Teledyne Technologies Incorporated (TDY) Earnings Call Transcript & Summary

Welcome to the Jefferies 2023 Industrials Conference. I'm Greg Konrad, Senior Vice President of Equity Research at Jefferies. I'm very excited to have Jason VanWees, Vice Chairman of Teledyne with us today. We'll just go through a fireside chat. Thanks, Jason.

Maybe just to start, how do you think about the portfolio today and puts and takes? Where have you been surprised by the strength versus maybe where areas where you've seen a little [indiscernible] of weakness?

I wouldn't want to say maybe surprised by the strength. What's been strong on an absolute basis for us and probably will continue to be strong is about the 40% of the portfolio that in terms of size in descending order, government, defense, medical, energy and then aero. It's about 40% of the company. The last 3 of those has been not only getting really good bookings, medical, aero, energy and good absolute growth. Defense has been flattish, but finally had good bookings in Q2, outlay has turned, as you know, sort of March, April 2023. So I'm probably most excited about that in terms of not just the absolute performance, but the predictability where we've got sort of 9 to 15 months of backlog for 40% of the company. The other 60% of the company, I think we've performed well. I would say, especially as earnings seasons kind of rolled on through here, certain parts that have been a little bit weak on an absolute basis, I think, have been actually outperforming the market, things like industrial automation, machine vision, where we were actually slightly up in the quarter -- year-on-year. These pockets of weakness here and there. But overall, I think that's been performing well. That is more global macro, though a little bit more uncertain, more like 2 weeks to 3 months of backlog. So a little bit less clear, but there hasn't been any part of the portfolio where -- of any size where we've seen 0.8 book-to-bill, 0.7. I mean I think 2 shorter-cycle subsegments are environmental instruments, electronic test and measurement. I think the worst book-to-bill over the last 4 quarters have been like 0.96, most of them been like 0.98. So I'm a little bit conservative on that. That's most of the top down the way we run the company. On an absolute basis, even that's been, I think, relatively good and probably better than some peers.

And then, I mean, just thinking about when markets have lagged, what's the typical Teledyne playbook or opportunities that come from this? I mean, historically, we've seen this with oil and gas and commercial aero as markets came down and then recovered. I mean what are you kind of seeing today in terms of the portfolio?

Well, right now, nothing of any magnitude is contracting. I mean organic growth in Q1, Q2 is low single digit, but there's still organic growth. Yes, there's little pockets here and there. But if something does go wrong, I'm not sure it will, but I guess I'm a little bit more and more bearish on global macro. But I mean, margins have been maintained, call it, be it 2009 financial -- global financial crisis, earnings actually went up. You mentioned oil in 2016, but it's a whole sort of sequestration and oil that's sort of a slow growth period 2013 through 2017. Margins held, earnings largely held. I think they went down a little bit in 2016. COVID margins actually went up in 2020 despite organic and traction, which even then given the diversity of the portfolio, full year 2020 organic contraction was actually 4.8%, but margins actually went up. So we know how to protect margin, protect earnings if there is a downturn. Part of me wants everything to remain healthy that maybe we muddle through here. Maybe there's no recession, that would be good. I guess on the other hand, part of me would like to see a little bit of a fallout here in a recession, the reason being -- our best acquisitions have been 12 to 24 months following one of those periods where we executed pretty well. And that's, again, what was formerly known as Teledyne DALSA, Teledyne LeCroy, that's our machine vision business and our Test and Measurement business, that was 2011, 2012. E2v was in 2017 following the 2016 acquisition. And then FLIR was following COVID. So again, I think either alternative is a good one. It just depends on your horizon. The capital allocation and M&A alternative probably is a little bit better, things get a little bit ugly, especially as our leverage has come down.

And then maybe if you could just talk about the trends that you're seeing in the broader defense business. I think if you looked at the 10-Q, it called out maybe mid-single declines -- mid-single-digit declines for U.S. government, but it seems like defense is maybe doing better than that. What are you kind of seeing more broadly against the defense portfolio?

Yes. So generally, say, if you look to the defense portfolio, and again, this is probably a little bit oversimplified. But where we've been a subcontractor, it's been growing, and that's largely Aerospace and Defense electronics segment, for example, that's been growing for 4 quarters or so at a reasonably good rate. When we've been a prime contractor and you've been more direct -- more dependent on direct awards from the government, be it either the U.S. government or foreign governments or consortiums or foreign governments in Europe, things have been a little bit slower. And yes, revenue in really only one business that was unmanned ground systems, was down in Q1 and Q2. Most of the FLIR unmanned air are legacy space business, the FLIR surveillance business inflected in Q1. That's all been healthy. I would say it was nice to see orders in that prime business finally inflect in Q2. Given the nature of the business, though, most of that won't hit revenue in Q3. It would probably be revenue in Q4. So the P&L versus order book, Q3 is probably going to look a lot like Q2 in government defense, but the order book was materially better in Q2 and thus revenue should be better, probably after way until Q4 until you see that.

And then you touched on one part of that, the unmanned ground. But how does FLIR play into that? You talked about where there's been weakness, maybe where have you seen better-than-expected growth? And if you just think about FLIR, where it's in a life cycle? Where are there potential synergies there?

A bit to unpack there. I'd first say in the legacy Teledyne portfolio, where we've been more often in a subcontractor, that has been good and the outlook remains good. The biggest part of that business that is in Digital Imaging to focus on that is face-based infrared. And right now, I think we were sole sourced on sensors for SDA tracking layer, tranche 0, tranche 1. We're currently on, I think, 7 different teams for tranche 2. So that's an important program. It's a growing market. And that's the defense side of that. The civil side is actually pretty big, too, our science satellites, be that there's a new NOAA satellite that's out there. There's more European space agency satellites. We expect to have sensors on all the above. I think that's going to be good. The FLIR business, I think the outlook and every part except unmanned ground has been growing. That's why if folks who look at our MD&A for Q1, Q2, it'll be surveillance was up, infrared components and subsystems were up. Unmanned air was up, partially offset by unmanned ground and I could get at the granularity of a program and why. But especially of late, I mean, I think it's been within the last couple of weeks, it's a little bit nebulous, I suppose, but there's been a lot of talk of attritable drones, replicator programs, things like that. I think, again, it's still a little bit nebulous of who, what and when and what the programs will be. But, a, the concept at a minimum of FLIR components, I mean things like Switchblades and other drones that are built by other companies, they get the thermal from FLIR. So I think we're going to be -- whenever you're talking like lower cost observation platforms in volume that placed a legacy FLIR in terms of components, but have placed a newer FLIR in terms of Black Hornet unmanned systems, units that are in the tens of thousands of dollars, maybe at a maximum in the FLIR, quadcopters maybe $100,000, but you're talking unmanned platforms that are $100,000, $10,000 type order of magnitude of selling price. That's a very positive thesis. Again, the commentary is very new, and it's still a little bit nebulous and -- but it's right in the correct wheelhouse for us, both at the component level for ourselves and our competition, but also the system hub.

And then maybe just kind of backing up a little bit, FLIR is within Digital Imaging, I'd say organic growth for that portfolio has lagged a little bit. I mean, how do you think about the biggest accelerators for that portfolio? And I think you've said a number before, but what's the structural growth rate of Digital Imaging?

Yes. So Digital Imaging, I guess you're fair if you say it's maybe lagged the last 4 quarters relative to Teledyne as a whole. It's been, call it, plus 2% to negative 1.5% for the last 4 quarters, where we've been positive, low single digit, mid-single digit the last 4 quarters. But I don't think it's like relative to competition. I mean, especially in certain verticals, automated quality control, industrial machine vision, I think we've outperformed considerably the last 3, 4 quarters in that market. So I don't think it's lagged in the market. I think it's actually beat the market, but it has lagged the mean. Again, Digital Imaging as a whole has been negative 1.5% to plus 2% relative to the balance of Teledyne, which has been faster. I would say if one were to look over the next 10 years and maybe trailing the last 10 years, the 2 fastest-growing parts of the portfolio have been Digital Imaging, the legacy Digital Imaging correlated with both medical and automated quality control, which I think are still positive thesis and the electronic test and measurement business, which is correlated with all things, new semiconductor development, cloud, data transfer speed, those have been on average over the last 5 years, high single digit, near double digit and probably will be the fastest-growing things in the next 5 years. If you were to have to ask me, though, the next 3 quarters, I think defense, energy, aero will probably be the fastest, and that it just depends on your horizon, I suppose. But structurally, I think Digital Imaging as a whole, probably mid- to high single digit. Depending on what happens with the global macro, we'll see. It could be a little bit slower in the next couple of quarters. Incidentally, I think FLIR will be faster than Teledyne and legacy Teledyne in Digital Imaging, maybe Q4 and 2024 in isolation. The FLIR portfolio probably will be a little bit faster because it's more leveraged to defense, and I'm a little bit more bullish on defense versus global macro, at least next 6 quarters.

And then maybe just kind of digging a little bit deeper into some of those trends. I mean, thinking about the vision part of Digital Imaging. If you can talk about that a little bit, difference across end markets. I know there's areas such as semis, warehouse, scientific and other markets? Kind of how do you bifurcate that?

Yes. So if you had to break down and again, these aren't unique businesses, unique factories. They just going to sell into different end markets and verticals out of the same business. But of the $600 million business that some other folks might call machine vision, we call it industrial and scientific vision. There's about $100 million, which I'd say are sensors. They're not cameras, but just sensors, which are either used by us or sold to other market participants. That's actually been flattish, a little bit negative, in part because the warehouse automation, the scanners for logistics, terms others would use, that's been down actually since about Q4 on a year-on-year basis. So it'd be seen actually flat. Bookings have been okay, but it's been down year-on-year since about Q4. That's about $100 million. The $200 million that's actually a little more and more like $225 million that really is the scientific part of industrial and scientific vision that's more correlated with things like a researcher looking through a microscope and wanting to take a picture, kind of a classic Teledyne high-spec application, low light, high magnification, maybe you want a very fast frame rate to see a chemical or protein pass a cell wall, that's been up. And that's been pretty consistently up for several years now. It hasn't really declined at all. So that's been up offsetting weakness elsewhere. There's about maybe $150 million or so that's general factory automation at the camera level. That's been flattish, down a little bit, mid-single digit. The balance, which is maybe depending on the quarter and annualizing can be as low as $150 million, as high as $200 million, that is more sort of semiconductor mask and wafer, flat panel glass. That's actually been net up. There's been certain things that might be consumer electronics, flat panel display oriented that are down a bit, things like new semiconductor development, mask and wafer inspection has been quite healthy. So net-net, that whole $600 million piece has actually been flat year-on-year to slightly up in each of Q1 and Q2. But again, there's just pockets of various end markets in there that change.

And then maybe if you could just talk about the health care business within Digital Imaging, I think, if I remember correctly, it was maybe up 18% last quarter. What's driving that? How much visibility do you have? And is that really market growth? Or is it market share?

It's more share, but rather than using the term share, I'd say maybe technological displacement. So that's about a $400 million a year business. That has been, other than Q2 and Q3 2020 during peak COVID when people weren't getting diagnosed with cancer or getting cancer radiotherapy because they're afraid to go to a hospital, that's probably been the fastest-growing piece of Teledyne since 2011 until today and probably will be. It's been solid double digits to use your point other than those 2 quarters. 2 principal product lines there. The biggest product line is specialty x-ray detectors, high resolution at low dose. And that is replacing with CMOS technology, standard centers that we design that are fab externally at foundries, replacing our legacy technology known as amorphous silicon or thin film transistors. And why would you buy our sensors? Well, again, you get higher resolution. People like. They had a lower x-ray dose. People like. So yes, the market for OEM medical equipment, medical imaging and or dental is not growing at double digits, not growing at 18%. It's been both unit volume growth and in terms of the market but also unit volume growth in terms of technological displacement, getting new OEMs signed up, getting new contracts. The other part of the business I made reference to is cancer radiotherapy, where we're the leading supplier of the actual x-ray generators that are used in radiotherapy. And whatever trend depressing as it may be, be it with more cancer diagnosis, both in America aging population, more penetration overseas in that market, I think there's more radiotherapy installations in developing markets. That's been a good business as well.

And then maybe just thinking about the space portion of DI, you mentioned the 7 partners in tranche 2, climate, some of the European stuff thinking about e2v. But I mean, how do you think about growth there, just given all we hear about what's going on in space?

Yes. So size it again, so all things, call it, space are about $400 million, $450 million of revenue on an annual basis for Teledyne, but about $300 million of that is in Digital Imaging. It's the specialty sensor portfolio, both infrared and visible light. And that one has been actually a little bit flattish this year. It's been growing considerably in the last 3, 4, 5 years because incidentally, we shipped tranche 1 last year. And if we -- the tranche 2 awards, we'll probably ship next year. So as is peaks and valleys because their space programs. But consequently, the -- both the DoD side as well as the NOAA NASA side as well as the European Space Agency side, it's been, let's call it, mid- to high single, hasn't been double, maybe any given quarter with an easy comp, but it's been growing mid-single digit, maybe mid- to high throughout of cycle. Again, space programs tend to be a little bit lumpy, but actually faster than the DoD the last 5 years has actually been the climatology satellites. So if you're looking for greenhouse gas emissions, the most efficient way of doing it is doing it from space. Incidentally, the systems that are used on the ground for ambient air monitoring if someone were to look at their phone and what's the dominant pollutant in the local geography via Yahoo Weather app and there's a little EPA symbol next to it, be it 2.5-micron particulates -- PM, 2.5 Ozone, CO2, all the stuff on the ground is done by Teledyne environmental instruments. But when people are doing policy globally and looking at greenhouse gas emissions and concentrations of CO2 or methane from space is more often than not the sensors we use. And so that's actually been a quicker growing business. As of right now, the DoD side and/or the military side is growing a little bit more. But again, the strongest push the last several years has actually been climatology.

And then maybe just parsing the T&M portfolio a little bit. It gets confusing with oscilloscopes and protocol analyzers and just thinking back to when you bought LeCroy, I mean I think there's a lot of different end markets in there. What are you seeing today just given the shorter backlog and maybe what end markets are doing kind of across the spectrum?

Yes. So we're really in electronic test and measurement. Again, to kind of size it, that's a separately reported product line and instrumentation. It's about $340 million, $350 million or so in terms of revenue. It's a relatively simple business. There's only 2 primary product families for us. One is oscilloscopes and related products. Largely for a new chip development, new semiconductor development sold to more research labs than production tests. And then the other half is what we call protocol analyzers. What is a protocol? Well, it's WiFi, it's Bluetooth. It's Ethernet. It's a language of communication for serial data amongst devices. It could be PCI Express, a lesser known one, but that's the language were of the data center, of the cloud. It's how NVIDIA video card connects to a motherboard is via PCI Express. Generally speaking, that group has grown 5% in each of Q1 and Q2, a little bit bifurcated though for the first time in a while where I think most market participants, including us, if you are selling devices for new semiconductor development with smaller feature sizes, the organic capacity expansion that is happening or likely to expand in that area, it's never been higher. We had record sales in Q1, Q2. I think in Q2, it might have been up. Scopes, that is about 20%. The protocol stuff had a sort of a short-term hiccup more correlated with, call it, the network, the cloud, memory infrastructure. I think maybe Western Digital sales to the cloud, that's actually been a little bit slower. That's been down for the last 2 or 3 quarters. Some people are calling for a bottom and that -- maybe that comes back up. But right now, it really hasn't been plus 5%, which it was, as a group, in Q1, Q2. It's has been more like plus -- plus 20%, negative 15% in Q1, Q2. That's happening to most of the markets. Some companies who have a broader portfolio, some of their segments are up, some of their segments are down. Some of the market participants are more up, some are contracting considerably. It kind of depends on if you're more in the network or more in the new semi where together that had been, like I said earlier, probably the fastest-growing part of the portfolio along with digital imaging and machine vision, the last 5 or 10 years. Right now, it's still growing above 5%, but one is very, very strong, and the other actually has a little bit of a short-term pause, which knock-on wood protocol maybe comes back, less so sure about Q3, but maybe Q4.

And then it's taking me to question 12 to ask about Digital Imaging margins. But I mean, you brought down the numbers within guidance this year a bit. What have been the challenges versus what you initially expected? And I think you set a target of 24%. How do you think about the drivers and time line to get there?

Yes, just for clarity, so we didn't take down numbers in terms of total Teledyne for revenue, for margin or for earnings at all this year. We did repackage it a little bit where instrumentation had an all-time record margin in Q2. A&D segment was the second highest ever in Q2. Yes, imaging was a little bit lower than what we had hoped and what we thought it would be for the full year. So imaging in isolation, we did take down, I guess, at the center of the guidance range, even though, I'd say my fidelity is only, I don't think I have 10 basis points of fidelity in any given segment, any given quarter. But yes, instrumentation was a little bit stronger. A&D was a little bit stronger, and we sort of hedged bets a little bit with Digital Imaging. In Q2, one of the main reasons, and I did get this question in a one-on-one today, people were a little bit surprised that, okay, margins, why they were maybe a little bit sequentially down? They were up year-on-year, but why was your gross margin up, but your SG&A higher in Q2 versus last year? And just more than one reason, but the main reason is we are carrying an engineering cost structure for defense, and orders didn't come until late in the quarter orders that we thought we were going to get as much as really last year. And in Teledyne P&L geography when you're carrying an engineering cost structure for a program you don't have, those engineers aren't in COGS, they're in SG&A. That's where we keep our IR&D. And so one of our commercial mix with less defense in terms of revenue in Q2 meant a higher gross margin, but more SG&A. There's more channel costs on the commercial, but there's also an engineering cost structure that was sitting in IR&D. Probably looks similar Q3, maybe sequentially a little bit better. But Q4, when we actually start shipping against that order book, that should change, [indiscernible] should be better. Anyway, we threw out on the call that 24% as being reasonable. That's not a fantasy, that's where we were in Q3, Q4 2021. The segment we already had that. So I think a lot of things didn't help broker buys last year carrying the defense cost structure in advance of defense earnings. So your 24-ish went to 22-ish. But getting back to 24-ish with a more normalized mix, it is still where we were. I don't think it's a fantasy. But guidance for next year is probably [indiscernible] '23 rather than '24, out of the box. But I think there was room for outperformance, if commercial stays strong. Again, the medical, the defense, I have good visibility on that, and that will get better. The question is, does the commercial stay the same? Does global macro get a little bit worse? Or does it actually stay okay with this kind of where it is right now. And that's really the swath of all possible outcomes on '23, a little bit more, a little bit less, we shall see. It should be better than '22.

We're coming up on time. So maybe just sneaking one last one in. I mean how do you think about free cash flow runway? I mean working capital has been a bit of a drag. How are you thinking about conversion? And maybe what are the biggest opportunities to drive free cash flow growth going forward?

Yes. So in terms of free cash flow, the -- you're right, working capital has been a bit of a drag. We added about $125 million to inventory over the last 6 quarters. Now that's largely stopped. But on the other hand, we haven't yet been successful in amortizing that inventory build that we did in 2020 -- late '20, even '21, 2022. So that would be the upside. The conversion right now, I hope that we amortize a little bit of that, but they get to the nuts and bolts and numbers of your question. So this year, I think overall free cash flow probably be $850 million, $900 million. $900 million is probably a little bit high, $850 million is probably a little bit more realistic. What are the headwinds to conversion? Cash taxes are a little bit higher than book taxes in part because of R&D, they still haven't changed the capitalization versus immediate deductibility. That's not particularly constructive. That's a $60 million or so headwind, $50 million to $60 million of headwind to conversion. But the real benefit is, do we get to $1 billion next year because we can amortize that $100-plus million of inventory build? Or is it $900 million, $950 million because we can amortize a little bit of it. Time will tell. But I think that's kind of, call it, the range.

Well. Thank you, Jason.

All right. Thanks, everyone.