ICE vehicle. Our overall average is about 7%, and that's because of the electrification that pulls that up as that's been beginning to roll out. It's a continuum really, and it's on the high voltage side, it's really -- our content depends on the voltage level. So the higher the voltage level, the higher the content. So if you have a high-end EV that's got an 800-volt system in it, it is going to have higher content that maybe it could be a side as a $40 content whereas a hybrid or a plug-in hybrid is going to be somewhere in a continuum depending on the voltage level that they're operating in.

Yes. Okay. Okay. Good. And then last but not least, your industrial segment, which has in my mind, changed pretty dramatically in terms of the end markets like today versus 10 years ago, where you really sort of skewed towards like mining and other areas and now you're across in terms of infrastructure. So could you talk about the end markets that you're serving there and the opportunities.

Yes. So if you go back a few years ago, the bulk of our Industrial segment was focusing on U.S. nonresidential construction, MRO, mining, oil and gas or stuff, having North America-centric business through acquisitions and organic investments we've made over the last several years we've really shifted that business. We still have business in those spaces, but we've grown the business into more traditional broad-based industrial players. So HVAC applications. Renewable energy is a high area and that's both on generation and energy storage, which energy storage continues to be booming. We've also seen, we've introduced some new technologies into industrial safety that has been an additional market for us as well that we have expanded. So where we used to be almost a complete distribution business there, now it's about 50-50 distribution and direct OEM sort of customer base there.

And is there an opportunity within the data center and hyperscale in terms of the power management and power requirements.

Yes, data centers, in general, for us continue to be an opportunity, obviously, and as AI and general compute grows. That's an opportunity for us and it falls in 2 areas. One is in the industrial segment, where that's really in the infrastructure of the building. So backup generators, power distribution in the buildings, switchgear, applications, those sorts of things, cooling systems, those are going to be more industrial products. And then when you get in the racks and on the servers, on the UPSs and the power supplies, then you're going to get out of our electronics segment that shows up there. So kind of both sides of it, play out.

Okay. I want to see if there's any questions from the audience, anyone have anything? No. Okay. So we talked about your 3 segments. In your commentary, Dave, you talked about M&A being a big part of your growth story and you've done many acquisitions. And you really broadened your product portfolio, where 10, 15 years ago was really all circuit protection and then now it's across different skill sets within a circuit board. So what's the -- and in terms of M&A, sort of what's next? Are there any sort of product areas where you think you need to fill voids and you do acquisitions there, synergy opportunities? What are you looking at these days?

Yes. The last few years, our acquisitions have been really targeted at changing the balance of our customer base and applications that we serve. So I continue to see that to be an opportunity. Industrial has been and it shows up in our industrial segment or actually in our electronics segment as well from an end-market exposure, increasing our exposure to broader based industrials has been a focus for us. We continue to see that as a nice opportunity for us to continue to build out. We target high-growth applications and markets, and we'll over-index to those on our organic investments and our M&A investments. Those are spaces we like. Actually, even though we have some cleanup work to do on Carling, we continue to like the commercial vehicle space in the long term. We think that's a pretty healthy place to be. I would tell you pass car is tougher. Return profiles in the pass car world or harder, there can be technology plays for us that may bring unique capabilities there, but we balance often the end market dynamics, how do we continue to shrink the amplitude of the volatility in our electronics business with exposure and to industrials and things like that. I think you're going to see us look at those types of things.

And I know a year ago, when I asked questions about M&A and opportunities. The answer was valuations are still relatively high. Has that changed as the market has changed here?

It's not changed as much as it needs to, I would say, our prototypical target tends to be a private company, often family-owned or maybe individually owned. And I would tell you, emotionally, they still will anchor to multiple holds and price points from 2 or 3 years ago because that's the high watermark, and that's always compared to. So you've got to get over that emotional hurdle, sometimes to get a more realistic -- look, the cost of money is more expensive today than it was 2 or 3 years ago. The markets aren't as high growth right now as they were 2 or 3 years ago. So there are still owners that are struggling a little bit to come off of that as their anchor point. But yes, they're moving.

Okay. Okay. We have a few minutes. A few seconds left. Anything else, any questions that are coming up and you all on ones that are worth bringing up, anything we didn't mention.

No, I don't think so. I think the critical thing is we're not going to magically change our business out of a cyclical industry. So cyclicality is going to be a reality that we deal with. We've made improvements there, and you'll see us to continue to find ways to try to maybe dampen the amplitude there, increase the flow of our performance during the bottom end of the cycle. And we think we're well positioned to do that.

Yes. Okay. Okay. Very good. Thank you, Dave. Thank you. David, I appreciate it. Thank you.

Thanks, Matt.