Ladies and gentlemen, thank you for standing by, and welcome to the Littelfuse Third Quarter 2019 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speaker presentation, there will be a question-and-answer session. [Operator Instructions] Please be advised that today's conference is being recorded.

[Operator Instructions] I would now like to hand the conference over to your speaker today, Trisha Tuntland, Head of Investor Relations. Please go ahead, ma'am..

Good morning and welcome to the Littelfuse Third Quarter 2019 Earnings Conference Call. With me today are Dave Heinzmann, President and CEO; and Meenal Sethna, Executive Vice President and CFO. This morning, we reported results for our third quarter, and a copy of our earnings release is available in the Investor Relations section of our website.

A webcast of today's conference call will also be available on our website. Our discussion today will include forward-looking statements. These forward-looking statements may involve significant risks and uncertainties.

Please review today's press release and our Forms 10-K and 10-Q for more detail about important risks that could cause actual results to differ materially from our expectations. We assume no obligation to update any of this forward-looking information. Also our remarks today refer to non-GAAP financial measures.

A reconciliation of these non-GAAP financial measures to the most comparable GAAP measure is provided in our earnings release available in the Investor Relations section of our website. Before proceeding, I would like to mention that we will be participating in the Baird and Morningstar conferences in Chicago on November 5 and 6.

We hope to see you at these events. I will now turn the call over to Dave..

Thank you, Trisha. Good morning, and thanks for joining us today. Our performance this quarter was consistent with our expectations and reflects successful execution by our global teams as we continue to work through the challenging macro environment.

We recorded third quarter sales of $362 million, and while navigating the soft demand, achieved an adjusted EBITDA margin of 21%. We delivered adjusted EPS of $1.78, above the high end of our guidance. We also generated strong cash from operations and remain on track to deliver free cash flow in excess of net income for the year.

We continue to see global trade tensions impacting the end markets we serve. Across electronics, sales were weaker than expected. While we saw some stabilization in Asia, end market demand was weaker across North America and Europe.

In response to this weaker demand, we continue to see further reductions in inventory in the channel by our distribution partners. Importantly, we began to see a decrease in weeks of inventory in the channel, though levels remain elevated. Our electronics book to bill exiting the third quarter was between 0.9 and 0.95.

We anticipate seasonal softness in the fourth quarter, and we expect a continued reduction in weeks of channel inventory into next year. We saw lower sales from our automotive products segment during the third quarter, which is normally the weakest quarter in the year due to summer holidays in Europe and North America.

Sales levels continued to reflect ongoing global car build decline as well as softness, as well as softer commercial vehicle markets. Europe saw more improvement in car production during the third quarter. However, this was more than offset by the low single-digit decline in North America and high single-digit decline in China.

Near term, our content growth continues to be dampened by our regional OEM mix and the planned reduction of our transmission sensor business with local OEMs in China to drive improved profitability. We expect fourth quarter global car production to be down low single digits.

Further, while the GM strike had limited impact on our third quarter automotive product segment results, the work stoppage is reflected in our fourth quarter guidance. Looking ahead to 2020, we are currently assuming global car production to be flat to modestly down.

Our industrial products segment continues to be a bright spot and delivered strong performance in the third quarter, with organic growth of 7% and operating margins of 23%, well above the company average.

Industrial end markets are providing good growth opportunities, and the strategic actions taken over the past couple of years are driving positive momentum. Despite the near-term challenges we are seeing, the fundamentals of our business are strong.

We are focused on driving long-term growth, profitability and cash generation as we continue to balance costs with long-term strategic investments. Growth through acquisitions remains a key part of our strategy, and we continue to have an active pipeline of opportunities which fit our M&A objectives.

We remain confident in the strength of our long-term growth drivers aligned to the secular themes of safety, resource efficiency and connectivity that will drive content increases across the transportation, industrial and electronics end markets we serve.

Our confidence is reinforced by our ongoing business wins and healthy funnel of new business opportunities across a wide range of high-growth applications. With that introduction, I'll now turn the call over to Meenal to provide additional color on our financial results..

Thanks, Dave, and good morning, everyone. In the third quarter, sales of $362 million were down 18% and down 16% organically versus last year. This included a 1% headwind from foreign exchange. Sales were slightly weaker than expected within electronics. As Dave noted earlier, our sales continue to reflect the challenging macroeconomic backdrop.

Third quarter GAAP diluted EPS was $1.44. Adjusted diluted EPS of $1.78 included $0.17 of benefits not in our original guidance, resulting from a mark-to-market gain on a non-operating investment and certain tax sites. The main tax benefit was an adjustment to the company's estimated U.S. federal tax liabilities for 2018.

Cost reductions and IXYS synergy savings were a significant benefit versus last year, while unfavorable foreign exchange reduced EPS about $0.07. GAAP operating margins finished at 13%, while adjusted operating margins were at 14.6%.

Volumes and related leverage in electronics was the largest driver of the decline in both operating income dollars and margins. As we start to see a return to growth, we expect company operating margins to return to our strategic target range. Volume leverage impacts were partially offset by a 15% reduction in adjusted operating expenses.

The reduction was a combination of both variable cost reduction including incentive compensation as well as structural cost reductions. With our focused efforts on aligning cost structure to business conditions, we've held adjusted EBITDA margins at 21% for the quarter and year-to-date, operating within our strategic target margin range.

Moving onto capital management. The company continues to be an excellent generator of cash. In the quarter, we generated $81 million in operating cash flow and $68 million in free cash flow. Year-to-date, we've generated free cash flow of $122 million, 105% conversion from net income.

We bought back nearly $50 million in shares this quarter this quarter and $95 million year-to-date. We've maintained our disciplined view on share buybacks, opportunistically repurchasing shares when we believe our stock price is below our intrinsic value.

Our balance sheet remains strong as we exited the quarter as we exited the quarter from 400, as we exited the quarter with $476 million in cash, essentially unchanged from last quarter. We ended the quarter with $200 million in net debt with gross debt-to-EBITDA ratio leverage at 2.0x and well under 1.0x on a net basis.

Moving onto our product segment. Electronics product segment sales declined 23% and 21% organically. Volume leverage continues to have the largest impact on segment margins, which finished at 15.2%. We've seen price erosion return to historical ranges, adding year-over-year pressure on margins.

These factors were partially offset by benefits from IXYS synergies and other cost reduction actions. We continue to make good progress on our IXYS-related manufacturing moves with the first move expected to be completed in the second half of 2020.

Automotive products segment sales declined 9% and 7% organically primarily due to ongoing car build decline, especially in the regional OEMs where we are aligned. With the steep decline in car builds, we have seen some higher levels of pricing pressure across our passenger vehicle products also trimming margins.

Profitability continues to be hurt by foreign exchange, which was a 200 basis point margin headwind versus last year for the segment. Despite these headwinds, operating margins were 10.9%, improving 140 basis points versus last year. During the quarter, we continued our cost reduction efforts while also closing our automotive sensor factory in Italy.

These are some of the many profitability improvement steps on our path to mid-teens target operating margins for the automotive segment. Our industrial products segment sales were up 6%, while organic sales grew 7%, led by solid demand across end markets. Operating margins of 22.7% improved more than 800 basis points over last year.

We're seeing the long-term benefits of the segment cost structure reductions we've taken over the past few years as well as savings from closure of our Canadian manufacturing plant late last year. While the macro environment continues to present challenges, our global teams remain laser-focused on the factors that we control.

We remain prudent with our spending, continuing to align near-term cost structure with the demand environment, while advancing our progress with longer horizon investments to drive our 5-year enterprise strategy. Despite the near-term demand weakness, we've achieved a 21% adjusted EBITDA margin and 105% free cash flow conversion year-to-date.

We are well positioned for profitable growth when end markets start to recover. And with that, I'll turn it back to Dave for more color on end market trends..

Thanks, Meenal. Now I will provide commentary on the key end markets we serve, beginning with transportation. Design win activity in our transportation end markets continues to be strong. The trends of safety, resource efficiency and connectivity are driving content increases across automotive platforms.

The shift towards hybrids and EVs within passenger cars and commercial vehicles continues to generate new opportunities on platforms which will launch over the next several years. Increased electrification and the increasing demand for driver assist systems are key factors for growth in automotive electronics.

In the quarter, we secured a broad range of design wins. We secured a significant win in Europe with our unique proprietary technology used to protect power electronic components against overheating. We were awarded business in India for ignition systems, in Germany for EV battery management systems, and in North America for drivetrain systems.

Also during the quarter, we secured wins with Tier 1s in North America, Europe, China and Japan for navigation and communication systems, window lifts and seat motors. Within our automotive sensor business, we secured new business in Asia and Europe for solar sensors, temperature sensors, and next-generation seat belt buckle sensors.

For all of these wins, our close collaboration with our customers and differentiated products are key drivers to continue to secure new business. Turning to commercial vehicles. During the third quarter, we saw lower sales across most of our end markets and geographies versus last year.

Due to our position in the supply chain, we started seeing softness ahead of the North America heavy-duty truck market decline as it comes off peak revenue. Our other commercial vehicle sectors have also slowed, mainly due to macro uncertainty, global trade and Brexit concerns.

Our commercial vehicle business remains focused in growth beyond North America and won new business in Europe during the quarter. We captured a key win for a power distribution module for electric motors and buses.

We also won new business based on our technical expertise and customer responsiveness to develop a custom solution for a promising utility truck program with a leading North America upfitter. Our new business pipeline of global opportunities remains healthy and will drive long-term growth in commercial vehicle markets.

I am confident that the increasing electrical complexity of transportation applications will drive additional content opportunities beyond the near-term end market softness.

We will continue to be successful and win new business based on our strong customer relationships, tactical expertise and our brand reputation for product quality, safety and reliability. Moving onto the industrial end markets. Our strong third quarter was driven by an increase in solar, power conversion and mining projects. Near-term, while U.S.

Nonresidential construction and MRO markets are flattening, HVAC and heavy industries such as oil and gas and mining remain stable. In addition, global renewables used in new power generation and energy storage are healthy. Across most of these applications is the requirement for higher power electrical protection and power conversion.

During the third quarter, we won new business for several mining projects in Latin America, Australia and Canada driven by our technical engineering capabilities, service and support. Related to renewables, we continue to see strong global demand for inverter applications.

We captured energy storage system wins in Asia and wind energy applications in Europe. Also with our electronic temperature sensors, we won business in North America for an alternative energy application.

In Europe, we secured a key power semiconductor win with the manufacturer of industrial machine tools as well as new business to protect motor drives and industrial elevators. With the ongoing global focus on energy conservation, we see the expanded need for our full range of product technologies increasing across the industrial end markets.

As a result, the new business opportunity funnel is robust, and we continue to invest to expand our addressable market to gain share with new and existing customers. Lastly, across electronics end markets, we continue to see good design activity across a range of applications.

During the quarter, we secured new business wins for power supply applications in data centers and telecom base stations, elevator control panels and smoke detectors for building and home automation and chargers and battery management systems for consumer electronics.

We also secured electronic position and level sensor wins across multiple appliance applications. This activity reinforces for us that despite the near-term macro pressures, our long-term strategy remains on track and is supported by the continuing secular themes of smarter and more connected devices driving demand for our products.

Our electronics business fundamentals are solid led by our global brand recognition, superior product quality, technical expertise and deep channel partnerships as evidenced by our sustained profitability.

We will continue to win new business opportunities by leveraging our broad product offering and our strategic relationships with far-reaching access into diverse end markets. With that, I'll turn the call over to Meenal to talk about guidance..

Thanks, Dave. Moving onto the fourth quarter, we expect sales of $333 million to $345 million. The midpoint of the guidance reflects a 16% decline in total sales versus last year and a 15% organic sales decline, with currency estimated to be about a 1% headwind. We expect fourth quarter adjusted diluted EPS to be in the range of $1.06 to $1.20.

Our guidance midpoint represents a 6% sequential sales decline, which is typical given holidays and customer shutdowns. Our fourth quarter forecast also assumes an ongoing reduction in weeks of channel inventory at our electronics distribution partner.

Across our automotive products, we assumed a low single-digit decline in car builds, and our forecast reflects a lost month of production at GM. Lower volumes and leverage across electronics is the main driver of fourth quarter EPS decline over last year. Foreign exchange is also estimated to be an $0.08 EPS headwind based on current rates.

Offsetting these headwinds, we are targeting adjusted operating expenses, excluding amortization, to be about $290 million for the full year, about $10 million lower than our view last quarter. This represents a $50 million reduction versus 2018, largely across SG&A.

Our fourth quarter adjusted effective tax rate is projected to be in the range of 19% to 20%. This year's rate is higher than last year's fourth quarter when we received a full year 2018 retroactive foreign tax holiday. We've assumed 24.6 million diluted shares for the fourth quarter, which incorporates the shares bought back to date.

Looking at the full year, foreign exchange has been a headwind throughout the year, impacting EPS about $0.35 for 2019. Our interest expense and amortization expense estimates are unchanged versus our view last quarter, with interest in the range of $22 million to $23 million and amortization of approximately $40 million.

With the benefit of the tax adjustments in the third quarter, we're expecting a 2019 tax rate of approximately 18%. We now expect to spend approximately $60 million in capital expenditures this year.

Though our near-term capital investment needs have come down with the volume reductions we're seeing, we continue to invest for our long-term growth, expansion and cost-saving initiatives. Despite the breadth of macro environmental and geopolitical factors we've seen during the year, our teams have risen to the challenges presented.

Keeping the long view in mind, we expect to maintain 2019 adjusted EBITDA margin in the low 20 percentage range and a free cash flow conversion rate over 100%, both measures within our 5-year financial target range. We remain fully committed to driving enhanced performance into the future.

And with that, I'll turn it over to Dave for some final comments..

Thanks, Meenal. With the ongoing backdrop of this challenging macro environment, the fundamentals of our business remain strong. Our long-term growth drivers are closely aligned to the secular themes of safety, resource efficiency and connectivity.

We continue to work hard to navigate the current environment, while remaining well positioned when stronger demands return. We remain confident that we will deliver ongoing superior value to our stakeholders. I will now turn the call back to the operator for Q&A..

[Operator Instructions] Our first question comes from Shawn Harrison with Longbow Research..

Maybe Dave, you could talk about what you're hearing from your distributors, Arrow, Future, et cetera, where they are in the inventory corrections? Are we, as we exit the fourth quarter, will they be more than halfway through [indiscernible]? And any insight in kind of where they are directionally with their destocking would be helpful..

Sure. Yes, Shawn, so what we kind of see as we've talked about in the past that kind of normal range for us on average is 11 to 14 weeks of inventory, and we've talked about the fact we've been operating at the higher end of that.

And in previous quarters, although absolute inventory dollars were coming down because of the sell-through dropping, the weeks of inventory were flat. Now the good news is that we saw kind of late in the third quarter, we really began to see a reduction in actually the days and weeks of inventory.

So kind of for the first time, we've started to turn the corner a little bit where it's starting to drive down weeks of inventory. So we made progress in the third quarter. We're expecting that certainly in the fourth quarter and probably through the first quarter of next year..

Okay. And then as a brief follow-up, Meenal, you said OpEx was down 15% year-over-year. Some of that obviously is temporary curtailments, other is permanent.

Is there a way to update us on how much the OpEx reductions year-over-year will be permanent as we move into 2020?.

Yes, Shawn, as we've been looking at the OpEx reductions overall, I would still say that they're about 50-50; about 50% being what I call variable linked to sales and other variable compensation items, and 50% are more structural like our IXYS cost synergies and other cost structure takedowns that we've made throughout the year..

Our next question comes from Christopher Glynn with Oppenheimer..

So just broad stroke, if you look at electronics revenues this year, you'll be down maybe $160 million, maybe a little more.

I'm wondering if we could kind of think about that $160 million in terms of how much you might ascribe the channel corrections versus maybe some share reversion against gains you had when the industry supply chain was strained or, and end demand, just your kind of thoughts around that?.

Yes, that's a complex question, Chris. What I would say is our view is that although end market demands were certainly robust over the last 2 or 3 years, I think when we look back and look at the data, we would say kind of in the fourth quarter of actually 2017 is when the channel began to, in earnest, build inventories.

And so through the course of late 2017 and through most of 2018, there clearly was a build of inventory. Clearly in 2019, there's been an effort to drive that back down. So the challenge in the comparative of 2018 to 2019 is you have the gap of both the swing up and the swing down in that. So it's a meaningful part of that $160 million swing.

I don't know that we have an exact number on that, but it's a significant portion of it. Obviously, end markets have been softer as well as the POS from our distributors have been down. So yes, I don't think we have an exact kind of mix on that.

But the swing from building inventory to reducing inventory from '18 to '19 is a significant chunk of that number..

Okay, that makes sense.

And just curious about how your acquisition pipeline's looking? And if you have, how your operational bandwidth stands to entertain on-boarding deals while you're doing a fair amount of restructuring in internal operations?.

Sure. So I think our strategy on M&A has not shifted. It continues to be a key part of an enabling growth platform. So as we look to M&A, it's really about getting into markets or technologies or applications that allow us to fundamentally grow our business faster. That's still the driver.

Clearly, a lot of heavy lifting we've been doing and continue to do on the integration of the IXYS business, however, I think our bandwidth to take on additional acquisitions is good. Clearly, our balance sheet is such that we have the flexibility to look at acquisitions.

So the good news for us is most parts of our portfolio, there are opportunities for us to do tuck-ins and bolt-ons that enhance the business. So would say we kind of stay the course on where we've been on M&A activity.

And when we get the right opportunities that meet those strategic requirements and the fundamental financial returns, we'll absolutely take those steps forward..

Our next question comes from Matt Sheerin with Stifel..

Just a question regarding the transportation markets, Dave, you talked about the incremental weakness in the heavy truck or commercial vehicle area. Both TE and Sensata this morning on their calls called that out as well, talking about supply chain inventory correction in addition to just end market weakness.

How do you see that playing out over the next few quarters? Do you think, see that getting worse? And do you also see those inventory issues?.

Yes. Clearly, there are some inventory issues, I wouldn't say necessarily inventory specific. We don't sell the bulk of that through channel. Some of it does, but much of it is direct. So certainly inventory in the supply chain in general with the Tier 1s or OEMs that we're selling to, we have seen impacts already.

Clearly, North America heavy truck, which is a meaningful driver for our business, but not the whole driver, kind of hit its peak and is now kind of certainly expected to drop down dramatically in the number of vehicles being produced. We saw that hitting already, expect that to actually get worse as we move forward.

Construction, agriculture, that's been a bit challenged, depending on the regions of the world. And that, those challenges will continue. We also sell into material handling, which is a nice growth part of our business. Material handling with, particularly have a lot of business there in Europe.

With the general slowing of the European economy, and Asian economies, that dampens growth in those areas. So yes, we've been doing well in commercial vehicle. We've seen that shift to more of a negative and expect it to continue to challenge us through the bulk of 2020..

Okay. And then just a broader question regarding your operating margins, your EBIT margins, which are obviously down pretty significantly, it looks like sort of down double what the revenue declines have been, but you do have cost cutting. You talked about IXYS integration.

So what should we expect in terms of positive margin contribution as volumes come back? Is that just a matter of volumes coming back? Or are there other drivers there?.

Yes, Matt, I would say volumes coming back are definitely the largest part of operating margins working their way back towards our strategic target range. I mean it's not going to happen overnight because we would expect the growth will be gradual. But right now, Dave talked about weakness we're seeing in commercial vehicles.

We're seeing market weakness, of course, on the passenger vehicle side. The electronics for us beyond the market weakness that's going on in the POS side, we're seeing a higher impact because of the distribution destocking.

So we've got to start to see some turnaround in some of the end markets and getting through the destocking for us to start to see the margin improvement come back..

But I think a point to kind of emphasize is if you look through the data and look at what's really driving kind of the steep decline in our operating margin dollars over the last few quarters, if you look through the data, you'll see the electronics portion of our business is driving the bulk of that decline.

The good news is we look at the fundamentals in that portion of the business to still be very sound. So when we get through inventory burns, get that more normalized and kind of stabilized, I think it certainly has an outsized impact on our ability to kind of return to margin levels we look for..

Our next question comes from David Leiker with Baird..

This is Erin Welcenbach on for David. Dave, my first question for you is just if you could extrapolate a little bit on the regional color you provided in electronics, especially given the mention of an uptick at the end of the quarter.

So whether it's really that Asia piece stabilizing that you're talking about, or if you are seeing at least signs of maybe life from a demand standpoint in either North America or Europe, which you called out as weaker markets?.

Yes. I don't know that we really saw an uptick at the end of the quarter. We saw an increase in inventory week reductions at our distributors kind of late in the quarter.

So what I would say is if we kind of look across the major regions, while Asia certainly has been pretty challenging for a while, what we're seeing there is it seems to kind of be finding its footing and it's kind of stabilized. So we don't see further declines now. It's kind of stable.

It's not necessarily in growth mode yet, but it's got to stabilize first, and we're kind of seeing that there. I think North America and Europe, general European POS continues to slow as does the need to continue to drive down inventory.

North America, which has been candidly the most stable in the last few quarters of demand in the electronics cycle, softening a bit in POS. But in addition to that is the inventory burn that's happening as well.

So I don't know that there's a, I wouldn't call it a sign of life sort of thing, but it does certainly feel like we're kind of starting to see some of those things kind of find their footing..

Okay, that's helpful.

And then just a second question, if you could provide an update on the sensor business in China and if the competitive environment is stabilizing there at all?.

Yes. So in that part of the business as a reminder, specific to transmission sensors with Chinese OEMs in the region, right. And that's the area where we have seen, over the last 1.5 years or so, yes, much stronger pressure from local competition.

And we made the decision a few quarters ago that it just wasn't a profitability profile that worked for us in the long term. So we began to step back from that. Now that's a process in the auto space, so it's not happening all at once.

So we certainly have seen some of that pullback, and there will be additional decline of that over the coming year or so. So it's in that range we've talked about. It's material to that segment, but not overall. It's less than $10 million we're talking about.

And other sensor businesses in China that we're participating in continue to look good, and we're winning new business. So it's really kind of isolated to that one area. And we're kind of part of the way through that, and they'll continue to burn through..

We'll take our next question comes from Karl Ackerman with Cowen..

Dave, you talked about certain improving data points of sales at distributors. But at the same time, I think inventory days still increased this quarter.

Can you maybe walk us through potentially how lead times are looking at this stage even into October? And I guess as lead times and backlogs normalize, what are you seeing in terms of pricing across your various segments? And I have a follow-up..

Okay. Yes, so first of all to be clear, I don't believe we're seeing improvements or upticks at POS at our distributors at this stage. So if we left that impression, that's not accurate. Clearly, POS continues to be challenged at our distributors in the electronics segment.

What we did talk about was the inventory burn where in the last few quarters, their POS was dropping kind of at the same rate they were dropping absolute inventory dollars. So the weeks of inventory of our products in their channel were flat.

What we've talked about is, and it's reflected in kind of the lower demand on us, is they've reached that stage where they're more aggressively driving down inventory. So the weeks of inventory are starting to move down.

So the good or bad of that, the good news is you have to get through that phase before you can find the bottom and get a return to kind of more normal demand patterns linked to POS. From a lead time perspective, our lead times during kind of the strong periods 1 year, 1.5 years ago were extended a bit, but really only extended by a couple weeks.

Our lead times have been normalized and at normal levels for several quarters, and there's kind of really no change in that. You asked about kind of the electronics or the, particularly in electronics, I guess, the pricing dynamics.

We've talked about that in the past where previously those were a favorable tailwind from us, for us where a typical environment for us is somewhere in the 4% to 6% price erosion. We were running at about half of that a year ago, and what we've seen now is it's kind of returned to more normal situations in electronics.

So we've seen a bit more pricing pressure, but kind of back to normal for us. That kind of happens over most environments..

And I just want to add just one other point to Dave's comments on the inventory. We're starting to see a decline in inventory sitting in the channel. But to be able to do that especially with the inventory weeks, we have a much greater decline in POS. We expect that to continue in the fourth quarter and very likely in the first quarter as well.

So you can continue to expect to see those kinds of trends..

That's helpful, Meenal. And that kind of dovetails in my next question, which it looks like your gross margins will be down, I don't know, maybe roughly 200 basis points in the fourth quarter.

But if we fast forward 6 months from today when the distribution overhang should abate, I think, is the future margin uplift primarily driven by volume? Or are there company-specific or mix effects within the various segments that we should consider that would drive margins back toward that 40% level you've attained, not just in 2018 when you said we were building inventory, but also it's really since mid-2016?.

Yes. So yes, I'd clarify a couple things. So you mentioned the 40% gross margin. That is when we think about our strategic target range, we talk about our gross margins in the 40% range, knowing that at various points in time, at times we'll be up or below that.

Having said that, on your specific question for us, yes, volume and the related leverage to volume is absolutely the largest driver for us from a margin, not just gross margin, but operating income.

And further to that, electronics for us because of the size of the business, but also the incremental margin, variable margin profile and now, unfortunately, the decremental margin that we're seeing, that has a big impact on the company margin profile overall.

So yes, when we start to see some growth returning, we level out on the destocking, we start to see some growth returning, we would expect to see especially because of electronics improvements in the company margin. Thanks, Karl..

Our next question comes from Steven Fox with Cross Research..

First off, I just want to make sure I'm clear on the pricing commentary. So it sounds like you said something similar to last quarter, which is that pricing pressure is equal, returning to more normal pricing that you're used to.

So when we think about the price erosion you called out in the prepared remarks for electronics, does that imply that pricing was relatively similar Q3 versus Q2? Or were you still seeing some price pressures? And if you could sort of add some color around like what kinds of products are under the most pressure, that would be helpful..

Yes, Steve. So you are right, we have been making that comment over the past couple of quarters about our electronics price erosion returning to the more historical ranges in the 4% to 6%. The only reason we wanted to clarify it in a few quarters is when you look at that on a year-over-year basis, last year was a very strong year.

We were not seeing the same level of pricing pressure. So you are correct that on a sequential basis, there's no change to the trend. But on a year-over-year basis when you're looking at margins, that is one of the drivers of the margin impact on a year-over-year basis..

And would the same thing be true for when you called out the pricing pressures on the passenger vehicles side in auto?.

Yes, I would say yes. We're just starting to see some of that now more recently. Because if you go back about a year in time, auto car builds were still doing okay at that point. We referred to certain areas like in China transmission sensors as an example where we were starting to see pressures there.

But I would say we're now seeing it much more broadly this year because this is more of a sustained downturn that we're seeing..

That's helpful. And then, Dave, one question for you, and I'm going to admit this is kind of unfair, but I'm going to ask it anyway. If you, obviously you're looking at a playbook for inventory reductions through the channel and at your customers and on your own balance sheets.

And on the other side, it seems like there's an inherent assumption that there's some kind of typical recovery, but there's some atypical things going on in markets right now.

I mean can you just sort of talk to your confidence level in terms of how things play out on the back end of what seems like a fairly aggressive inventory work down that goes on between now and the end of March?.

Yes. It's, that's a challenging view to try to get our arms around right now. There's a lot moving on around trade tensions. Yes, we don't know what might change in those sorts of environments. Fridays are bad days. You never know when you might get a change of position on those things.

So what I would say is historically, right, so this inventory cycle that we're going through, it's not completely abnormal. Maybe inventories at the contract manufacturers and ODMs and things like that were a bit higher than we've seen before because of kind of the long lead times in some areas.

So we're kind of bleeding through that, bleeding through the excess inventories in our distribution channels. So what's got, we've got to get through that phase, so that we can get to the stage where our sell-in and our POS is matching. Because right now, they're mismatched, right.

So we think over the coming quarter or 2, that clearly we're still working to kind of get that, to find that matching point. So that clearly is going in through Q1. We don't know exactly when that'd be. Will that maybe bleed into Q2? Could. We'll see when that hits that.

Once we reach that kind of stability point, fundamentally the demands on us will have some improvement. Exactly what's going on in the end markets, it's a little hard to call right now.

So I think our current view would be yes, we think that there'll be some improvement and some potential to return to modest growth kind of in the back half of next year. But how robust that will be is pretty hard to get visibility to at this point in time..

Like I said, it was an unfair question, but I appreciate the thoughts..

Sure..

Thanks, Steve..

And our next question comes from David Kelley with Jefferies..

I guess on the automotive segment, could you provide some color on your exposure to the GM UAW strike? I think you mentioned no real impact to Q3, but maybe something embedded in Q4 guidance, so love to get the financial impact embedded there..

Yes. So obviously through our Tier 1s, we sell a great deal into GM as an end customer. Certainly, it's not necessarily an outsized sort of position versus other OEMs. But just kind of timing of things, we saw a limited impact in Q3.

So if we were to estimate the drag, if you will, on our automotive segment during the fourth quarter, it's probably a 1% to 1.5% drag on revenue on the fourth quarter. It's in that range..

And maybe as a follow-up, automotive margins have held up well despite the macro headwinds in all directions. I think you referenced the sensor plant closure, ongoing cost initiatives.

Can you walk us through the impact in your ability to offset lower vehicle builds? And I guess if we were ever to get back to say, flat or stable light vehicle and commercial vehicle underlying market growth, do you see some step up in the longer-term margin potential, given some of these recent initiatives?.

Yes. So we've been, a couple of questions, we've been getting questions around what's really going to drive margin improvement for us. And absolutely volume across the company, volume for us helps a lot.

We've done a lot of work over the past 10 to 15 years about reducing our fixed cost infrastructure and then maintaining that even when we make acquisitions. So for us, we see some good incremental margins of the company, but then during times where volume drops, that reverts into some higher decrementals as well absolutely.

We start to see volumes pick back up across the automotive segment, whether that's in passenger as well as commercial vehicles, that will help the margin profile.

And as I mentioned earlier though, when you step back and think about the company though, because of the size, and also because our electronics business runs a little bit higher than the company average on incremental, and therefore decremental margins, the electronics part of our business will have more of an outsized impact for us overall..

Yes. With that said, David, as we said in the prepared remarks, we believe the right operating margin range for our automotive business is in the mid-teens. And we're obviously, we're operating in double digits, but we're not in the mid-teens range.

We did talk about the sensor factory that we shut down and just began to see some of those impacts hitting the P&L. Clearly, there's more actions we're doing and more activities, vertical integration in some cases and things like that, that are going to drive improvements.

So over the, as things stabilize and over the next 2, 3 years, we absolutely believe that we work that business back up into mid-teens sort of margin profile..

Our next question comes from George Godfrey with CLK..

I just wanted to drill in a little bit, specifically on the pricing pressure in the automotive segment and what pricing pressure is being applied beyond what's contractually negotiated in your contracts? And are your customers threatening to go to competitors, not include you on future design wins? And I'm just trying to get the magnitude of that pricing pressure and is it across all products in the automotive sector?.

Yes. No, it's a good question, George. And so I don't think it's quite that dramatic. We're not getting pressure that says, "Hey, you hit these targets or we're walking." It's not that kind of environment.

What I would say is if you look back over the last 1.5 years, couple years, we've had a lot of headwinds from currency devaluations or changes and for commodity cost changes. And historically what we would find is we renegotiate contracts depending, and they're staggered across different Tier 1s and OEMs and things like that.

Typically, what we have been able to do is if those fundamental costs are going up, those get reflected in the negotiations. And so we get to help offset some of those things. And what I would say we're seeing is not this particular strong ramping up from OEMs or Tier 1s driving aggressively.

What we're finding is some of our competition as they're trying to gain share against us, they're being a bit more aggressive on pricing, particularly when overall demands are down, and that kind of gets me a little hungrier for that. And so what we're finding is it's a little more challenging to pass-through some of those cost impacts.

So order of magnitude, where we typically would see maybe 2% is kind of a normal annual pricing pressures in the automotive space, yes, maybe it's 3% or 4%. So it's not some major shift, but yes, it's a bit more pressure than we've seen in the recent past..

We'll take our next question comes from Shawn Harrison with Longbow Research..

Just 2 brief follow-ups. Meenal, on the decremental for the gross margin for the December quarter, I guess a little greater than typical. Is there anything incremental here this quarter that's further pressuring gross margin? Just looks like it's about 60% or 65% decremental this quarter..

Yes. I would say just really the decrementals for this quarter are really almost all electronics in terms of the top line decline and for the reasons Dave has been talking about. So you're going to see a little bit higher decremental impact on a gross margin perspective because of that..

And then lastly maybe to end my question is on a high note. The industrial EBIT margins have been fantastic this year and hit a new high this quarter. Four or 5 years ago, we were wondering when they were going to break even.

I'm just wondering really about what's changed in the business, particularly even this year and just the sustainability of it, because it's a fantastic turnaround story..

Yes. I think some of that, Shawn, is if you recall, we, 2, 3 years ago, we were embedded into this custom electrical business kind of in the mining space. Last year, we fundamentally exited that segment of our industrial business because it just wasn't for us. So we exited that. That certainly has helped.

You may recall last year, we actually shut down an operation up in Canada and transitioned that into one of our other operations. So we consolidated and took out one of the factory locations. That certainly has had an improvement in the business. So kind of all the way around and just fundamental management of that business has been solid.

Our performance out of our factories is good. Volumes are up as that business, which has been pretty North America-centric historically, has begun to gain some footing and traction globally, which has allowed us to, in candidly a fairly flat industrial environment, have some reasonable revenue growth.

All those things together made for a pretty good turnaround on that. And we feel good about the sustainability of the margin profile in that business as we move forward..

We appreciate your questions, Shawn. Thank you. Thanks for joining us on today's call and your interest in Littelfuse. We look forward to talking with you again soon. Have a great day..

Thank you. Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect..