Teledyne Technologies Incorporated (TDY) Earnings Call Transcript & Summary

Okay. Great. Can you all hear me? All right. Good morning, everyone. I'm Kristine Liwag, senior aerospace and defense analyst here at Morgan Stanley. Before we begin, standard disclosures. For important research disclosures or for important disclosures, please use the Morgan Stanley research disclosure website at www.morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley representative. So with that, I'm really excited to kick off our session. And I think for the time mark, can we also get that started, kick off our session with Teledyne? And today, I'm very honored to have Jason VanWees, who is a man of many hats and many jobs within Teledyne, the primary being the Vice Chairman of the Board of Directors.

So Jason, what other roles do you wear at Teledyne these days?

Well, I've -- for those folks who don't know me, again, I'm Vice Chairman of Teledyne, have been with the company a little over 24 years. So easy trip for me here. We're based in Los Angeles, always been based in Greater L.A. Today, we're in Thousand Oaks, which is sort of L.A. West Valley. But I've been with the company, and the company has changed quite a bit since I've been there, quite a bit for the better. And my primary responsibility right now is acquisitions and capital allocation. But of course, that's not done in isolation. Our operating index clearly aren't, just given acquisitions, there's buy-in by them. There's only businesses they want to own, et cetera. But that's my primary job these days is to fortunately spend the cash we generate and explain to the folks on this room why and on what, that's most of it today.

Great. And I mean, with your M&A background, I mean, Teledyne has been pretty acquisitive over the years and at its core, Teledyne is a sensor and a decision support technology company. But you have such a broad set of complex products and many different verticals with different end markets. Can you help us understand what Teledyne is today and where it's headed?

Yes, sure. So sometimes, people think we're a little bit too complicated, and that's probably as much my fault because I'm happy to tell everybody everything we make and every customer we serve in every end market. And so I guess I bear some of that, it's the reason why people think that. But actually, we're quite simple. I mean in digital imaging, this is a little bit of an exaggeration, but only a small exaggeration. What we're really good at doing is making sensitive sensors. And so we end up in certain niches like semiconductor wafer inspection, where microns and nanometers matter a lot versus maybe a machine vision application like fill level in a bottle. We also end up on satellites where people want a really high resolution from space to ground, but it's not necessarily in all these cases a unique facility or even a unique engineering team. There's a lot of commonality. And again, in X-ray, what do we do in X-ray, we make high-resolution, low-dose sensors. We're fabless there. We design and then make it to the CMOS foundry. But again, fundamentally, what we and FLIR, which we acquired 2 years ago, are really being sensor leadership, making sensitive sensors and then you end up in various verticals. And we do compete against other people in these verticals. But fundamentally, both companies have their heart as sensor. And even in some of our other segments, again, sometimes it looks more complex. And Aerospace and Defense Electronics, again, I'm exaggerating a little, but really only a little. We essentially do two things as most of our businesses. We make microwave devices or specialty components and subsystems for radar electronic countermeasures, and we make high-reliability interconnects. That's the vast majority of Aerospace and Defense Electronics. And we have a Marine business, it's about $500 million this year. But again, really, what we do there is we make specialty acoustics sonar-type systems and specialty interconnects that work underwater. And I could go around the portfolio, but the portfolio is actually relatively simple. But if someone wants to know every product, every customer, competitor landscape, I'm happy to do it in some of the -- maybe I should just shut my mouth and say we're a diversified industrial tech and leave it at that. But we really aren't that complicated. That's been -- part of the goal is to double-down acquisitions in certain markets, make those markets bigger and more material and really have less moving parts with time despite doing nearly 70 acquisitions.

And so when you talk about where the company is headed going into the future and thinking about maybe your M&A strategy, is there a particular end market that you want to expand to or more product type? I mean because as you said, it's a diversified industrials, you do things all the way to space and all the way undersea and everything in between. Where is the direction in terms of your priority?

Yes. A couple of maybe sort of high-level guidance principles. One, we don't want to be in commoditized businesses or businesses that we think are subject to commoditization. So most of our markets tend to be relatively rational competitors, including ourselves, it's an oligopoly of competitors and it's something that's a little bit more nichey. I would say that's an overriding theme across the portfolio. We have made a push over the last couple of decades. I'd say the portfolio shaping, you're never really done because we're going to keep doing acquisitions. But that was most of the first decade, a little more. Probably 2011, 2012 was where we finally felt good with the portfolio. We still have aerospace and defense is kind of the largest single end market. All things aero and defense are sort of about 30% of sales. But there's a time when I joined, we were 50% government. And at that point, we didn't really view the defense business as a nice shock absorber to global macro, which we sort of view there's now actually maybe even a growth engine over the next 6 quarters or so relative to who knows what with global macro. But when the 50% of your business, the investment accounts were your top line, can't run, can't hide and it kind of was more of a ball and chain than a shock absorber. So we like defense business. We like aerospace business. We like energy business. We like some of those businesses, but in their proper proportion. We have leaned to more commercial now. We've bought in instruments. We've bought in imaging. We've probably done more unit count acquisitions in instrumentation. We spend more capital in digital imaging. But nonetheless, being a little bit more commercial is the 65%, 75%. Why more commercial? At least through cycle, commercial is a little bit higher gross margin. It's a little bit higher growth than government spend, which may be 2% through cycle, maybe higher for outlays next year in Q4. But anyway, avoiding commoditized markets, being a little bit more commercial in a few of the markets. But again, not running from a nice portfolio of long-cycle, predictable businesses. And I'd actually extend that to 40% if you include, in descending order, government, medical, energy and commercial aero. That's about 40% of the portfolio. The rest is 60% higher-margin, higher-growth through cycle.

And going back to digital imaging, FLIR was the biggest acquisition the company has ever had 2021, right in the midst of the pandemic uncertainty. Can you walk us through the rationale of expanding into the digital imaging, expanding your portfolio there with FLIR? And also in hindsight, how has the transaction been?

Yes. So first on the rationale. I mean we actually have been watching FLIR for a long, long time. It's more sort of theoretical and exploratory, but the first meeting amongst our Chairman was actually 2011, almost a decade before the deal. Again, it's more sort of theoretical at the time. And maybe just to segue from my previous comment, again, even though the valuations and the numbers probably don't work then, we really weren't that interested because the corporate strategy at the time was to basically enter commodity markets to "democratize infrared, home security cameras and the like." That was completely uninteresting for us. Now they sold those businesses in February 2018. That's when it became a very interesting, kind of return to its roots of its dialogue don't change much, much more to, I'm a defense company. I'm going to open an Arlington corporate office. But when you look at the 2020 10-K and the year before the deal, they were 30% U.S. government. It kind of returned after that divestiture in 2018 to a high rail, commercial, industrial with the backbone of government defense, which is what we are. However, all the products were really complementary. And the one thing that really got us more interested in FLIR other than the fact that they return the portfolio to its roots was that we tried to enter FLIR's markets. We have a legacy in space-based infrared sensors. We can talk about it later, but we run a wide field of view tracking layer, SDA tracking layer Tranche 0. We're on Tranche 1. We're bidding with many, many primes on Tranche 2 right now. That's been our legacy, but those are more nichey smaller markets. They're good markets for us, they're great markets for us. We try to get it to FLIR's still high-reliability but higher-volume ground-based infrared, and we largely failed. I think in hindsight, we dramatically underestimated the combined power of the technology, the brand, the channel, and that really made us more exciting about FLIR. And FLIR frankly, it fits the model of all our other acquisitions. Not that maybe we'll never buy a direct competitor, perhaps we'll do that. We haven't done that though. I mean every acquisition has sort of followed the thesis of adding complementary products to markets we're already in or customers we already serve, and FLIR fit that. Now how is it doing so far? The commercial businesses are actually holding up probably a little bit better than I thought. Even in real time, I maybe kind of run the company as pessimist, that's sort of our human nature. And I'm sort of a little bearish only from a top-down point of view. The bottom of Teledyne stuff, it is actually reasonably well. But the FLIR commercial businesses are growing, and they grew in the first 6 months of this year. If you were to ask me 2 years ago, I'm sure you have some of your other companies where they express their sentiment that defense outlays would be down until kind of March, April 2023. That was not the base case in 2020. So defense has been a little bit slower than we otherwise would have liked. That said, it finally inflected in the last business on the defense side in Q2 of this year, where FLIR defense bookings were about 1.5. All things FLIR book-to-bill in Q2 was 1.2. So finally, we got the momentum on the defense side, where defense side have been lagging a little bit. A lot of nice awards, some competitive takeaways over the last 12 months. So in terms of sales, I'd say maybe a little bit behind, but only because of defense. But commercial has been ahead in terms of absolute profit and margin [ both online ] from where we are right now.

Let's talk margins. Last quarter, you guys rolled out some cost synergies with integration and plant consolidation. Can you tell us where you are in the journey for extracting cost synergies? How much could that expand margins?

Yes. So in terms of -- that's really particular to the digital imaging segment. I mean actually, margins and instrumentation were an all-time record in Q2. Aerospace and Defense Electronics had their second highest margin of all time in Q2, only Q4 of last year was higher. Digital imaging, while it was up year-on-year, was a little bit lower than, say, peak margins from maybe Q3, Q4, of 2021 when margins were closer to 23%, 23.5%. And in the quarter, they were, let's call it, 22%. So we said on the call that we think margin of digital imaging can get back to 24%. Those cost reduction actions, all the corporate costs were taken out right away. There wasn't a charge and then cash costs trickled out. The corporate office was vacated the quarter we did the deal. I spent 6 weeks in Arlington, making sure personally that happened. You sort of say, well, why now? Well, some of these items, one of the programs that FLIR had last year, there's a little bit of a program added gap this year in the unmanned ground systems business. And rather than keep that cost structure and wait 2 years when we think the new program will be awarded, we'll worry about that then. Let's get the cost out now, having shipped most of those units on this one program called Man Transportable Robotic System. So the largest of the lease terminations that we referenced are in the unmanned ground business. We're relocating it to 2 nearby own sites, one that's a FLIR, one that's legacy Teledyne. And then I think there was a poor acquisition, in our view, actually made during due diligence in 2020 of a commoditized drone business that we partially shut down last year in 2022, and there was a lease termination in September 2023. So it made sense to basically close the rest of that business. But I think that's part of the reason we get back from the 22% to 24% over the next couple of years. But the other thing with FLIR that I'm excited about now is that the first 2 years, we spent some time on what I'd call more revenue-degrading activities. That's kind of a Teledyne flavor for public acquisition given that the corporate office, I mean, our revenue went up 40%, and corporate costs went from like $62 million to $65 million. There's really no additions of anyone significant in terms of corporate costs. But what FLIR always had, which is one of the reasons why we like the business, is their gross margin was 50% as a whole relative to Teledyne's 40%. Their sales per square foot was 50% higher or their sales per employee were 50% higher. Their sales per square foot is actually 100% higher than Teledyne. They had large big-box sites generating hundreds of millions of revenue. But as we did some 80-20, some shutting down of commoditized businesses, the commercial business, as I mentioned before, were growing. But the overall top line has kind of been flat because these 80-20 activities to reduce certain product lines, Raymarine, freshwater fishing, commoditized drones, we really haven't enjoyed the incrementals on a pretty big revenue stream of just shy of $1.9 billion and a very high gross margin. There has been really -- there has been net shrinkage, but there really hasn't been net growth of that business. And getting the incrementals of that high gross margin business when it finally starts to inflect, which I think is probably Q4 of this year, probably not Q3, despite the nice orders in Q2 to turn those orders into revenue, it's defense business. It's going to take another quarter. So I think Q4 will finally inflect. And then the incrementals on that, in addition to the cost cuts, I think that's going to considerably help the margin one back to where we were maybe 23%, 24% in 2021.

And just to clarify, Jason, it's about 200 basis points you think in the next year or two?

I wouldn't say a year, I'd say a year or two. My guidance for next year is closer to sort of 23%, but the room for outperformance or underperformance is really going to depend on global macro. Some of the commercial markets in that segment outside FLIR, industrial and scientific vision, if that stays healthy or grows, I think it could even be next year. On the other hand, if there is some sort of global macro event or things get ugly in some of those more commercial markets more so than modeled this year, then maybe there's some room for underperformance. But either way, I think next year is higher than this year, in part because of the cost cuts. But outperformance, underperformance say relative to 23%, it's probably going to depend on -- this is true for all of Teledyne. The 60% of the portfolio, that's not government, aero, energy, medical, how that performs. And we shall see, yes.

And FLIR doubled your revenue, right, with that deal. When you think about the integration journey, how far along are you with extracting revenue synergies? Because there's a lot of commonalities with diversified industrials, is there incremental opportunity there for outsized growth from that synergy?

Well, first of all, I think, yes, but I mean we've actually never quoted a revenue synergy number. To me it's sort of how do you parse between a revenue synergy and you're just running the business and it's growing now. It's -- that's always been something challenging for us even though, again, you mentioned the M&A track record and the returns we've had, they've all been very good. I would say in some areas, there definitely were some quick wins. And this really even went to due diligence, to your point, sort of peak COVID. It just so happens that FLIR had an industrial machine vision business, and it was in Canada. We couldn't travel there to do due diligence, but where is our industrial machine vision business headquartered? Canada. So really integration, and we started doing due diligence between their business and our business. We could visit it, and that business largely is run by what's formerly known as Teledyne DALSA. DALSA is still the brand name we use for machine vision cameras. And definitely, that's going extremely well. I mean I think we've, probably fair to say, probably outperformed industrial automation and machine vision peers, especially the last couple of quarters where there's been -- the market is not easy right now. But the FLIR business contracted a little bit in Q2, but it grew in Q1, grew in the first 6 months, which has really been an outlier for machine vision. So that one where our channel is much better. We're much stronger in Europe and Asia in that commercial market and FLIR, which is historically more North American-centric. So that business has done very well, really leveraging the Teledyne channel. What we've tried to do, and it's slowly happening as we have some of our rejects, if you will, on space-based infrared, they get scrapped if they're not absolutely perfect either for a big science project. We made 95% of the pixels on James Webb Space Telescope. But those sensors have to be absolutely perfect. Same thing for maybe a classified application that's looking down. But those are definitely good enough for tactical grade. In the past, that might have been something that we'd scrap. We're seeing how much that can be used by FLIR to have very, very high performance, maybe not space grade but very, very high-performance tactical, something that's not in their portfolio because even at the sensor level, the exact chemistry that we use to make our space-based sensors is slightly different. FLIR doesn't do it. And we also don't do what FLIR does. Historically, we don't do uncooled infrared, indium antimonide, another technology called Type-II SL, type strained-layer superlattice. We historically did mercury cadmium telluride. So there's new products also that didn't exist and probably wouldn't have existed because we didn't have the channel. I said we failed in some of the tactical applications, and FLIR didn't have the sensors at the quality. Even though they were very, very good quality in their application, they didn't have the same quality that we did. So I think it's gone pretty well because, again, the revenue is flattish. I guess I'm not really happy about, but that's inclusive of 80-20, inclusive of [ fitting it out on a product ] line. It's been flat, but I hope we inflect and grow again starting in Q4, yes.

Great. Maybe going back to the topic that's near and dear to your heart, which is acquisitions. Looking back, Teledyne has historically been acquisitive with roughly 70 deals, what, $12 billion in consideration over the past 2 decades. I mean these are pretty large numbers, Jason. So the playbook has been consistent. You quickly delever after one acquisition and build capacity for the next target post FLIR. Now your leverage is just slightly above 2x net debt to EBITDA.

2.1.

How do you think about the pipeline of opportunities today? And before, you've done smaller deals before FLIR. What's your appetite small versus large? And how should we think about capital deployment?

Yes. So well, first, in terms of -- you're right, the leverage immediately after the FLIR transaction was almost 4x debt to EBITDA as the last quarter was 2.1x, so we've really burned down the leverage quite a bit. And that's despite even in the last year is really only that one year immediately following the FLIR deal that the priority was deleveraging. The priority, even though the biggest use of funds will probably be deleveraging just given the cash flow, but the priority return to acquisition is about one year following the deal. And we haven't done tons, but in the last 15 months, we've done 3 bolt-on acquisitions, spent about $160 million. So we sort of got back on the treadmill really in mid-2022, and we continue that right now. I think the environment for bolt-on acquisitions and our appetite, frankly, is really good. I don't want to say it's probably the best ever, but it's an odd time right now where really regardless of the high-reliability market that Teledyne is in, I mean, COVID happened and is over. Aero was down, now it's over. Defense was slow and now outlays are up. Commercial markets, most people, entrepreneurs have pretty good trailing numbers, but the future is a little uncertain. So if you're going to do a once in a lifetime decision and even if an entrepreneur is maybe looking to diversify, well, treasury is at 5% or 0%, that's a different environment to contemplate the sale of your business and diversifying. So I think those are good. If we don't do another 2, 3, 4, 5 over the next 15 months, I'd be disappointed. The appetite and the bandwidth for something large is definitely there. I mean we've done 8 public companies in 3 separate countries. Of course, FLIR was the largest, but the playbook is really the same in all those events, and we have the capacity to do it. But again, that's going to depend on the right deal at the right time at the right price. And we'll be prudent. But I'd say the appetite certainly then the balance sheets there. And it's -- again, I mentioned before, we've never bought a direct competitor. I mean even in kind of today's strange environment of FTC and whatnot globally, we've never got a second hard question on any jurisdiction anywhere on any one of our deals. U.S., China, we had to do merger control plans there, never happened. So buying a complementary business, again, but in markets and customers that we already serve, that's really who we are. And again, we do those all day long if we could, and we'll try.

And for targets, what are your thresholds? Because you talked about not wanting to be in the commoditized business, that's very clear. But what other metrics do you look at for the target?

Yes. So I mean what -- I say we show, but really I show to the Board is a return on capital metric. And I mean, most people say that you want to get a return on capital after-tax year 3, year 4, but it depends if it's a smaller deal, the stock deal, there's some risk. Maybe that's to get there, maybe that's to be 24 months. For FLIR, and we were happy, actually, we paid a high price for us. And admittedly, we probably looked at the deal a little bit more on an ROE basis than an ROC basis. I mean at the time, we were a net cash, and we were able to recapitalize Teledyne completely at $4 billion of fixed rate sub-2% debt in 2021. So yes, I think we're going to get solidly double-digit ROE. Is it going to be 10% ROC on total capital by year 3? Probably not. That would be next year, but we'll be there by ROE given the cost of capital on that deal specifically, I'm pretty confident. But that said, I mean, yes, we've not been wanting to pay crazy prices. On the other hand, I think you said we've done 67 deals and no one has been a [ marketer ] for Teledyne along the way. So every process is competitive. We buy good businesses at fair prices. That's -- but again, every deal is a little bit different.

Let's switch gears to supply chain. During the pandemic, difficulty sourcing some parts led Teledyne not to be able to ship parts, and then you were able to reengineer some parts or buy at a premium from some brokers. Where do we stand now on supply chain lead times and your ability to ship the orders that you have?

Yes. Maybe sort of bifurcate that. So in terms of actual availability of parts, I mean, it was a challenge, both in the availability as well as the cost. I mean we never sort of added that broker premiums in a non-GAAP presentation, but they were significant in late 2021, 2022. That's come down a lot. Now the OEM price is not the 2019 OEM price, there's still inflation. But it's clearly not the broker price, and building materials has been substantially lower on certain components. I wouldn't want to say Teledyne as a whole, just given the inflationary environment, but certain components are definitely cheaper this year than last year because we're buying from OEMs as opposed to brokers. Now the flip side of that, that we're not particularly proud of, we build a lot of inventory mostly in 2022, about $125 million actually of inventory in 2022. We've largely stopped that build, but we haven't yet been able to amortize that inventory build, get it down to really drive conversion. I'm hopeful that we'll start seeing some of that in Q3 and in Q4. Part of that was when we were able to wean ourselves off the brokers and hide from OEMs. At least late 2022, the OEMs were noncancelable commitments up to a year. And so we basically had to make those purchases, and those purchases keep arriving sort of through Q3. But then I think after that, lead times have gone down. The amount of required purchase commitment you make has gone down. And I think we'll be able to amortize some of that inventory build and get better conversion next year, where today, again, we haven't had inventory build that we did last year. But again, we haven't had the high conversion that Teledyne's really used to in the past. But I think maybe late Q3, Q4 next year, we'll be able to get some of that back, yes.

Now we want to leave some time for questions from the audience. So if you want to ask a question, raise your hand, we'll give you a mic. Don't be shy. I know it's really early, but not in Eastern time. Anybody? Nobody? It's okay, I've got lots, so okay. So I am an A&D analyst, so let's focus on A&D a little bit. A&D electronics has been a particularly bright spot, right? You had 80 basis points of margin improvement this year versus last year for your expectation. How much of this is related to aircraft OEM increases finally flowing through? And you mentioned defense, you think it's going to be another quarter. So what are you seeing in that aerospace environment? Because when you look at the production rates out of Boeing, out of Airbus, I mean we're looking at 70% volume increase in the next 2, 3 years.

Yes. So first of all, I mean, the segment -- in that segment, defense has grown. So this is -- one, I think the execution has been good. There have been some competitive wins. [ But I have them ], it's been a little bit easier to be a subcontractor than to be a prime contractor. Getting those awards that are more dependent on the outlay itself, it's been a little bit harder at FLIR. And you don't see, it's been a little bit harder in some of our other segments where we've grown in places like NASA and things like that. But Aerospace and Defense Electronics, both the commercial aero, to your point, has grown. I'll get into your question a little bit. But the defense is actually growing on an absolute basis for the last several quarters. And part of that segment is also not aerospace or defense, but it's high rail, industrial that's built in a defense factory. So it's a classic Teledyne high-spec multi-market component. It may go on electronic test and measurement equipment or it may go on a satellite high-spec, again, microwave devices or microwave cable, for example. They'd be in an RF test end or it may be on a satellite. That business for aero sort of size it. I mean commercial aero is definitely in a good cycle. That's probably about $180 million of that segment so it's not huge. That's why I said sort of in descending order, government, defense, medical, energy and then aero on the longer cycle side of things. Today, we're about 2/3 aftermarket. Part of that is the OEM being a little bit of a funk. Part of that is just the nature of the business sort of coming off the bottom of the cycle. But we're about 2/3 aftermarket, and that's aftermarket, that's service and spares, but that's also new avionics for old aircraft, what we define as retrofit. Those two together, about 65% of the total volume. So OEM coming back would be good, but we're not dependent on it. Today, we're more of an aftermarket house on aero and we -- that's helped us. But again, the defense business has also been growing. I mean commercial aero was up teens during the quarter year-on-year, but defense was high single. Maybe a little bit less because we had one commercial satellite program that was with OneWeb for commercial communications. That shipped last year, so that was actually down. But defense, defense was actually up, I think, high single and commercial aero was double in the quarter. So it's been -- and margins have been a good spot for us, too. Supply chain has been tough. It's probably been a little bit more acute in parts of imaging and parts of instrumentation. It's not been easy in aerospace and defense, but execution has been really, really good, both on the commercial aero but also in defense electronics, it's been very, very good for us, yes.

Diving a little bit more on the aftermarket comment. There are some bears in aftermarket that look at global air traffic and here we are, we're kind of back to pre-pandemic levels. What are you seeing from order activity from your customers? Are you seeing a slowdown? Or are you seeing continued strength? And what's the pricing environment like?

So the pricing environment, I mean, all of Teledyne, we haven't really been gouging pricing. This year, as an example, it's maybe 3.5%. It's probably a little bit higher in certain parts of aero or in certain parts like energy, where the energy companies, obviously, is in a different upcycle right now. Brent is $80 or more. So it's been a little bit higher there than maybe some of the pure commercial has been a little bit less. But there's not a huge deviation. We haven't had, as a big group, any certain business of 20% or something like that. That's not been the case. I'd say, again, order trends have been good. A&D is a little bit lumpy. But on a full year basis, last year, I think it was maybe 1.05 book-to-bill. So backlog is still growing. It's not coming down. Despite the revenue growth, there's still orders over a couple of quarter period exceeding sales. So I'm not particularly concerned about it. In fact, pardon me, I actually wish I had a little bit more aero. It's been in an up cycle. I mean right now, it's only, like I said, $180 million of Teledyne's $5.7 billion. So either way you look at it is sort of 3% of sales. So if it keeps doing great, great. If the bears are right and 3% goes to 2.8%, it's not going to matter that much, to be honest.

Well, great. I think that's it for the time. This concludes our session on Teledyne. Jason, thank you very much for joining us this morning.

Thanks, Kristine.

Great.

All right. Goodbye, everyone.